interpreting ratios

Question 1

interpreting liquidity ratios

Answer 1

• liquidity ratios measure the ability of a business to use its assets to meet its short term financial obligations
• liquidity is vital to the survival of the business, however too high may mean the business is not using its cash productively
• the higher the current ratio, the more liquid the business is

i. e. it has sufficient short term current assets to pay its short term debts
- the acid test ratio doesn’t take into account stock so its a more accurate measure of liquidity

Question 2

how to improve liquidity ratios?

Answer 2

• improve cash flow
• ensure effective stock control systems are in place
• pay suppliers on time
• avoid loans that overstretch the business

Question 3

interpreting profitability ratios

Answer 3

• measures the amount of profit generated from each £ of gross profit and each £ of net profit
• profit margins: measure how much profit is generated by the sale of one unit of output
• improved PM means business is making more profit from each sale
• ROCE: the business would want ROCE to be greater than the rate it pays for its borrowed funds

Question 4

how to improve profitability ratios

Answer 4

• GPM: reduce the cost of sales
• NPM: take steps to reduce business expenses including labour, energy, and raw material costs
• ROCE: increase the net profit of the business; increase gross profit and reduce expenses (this in turn will have the benefit of increasing both gross and net profit margins)

Question 5

interpreting performance ratios

Answer 5

• performance measures relate to how well the business is using its resources
• if labour productivity improves, it means each worker is producing, on average, more units of output in a given period of time
• a short inventory turnover period is generally preferred because holding inventories involves inventory holding costs as well as no sales revenue being generated from the stock

Question 6

how to improve performance ratios

Answer 6

• labour productivity: improve training of the workforce; reduce the size of the workforce and increase investment in capital equipment
• inventory turnover: improve inventory control system; increase sales
  carrying too little stock can result in a loss of sale; price increases in supplies can increase the costs of purchasing stock; take account of seasonal fluctuations in sales