Chapter 32

Question 1

what are the different ratios to asses a company’s performance?

Answer 1

1. Profitability ratio
2. liquidity ratio
3. financial efficiency ratio
4. Shareholders ratio
5. Gearing ratio

Question 2

Profitability ratio?

Answer 2

This compares the gross and operation profits of the business with sales revenue.

Question 3

Liquidity ratio?

Answer 3

this gives a measure of how easily a business could meet its short-term debts or liabilities

Question 4

Financial ratios

Answer 4

these give an indication of how efficiently a business is using its resources and collecting its debts

Question 5

Shareholders ratio?

Answer 5

these can be used by existing or potential shareholders to asses the rate of return on shares and the prospects for their investment

Question 6

Gearing ratios

Answer 6

these examine the degree to which a business is relying on long-term loans to finance its operations. it is a reflection of a business’s financial strategy

Question 7

What are the profitability ratios?

Answer 7

Gross profit ratio
Net profit ratio
Return on capital employed (ROCE)

Question 8

what is capital employed?

Answer 8

the total value of all long term finance invested in the business.
=(non-current assets + current assets) -current liabilities + shareholders equity.

Question 9

what is the formula for ROCE?

Answer 9

assesing the profitability of a business
net or operating profit x 100
capital employed

Question 10

Points to note on ROCE?

Answer 10

• the higher the value of the ratio the greater the return on the capital invested in the business
• The return can be compared both with other similar companies and the ROCE of the previous year’s performance. Making comparisons over time allows the trend of profitability in the company to be identified

Question 11

Gross profit margin formula?

Answer 11

gross profit x100

sales turnover

Question 12

Net profit margin formula?

Answer 12

Net profit x100

sales turnover

Question 13

What are the liquidity ratios?

Answer 13

current ratio
acid test ratio
liquid assets

Question 14

Current ratio formula?

Answer 14

this compares the current assets with the current liabilities of the business
=current assets/current liabilities

Question 15

Acid test ratio formula?

Answer 15

= liquid assets/ current liabilities

Question 16

Liquid assets formula?

Answer 16

=Current assets - stock

Question 17

limitations of the Liquidity ratios

Answer 17

• give an incomplete analysis
• one ratios result on its own is very limited value - needs the others
• Poor ratio results only highlight a potential business problem

Question 18

Financial efficiency ratios

Answer 18

Inventory (stock) turnover ratio

Debtors days

Question 19

Shareholder or investment ratios

Answer 19

Dividend yield ratio
Dividend cover ratio
Price/earnings ratio (P/E ratio)

Question 20

What are the Gearing ratios?

Answer 20

Gearing ratio

Question 21

Inventory (stock) turnover ratio formula

Answer 21

The lower the amount of capital used in holding stocks, the better. Modern stock-control theory focuses on minimising investment in inventories. This ratio records the number of time the stock of a business is bought in and resold in a period of time.

Inventory (stock) turnover ratio = cost of goods sold
value of inventories

Question 22

Points to note on Inventory turnover ratio

Answer 22

The higher the number, the more efficient the managers are in selling stock rapidly. Very efficient stock management – such as the use of the JIT system – will give a high inventory turnover ratio.

Question 23

Debtor days ratio

Answer 23

This ratio measures how long, on average, it takes the business to recover payment from customers who have bought goods on credit – the debtors. The shorter this time period is, the better the management is at controlling its working capital.

Debtor days ratio = Accounts receivable (debtors) x 365
Sales turnover

Question 24

Points to note on Debtor days ratio

Answer 24

There is no ‘right’ or ‘wrong’ result – it will vary from business to business and industry to industry.

However, if the results are higher than average this could mean that the business has a poor control of debtors and repayment periods.

Question 25

Dividend yield ratio

Answer 25

This measures the rate of return a shareholder gets at the current share price. Dividend yield ratio (%) = dividend per share x 100 current share price Dividend per share = total annual dividends total number of issued shares

Question 26

Points to note on Dividend yield ratio

Answer 26

If the share price rises and the dividend remains unchanged, the dividend yield will fall. If the dividends rise and the share price remains unchanged, the dividend yield will rise.

Question 27

Dividend current ratio

Answer 27

This is the number of times the ordinary share dividend could be paid out of current profits. The higher this ratio, the more able the company is to pay the proposed dividends, leaving a considerable margin for reinvesting profits back into the business. Dividend cover ratio = profit after tax and interest annual dividends

Question 28

Point note on Dividend current ratio

Answer 28

If directors decided to increase dividends to shareholders, with no increase no profits, then this ratio would fall. Potential investors might start to query whether this level of dividend can be sustained in future. A low result means the directors are retaining low profits for future investment and this could raise doubts about the company’s future expansion.

Question 29

Price/earnings ratio (P/E ratio)

Answer 29

This is a vital ratio for shareholders and potential shareholders. It reflects the confidence that investors have in the future prospects of the business. In general, a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared with companies with a low P/E ratio. price/earnings = current share price earnings per share earnings per share = profit after tax total number of shares This is the amount of profit earned per share.

Question 30

Gearing ratio

Answer 30

long term loans x100 | capital employed

Question 31

Points to note on Gearing ratio

Answer 31

The ratio shows the extent to which the company’s assets are financed from external long-term borrowing. A result of over 50 % would indicate a highly geared business. The higher this ratio, the greater the risk taken by shareholders when investing in the business. This risk arises for two main reasons: The higher the borrowings of the business, the more interest must be paid and this will affect the ability of the company to pay dividends and earn retained profits. Interest will still have to be paid – but from declining profits.

Question 32

Advantages of ratio analysis

Answer 32

Ratios are widely used by company analysts and prospective investors before making assessments and taking important decisions on: whether to invest in the business whether to lend it more money whether profitability is rising or falling whether the management are using resources efficiently.

Question 33

Disadvantages of ratio analysis

Answer 33

One ratio result is not very helpful – to allow meaningful analysis to be made, a comparison needs to be made between one result and either: other businesses, called inter-firm comparisons or other time periods, called trend analysis. Trend analysis needs to be take into account changing circumstances over time which could have affected the ratio results. These factors may be outside the company’s control, such as economic recession.