4.11: Purpose, Features and Interpretation of Financial Ratios Flashcards
Describe the purpose of basic financial ratios
- a management tool for judging the financial performance of a business
- to assess if the financial performance has improved compared to another period of time
- to compare the performance of a business against its competitors and the actual figures with projected budget figures
- to analyse and assess a business’s financial position to assist in decision making
Describe the purpose of the Profit Ratio
- is equal to a business’s profit divided by its net sales
- the profit margin ratio shows the percentage of profit after income tax that is contained in each dollar of sales
- the profit after tax is used as this is the profit available to the shareholders
- for every $1 of sales made by a business, (%) cents in profit after tax
Describe the interpretations of the Profit Ratio
An increase may be caused by:
- a reduction in expenses
- an increase in the selling prices of the products of the company greater than any increase in the cost of sales
- a cheaper supplier of inventory has been found
A decrease may be caused by:
- expense increases that are not being fully passed on to consumers in the form of increased cost of sales
- increased competition causing the business to lower its selling prices
Describe the purpose of the Gross Profit Ratio
- is equal to a business’s gross profit divided by its net sales
- shows the percentage of profit the business has earned from the sale of stock or inventory
- this means that for every $1 of sales; (%) cents is gross profit
Describe the interpretations of the Gross Profit Ratio
An increase generally means, that the profit earned from the sale of stock or inventory has increased in proportion to the total sales and may be caused by:
- an increase in the selling price of products
- might be selling a greater proportion of high-profit items
- a reduction in cost of sales
A decrease generally means, the profit earned from the sale of stock has decreased in proportion to the total sales and may be caused by:
- selling a greater proportion of low profit items
- increased competition forcing the business to lower its prices
- increased cost of sales
Describe the purpose of the Expense Ratio
- is equal to a business’s operating expenses divided by its net sales
- indicates the amount of sales dollars required to cover expenses
- this means for that for every $1 the business is incurring (%) cents in expenses
Describe the interpretations of the Expense Ratio
An increase generally means, that expenses are increasing in proportion to the total sales and may be caused by:
- greater rate of increase in expenses than the rate of increase in sales
- the incursion of an extraordinary expense
A decrease generally means, that expenses are decreasing in proportion to the total sales and may be caused by:
- lower rates of increase in expenses than the rate of increase in sales
Describe the purpose of the Return-on-Equity Ratio
- is equal to a business’s profit divided by its equity at the end of the financial year
- this ratio measures a firm’s profit (revenue subtract all expenses) divided by its shareholders’ equity
- it directly represents how much profit is generated by the business in proportion to the equity it gets from its shareholders.
- this means that for every $1 in equity the business has (%) cents in profit
Describe the interpretations of the Return-on-Equity Ratio
An increase generally means, that profit is increasing in proportion to the total equity of the firm and may be caused by:
- increases in profits for that period
- value of shareholder’s equity has decreased
- less equity has been invested in proportion to the growth of the firm
A decrease generally means, that profit is decreasing in proportion to the total equity of the firm and may be caused by:
- reduced profits due to an increase in expenses
- value of shareholder’s equity has increased due to decreased liabilities
Describe the purpose of the Current Ratio
- is equal to a business’s current assets divided by its current liabilities
- the current ratio is measures the liquidity of the business
- it measures how many current assets it has to meet its short-term debt
- this ratio means that the business has (%) cents of current assets available to pay every $1 of current liabilities / short term debt
Describe the interpretations of the Current Ratio
<100%:
- indicates either that a business may find it difficult to pay its short term debts or that the business is operating in an industry in which money is collected from sales very quickly
100%-200%:
- indicates that a business should be able to pay its short term debts
>200%:
- indicates that a company should be able to comfortably pay its short term debts or that a company has an excessive level of current assets and is not making the best use of its resources to generate revenue
Describe the purpose of the Debt-to-Equity Ratio
- is equal to a business’s total liabilities divided by its total equity
- debt to equity measures the financial gearing of the business
- the debt-to-equity ratio shows the percentage of company financing that comes from creditors and investors
- a higher debt to equity ratio indicates that more debt (bank loans) is used than equity (shares).
Describe the interpretations of the Debt-to-Equity Ratio
- there is no one acceptable figure for the debt to equity ratio
- a debt to equity ratio of below about 40% would be considered by many investors to be conservative and a debt to equity ratio of more than 100% would be considered to be high
- it should be noted that the debt level of a company must be considered in relation to the profit made by the company, that is, how the company has used its debt finance to generate income
- a very low debt to equity ratio may be a sign of nonoptimal resource allocation, as they may not be seizing growth opportunities
