Chapter 9 - Financial Ratios Flashcards
The standard ratios fall into which five categories?
- profitability ratios
- productivity ratios
- liquidity ratios
- activity or turnover ratios
- gearing ratios
What are the three main profitability ratios?
- gross profit percentage
- net profit percentage
- return on capital employed
What is the formulae for the gross profit percentage ratio?
Gross profit / sales (revenue) x 100
What can a decrease in the gross profit percentage show?
Greater competition in the market, causing lower selling prices and a lower gross profit
or
Increase in cost of purchases
What can an increase in the gross profit percentage show?
Company is in a position to exploit the market and charge higher prices for its products
or
Company is able to source its purchases at a lower cost
A change in the gross profit percentage ratio may indicate?
A change in the mix of products sold (An increasing volume of a product with a high gross margin will increase the overall ratio)
What is the net profit percentage ratio?
Net profit / sales (revenue or turnover) x 100
The relationship between the gross profit and net profit percentage gives an indication as to how well a company is managing its what?
Business expenses
If net profit has decreased over time, yet gross profit has remained the same, what may this indicate?
A lack of control over expenses
Higher management efficiency would be indicated by a high or low net profit percentage ratio?
High
What is the return on capital employed formulae?
ROCE = profit before interest charges and tax / share capital + reserves + borrowings x 100
As a rough guide to ROCE, a shareholder will want at least three times the return than if they was to…
Put their money in a typical bank deposit account
The higher the risk in the company the higher the…
Return required
A start up company would be expected to produce a high or low return?
High
Companies will seek to collect their debts as…
Soon as possible
Which ratio shows how efficient debt collection has been? Give the formulae
Debtors or trade receivables / sales x 365 days
Which ratio shows how long the company is taking to pay its own creditors?
Creditors or payables / purchases x 365 days
What is the ratio showing the average number of days that inventory/stock is held for?
Inventory or stock / cost of sales x 365 days
What are liquid assets?
All the assets that are money (cash) or can be turned into cash at short notice
In regards to liquidity ratios, what are the two most important ratios?
Current ratio and the quick ratio
What is the formula for the current ratio?
Current assets / current liabilities
What is the formula for the quick ratio?
Current assets excluding stock / current liabilities
To maintain creditworthiness a current ratio of ? Is seen as prudent. In more recent years a current ratio of ?.? Is more normal
- Now 1.5 is quite normal
Which businesses can usually survive on a current ratio less than 1? And why? (Think big and practical)
Supermarkets because they buy on credit and sell mainly for cash
Activity ratios measure what? sales of purchases) with a relevant…
They compare some aspect of the company’s activities (usually sales or purchases) with a elevant Balance sheet item
What three types of ratio are useful in regards to activity ratios
Stock as well as debtors and creditors.
What is the stock turnover ratio
Cost of sales / average stock
If a company has an annual cost of sales of 120 and holds an average stock of 20. The stock turnover is how many times per year? And once every how many months?
6 times per year and once every 2 months
What is the debt turnover ratio?
Sales / debtors
What is the creditor turnover ratio?
Purchases / creditors
Sales of 180 per year and average debtors of 30 would produce a debtor turnover of how many times per year?
6
If the debtors turnover ratio is 6 then this is the same as saying that debtors add turned over once every …
Two months. Debtors take on average two months to pay.
Why is the gearing ratio one of the best measures of a company’s future?
It shows how much the business relies on debt to finance the business.
What is the gearing ratio?
Long term borrowings / shareholders equity x 100
Depending on the business, what is usually a good figure of gearing?
80-110%
Explain why a company relying on a lot of debt to finance their business is in a potentially worse position than a company with not as much debt?
With debt, interest must be paid on it. The debt must also be paid on the due date, so regardless if the company is doing well or not, it must still repay this debt. If a company without debt has a bad year than it may not pay dividends to its shareholders, a company with debt however still has to pay back their money back regardless of how well they are doing.
If borrowing and gearing is potentially more risky, why do companies bother borrowing money At all?
