Interpreting Income Profitability Ratios

Question 1

What does ROCE tell us?

Answer 1

% return achieved on capital employed in the business

Shows how efficiently a company makes use of its available capital

Question 2

The lower the ROCE the better, True or False?

Answer 2

False

Question 3

What does the Profit Margin tell us?

Answer 3

How much profit made for each £ worth of sales

Question 4

The higher the profit margin the better, True or False?

Answer 4

True

Question 5

What does debt to equity ratio tell us?

Answer 5

Indicates the sensitivity of a company’s profits to change in interest rate

Question 6

What number should the debt to equity ratio be?

Answer 6

Less than 1

Question 7

What does a high debt to equity ratio mean?

Answer 7

May not be able to generate enough cash to satisfy obligations

Question 8

What else can a low debt to equity ratio mean?

Answer 8

Not taking advantage of increased profits leverage would bring

Question 9

What does interest cover tell us?

Answer 9

How many times interest bill can be paid out of current profits

Question 10

What does the Current (working capital) Ratio tell us?

Answer 10

Cushion to protect company against downturn in sales

Question 11

What number should the Current (working capital) Ratio ideally be?

Answer 11

Between 1.5-2

Question 12

What could a low Current (working capital) Ratio indicate?

Answer 12

Potential future insolvency

Question 13

What does the Liquidity Ratio (acid test) tell us?

Answer 13

Company’s ability to meet sudden cash call without relying on sale of stock

Question 14

What does a Liquidity Ratio of more than 1 mean?

Answer 14

Sufficient short term cash to meet short term liabilities

Question 15

What does a Liquidity Ratio of less than 1 mean?

Answer 15

May need to raise new finance

Question 16

What does the Z score mean?

Answer 16

If negative = imminent insolvency

Question 17

What makes up capital employed?

Answer 17

Total assets - current liabilities

Question 18

What type of business might have a low liquidity ratio and why?

Answer 18

Supermarkets

Buy goods on credit sell for cash and have high turnover of stock

Question 19

How does gearing levels affect profitability?

Answer 19

When profits are high high gearing boosts ROE and when profits fall ROE falls further if company highly geared than of lower geared

If profits fall companies less likely to secure loans

Amy increase in interest rates will increase costs for highly geared companies

Question 20

What are non-current assets?

Answer 20

Long term

used by company to generate revenues

Tangible assets - use in production and supply
Intangible - non-physical (trademarks)

Question 21

What are current assets?

Answer 21

Bought to be resold within 12 months

Such as cash, stock, raw materials

Question 22

Limitations of financial ratios to analyse a business?

Answer 22

Historic information

Snapshot of the business at the time

Accounting differences/open to manipulation

Comparison between sectors difficult

Accounting practices differ and change over time

Consider full factors/soft factors - reputation/management style

Question 23

What is quality of earnings?

Answer 23

Accurately represents trading performance of business
Not manipulated by accounting policies
Cash generation
Performance sustainable/repeatable

Question 24

Goodwill items?

Answer 24

Intangible asset
Accounts for excess purchase price of another company
E.g. intellectual property and brand recognition
Determined by management
Subjective
May have overpaid on a takeover

Question 25

Exceptional items?

Answer 25

Related to day to day business - e.g. restructuring, cutting staff, merging divisions, disposal of assets
Reported separately so not seen as sudden surge/drop in sales/costs
Open to manipulation
Could hide ongoing problems