3.5

Question 1

what is ratio analysis?

Answer 1

It is a quantitative management tool for analysing and judging the financial performance of a business. We do this by calculating the financial ratios from the organization’s final accounts.

Question 2

when is ratio analysis used?

Answer 2

Current figures are normally compared with historical figures to asses if the financial performance of the company has improved.
They are also used to compare performance with competitors

Question 3

what is the purpose of a ratio analysis?

Answer 3

Assess a firm’s financial position

Examine a firms financial performance

Compare actual figures with projected or budgeted figures (this is know as variance analysis)

Help with decision making (i.e. if investors should risk their money on the business)

Question 4

what are the two ways ratios are compared?

Answer 4

historical and inter-firm.

Question 5

can you expand on historical as a way to compear ratios ?

Answer 5

Historical – compares the same ratio in two different time periods for the same business (i.e. trends that might help the managers to asses the financial performance over time)

Question 6

can you expand on inter-firm as a way to compear ratios?

Answer 6

involved comparing the ratios of firms in the same industry
Care should be taking on comparing business in the same industry, it has to be ‘like to like’ (i.e. Coca- Cola with Pepsi)

Question 7

what are the three different ways a ratio can be expressed?

Answer 7

Numbers in terms of another (2:3)
Percentages
Number of days

Question 8

what are some questions that could come up when you have a set of ratio analysis?

Answer 8

How does the firm perform over time? (based on trend)
How is the business performing? (based on financial data)
What extra things need to be considered if they are not in the data? (business objectives)

Question 9

what is a profitability ratio?

Answer 9

a profitability ratio assesses the performance of the firm in terms of profitability. It examines the profit in relation to other figures (i.e. the ratio of profit to sales revenue).

Question 10

what are the two differ types of profitability ratio?

Answer 10

Gross profit margin (GPM)
Net profit margin (NPM)

Question 11

what are the four was you can improve gross profit margin?

Answer 11

increase price or use cheaper suppliers. reduce direct labour costs, Aggressivepromotional strategies

Question 12

can you expand on increasing price as a way to increase gross profit margin?

Answer 12

Firms can increase their prices in less competitive markets or where customers are not sensitive to prices changes. Inevitably, an increase in price raises the sales Revenue. However, this could damage the image of the business and some loyal customers will feel betrayed.

Question 13

can you expand on using cheaper suppliers as a way to increase gross profit margin?

Answer 13

This will help reducing the cost of sales and help increase the GPM. However, the firm needs to be careful not to compromise the quality of their products since they can create customer dislike.

Question 14

can you expand on reducing direct labour costs as a way to increase gross profit margin?

Answer 14

use less staff and decrease wages (select the more productive staff and get rid of the rest).

Less staff could put stress on them and demotivate them, cutting wages could lead to people leaving the job or union uprises.

Question 15

can you expand on aggressive promotional strategies costs as a way to increase gross profit margin?

Answer 15

This could definite increase sales and hence increase the GPM. However, too expensive promotional strategies could also increase the costs to the point that the increase in sales will not be worth it.

Question 16

what is the net profit margin?

Answer 16

It represents the percentage of the sales turnover that is turned into net profit.This is a measure of the profit that remains after deducting all costs from the sales revenue.

Question 17

what else can you calculate when you have the GPM and the NPM?

Answer 17

The difference between the GPM and the NPM represent the expenses.

Question 18

which is better, GPM VS NPM, and why?

Answer 18

The NPM is a better measure than the GPM as it takes into account both (direct and indirect) costs.

Question 19

what are the three ways ou can improve NPM?

Answer 19

Negotiate preferential payment terms with creditors and suppliers

reduce indirect cost

negotiate cheaper rent

Question 20

can you expand on ‘Negotiate preferential payment terms with creditors and suppliers’ as a method to improve NPM?

Answer 20

Firms can negotiate discounts or delay payments which will improve the firm’s working capital.

However, debts to suppliers need to be paid anyway.

Question 21

can you expand on ‘reducing indirect cost’ as a method to improve NPM?

Answer 21

Organizations can analyse “where” can they cut costs. For example, manager can fly in business instead of first class; reduce advertising, stationary etc. This could, however, demotivate staff.

Question 22

can you expand on ‘negotiating cheaper rent’ as a method to improve NPM?

Answer 22

decrease general costs and hitens the percentage of sales turn over that becomes net profit, however, it could mean that the firms will need to a location that won’t be as attractive to customers.

Question 23

what is an efficeny ratio?

