9. Financial ratios

Question 1

What are the five categories of standard ratios?

Answer 1

1. Profitability ratios
2. Productivity ratios
3. Liquidity ratios
4. Activity (or turnover) ratios
5. Gearing ratios

Question 2

What are the main profitability ratios?

Answer 2

1. Gross profit percentage
2. Net profit percentage
3. Return on capital employed (ROCE)

Question 3

How is the gross profit percentage ratio calculated?

Answer 3

Gross profit ÷ Sales (revenue) × 100

Question 4

What factors can change the gross profit percentage ratio?

Answer 4

• 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.

Question 5

How is the net profit percentage ratio calculated?

Answer 5

Net profit ÷ Sales (revenue/turnover) × 100

Question 6

What does the net profit percentage ratio indicate?

Answer 6

It shows how well a company is managing its business expenses.

Question 7

How is the return on capital employed (ROCE) ratio calculated?

Answer 7

Profit before interest and tax ÷ (Share capital + reserves + borrowings) × 100

Question 8

Why is the ROCE ratio important?

Answer 8

• 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.

Question 9

What does the return on equity (ROE) ratio measure?

Answer 9

It measures the return after tax attributable to shareholders as a ratio on equity.

Question 10

What does a productivity ratio measure?

Answer 10

It measures production efficiency by dividing business outputs by the inputs used in production.

Question 11

How does productivity differ from profitability?

Answer 11

Profitability compares the value of outputs and inputs to determine profit, while productivity compares inputs and outputs without using money.

Question 12

What is often the cause of bankruptcy, even if a company is profitable?

Answer 12

A lack of liquidity.

Question 13

What are liquid assets?

Answer 13

Assets that are either money or can be quickly turned into money.

Question 14

What is the current ratio formula?

Answer 14

Current assets ÷ Current liabilities

Question 15

What is the quick ratio formula?

Answer 15

(Current assets excluding stock) ÷ Current liabilities

Question 16

What current ratio is considered prudent for maintaining creditworthiness?

Answer 16

A ratio of more than 2 is seen as prudent

Question 17

What type of business can operate with a lower current ratio?

Answer 17

Supermarkets (due to their ability to buy goods on credit and sell for cash)

Question 18

What does it mean if a company’s quick ratio is below 1?

Answer 18

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.

Question 19

What are activity ratios used for?

Answer 19

To compare aspects of a company’s activities (usually sales or purchases) with relevant balance sheet items.

Question 20

What is the stock turnover ratio formula?

Answer 20

Stock turnover ratio = Cost of sales ÷ Average stock.

Question 21

What does the stock turnover ratio indicate?

Answer 21

A higher turnover means more cash is generated.

Question 22

What is the debt turnover ratio formula?

Answer 22

Debt turnover ratio = Sales ÷ Debtors

Question 23

What is the credit turnover ratio formula?

Answer 23

Credit turnover ratio = Purchases ÷ Creditors

Question 24

What does the credit turnover ratio measure?

Answer 24

A higher turnover means a company takes less time to pay its creditors.

Question 25

What does the gearing ratio measure?

Answer 25

It measures the financial leverage of a company, showing the extent to which the company is financed by debt compared to shareholders’ equity.

Question 26

What is the formula for the gearing ratio?

Answer 26

(Long-term borrowings ÷ Shareholders’ equity) × 100

Question 27

What is the typical range for gearing ratios of a general business?

Answer 27

Between 25% and 50%

Question 28

What is a company with a high gearing ratio referred to as?

Answer 28

Highly leveraged

Question 29

What is the solvency ratio for general businesses?

Answer 29

The total eligible capital ÷ solvency capital requirement

Question 30

What is the solvency ratio for insurance companies?

Answer 30

net assets ÷ earned premium net of reinsurance

Question 31

How does a higher solvency ratio affect the company?

Answer 31

A higher solvency ratio generally indicates a stronger company.

Question 32

What does it mean to be overcapitalised?

Answer 32

When a company has a high level of capital relative to the premiums written, which can lead to a lower return on equity.

Question 33

What is the generalised formula used to assess an insurer's liquidity?

Answer 33

Total liabilities ÷ (Cash + Investments)

Question 34

What does a lower result in the liquidity ratio indicate?

Answer 34

greater liquidity

Question 35

What is the formula for calculating Return on Equity (ROE)?

Answer 35

(Profit after tax ÷ Shareholders' equity) x 100

Question 36

What is the typical gearing ratio for an insurance company?

Answer 36

between 10% and 25%

Question 37

What three ratios drive the combined ratio?

Answer 37

1. Claims ratio 2. Expense ratio 2. Commission ratio

Question 38

What does a combined ratio of 100% generally indicate?

Answer 38

A combined ratio below 100% generally indicates good underwriting performance, and a ratio above 100% indicates poor underwriting performance or catastrophe losses.

Question 39

How is the claims ratio calculated?

Answer 39

(Claims incurred net of reinsurance ÷ Earned premium net of reinsurance) × 100

Question 40

How is the expense ratio calculated?

Answer 40

(Administrative expenses ÷ Earned premium net of reinsurance) × 100

Question 41

How is the commission ratio calculated?

Answer 41

(Acquisition costs ÷ Earned premium net of reinsurance) × 100

Question 42

How is the combined ratio calculated?

Answer 42

(Claims + Expenses + Acquisition costs) ÷ Earned premium net of reinsurance × 100

Question 43

What is the commission ratio in insurance?

Answer 43

It measures the acquisition costs or commission paid to brokers and intermediaries for acquiring business for the insurer.

Question 44

What is the typical range for the commission ratio in insurance?

Answer 44

It typically ranges from 10% to 20%, though it can be higher, especially in delegated authority schemes.

Question 45

What are outstanding claims?

Answer 45

Claims that have been reported but not yet settled.

Question 46

What is the outstanding claims ratio?

Answer 46

outstanding claims net of reinsurance ÷ net assets

Question 47

What is the significance of the outstanding claims ratio?

Answer 47

It indicates the company’s ability to cover its outstanding claims with its net assets.

Question 48

What are the six key ratios used to assess an insurance company's performance?

Answer 48

1. Claims ratio 2. Expenses ratio 3. Commission ratio 4. Combined ratio 5. Return on equity (ROE) 6. Solvency coverage ratio

Question 49

How can ratios be used to analyse a business?

Answer 49

- Analyse the performance of a business. - Compare the performance of a company over time. - Compare the performances of different businesses.

Question 50

What are some limitations of ratios?

Answer 50

- 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.