4.11: Purpose, Features and Interpretation of Financial Ratios

Question 1

Describe the purpose of basic financial ratios

Answer 1

• 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

Question 2

Identify the 4 profitability ratios

Answer 2

• profit ratio
• gross profit ratio
• expense ratio
• return-to-equity ratio

Question 3

Describe the purpose of the Profit Ratio

Answer 3

• 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

Question 4

Describe the interpretations of the Profit Ratio

Answer 4

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

Question 5

Describe the purpose of the Gross Profit Ratio

Answer 5

• 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

Question 6

Describe the interpretations of the Gross Profit Ratio

Answer 6

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

Question 7

Describe the purpose of the Expense Ratio

Answer 7

• 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

Question 8

Describe the interpretations of the Expense Ratio

Answer 8

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

Question 9

Describe the purpose of the Return-on-Equity Ratio

Answer 9

• 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

Question 10

Describe the interpretations of the Return-on-Equity Ratio

Answer 10

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

Question 11

Identify the liquidity ratio

Answer 11

• current ratio

Question 12

Describe the purpose of the Current Ratio

Answer 12

• 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 (within 12 months)
• this ratio means that the business has (%) cents of current assets available to pay every $1 of current liabilities / short term debt

Question 13

Describe the interpretations of the Current Ratio

Answer 13

<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

Question 14

Identify the stability ratio

Answer 14

• debt-to-equity ratio

Question 15

Describe the purpose of the Debt-to-Equity Ratio

Answer 15

• 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).

Question 16

Describe the interpretations of the Debt-to-Equity Ratio

Answer 16

• 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