9. Financial ratios Flashcards
What are the five categories of standard ratios?
- Profitability ratios
- Productivity ratios
- Liquidity ratios
- Activity (or turnover) ratios
- Gearing ratios
What are the main profitability ratios?
- Gross profit percentage
- Net profit percentage
- Return on capital employed (ROCE)
How is the gross profit percentage ratio calculated?
Gross profit ÷ Sales (revenue) × 100
What factors can change the gross profit percentage ratio?
- Decrease: Greater competition or increased purchase costs.
- Increase: Ability to charge higher prices or source purchases at a lower cost.
- Change in product mix: More high-margin products will increase the ratio.
How is the net profit percentage ratio calculated?
Net profit ÷ Sales (revenue/turnover) × 100
What does the net profit percentage ratio indicate?
It shows how well a company is managing its business expenses.
How is the return on capital employed (ROCE) ratio calculated?
Profit before interest and tax ÷ (Share capital + reserves + borrowings) × 100
Why is the ROCE ratio important?
- It shows how well management uses resources.
- A low return may be lost in a recession.
- High ROCE is needed when acquiring businesses or entering new markets.
- A low ROCE over time may suggest selling a business division.
What does the return on equity (ROE) ratio measure?
It measures the return after tax attributable to shareholders as a ratio on equity.
What does a productivity ratio measure?
It measures production efficiency by dividing business outputs by the inputs used in production.
How does productivity differ from profitability?
Profitability compares the value of outputs and inputs to determine profit, while productivity compares inputs and outputs without using money.
What is often the cause of bankruptcy, even if a company is profitable?
A lack of liquidity.
What are liquid assets?
Assets that are either money or can be quickly turned into money.
What is the current ratio formula?
Current assets ÷ Current liabilities
What is the quick ratio formula?
(Current assets excluding stock) ÷ Current liabilities
What current ratio is considered prudent for maintaining creditworthiness?
A ratio of more than 2 is seen as prudent
What type of business can operate with a lower current ratio?
Supermarkets (due to their ability to buy goods on credit and sell for cash)
What does it mean if a company’s quick ratio is below 1?
The company would need an overdraft facility to pay its creditors and collect from its debtors, which may indicate potential trouble if bankers are unwilling to provide it.
What are activity ratios used for?
To compare aspects of a company’s activities (usually sales or purchases) with relevant balance sheet items.
What is the stock turnover ratio formula?
Stock turnover ratio = Cost of sales ÷ Average stock.
What does the stock turnover ratio indicate?
A higher turnover means more cash is generated.
What is the debt turnover ratio formula?
Debt turnover ratio = Sales ÷ Debtors
What is the credit turnover ratio formula?
Credit turnover ratio = Purchases ÷ Creditors
What does the credit turnover ratio measure?
A higher turnover means a company takes less time to pay its creditors.
What does the gearing ratio measure?
It measures the financial leverage of a company, showing the extent to which the company is financed by debt compared to shareholders’ equity.
What is the formula for the gearing ratio?
(Long-term borrowings ÷ Shareholders’ equity) × 100
What is the typical range for gearing ratios of a general business?
Between 25% and 50%
What is a company with a high gearing ratio referred to as?
Highly leveraged
What is the solvency ratio for general businesses?
The total eligible capital ÷ solvency capital requirement
What is the solvency ratio for insurance companies?
net assets ÷ earned premium net of reinsurance
How does a higher solvency ratio affect the company?
A higher solvency ratio generally indicates a stronger company.
What does it mean to be overcapitalised?
When a company has a high level of capital relative to the premiums written, which can lead to a lower return on equity.
What is the generalised formula used to assess an insurer’s liquidity?
Total liabilities ÷ (Cash + Investments)
What does a lower result in the liquidity ratio indicate?
greater liquidity
What is the formula for calculating Return on Equity (ROE)?
(Profitaftertax ÷ Shareholders’ equity) x 100
What is the typical gearing ratio for an insurance company?
between 10% and 25%
What three ratios drive the combined ratio?
- Claims ratio
- Expense ratio
- Commission ratio
What does a combined ratio of 100% generally indicate?
A combined ratio below 100% generally indicates good underwriting performance, and a ratio above 100% indicates poor underwriting performance or catastrophe losses.
How is the claims ratio calculated?
(Claims incurred net of reinsurance ÷ Earned premium net of reinsurance) × 100
How is the expense ratio calculated?
(Administrative expenses ÷ Earned premium net of reinsurance) × 100
How is the commission ratio calculated?
(Acquisition costs ÷ Earned premium net of reinsurance) × 100
How is the combined ratio calculated?
(Claims + Expenses + Acquisition costs) ÷ Earned premium net of reinsurance × 100
What is the commission ratio in insurance?
It measures the acquisition costs or commission paid to brokers and intermediaries for acquiring business for the insurer.
What is the typical range for the commission ratio in insurance?
It typically ranges from 10% to 20%, though it can be higher, especially in delegated authority schemes.
What are outstanding claims?
Claims that have been reported but not yet settled.
What is the outstanding claims ratio?
outstanding claims net of reinsurance ÷ net assets
What is the significance of the outstanding claims ratio?
It indicates the company’s ability to cover its outstanding claims with its net assets.
What are the six key ratios used to assess an insurance company’s performance?
- Claims ratio
- Expenses ratio
- Commission ratio
- Combined ratio
- Return on equity (ROE)
- Solvency coverage ratio
How can ratios be used to analyse a business?
- Analyse the performance of a business.
- Compare the performance of a company over time.
- Compare the performances of different businesses.
What are some limitations of ratios?
- Comparative data is crucial for ratio analysis.
- Ratios can be distorted by inflation and asset valuation differences.
- Poor financial data can lead to incorrect conclusions.
- Past performance doesn’t guarantee future results.
