financial accounting - ratio analysis Flashcards
why are ratios useful?
- 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
what are the limitations of ratios?
- 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
how to calculate GPM (gross profit margin)?
(gross profit÷sales revenue) x 100
how to calculate NPM (net profit margin)?
(operating profit÷sales revenue) x 100
how to calculate Return on capital employed (ROCE)?
(operating profit÷(total equity+non-current liabilities)) x 100
how to calculate return on equity?
(operating profit÷total equity) x 100
what does GMP and NPM tell you?
how many pence from every pound of sales is gross profit
e.g. 40% = for every £1 of sales, 40p is GP
why is ROCE useful?
- evaluate overall performance
- provide a target return for individual target
- benchmark performance with competitors
why is ROCE limited?
- based on snapshot of business’ balance sheet
- varies between industries
what is the formula for Return on Equity?
(Operating profit ÷ total equity) x 100
what is the formula for current ratio?
current assets ÷ current liabilities
what is the formula for acid test ratio?
(current assets - stock) ÷ current liabilities
evaluate current ratio:
- ratio of 1.5-2.0 = efficient management of working capital
- below 1 = cash problems
- above 3 = too much working capital
evaluate acid test ratio:
- better indicator of liquidity problems for inventory holding businesses
- significantly less than 1 = Very bad
what is the formula for asset turnover?
sales rev ÷ net assets
net assets = assets - liabilities
what is the formula for stock turnover?
(stock (inventories) ÷ cost of sales) x 365
evaluate stock turnover?
- higher number = better
evaluate asset turnover
- higher number = better, as it implies assets are being used in a more efficient way
what is the formula for gearing?
(non-current liabilities ÷ (total equity + non-current liabilities)) x 100
evaluate gearing?
- 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
how can a business reduce its gearing ratio?
- pay off long term debts
- increase shares
- reinvest retained profit instead of paying dividends
what is the formula for interest cover?
operating profit ÷ interest payable
evaluate interest cover
- higher the number the better (business can afford interest)
what is the formula for receivables (aka debtor days)?
(trade receivables ÷ sales rev) x 100
