Chapter 26 - Ratios

Question 1

Definition for capital employed

Answer 1

Permanent capital invested in the business

Question 2

What is liquidity

Answer 2

the ability of a business to pay back its
short-term debts

Question 3

What is profitability

Answer 3

measurement of the profit made relative to either the value of sales achieved or the capital invested in the business.

Question 4

Who is profitability important to

Answer 4

investors when deciding which business to invest in

directors and managers of the business to assess if the business is becoming more or less successful over time. Could cause them to take action if it is decreasing.

Question 5

What are the 3 profitability ratios and their full forms

Answer 5

ROCE (Return on capital employed)
NPM (Net profit margin)
GPM (Gross profit margin)

Question 6

What is ROCE formula

Answer 6

Net profit/capital employed * 100

Question 7

What is NPM formula

Answer 7

Net profit/revenue * 100

Question 8

What is GPM formula

Answer 8

Gross profit/revenue * 100

Question 9

What is the meaning of illiquid assets

Answer 9

means that assets are not easily convertible
into cash.

Question 10

2 liquidity ratios

Answer 10

Current ratio
ACID test ratio

Question 11

What is the current ratio formula
a good range for it

Answer 11

Current assets/Current liabilities
recommended to be in between 1.5 to 2

Question 12

What happens if current ratio is below 1 or above 2

and 1 drawback of the current ratio

Answer 12

below 1: the business could have real cash flow problems. It would not be able to not pay off its short-term debts from current assets.

above 2: that too much working capital is tied up in unprofitable current assets

drawback:
always assumes that all current assets can be turned into cash quickly. Not always the case (if inventory is hard to sell etc)

Question 13

What is ACID test ratio formula
good range for it

Answer 13

(Current assets - inventory)/current liabilites

good range: 1 to 1.5

Question 14

What happens if ACID test ratio is within the range
below the range

Answer 14

Means that the business can pay off its short term debts using its most liquid assets.

if the ACID test ratio is below 1 that shows that the business can’t pay off its short term debts using its most liquid assets and could run into a cashflow problem

Question 15

Why do managers need the financial statements and ratios

Answer 15

Control and monitor the performance of each product or division of the business.
Managers will be able to identify which parts of the business are performing well or poorly
Compare the business’s profitability and liquidity to other years and other businesses

Question 16

Why do shareholders need the financial statements

Answer 16

Want to compare the business’s profitability and ratios to other businesses’ profitability and liquidity to decide which is the best investment. Also want to compare to previous years to see if the performance is increasing or decreasing.

Question 17

Why do creditor’s need a business’s financial statements

Answer 17

Liquidity ratios - need to know the ability of the company to pay back their debts

If there the business faces a liquidity problem then the suppliers may refuse to supply on credit.

Question 18

Why banks need a business’s financial statements

Answer 18

If the business seems to be at risk of becoming illiquid, it is unlikely that a bank will be willing to lend more.

Question 19

Why do workers and trade unions need a business’s financial statements

Answer 19

Workers and trade unions will want to assess whether the future of the company is secure or not

Would want to see if the profitability of the company is increasing or not in order to bargain for a raise.

Question 20

why do Other businesses – especially those in the same industry need the business’s financial statements

Answer 20

The managers of other companies may be considering a bid to take over the company or they may just wish to compare the performance of the business with that of their own.

Question 21

Limitations of ratio analysis

Answer 21

External users will only have access to accounts and data required by law, and not all the accounts

Ratios are based on past performance and may not indicate how the company will perform in the future

accounting data overtime is affected by inflation and therefore it may be misleading to compare data between years

Different companies may used different accounting methods and valuation methods. These could lead to different ratio results, making comparisons different.