3.5.2 Ratio Analysis Flashcards
Working capital formula
Current assets-current liabilities
Ratio analysis definition
the calculation and interpretation of key financial performance indicators to provide useful insights into business performance
Liquidity definition
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.
Current ratio formula
Current ratio= current assets/ current liabilities.
What is the ideal current ratio
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.
Acid test ratio
(current assets-inventory)/current liabilities
Why is acid test better than current
Better indicator and more realistic picture of liquidity problems because it discounts inventories as something that can be quickly converted to cash.
What does it mean if acid test below 1
Significantly less than one is often bad news because suggests may struggle to cover short term debts.
What is it called when acid ratio went from 1.5:1 to 0.8:1
A deteriorating liquidity position
What should a firm do if liquidity too high
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.
Gearing definition
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.
Gearing
non-current) liabilities/ capital employed x 100 OR
non-current liabilities/ equity + non-current liabilities x100. Expressed as a %.
Less than 50% gearing means
a business is ‘low geered’.
High geering implications
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
However point for high geering
this is not necessarily bad because debt is often cheaper than equity
To reduce an unhealthily high gearing ratio:
issue more shares, retain more profits, repay some loans.
Why is is had to be highly geered
Banks less likely to loan if highly geered and low liquidity.
Highly geared bad as vulnerable to increases in interest rates.
How to improve gross profit margin
price up, unit variable costs down
How to improve operating profit margin
boost gross margin, cut overheads per £ of sales, increase sales
Problem if gross profit margin is too low
may not be able to cover overhead expenses
Problem if operating profit margin is too low
limited growth because may not be enough operating profit to reinvest into the business.
Problem if net profit margin is too low
shareholders might not get acceptable annual dividends.
Return on capital employed ROCE
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
ROCE Formula
ROCE= Operating profit/ capital employed x 100 (CA is equity + non-current liabilities)
