financial ratios

Question 1

return on equity

Answer 1

measures the return on the owner’s investment in the business

the higher the better

can be improved by increasing profits or reducing owners investment in the business

Question 2

return on total assets

Answer 2

indicates how effectively assets have been used to generate profits

the higher the better

it can be improved by selling unproductive assets and utilising assets more effectively

Question 3

profit margin

Answer 3

measures the percentage of sales that is generated into profit

the higher the better

can be improved by increasing sales and decreasing expenses

Question 4

expense

Answer 4

shows the proportion of the expense category to revenue

the lower the better

can be improved by decreasing expenses and increasing revenue

Question 5

gross profit margin

Answer 5

indicates the mark-up applied on products sold

Higher is better

can be improved by increasing prices or decreasing cogs

Question 6

quick ratio (acid test)

Answer 6

an indication of immediate liquidity, within 90 days

recommended between 1:1 - 2:1

can be improved by selling inventory and acquiring external financing

Question 7

working capital (current ratio)

Answer 7

an indication of short-term liquidity within the year

recommended to be between 1.5:1 to 2:1

can be improved by increasing sales and reducing current liabilities

Question 8

debtor turnover

Answer 8

indicates how quickly credit sales are converted into cash and the effectiveness of debtor management

Recommended for average days to be within the payment terms

can be improved by offering discounts for early payment, and fees for late payment

Question 9

inventory turnover

Answer 9

indicates how quickly stock is sold within a period
a fast turnover indicates high sales volume and effective control of inventory

faster is better

can be improved by more effective control of inventory levels, using jit, just in time system and enhancing inventory forecasting

Question 10

debt ratio

Answer 10

indicates to what extent assets are being leveraged or purchased using debt finance

lower is better

can be improved by using more equity as a source of finance

Question 11

debt/equity

Answer 11

indicates a businesses gearing. shows how much of the bussines has been financed by debt,

lower is better

can be improved by using more equity as a source of finance

Question 12

times interest earned

Answer 12

shows the business’s ability to pay its interest on debt

higher is better

can be improved by obtaining lower interest rates on debt