Interpreting Income Profitability Ratios Flashcards
What does ROCE tell us?
% return achieved on capital employed in the business
Shows how efficiently a company makes use of its available capital
The lower the ROCE the better, True or False?
False
What does the Profit Margin tell us?
How much profit made for each £ worth of sales
The higher the profit margin the better, True or False?
True
What does debt to equity ratio tell us?
Indicates the sensitivity of a company’s profits to change in interest rate
What number should the debt to equity ratio be?
Less than 1
What does a high debt to equity ratio mean?
May not be able to generate enough cash to satisfy obligations
What else can a low debt to equity ratio mean?
Not taking advantage of increased profits leverage would bring
What does interest cover tell us?
How many times interest bill can be paid out of current profits
What does the Current (working capital) Ratio tell us?
Cushion to protect company against downturn in sales
What number should the Current (working capital) Ratio ideally be?
Between 1.5-2
What could a low Current (working capital) Ratio indicate?
Potential future insolvency
What does the Liquidity Ratio (acid test) tell us?
Company’s ability to meet sudden cash call without relying on sale of stock
What does a Liquidity Ratio of more than 1 mean?
Sufficient short term cash to meet short term liabilities
What does a Liquidity Ratio of less than 1 mean?
May need to raise new finance
What does the Z score mean?
If negative = imminent insolvency
What makes up capital employed?
Total assets - current liabilities
What type of business might have a low liquidity ratio and why?
Supermarkets
Buy goods on credit sell for cash and have high turnover of stock
How does gearing levels affect profitability?
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
What are non-current assets?
Long term
used by company to generate revenues
Tangible assets - use in production and supply
Intangible - non-physical (trademarks)
What are current assets?
Bought to be resold within 12 months
Such as cash, stock, raw materials
Limitations of financial ratios to analyse a business?
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
What is quality of earnings?
Accurately represents trading performance of business
Not manipulated by accounting policies
Cash generation
Performance sustainable/repeatable
Goodwill items?
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
Exceptional items?
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
