3.5.2. Ratio Analysis

Question 1

Types of ratio

Answer 1

1. Profitability- relationship between gross, net profit, revenue, assets and capital
2. Liquidity- firms ability to meet short term debts either cash or near cash assets
3. Gearing- proportion of long term finance in business that comes from loans

Question 2

Liquidity ratios

Answer 2

1. Current ratio= current assets/ current liabilities

too high liquidity- too much money tied up in stock, debtors or cash. Could be used to generate far greater return if invested in non current assets.
Too much ca likely to damage businesses ROCE ratio

Question 3

Acid test ratio

Answer 3

Acid test ratio= CA - inventories / CL

-Discounts inventory as something that can be quickly converted to cash.
-Low liquidity ratio is below 1 indicates financial problem.

Question 4

Gearing

Answer 4

GR= long term liabilities/ capital employed X 100
~capital employed= current liabilities- total assets

Gearing ratio expresses long term liabilities as a % of tot. amount of long term capital( capital employed) in the business.

Question 5

Ways to reduce high gearing ratio

Answer 5

-Issue more shares
-Retain more profits
-Repay some loans

Question 6

How to improve profitability ratios

Answer 6

1.GPM- price up, unit variable costs down
2.OPM- boost gross margin, cut overheads per £ of sales, increase sales
3. NPM- boost operating profit margins, cut corporation tax bills

Question 7

Problems if profitability ratios too low

Answer 7

1.GPM- may not be enough gross profit to cover overheads
2.OPM- may not be enough op to reinvest into business and so get growth
3.NPM- may be too low to provide shareholders with acceptable annual dividends

Question 8

ROCE

Answer 8

ROCE= Operating profit / capital employed X 100

-Higher ROCE is better as high returns means money invested is generating higher returns on that investment.

Question 9

Ways to boost ROCE ratio

Answer 9

1. Increase operating profit
2. Reduce capital employed without damaging operating profits

Question 10

Interpret ratios to make business decisions

Answer 10

-Gearing and liquidity ratios help to identify whether a business can afford to reinvest money into new projects

-ROCE can help assess attractiveness of new investment or identify underperforming parts of a business.

Question 11

Limitations of ratio analysis

Answer 11

-Lack of detail provided within financial accounts
-Bad debts from failing customers, acid test and current ratio will paint misleading pictures.