3.5.2 Ratio Analysis

Question 1

Working capital formula

Answer 1

Current assets-current liabilities

Question 2

Ratio analysis definition

Answer 2

the calculation and interpretation of key financial performance indicators to provide useful insights into business performance

Question 3

Liquidity definition

Answer 3

This shows the ability of a firm to meet its short-term debts with cash or near cash assets. Assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as and when they fall due. The ratios are current and acid test.

Question 4

Current ratio formula

Answer 4

Current ratio= current assets/ current liabilities.

Question 5

What is the ideal current ratio

Answer 5

The ideal value would be 1.5, meaning that a business would have £1.50 of current assets for every £1 of short-term debt which is enough to cover debts comfortably without holding too many resources in unproductive forms, where they could be better invested elsewhere. Low ratio indicates possible liquidity problems and high ratio shows there is too much working capital tied up in inventories or debts.

Question 6

Acid test ratio

Answer 6

(current assets-inventory)/current liabilities

Question 7

Why is acid test better than current

Answer 7

Better indicator and more realistic picture of liquidity problems because it discounts inventories as something that can be quickly converted to cash.

Question 8

What does it mean if acid test below 1

Answer 8

Significantly less than one is often bad news because suggests may struggle to cover short term debts.

Question 9

What is it called when acid ratio went from 1.5:1 to 0.8:1

Answer 9

A deteriorating liquidity position

Question 10

What should a firm do if liquidity too high

Answer 10

the firm may have too much money tied up in stock, debtors or cash. This money could generate a far greater return if invested in non-current assets.

Question 11

Gearing definition

Answer 11

How dependent a business is on loans and external finance. Measures the long-term financial health of a business. Expresses long-term liabilities (debt) as a percentage of the total amount of long-term capital in the business.

Question 12

Gearing

Answer 12

non-current) liabilities/ capital employed x 100 OR

non-current liabilities/ equity + non-current liabilities x100. Expressed as a %.

Question 13

Less than 50% gearing means

Answer 13

a business is ‘low geered’.

Question 14

High geering implications

Answer 14

reliant on external sources of finance) suggests potential problems in financing. With interest payments to make, as well as loan repayments, high levels of debt can suck the lifeblood from a business rapidly

Question 15

However point for high geering

Answer 15

this is not necessarily bad because debt is often cheaper than equity

Question 16

To reduce an unhealthily high gearing ratio:

Answer 16

issue more shares, retain more profits, repay some loans.

Question 17

Why is is had to be highly geered

Answer 17

Banks less likely to loan if highly geered and low liquidity.
Highly geared bad as vulnerable to increases in interest rates.

Question 18

How to improve gross profit margin

Answer 18

price up, unit variable costs down

Question 19

How to improve operating profit margin

Answer 19

boost gross margin, cut overheads per £ of sales, increase sales

Question 20

Problem if gross profit margin is too low

Answer 20

may not be able to cover overhead expenses

Question 21

Problem if operating profit margin is too low

Answer 21

limited growth because may not be enough operating profit to reinvest into the business.

Question 22

Problem if net profit margin is too low

Answer 22

shareholders might not get acceptable annual dividends.

Question 23

Return on capital employed ROCE

Answer 23

Expresses operating profit as a percentage of the capita that has been invested in the business. Therefore can see if it would be more profitable to leave in bank to earn interest

Question 24

ROCE Formula

Answer 24

ROCE= Operating profit/ capital employed x 100 (CA is equity + non-current liabilities)

Question 25

Implications of high and low roce

Answer 25

Higher is better for this RATIO because it means the money invested in the business is generating a higher return on that investment. Where ROCE falls below current interest rates, a business may question whether it would be better off closing, liquidating its assets and putting all money in the risk-free bank for a higher return than the risky option of running a business.

Question 26

In order to boost ROCE:

Answer 26

1. Find a way to increase operating profit

2. Reduce capital employed without damaging operating profit e.g. buy back shares from shareholders.

Question 27

Gearing and liquidity rations help to identify whether

Answer 27

a business can afford to invest money in new projects.

Question 28

ROCE can help to assess

Answer 28

The attractiveness of a new investment (alongside ARR), or identify underperforming parts of a business.

Question 29

Examples- Can we afford a £50 million spend on launching in China with an acid test ratio of 0.95 and gearing of 24.5%?

Answer 29

Yes- finance can come from extra borrowing (to a 50% gearing maximum) plus some use of working capital (to an acid test minimum of 0.6).

Question 30

Limitations of ratio analysis- receivables figure

Answer 30

It doesn’t tell us the whole story. If money owed by customer is mainly owed by reliable, regular customers, this should turn into cash received on time. However, if much of the receivables figure on the balance sheet consists of bad debts from failing customers, acid test and current ratio results will paint a misleadingly healthy picture.

Question 31

Limitations of ratio analysis- obselete

Answer 31

If stock is about to go out of fashion and become worthless, current ratio will present a misleadingly healthy picture.

Question 32

Limitations of ratio analysis- non-qualitative factors

Answer 32

Does not take into account qualitative issues such as comp advantages like brand image or customer service performance, quality, ethical reputation, future prospects (they are backwards looking), changes in external environment.

Question 33

Limitations- short-term

Answer 33

Does not take into account the impact of long-term decisions, such as investments today that may lower profitability in the short term but boost it in the long term.

Question 34

Limitations- economic

Answer 34

Economic climate- ratios do not take into account economic conditions or the performance of other businesses.

Question 35

Limitations- 1 data set

Answer 35

One data set is not enough- need to compare with competitors and analyse over time for trends. Circumstances change over time, markets and industries change and different economic and market conditions.

Question 36

Limitations- reliability

Answer 36

How reliable? Based on historical financial accounts. Financial information involves making subjective judgements, potential for manipulation of accounting information (window-dressing, making balance sheet look more advantageous than it really was).
Identify issues but don’t solve problems

Question 37

Key term to remember surrounding limitations

Answer 37

window-dressing, making balance sheet look more advantageous than it really was