Financial accounting ratios

Question 1

Name all 5 relevant profitability ratios

Answer 1

1. Return on capital employed.
2. Asset turnover
3. net profit margin.
4. Gross profit margin
5. Expenses as a % of sales

Question 2

Return on capital employed (ROCE) formula and meaning

Answer 2

PBIT / Equity + Long debt (Capital employed)

Effective measurement of how well a company is using all thats made available to it to create a profit.

A higher ROCE suggests a more efficient company.

Question 3

Asset Turnover formula and meaning

Answer 3

Revenue / capital employed

A higher number shows the company can effectively use its assets to generate revenue.
Low suggests internal problems.

Question 4

Net profit margin

Answer 4

Net profit / revenue

The amount of revenue which is true profit. Creates a profit margin. Highly affected by overhheads.

Question 5

Gross profit margin

Answer 5

Gross profit / revenue

The profit earned from the trading activities of the business.

Question 6

Expenses as a percentage of sales

Answer 6

Epense item / revenue

As the business grows, economies of scale should make this ratio decrease.
It shows if a business is using its revenue effectively.

Question 7

What are the two main liquidity ratios and discuss liquidity as a concept.

Answer 7

Current ratio
Liquid ratio

The ability of a business to meet its short-term liabilities as they fall due.

Businesses need cash to do so, but also consider highly liquid assets in calculations.

Net current assets = Current assets - current liabilities.

Question 8

Current ratio

Answer 8

Current assets / current liabilities

Measures the balance of current assets and liabilities, expressed as a ratio. You don’t want too much cash tied up in receivables (CA) or too many receivables (CL)

Question 9

Liquid ratio / Acid test / quick ratio.

Answer 9

Current assets - inventories / Current liabilities

The same as the current ratio but excludes inventories as to not skew result.

Question 10

What are the main four efficiency ratios?

Answer 10

1. Asset turnover
2. Inventory turnover
3. Receivables collection period.
4. Payable payment period.

Efficiency ratios put a time - frame on how quickly a business can convert its assets into cash.

Question 11

Inventory turnover

Answer 11

Inventories / cost of sales x 365

Inventories as an average of opening and closing, or closing if no opening figure is given.

Question 12

Receivables collection period

Answer 12

Trade receivables / credit sales x 365

Measure of how long credit customers take to pay their bill.

Credit sales might not be available, so total sales is used.
An average of opening and closing receivables is a good denominator.

Question 13

Payable payment period

Answer 13

Trade payable / credit purchases x 365

If credit purchases not available, we use COS.

Provides a useful indicator of credit period taken from the supplier.

Question 14

The working capital cycle

Answer 14

Estimates the time taken to convert cash back into cash through the operating cycle.

Inventory turnover + Receivables collection period - payables payment period.

Question 15

What are the three main gearing ratios?

Answer 15

1. gearing
2. Financial leverage.
3. Interest cover

Question 16

Capital gearing

Answer 16

Total borrowings / capital employed.

The proportion of capital financed by debt, rather than equity funds.

Higher suggests more risk, and lower EPS as payments for interest required.

Question 17

Debt / equity ratio

Answer 17

Total borrowings / shareholders funds x 100

The higher the percentage, the higher the risk.

Question 18

Interest cover

Answer 18

PBIT / Finance cost
Expressed as number of times.

Higher, less risky. As a companies gearing increases, the interest cover will decrease as interest payments (finance costs) increase

Question 19

What are the 7 main investor / stock market ratios?

Answer 19

1. Return on equity (ROE)
2. Earnings per share (EPS)
3. Price earnings ratio
4. dividend per share
5. dividend cover
6. dividend yield.
7. Total shareholder returns.

Question 20

Return on equity

Answer 20

Profit to shareholders / shareholders funds (equity)

Assesses the total returns going back to shareholders. expressed as a percentage.

Question 21

Earnings per share

Answer 21

Profit after tax and dividends / number of ordinary shares in issue.

Key ratio for equity investors.
Could be basic EPC (Shares in issue) OR
Diluted EPS (Shares being considered).

A high number reflects a better performance.

Based on historical information, doesn’t look at inflation.

Question 22

Earnings per share info

Answer 22

EPS Is the only ratio required to be shown on the face of a publicly traded companies’ income statement.

Some unusual items are excluded from the statistic. Disposals, write offs, etc.

EBITDA is often an alternative EPS figure.

Question 23

Price / earnings ratio

Answer 23

Market price per share / earnings per share

Question 24

Dividend cover

Answer 24

Profit after tax and preference dividends / Paid and proposed ordinary dividends .

How comfortably are dividends covered by profits.

Measured in a number of times. Higher is more coverage.

Question 25

Dividend yield

Answer 25

Dividend per share / market price per share x 100

Measures the annual return received by way of dividend, the higher the better for shareholders.

High dividend yield may mean the company is not retaining enough profit to invest in future growth.

Question 26

The limitations of ratio analysis

Answer 26

• They assume the faithful representation within the statements they are based on.
• The year end figures are used, which may not be reflective of common practice throughout the year.
• Inter-company comparisons may be invalidated. Each company may apply different accounting policies.
• Inflation, safe levels.