3.7.2 - Financial Ratio Analysis

Question 1

What are liquidity ratios?

Answer 1

Assesses whether businesses have sufficient cash/funds to pay off debts

Question 2

What is an income statement?

Answer 2

Shows the profit or loss made by a business over a period of time (usually a year) which is different to business total costs & income

Question 3

Why are income statements important?

Answer 3

• To let shareholders see if the business has made profit
• Helps identify if profit made by a business is sustainable
• Enables comparison to other competitors

Question 4

What is a balance sheet (statement of financial position)?

Answer 4

A document describing the financial position of a business in a particular moment of time. It compares businesses assets and liabilities

Question 5

What is a cash flow statement?

Answer 5

Shows the amount of cash going in and out a business

Question 6

What is liquidity?

Answer 6

Assets that can be easily turned into cash.

Question 7

How do you work out current ratio?

Answer 7

Current assets/Current liabilities

Question 8

What are examples of liquid assets?

Answer 8

• Stocks&shares
• Inventory
• cash

Question 9

What are non-liquid assets?

Answer 9

assets that cannot be turned into cash easily

Question 10

Examples of non-liquid assets?

Answer 10

-Real estate

Question 11

What are assets?

Answer 11

Something you own e.g inventory,cash

Question 12

What are liabilities?

Answer 12

Something you owe eg. payables,overdraft

Question 13

What is considered a good current ratio?

Answer 13

1.5-2.5 - good
below 1 - a lot of liquidity
Above 2.5 - Too much cash ties up in inventories

Question 14

What is gearing?

Answer 14

The proportion of a businesses finances that are provided by debt

Question 15

Why is gearing ratio useful?

Answer 15

• To measure the financial health of a business by how much debt it is in. A high gearing ratio could mean the business it at risk but not always

Question 16

What are two ways of measuring gearing?

Answer 16

• debt/equity ratio

- gearing ratio

Question 17

What is the gearing ratio formula?

Answer 17

total debt/total equity
or
long term liabilities/capital employed x 100

Question 18

What is debt?

Answer 18

Finance provided to the business by external parties e.g.bank loans

Question 19

What is equity?

Answer 19

Amounts invested by the owners of a business

Question 20

What is the formula for gearing ratio (%)

Answer 20

non-current liabilities/(Total equity = non-current liabilities) x100

Question 21

What is considered a high gearing ratio?

Answer 21

50% + but level accepting gearing depends on business & industry

Question 22

What is considered a low gearing ratio?

Answer 22

less than 20%

Question 23

What are benefits of high gearing?

Answer 23

• Less capital required to be invested by the shareholders
• Debt can be a relatively cheap source of finance compared with dividends
• Easy to pay interest if profits and cash flows are strong

Question 24

What are benefits of low gearing?

Answer 24

• Less risk of defaulting on debts
• Shareholders rather than debt providers “call the shots”
• Business has the capacity to add debt if required

Question 25

What is inventory turnover?

Answer 25

Measures how often each year a business sells and replaces its inventory

Question 26

What are the 3 key financial efficiency ratios?

Answer 26

• Inventory turnover
• receivable days
• Payable days

Question 27

What do financial efficiency ratios analyse?

Answer 27

How effectively a business is managing its assets

Question 28

What is inventory?

Answer 28

The raw materials, work-in-progress and finished goods held by a business to enable production and meet customer demand

Question 29

What are the 3 main types of inventory?

Answer 29

• Raw materials & Components
• Work in progress
• Finished goods

Question 30

What is the inventory turnover equation?

Answer 30

cost of sales/inventories

Question 31

What are industries with low inventory turnover?

Answer 31

• Construction
• Engineering
• Industrial Distribution

Question 32

What are industries with high inventory turnover?

Answer 32

• Fast-food
• Supermarket retail
• Motor vehicle production

Question 33

Evaluation of inventory turnover?

Answer 33

• Holding more inventory may improve customer service & allow the business to meet demand
• Seasonal fluctuations in demand during the year may not be reflected in the calculations
• Inventory turnover is not relevant to most service businesses

Question 34

How can inventory turnover be inreased?

Answer 34

• Sell-off or dispose of slow-moving or obsolete inventory
• Introduce lean production techniques to reduce amounts of inventory held
• Rationalise the product range made or sold
• Negotiate sale or return arrangements with suppliers – so inventory can be returned if it does not sell

Question 35

What are debtors?

Answer 35

Amounts owed to a business by customers

Question 36

What are creditors?

Answer 36

Amounts owed by a business to suppliers & others

Question 37

What are receivable days?

Answer 37

-Average length of time taken by customers to pay amounts owed

Question 38

What are payable days?

Answer 38

-Average length of time taken by a business to pay amounts it owes

Question 39

What is the equation for receivables days?

Answer 39

trade receivables/revenue(sales) x365

Question 40

What is the equation for payable days?

Answer 40

Trade parables/cost of sales x365

-Higher payable days are usually better for cashflow

Question 41

What are the limitations of ratio analysis?

Answer 41

• Based on the past
• Reliability-subjective judgements
• One data set is not enough-need to compare with competitors + overtime to see trends
• Comparability

Question 42

What do ratios not tell you?

Answer 42

• Competitive advantage
• Quality
• Ethical reputation
• Future prospects
• Changes
• Changes in the external environment