Chapter 36- introduction to ratio analysis and liquidity ratios

Question 1

Ratio analysis

Answer 1

• method of measuring the performance of a business from various perspectives for the benefit of a range of stakeholders of the business
  E.g.
• directors/ managers
• employees
• banks
• suppliers
• customers
• shareholders
• competitors
• government
• all stakeholders require information about a business and can gain that information from some or all of the ratios

Question 2

Ratio analysis enables a business to

Answer 2

• measure its performance over a given period of time
• make comparisons to be made over time and between other businesses
• make comparisons between different departments within a business

Question 3

Ratios are usually divided into various categories

Answer 3

• liquidity
• profitability
• financial efficiency
• shareholder
• gearing

Question 4

Liquidity

Answer 4

Ratios included
- current ratio
- acid test

Concerned with
- the ability of a business to cover its short tem (current) liabilities

Question 5

Profitability

Answer 5

Ratios included
- gross profit margin
- net profit margin
- return on net assets
- return on capital employed

Concerned with
- consider the level of profit in relation to the actual business
- consider how profitable the business is in relation to its sales, assets or the capital invested

Question 6

Financial efficiency

Answer 6

Ratios included
- asset turnover
- stock turnover
- debtor days
- creditor days

Concerned with
- concentrate on the efficiency of the business in terms of its ability to move stock or how efficient it is at collecting money it is owed or paying money it owes

Question 7

Shareholder

Answer 7

Ratio included
- dividend per share
- dividend yield
- price earnings ratio

Concerned with
- allow shareholders to judge how their investment in shares of the business are performing compared to alternative investment opportunities

Question 8

Gearing

Answer 8

Ratios included
- gearing
- interest cover

Concerned with
- concentrates on the long term liabilities of the business and its ability to borrow money and its ability to cover the cost of borrowing

Question 9

Liquidity ratios

Answer 9

• measures the ability to convert assets into cash
• liquidity is all about having sufficient cash’s to keep the business working (working capital)
• liquidity ratios focus on the ability of a business to have sufficient current assets in relation to the amount of current liabilities

Question 10

Current ratio

Answer 10

• considers the current assets and the current liabilties
• ratio between the assets and the liabilities indicate the level of liquidity within the business
• considers the level of liabilities in relation to the level of assets to ensure that there is sufficient working capital (enough cash to meet the short term debts of the business)

Question 11

Current ratio formula

Answer 11

Current assets/ current liabilities

E.g.
current assets- 300
Current liabilities- 200

300/200= 1.5:1

Significance of the answer of 1.5 is that for every 1 of liabilities the business holds 1.5 in assets
There are 1.5 times as many assets as there are liabilities
Implies that there are sufficient assets to cover liabilties

Question 12

Acid test

Answer 12

• business can’t be certain that it will be able to see all its stock so it takes it into consideration
• much more reliable test of liquidity

Question 13

Acid test formula

Answer 13

Current assets - inventory stock/ current liabilities

Question 14

Value of ratios

Answer 14

• comparisons from year to year can be made
• stakeholders may be able to use ratios in order to assess if business is worth to trade with
• management of a business will want to consider certain ratios as as a measure of performance and whether financial objectives have been met
• suppliers and potential creditors will want to know the business is worth trading with
• employees will be interested to see how the business is performing to ascertain if their jobs are secure and the potential for a pay rise
• ratios are useful for providing a source of information in order to spot and possibly solve problems within a business
• may help management in their decision process and choosing the strategy to adopt

Question 15

Limitations of ratios

Answer 15

• inflation may distort figures such as revenue, profits and return on capital employed
• state of economy may mean that a fall in certain ratios is not due to the poor performance of the business
• assumed that the figures used within the ratios are calculated in the same way over time to enable comparisons to be made
• external figures may distort the figures which are outside the control of the business