Accounting Ratios Flashcards
What is the primary purpose of accounting ratios?
To better assess:
Returns Received
&
Risks Faced
What are the four types of accounting ratio?
1) Profitability
2) Liquidity
3) Gearing
4) Investor Ratios
Define the four types of accounting ratio
1) Profitability - Asseses the trading or operating performance of the business
2) Liquidity - Assess the trading risk of the business - the risk that through the course of business the firm will be unable to pay its suppliers and cease to be a going concern
3) Gearing Ratios - The companies ability to pay long term debt & the risk to those providing financing for the company
4) Investor Ratios - The returns recieved by those financing the business.
What are the three profitability margin ratios?
Gross Profit Margin - The amount of profit that goes towards COGS and therefore the amount remaining for operating expenses.
Net Profit Margin - The amount of actual profit after all costs are deducted - e.g 4.4% means £4.40 profit for every £100 sold.
Operating Profit Margin - The amount of profit spent on COGS and operating expenses
These operating expenses can include: Research and Development, Marketing & Financing Costs.
What are the benefits of the three profitability margin ratios?
Gross Profit - Compare performance to industry peers - It’s an important starting point
Net Profit - Final picture of companies health - enables an investor to see are management generating enough profits from sales
Operating Profit - Measures how efficiently a company can manage its expenses
What are the limitations of the three profitability margin ratios?
Gross - Does not take into acount any costs - can’t analyse changes in cost of production
Net - Can be influened by a one off sale and does not provide insight into cost management
Operating - Comparisons are hard due to lack of consistency in accounting standards - e.g method of depreciation.
What does return on equity measure?
How is it calculated?
The return on the amount of capital provided by shareholders.
It is calculated as Net Income / Shareholder Equity
The ratio outcome depends on: Industry, State in companies lifecycle & broader economic situation
What are the limitations of using RoE?
1) It does not show the risk associated with generating that level of return
2) It can be manipulated by deflating shareholder equity or inflating net income
3) Misleading for new companies as capital requirement is high and will lower RoE.
Asset Turnover
1) What does it show
2) How is it calculated
3) What kind of companies have high or lower ratios
1) How efficiently a company use their assets to generate revenue
2) Revenue / Capital Employed (or average total assets)
3) Supermarkets / Retail = High & Capital Intensive (e.g. Telecoms) = Low
One drawback is that it cannot be used to compare companies that operate in different industrial sectors.
What is equity multiplier & how is it calculated?
A gearing ratio that shows what portion of RoE is debt
Total Assets / Shareholder Funds
Makes up part of the DuPont Analysis to analyse the level of gearing in RoE.
What is ROCE?
How is it calculated?
Measures how effectively you use your long term capital to generate a profit.
Operating Profit / Capital Employed
Capital Employed = Assets - Current Liabilities or (Equity + Non-current liabilities)
What is ROCE useful for?
Analysing companies in the same sector. Particuarly capital intensive sectors.
However, it also does not capture risk through things like borrowing to gauge how returns are made.
It also cannot be used to compare companies in different sectors.
It should be used alongside other profitability ratios and liquidity ratios to better understand how the profits are generated and the risks / changes to profitiability.
What is the difference between solvency and liquidity?
Solvency is long term ability to pay long-term liabilities
Liquidity is concerned with short-term operations and the ability to meet cash requirements.
What does the current ratio show and how is it calculated?
How easil current assets can cover our current liabilities
Current Assets / Current Liabilities
Higher is better - but too high can show a problem e.g. too much cash on hand.
What is the desired level of the current ratio?
Between 1.5 - 2
What are some shortcomings of the Current Ratio?
- Overdraft included - Could realistically be a long term source of financing though.
- Balance sheet is a snapshot - not indicative
- Different industries cannot be compared e.g (manufacturing ratio is high and supermarkets low)
- A liability may be due immediately but inventory cannot be sold instantly (especially not at book price)
Supermarkets have little to no trade receievables and therefore low ratios
What is the working capital turnover ratio?
Average Annual Sales / Working Capital
Where working capital = Current Assets - Current Liabilities
This is the remedy to the current ratio being a static snapshot in time.
What is the acid test (quick ratio)
Current Assets - Inventory / Liabilities
Retail companies often have lower quick ratios and as such fall victim to recessions more often than other industries.
Supermarkets operate with very very low ratios
The quick ratio should be 1:1 or better
What is the working capital cycle?
Measures the velocity of cash flow.
I.e. how long it takes to purchase materials and then how long it takes to sell the goods.
How can the working capital cycle be improved?
1) Minimise inventory levels
2) Ensuring debtors pay quickly
3) Delaying payments to creditors
What are the three working capital cycle ratios?
1) Receivables Collection Period
2) Payables Collection Period
3) Inventory Holding Days
What is Receivables Collection Period?
Receivables / Revenue * 365
Shows how many days it takes you to get paid - therefore lower is better.
The number is only an average, some payments will be shorter / longer (if larger payments take longer this isn’t shown by the ratio)
What is Payables Collection Period?
Payables / Cost of Goods Sold * 365
Shows how long you take to pay your payables.
Longer is better but there is a fine balance - you don’t want to spread liquidity fears or upset suppliers.
If you upset suppliers you could lose out on trade discounts
What is inventory holding days?
How quickly a company is selling its inventory
Too low and you can’t keep up with a surge in demand
Too high and the cost of holding inventory is too much
Supermarkets will have lower days as their stock is often perishable.
What is debt to equity ratio?
Debt + Preference Share Capital / Shareholder Equity
Measures to what extent a company is funded by borrowing compared to shareholder funds.
If the ratio is too high, then growth is being delivered by too much borrowing. Too low and it shows an over reliance on expensive and ineffective equity.
What is net debt to equity?
Debt - Cash / Shareholder Equity
Same as debt to equity but includes how much debt could be offset by cash.
What is interest cover?
Operating Profit + Interest Receivable + Other Income Receivable / Interest Payable
Measures how well a company can afford to pay its interest on borrowings
Higher is better for lenders as it indicates less risk
Does not include trade receivables as this is already included in operating profit
What is asset cover?
Total Assets - Current liabilities / Debt
- the ratio between loans granted and the assets available to repay them.
- Some loans have a different priority than others – the asset cover ratio should be calculated for each in priority order.
