3 + 4 Appraisal of Annual Reports Using Ratio Analysis

Question 1

What can ROCE be used for?

Answer 1

• indicates how successfully the management are using the funds provided to them from shareholders and debentures holders.
• It can help shareholders and providers of finance decide whether to invest in the company, by indicating how well funds provided in the past have been used (in terms of generating profits).

Question 2

What is profitability?

Answer 2

gross profit and operating profit margins

Question 3

What can ROCE figure achieved by as business be a result of?

Answer 3

profitability and/or efficient ultilisation of assets (net asset turnover)

Question 4

What is ROCE?

Answer 4

Is the key ratio to how a company is performing this can be explained in isolation but is a product of a company’s profitability and efficiency
ROCE = Operating profit margin X net asset turnover

Question 5

What does liquidity refer to?

Answer 5

the ability of a business to generate sufficient cash to pay its liabilities as they fall due
directly linked to the short term solvency of a business. A business will go bankrupt if it cannot pay its debts

Question 6

What is working capital?

Answer 6

Current assets- Current liabilities

Question 7

What is working capital management?

Answer 7

• not holding too much inventory for too long,
• good collection policy on trade receivables
• prompt payment of trade payables
• Inadequate and inefficient working capital policies may lead to an overdraft which is an expensive form of finance

Question 8

What is the working capital cycle?

Answer 8

cash > purchase inputs > production > inventories > sales > trade recievables > cash

Question 9

What does ROCE stand for?

Answer 9

Return on capital employed

Question 10

How can ROCE be calculated?

Answer 10

operating profit/(equity funds + non current liabilities)

Question 11

What is efficient utilisation of assets?

Answer 11

net asset turnover

Question 12

How is gross profit margin calculated?

Answer 12

(gross profit / turnover) * 100

Question 13

How is operating profit margin calculated?

Answer 13

(operating profit / turnover) * 100

Question 14

What does operating profit include?

Answer 14

cost of sales, administration and distribution costs

Question 15

How is net asset turnover calculated?

Answer 15

turnover / (equity + non-current liabilities)

Question 16

What can the net asset turnover figure be used for?

Answer 16

can be compared over time and against companies in the same industry to assess if management are utilising the resources at there disposal to generate revenue

Question 17

What is liquidity?

Answer 17

refers to the ability of a business to generate sufficient cash to pay its liabilities as they fall due.
Directly linked to the short term solvency of a business.

Question 18

What are examples of current assets?

Answer 18

Inventory
Trade receivables
Cash

Question 19

What are examples of current liabilities?

Answer 19

Trade payables
Tax payable
Overdraft

Question 20

How is the current ratio calculated?

Answer 20

current assets / current liabilities

Question 21

Is a high current ratio good?

Answer 21

Too high a ratio can mean inefficiency a company should not hold large reserves of cash.
The cash should be invested and generating profits

Question 22

What is the acid test ratio?

Answer 22

(current assets - inventory) / current liabilities

Question 23

Why remove inventory in the acid test ratio?

Answer 23

The time lag of turning inventory into cash

inventory > trade receivable > cash

Question 24

How is the inventory holding period?

Answer 24

( closing inventory / cost of sales) *365

Question 25

How is the collection period calculated?

Answer 25

(trade receivable / revenue) * 365

Question 26

What is the problem if the collection period is too long?

Answer 26

may indicate poor collection policy.

Or unsatisfied customers who are refusing to pay, poor quality product.

Question 27

What is the problem if the collection period is too short?

Answer 27

may lose customers to competitors who offer better credit terms
Or may be offering discount for prompt payment which will effect margins.

Question 28

How is the payment period calculated?

Answer 28

(trade payables / cost of sales) * 365

Question 29

Is a long payment period good?

Answer 29

If pay on a timely basis may receive discount which will help with profitability compared to competitors.
If too high may have a poor relationship with suppliers which could effect future supplies and prices.

Question 30

What is the risk to investors?

Answer 30

Investors face a risk of not receiving an annual return on their investment and also not having their investment repaid.

Question 31

How can solvency of a business can be assessed?

Answer 31

by looking at its gearing

Question 32

What is financial gearing?

Answer 32

looks at how the company is financed.

Question 33

What is debt also known as?

Answer 33

non-current liabilities

Question 34

What is equity?

Answer 34

Ordinary share capital plus the reserves. `

Question 35

How is gearing calculated?

Answer 35

debt to equity ratio

debt/equity = (loans + overdrafts) / (share capital + reserves)

Question 36

How is the interest cover?

Answer 36

operating profit / interest payable

Question 37

What is the impact of gearing?

Answer 37

It can be seen that a highly geared firm has a greater financial risk. This is because the interest charge is fixed and must be repaid no matter what the level of profit or loss.