financial accounting - ratio analysis

Question 1

why are ratios useful?

Answer 1

• comparisons can be made
• stakeholders can assess whether investment is worth it
• management can use them for a measure of performance
• employees can see for job certainty
• find problems to solve

Question 2

what are the limitations of ratios?

Answer 2

• inflation may distort figures e.g. revenue, profit and return
• state of economy may mean a fall in certain ratios
• calculations are made the same way over time so comparisons may not be accurate
• external factors may distort figures outside control of business
• no set benchmarks for judging ratios

Question 3

how to calculate GPM (gross profit margin)?

Answer 3

(gross profit÷sales revenue) x 100

Question 4

how to calculate NPM (net profit margin)?

Answer 4

(operating profit÷sales revenue) x 100

Question 5

how to calculate Return on capital employed (ROCE)?

Answer 5

(operating profit÷(total equity+non-current liabilities)) x 100

Question 6

how to calculate return on equity?

Answer 6

(operating profit÷total equity) x 100

Question 7

what does GMP and NPM tell you?

Answer 7

how many pence from every pound of sales is gross profit
e.g. 40% = for every £1 of sales, 40p is GP

Question 8

why is ROCE useful?

Answer 8

• evaluate overall performance
• provide a target return for individual target
• benchmark performance with competitors

Question 9

why is ROCE limited?

Answer 9

• based on snapshot of business’ balance sheet
• varies between industries

Question 10

what is the formula for Return on Equity?

Answer 10

(Operating profit ÷ total equity) x 100

Question 11

what is the formula for current ratio?

Answer 11

current assets ÷ current liabilities

Question 12

what is the formula for acid test ratio?

Answer 12

(current asses - stock) ÷ current liabilities

Question 13

evaluate current ratio:

Answer 13

• ratio of 1.5-2.0 = efficient management of working capital
• below 1 = cash problems
• above 3 = too much working capital

Question 14

evaluate acid test ratio:

Answer 14

• better indicator of liquidity problems for inventory holding businesses
• significantly less than 1 = Very bad

Question 15

what is the formula for asset turnover?

Answer 15

sales rev ÷ net assets
net assets = assets - liabilities

Question 16

what is the formula for stock turnover?

Answer 16

(stock (inventories) ÷ cost of sales) x 365

Question 17

evaluate stock turnover?

Answer 17

• higher number = better

Question 18

evaluate asset turnover

Answer 18

• higher number = better, as it implies assets are being used in a more efficient way

Question 19

what is the formula for gearing?

Answer 19

(non-current liabilities ÷ (total equity + non-current liabilities)) x 100

Question 20

evaluate gearing?

Answer 20

• 50%+ = highly geared, so more debt, so greater financial risk
• 20-50% = normal/optimal
• 20%- = low risk

being highly geared means less capital is required by investors and is easy to pay investors if profit and cashflows are strong

being lowly geared means less risk of being in debt, and business has capacity to take on debt if needed

Question 21

how can a business reduce its gearing ratio?

Answer 21

• pay off long term debts
• increase shares
• reinvest retained profit instead of paying dividends

Question 22

what is the formula for interest cover?

Answer 22

operating profit ÷ interest payable

Question 23

evaluate interest cover

Answer 23

• higher the number the better (business can afford interest)

Question 24

what is the formula for receivables (aka debtor days)?

Answer 24

(trade receivables ÷ sales rev) x 100

Question 25

what is the formula for payable (aka creditor days)?

Answer 25

(trade payables ÷ cost of sales) x 100

Question 26

evaluate receivable days

Answer 26

• shows average time customer has to pay business
• look for trends and changes
• compare w competitors
• you want this to be LOW

Question 27

evaluate payable days

Answer 27

• you want this to be HIGH
• can look at current/acid test ratio about issues paying creditors

Question 28

what is the formula for dividend per share?

Answer 28

total dividends paid ÷ number of shares per issue

Question 29

evaluate dividend per share?

Answer 29

+ basic calculation which identifies return per share
- doesn’t show how much you paid for the share

Question 30

what is the formula for dividend per yield

Answer 30

(dividend per share ÷ share price) x 100

Question 31

evaluate dividend per share

Answer 31

• high yield might suggest undervalued share prices or a possible dividend cut
• shareholders look at this when deciding to invest or not

Question 32

what is the formula for earnings per share?

Answer 32

profit after tax ÷ number of shares issued

Question 33

what is the formula for price earnings per ratio

Answer 33

market share price ÷ earnings per share

Question 34

what is the formula for dividend cover?

Answer 34

profit after tax ÷ dividends

Question 35

what does earnings per share tell us?

Answer 35

what each share earned in a financial year per share

Question 36

what does price earnings ratio tell us?

Answer 36

measure of confidence about what the shares will earn

Question 37

what does dividend cover tell us?

Answer 37

how many times dividends can be paid from net profit

Question 38

evaluate dividend cover

Answer 38

• 1+ = can be dividends
• 2+ = very good
• 1.5- = concern
• 1- = do not invest