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Business > Analysis and Interpretation of Ratios > Flashcards

Analysis and Interpretation of Ratios Flashcards

1
Q

Relation between profitability and leverage

A
  • A profit increases the level of equity, and therefore changes the leverage ratio.
  • level of profitability and the cost of borrowings.
    If returns generated from the borrowed funds exceed the interest cost of borrowing, the higher the leverage the better the profitability.
     If returns generated from the borrowed funds are below the cost of borrowing, then the higher the leverage the lower the profitability
  • The greater the level of liquidity the higher the ** level of leverage that an entity can safely
    sustain.**
     This is because if creditors seek their funds the organisation can more readily pay them
    without selling non-current assets.
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2
Q

what are the two market based ratios?

A

Price earning ratio (P/E ratio):

Dividend Yield

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3
Q

Market-based Ratio

  • Price Earning Ratio (P/E ratio)

Formula

A

Market Price per ordinary share/earnings per share

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4
Q

Market-based Ratio

  • Price Earning Ratio (P/E ratio)

To judge whether a P/E ratio is high (overpriced) or low (underpriced), what two main factors need to be taken into account?

A

It’s difficult to decide whether a particular P/E is
high or low without taking into account two
main factors:

  1. Company growth rates
  2. Industry P/E ratio
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5
Q

Market-based Ratio

  • Price Earning Ratio (P/E ratio)

What is it?

A

Price earnings ratio shows the amount investors are prepared to pay per dollar of earnings.

It also reflects
market expectations for a company’s growth.

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6
Q

Market-based Ratio

Dividends Yield

Formula

A

Dividends per ordinary share/ market price per ordinary share

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7
Q

Market-based Ratio

Dividends Yield

It can be compared with?

A
  1. Competitors
  2. Current interest rate
  3. Industry average

whether annual return is attractive to investors who aim to maximise their return

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8
Q

Market-based Ratio

Dividends Yield

What is it?

A

is amount of dividends shareholders will receive in relation to the share price.

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9
Q

What are limitations of ratio analysis?

A
  1. Ratios are as accurate as financial statements
  2. Ratios offer restricted view of ‘relative’ performance and position (statement of financial position is fixed at a particular point of time)
  3. Need to compare with benchmarks
  4. two businesses are identical
    and the greater their differences, the greater the limitations of
    ratio analysis as a basis for comparison
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10
Q

Common size statements express

A

balance sheet items as a percentage of total assets

income statement items as a percentage of sales

cash flow statements items as a percentage of cash receipts from customers

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11
Q

if user wishes to compare ratio between business over time, it is essential that the ratios

A

be calculated on a consistent basis

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12
Q

profitability measures include

A

 Rate on assets (ROA)
 Rate on equity (ROE)
 net profit margin
 gross profit margin
 earnings per share

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13
Q

Describe ROA

A

ROA indicates how effective are funds invested in assets in generating profit. Higher ROA percentages are preferred as assets are used more efficiently to generate profit.

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14
Q

ROA formula

A
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15
Q

Describe ROE

A

Return on Equity (ROE) measures how effectively shareholder’s equity is used to generate profit. The higher the ROE, the more efficiently the company is using its investor’s funds to generate profit

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16
Q

ROE formula

A
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17
Q

Gross profit margin

A

The gross profit margin is a measure of the business’s profit margin and control over production costs

Gross profit/ sales

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18
Q

describe net profit margin

provide formula

A

Net profit margin measures net profit as a proportion of sales revenue.

net profit/ sales revenue

19
Q

describe earnings per share

A

Earnings per share measures the amount of profit earned per outstanding share of company stock

20
Q

what is earnings per share used for?

A

 The trend in earnings per share over time is used
to assess the investment potential of a company’s
shares

21
Q

Only important in comparison to previous EPS not
other companies’ EPS. Why?

A

 A company’s financing decisions may impact on its
EPS considerably.

22
Q

measures of efficiency

A
  1. Asset turnover: efficiency of total assets
  2. Inventory turnover: efficiency of current assets
  3. Accounts receivable turnover: efficiency of current assets
  4. Accounts payable turnover
23
Q

Efficiency- inventory turnover

formula

A
24
Q

Efficiency- inventory turnover

what does this measure

A

 Inventory turnover in days (average inventory
turnover period): shows the average number of
days to convert inventories to sales

25
Q

Efficiency - accounts receivable turnover

this measures

A

Accounts receivable turnover in days (Average settlement
period for accounts receivable): shows the average time taken to collect accounts receivable.

26
Q

Efficiency- accounts receivable turnover

formula

A
27
Q

Efficiency- accounts payable turnover

what does this measure?

A
28
Q

Efficiency- accounts payable turnover

formula

A
29
Q

Efficiency turnover in times

A
30
Q

the relation between profitability and efficiency

A
31
Q

measures of liquidity

A

Assess how well the business can meet
short-term obligations or claims against
the assets when they fall due

32
Q

Three ratios are commonly used to assess
short-term liquidity risk:

A

 current ratio
 quick ratio
 cash flow from operations to current liabilities

33
Q

Liquidity current ratio

describe and provide formula

A
34
Q

liquidity - quick ratio

describe and provide formula

A
35
Q

Liquidity - Cash flow from
operations to current liabilities ratio

describe and provide formula

A
36
Q

Relation between profitiability and liquidity

A

Profit is one of the major sources of funds and
therefore profit can increase liquidity
Nevertheless there can also be an inverse
relationship between liquidity and profitability:
Liquid assets such as cash, accounts
receivable and inventories may produce
_relatively little profit _
Illiquid assets such as plant and machinery
can substantially increase profit

37
Q

what is financial leverage (gearing)?

A

: occurs when a
business is partly financed by outside parties
(creditors).
The level of gearing, or the extent to which a
business is financed by outside parties is an
important factor in assessing risk

38
Q

Why a business would want to take on gearing?

A
  1. Gearing may be used to adequately finance the business when owners have insufficient funds
  2. Increase the returns to owners - provided that the returns generated from the borrowed funds _exceed the interest cost of borrowing _
39
Q

what ratios may be used to
evaluate the gearing/long term financial
solvency of a business?

A
  1. Debt to total assets (gearing/leverage
    ratio)
  2. Cash flow from operations to total
    liabilities
  3. Interest cover ratio
40
Q

Leverage
- Debt to total assets ratio

describe

provide formula

A
41
Q

Leverage : Cash flow from operations to total
liabilities ratio

describe

formula

A
42
Q

Leverage - Interest cover ratio

describe

formula

A
43
Q

Relation between leverage and liquidity

A

The greater the level of liquidity the higher the
level of leverage that an entity can safely
sustain.
This is because if creditors seek their funds the
organisation _can more readily pay them
without_selling non-current assets.
Organisations need to be very careful about
the impact of changes in the liquidity on
leverage levels.

Business (11 decks)

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