The borrowing option may be more profitable to shareholders, if the company can borrow money, it may be able to for example, build a new plant and sell more goods on a decent margin, which will therefore make more money for the company, despite it having to pay interest on the debt.
What are the ratios in the insurance industry?
- solvency
- liquidity
- capital adequacy
- profitability
- claims
What is the solvency ratio?
Net assets / earned premium net of reinsurance
The higher the solvency ratio the better or worse the company’s position?
Better
What is an issue with the solvency ratio in regards to a hard market?
Premium rates increase so solvency ratio shows appearing deterioration whereas the economic position is an improvement.
Another way to asses solvency is to compare the surplus regulatory capital available to the regulatory capital required. This can be calculated as…
Surplus regulatory capital / regulatory capital available
In what way do insurance companies have an advantage to manufacturing companies in terms of liquidity?
Premiums are received before claims need to be paid so often positive cash flow.
A generalised formulae for liquidity for an insurance company is?
Total liabilities / cash + investments
Why is there a different liquidity ratio used for insurance companies as oppose to regular companies?
Insurers liquidity can easily come from freely marketable investments as these are mainly held to fund claims.
What is the return on equity ratio for an insurance company?
Profit after tax / shareholders equity (capital) x 100
In an insurance company, the ROE ratio expected by investors would be what?
2.5 times the amount that they would earn in a bank deposit account over a five year period. ( the hard and soft market cycle will distort the figures )
What percentage in regards to an insurance company is considered to be high in regards to gearing?
Over 120% of fixed interest finance
In an insurance company, what would be a low gearing percentage?
Below 60%
In regards to gearing in an insurance company, why might a high gearing ratio be preferred in relation to shares?
If a company issues too many shares it will lose control. There are also with fewer shares, fewer shareholders to participate in the profit, so a small increase in pre-interest profit could lead to a large increase in dividends.
The combined ratio will be of interest to competitiors because…
They will want to see how effectively the competition is underwriting
The combined ratio does not take into account what income?
Investment
A combined ratio of below 100% will generally indicate …
Good underwriting performance
A combined ratio over 110% generally indicates…
Poor underwriting or catastrophe loses
What is the formulae for the claims ratio?
Claims incurred net of reinsurance / earned premium net of reinsurance x 100
What is the expenses ratio?
Administrative expenses / earned premium net of reinsurance x 100
What is the commissions ratio?
Acquisition costs / earned premium net of reinsurance x 100
The three ratios, claims, expenses and commissions combine to form the combined ratio which is…
Claims + expenses + acquisition costs / earned premium net of reinsurance x 100
The ratio in regards to commission is usually between what?
10-20%
Ratios are usually used to compare what?
Performance of two or more companies in one particular year or
to compare the performance of a company over a number of years.
The fact a company’s combined ratio exceeds 100% shows the company is making an underwriting profit or loss?
An underwriting loss
Underwriting result is only part of the story in an insurance company, to get the total profit or loss we have to add…
Investment income and any other income the company might earn.
The outstanding claims ratio is?
Outstanding claims net of reinsurance / net assets
The lower the outstanding claims ratio the more…
Secure the position
How can we use ratios?
- to analyse the performance of a business
- compare performance of a company over time
- compare the performances of a number of businesses
What are the limitation of ratios?
- comparative information is essential for any meaningful analysis
- accounting ratios are based on income statements and balance sheets, which are subject to judgements and the limitations of historical cost accounting. Inflation differing bases for valuing assets, or specific price changes which can distort the inter company comparisons and comparisons made over time.
- depends on quality of financial information
- past performance not necessarily best indicator of future performance
For a typical trading or service company, what ratios normally used are:
- profitability ratios
- productivity ratios
- liquidity ratios
- activity or turnover ratios
- gearing ratios
For an insurance company the normal types of ratios to use are:
- solvency
- liquidity
- profitability
- claims
What is the gearing ratio in an insurance company?
long term borrowings divided by shareholders equity x 100
