Chapter 11

Question 1

What are the 4 categories for ratio analysis?

Answer 1

Profitability
Liquidity
Use of resources
Financial Position

Question 2

What can we compare ratios to?

Answer 2

Previous year financial statements

Forecasted financial statements

Financial statements of another company

Average figures for the whole industry

Question 3

What is the formula for gross profit Margin / percentage?

Answer 3

(Gross profit / revenue) x 100

Question 4

What can gross profit % tell you about a business?

Answer 4

Should be similar year on year, any significant changes (especially a decrease) should be investigated.

Inventory cut off procedures should also be investigated, as incorrect inventory will impact gross profit twice.

Question 5

How to calculate operating profit percentage?

Answer 5

(Profit from operations / Revenue) x 100

Question 6

What is operating profit % and what does it tell you?

Answer 6

Profit from operations is profit before finance costs and tax. Avoids distortion when comparisons are made between 2 companies when one is heavily financed and the other is not.

Question 7

How to calculate Expense / Revenue %?

Answer 7

(Specified expense / revenue) x100

Question 8

Why is the expense / revenue percentage formula useful?

Answer 8

Useful for seeing how an expense has been affected by growth in sales from one year to the next, or for comparing the cost control of 2 different companies.

Question 9

How to calculate Return on Capital Employed (ROCE)?

Answer 9

(Profit from operations / total equity + non current liabilities) x 100

Question 10

Why is ROCE useful / what does it show?

Answer 10

Expresses the profit of a company in relation to the capital employed to generate it. Returns is best compared to another investment eg interest rate for bank

CAREFUL FOR COMPARING ACROSS INDUSTRIES - NO DIRECT COMPARISON

Question 11

How to calculate return on equity?

Answer 11

(Profit after tax / total equity) x100

Question 12

What does ROE ratio show / how is it useful?

Answer 12

Focuses on the return for ordinary shareholders.

Question 13

What are the 5 profitability ratios?

Answer 13

Gross profit percentage
Operating profit percentage 
Expense / revenue percentage 
Return on capital employed (ROCE)
Return on Equity (ROE)

Question 14

What are the liquidity ratios?

Answer 14

Current ratio (working capital ratio)

Acid test (quick) ratio

Question 15

What is the formula for current (working capital) ratio?

Answer 15

Current assets / current liabilities = X:1

Generally Expect around 2:1

Question 16

How is the current ratio useful / what does it show?

Answer 16

Measures the relationship between current assets and current liabilities. Should not operate at a level too low so that it’s assets do not cover debts. Equally, too high of a ratio may suggest the company has too much inventory, recievables or cash.

Question 17

How to calculate the acid test (quick) ratio?

Answer 17

(Current assets - inventories / current liabilities)

Question 18

How is the acid test / quick ratio useful : what does it show?

Answer 18

Omits inventories as they are the least liquid current asset that a company has, as it has to be sold, turned into receiveables and then cash received.

Ratio of less than 1:1 could indicate a company has difficulty paying its debts as they fall due.

Question 19

Formula for inventory holding period in days?

Answer 19

(Inventories / Cost of Sales) x 365

Question 20

What is inventory holding period, how is it useful / what does it show?

Answer 20

Number of days that inventory is held by a company on avg. Aside from certain industries most companies should aim for as lower days as possible, as well as being able to meet customer demands.

Question 21

How to measure inventory turn over (in times per year)?

Answer 21

Cost of sales / inventories

Question 22

What does inventory turn over show?

Answer 22

Show on average how many times per year a company is able to sell its total inventory in a year. Should aim for this to be high.

Question 23

How to calculate trade receivables collection period (days)?

Answer 23

(Trade receivables / revenue) x 365

Question 24

What does trade receivables collection period show?

Answer 24

Shows on average how many days it takes for debtors to settle their account balance with the company. Should only be compared with that of the previous year or against a similar company.

Question 25

How to calculate trade payables payment period?

Answer 25

(Trade payables / cost of sales) x365

Question 26

What does the trade payables payment period show / tell us?

Answer 26

Shows the time it takes for the company to settle its payable balances.
Delaying payment too long can lead to operational problems. But it is a valuable source of short-term finance.

Question 27

Working capital cycle calculation?

Answer 27

Inventory days + receivable days - payables days

Question 28

Net assets turnover ratio calculation?

Answer 28

Revenue / total assets - current liabilities

Question 29

What does the net assets turnover calculation show?

Answer 29

Measures the efficiency of the use of key assets in generating revenue. A measure of the number of pounds of revenue generated per pound of net assets invested in the company.

Question 30

Ideal value for asset turnover?

Answer 30

Ideally increasing but need to be careful of assumptions - could have bought lots of assets late i. The year and not had time to start generating revenue yet. Eg timing issues will impact this calculation

Question 31

What is the asset turnover for total assets calculation?

Answer 31

Revenues / total assets

Question 32

What is interest cover calculation?

Answer 32

Profit from operations / finance costs

Question 33

Why is interest cover calc important / what does it show?

Answer 33

Considers the number of times a company could pay its interest payment using its profit from operations

Question 34

What is the gearing formula?

Answer 34

( non current liabilities / total equity + non current liabilities ) x100

Question 35

What does the gearing of a company show?

Answer 35

Concerned with long term financial stability of a company. Looks at how much the company is financed by debts. The higher the gearing ratio - the less secure the financing and thus the companies future.