chapter 33: ratios; interpretation and evaluation of financial statements Flashcards
define and list the accounting ratios
an analysis which provides the way in which the relationship between the financial information is expressed
- solvency ratios
- liquidity ratios
- efficiency ratios
- profitability ratios
define liquidity ratios and explain its uses
current ratio= current assets/ current liabilities
- measures the ability of the business to meet its short-term debts
currrent ratio - to check if the business is able to repay its short term debts
- to compare with the previous years
quick/ liquid ratio - to check if the business is able to repay its short-term debts in case inventory is not sold
- to compare with the previous years
quick ratio= current assests- inventory/current liabilities
define efficiency ratios and explain their uses *rate of inventory turnover
average inventory= opening inv+ closing inv/ 2
used to emasure how effectively the business uses its assets and liabilities internally
rate of inventory turnover
- used to show no. of times inventory’s replaced in business during financial period
- always if inventory’s replaced in business more often, hence, relatively high no. than previous years is preferred; indicates the resources allocated to acquiring inventory are used effciently
- helps business in planning so inventory orders are made on time to avoid it pilling or running out
= cost of sales/ average inventory
define and explain the efficiency ratios
* debtors collection period
debtors/ credit sales* 365 days
- useful in measuring average duration it takes debtors to settle their accounts
- provides hint on whether to revise credit and collection policies by giving cash discounts, charging interest on overdue accounts
- a shorter collection period is usually preferred; money is needed for day-to-day running of the business
- shorter period is also preferred as it minimises risk of bad debts
define and explain the efficiency ratios
* creditors payment period
creditors/ credit purchases* 365 days
- useful in measuring average length of time it takes to settle the creditors accounts
- a longer period of time is preferred, it allows the business to have adequate funds that can be used to genrate more income in that period
define and explain the uses of the profitability ratios
gross profit margin= gross profit/sales *100
measures the ability of the business to generate profit
gross profit margin
- shows gross profit earned from every 100 dollars of sales
- gross margin is used in comparing wih different years
- higher % is preferred as it leaves sufficient gross profit to cover other operating expenses
mark up
- measures ability of business to control cost of inventory
- shows gross profit% added to each product sold
- used in comparing wih previous years
- higher % is always preferred; indicates better control of cost of inventory
mark up = gross profit/cost of sales *100
define and explain profitability ratios
* net profit margin
* return on capital employed
net profit margin= net profit/ sales *100
** net profit margin**
- shows net profit earned from every 100 dollars made in sales
- ratio can be compared with previous years
- indicates how well business controls its expenses
- indicates ability of the business to generate further income
return on capital employed
- shows profit earned from every 100 dollars invested in the business
- used in comparing with previous years
- shows how efficiently apital is being employed
retrn on capital employed= net profit/ opening capital*100
define and explain solvency ratios
measures ability of the business to survive in the long run
- to check if business is able to pay its long-term debts
- to compare with the previous years
solvency ratio= total assets/ total liabilities
suggest how profitability can be improved
- negotiate trade discount with current suppliers
- look for cheap suppliers
- initiate other income generating activities
- look for means to reduce operating expenses
how can working capital be improved?
- invest more capital into the business
- sell unwanted/ unused non-current assests
- look for cheaoer suppliers
- reduce drawings from the business
- acquire long-term loans
what are the possible disadvantages of not having enough working capital?
may not be able to:
- settle the debts of the business when due
- get discounts for early settlement
- cover all running expenses of the business
explain the importance of the ratios to owner(s)/ manager(s) and lenders
owner(s)/manager(s)
- to see if investment is yeilding any desired results
- to see if the business has any financial strength to continue to operate
- to compare financial performance of the business with other businesses in the industry
lenders
- to see if the business is liquis enough to pay back the loans
explain the uses of the ratios to trade creditors, employees, and potential investors
trade creditors
- to see if the business is financially sound to pay their accout on time
employees
- interested in findind out if the performance of the business is sounfd enough to secure them jobs or increase their salaries
potential investors
- interested in finding out if their investment will yeild any returns
list three factors to consider when comparing ratios between businesses
- you should compare with businesses in the same trade
- compare with businesses that are approximately the same size
- quality of the management and skills of the workforce.
what could be the possible limitations of the accounting ratios?
non-financial aspects- info that couldn’t be expressed in monetary terms isn’t considered, even if it influences the business’s performance
historical cost- transactions are always recorded at historical cost, which means it can be difficult to compare transactions that took place at different times because of the effect of inflation
accounting policies- some businesses may be using different depreciation methods and rates which may cause differences in profitability.
