Finance Directors View on A Single Co And Its Profitabiliity

Question 1

Gearing Ratio - debt to equity ratio

= long term loans + pref shares
——————————————
Total Equity - pref shares

Answer 1

• Helps determine what proportion of the co’s share capital is being leveraged by borrowing.
• > 1 = co’s borrowing is above its equity value, so highly geared, perhaps aggressive with its financing.
• this can impact earnings cos’ of the extra interest expense payable
• financial leverage is the ratio of long term debt to equity referred to as “gearing”

Question 2

Current Ratio - working capital ratio

= Current Assets
———————-
Current liabilities

Answer 2

• Typical current ratio should be btwn 1.5 - 2 but depends on the type of business and the prevailing economic conditions
• low ratio for a particular business may indicate a potential future insolvency
• a high ratio may mean a business may have too much working capital, which usually means that assets are not being used as profitably as they might be

Question 3

Liquidity Ratio - quick or acid ratio

= current assets - stock
——————————-
Current liabilities

Answer 3

• A more cautious ratio is the liquidity ratio (also called the quick or the acid test) as it measures only those assets that can be quickly and definitely turned into cash.
• as a generalisation - liquidity ratio should be at least 1