Answer 23

show how well a firm’s financial resources are being used. Basically, how well an organizations internally utilizes its assets and liabilities.

Question 24

what is the return on capital employed ratio (ROCE)?

Answer 24

ratio which measures both the efficiency and profitability of a firm’s invested capital.

Question 25

what is the relationship between the ROCE and the return?

Answer 25

The higher the ROCE the greater the return the firm gets form the capital employed and its an incentive for owners to put more money in the business.

Question 26

what can you analyse with the ROCE?

Answer 26

The ROCE analyses how well a firm is able to generate profits from its key sources of finance.

Question 27

what are the two ways you can improve ROCE?

Answer 27

pay additional dividend to stakeholders, Reduce the amount of loan capital

Question 28

can you expand on reducing the amount of loan capital as a way to improve ROCE?

Answer 28

This can keep the net profit unchanged but the firm will face the challenges of the ‘lack’ of cash that was probably destined to something specific (i.e. buy new machinery)

Question 29

can you expand on paying additional divines to shareholders as a way to improve ROCE?

Answer 29

This will reduce the retain profits and therefore increase the ROCE (assuming the net profit remains unchanged). However, reducing retain profit can affect the future ‘internal investment’ if the firm.

Question 30

what are liquidity ratios?

Answer 30

they calculate how easily a firm can pay its short term financial obligations (debt) from its current assets. Basically how quickly an asset can be converted into cash.

Question 31

what are the two liquidity ratios you need to know about?

Answer 31

The current ratio
The acid test (quick) ratio

Question 32

what is the current ratio?

Answer 32

it is compares the firms current assets and the current liabilities (which we can obtain from the balance Sheet).

Question 33

how can you Annalise the current ratio?

Answer 33

A ratio between 1.5 and 2.5 would suggest acceptable liquidity

A low ratio (possibly below 1) might indicate liquidity problems

A very high current ratio (i.e. 5) is not so good since it might suggest that there is ‘too much’ assets that are not properly used (i.e. too much stock that needs to be sold, too much cash is been held and not invested)

It is also important to compare the ratios with competitors to assess the position the firm is in.

Question 34

how can you improve current ratios?

Answer 34

Sell long-term assets for cash

reduce bank overdraft.

Question 35

can you expand on reducing bank overdraft as a way to improve current ratios?

Answer 35

The firm can seek for long-term loans instead and this will reduce the current liabilities. Nevertheless, increasing long-term loans will increase the interest rate affecting its future liquidity position

Question 36

can you expand on selling long-term assets for cash as a way to improve current ratios?

Answer 36

This will increase the available working capital for the business but when the items are needed in the long run the firm will have to face the costs (i.e. lease the asset)

Question 37

what is the acid (quick) ratio?

Answer 37

The acid test (quick) ratio – this is a more accurate indicator that shows how well a firm can meet its short-term obligations since it removes the stock as part of the current assets.

Question 38

how do you analyse the results from the acid (quick) ratio?

Answer 38

The acid ratio shows to creditors how much of a firms short-term debit can be paid by selling its liquid assets at short notice.

Same as with the current ratio an acid ratio of less than 1 might indicate liquidity problems. Ultimately that means that the firm wont be able to pay its short-term debts.

A high acid ratio has the same repercussion as a current ratio except that there is no stock to be considered.

Question 39

what are some additional strategies to improve acid test ratio?

Answer 39

increase its credit period, Sell of stock at a discount price

Question 40

can you expand on the selling of stocks at a discount price as an additional statragie to improve the acid test ratio?

Answer 40

This will help the business raise quick cash to pay its short-term debts. However, selling stock at a lower price will reduce the sales revenue and hence reduce the profits.

Question 41

can you expand on the increase credit period as a startaigie to improve the acid test ratios?

Answer 41

This will help the firm to purchase more stock on credit but the main problem is that it will increase debt.

Question 42

what are the limitations to ratio analysis?

Answer 42

It is difficult to generalize about whether a ratio is good or not, it all depends on the type of business.

A company may have some good and some bad ratios, making it difficult to tell if it’s a good or weak company.

Seasonal factors can also distort ratio analysis.
Understanding seasonal factors that affect a business can reduce the chance of misinterpretation (i.e. a retailer’s inventory may be high in the summer in preparation for the back-to-school season)

Question 43

what is the difference between sales revenue and sales turn over?

Answer 43

sales revenue is the total amount of MONEY received for the selling of goods, calculated by the cost of goods times by the number of goods sold.

Sales turn over it the total amount of VALUE that the selling of products will have generated e.g if you sold via credit.