Interpruting Financial Statements Flashcards
Profability & Efficiency Ratios, Liquidity Ratios, Use of Resources, Financial Position, Assessment, Limitations of Ratio Analysis, Explaining Ratios
1
Q
Name the 7 profitability and efficiency ratios?
A
- Gross Profit Percentage (%)
- Operating Profit Percentage (%)
- Expenses/Revenue Percentage (%)
- Asset Turnover (Net Assests)
- Return on Capital Employed (ROCE)
- Asset Turnover (Non-current Assets)
- Return on Shareholders’ Funds
2
Q
Why are gross and operating profit percentages used?
A
- They are used to make pricing decisions
- Increased sales prices relative to direct costs will result in increased profit margin
- Decreasing margins may be due to increased costs or reduced sales prices - perhaps an increased market share
- Differences in both margins allow you to estalish if the changes are direct or casued by overheads.
3
Q
Why is Expenses/Revenue percentage used?
A
- Measures a specified expense as a percentage of revenue
- A rise could indicate a problem with cost control, as not all expenses are expected to rise in line with revenue.
4
Q
What does Asset Turnover (Net Assets) show?
A
- Measures the turnover generated for every £1 of Assets employed.
- Helps assess how efficiently a company utilises its assets to generate revenue.
- A higher ratio indicates better asset utilisation and operational efficiency.
- A lower ratio may suggest potential inefficiencies that require attention.
5
Q
Why is Return on Capital Employed (ROCE) used?
A
- To show how much profit is generated for every £1 of assets employed.
- Assess a company’s profitability and efficiency in generating returns relative to the capital invested/assets in the business.
- A higher ROCE indicates that the company is generating greater profits per unit of capital employed, suggesting efficient use of resources.
- A consistently high ROCE indicates a sustainable business model and effective capital allocation strategies.
6
Q
What does the Asset Turnover (Non-current Assets) show?
A
- The return generated per £1 of Non-current Assets.
- Measures a company’s efficiency in generating revenue relative to its non-current assets.
- A higher ratio indicates the company is effectively utilizing its long-term assets to generate sales
- A lower ratio suggests that the company may not be efficiently utilizing its non-current assets to generate revenue
7
Q
What does the Return on Shareholders’ Funds (ROSF) show?
A
- The return generated per £1 of shareholders’ equity.
- Measures the profitability of a company relative to the funds provided by shareholders.
- A higher ROSF indicates efficient utilisation of shareholders’ funds and effective management of the company’s resources.
- A higher ROSF indicates better returns on shareholders’ investments, which enhances shareholder value and can attract potential investors.
8
Q
What are the 2 liquidity ratios?
A
- Current Ratio
- Quick Ratio
9
Q
What does the Current Ratio indicate?
A
- Used to evaluate a company’s short-term liquidity and its ability to meet its short-term financial obligations.
- Short-Term Solvency: assesses the company’s ability to cover its short-term liabilities with its short-term assets.
- Stability: A healthy Current Ratio signifies that the company has a cushion of current assets to handle unexpected expenses or disruptions in cash flows.
- Inventory and Receivables Management: A high Current Ratio may indicate excessive levels of inventory or outstanding receivables, while a low ratio may suggest inventory shortages or delays in collecting receivables
10
Q
What does the Quick Ratio show?
A
- Used to evaluate a company’s short-term liquidity and its ability to meet its immediate/near-term financial obligations without relying on inventory.
- It’s a more stringent measure of liquidity compared to the Current Ratio because it excludes inventory, which may not be easily converted into cash.
- Ability to Cover Short-Term Liabilities:: measures the company’s ability to cover its short-term liabilities with its most liquid assets, such as cash or cash equivalents, and accounts receivable.
- Risk Management: A higher Quick Ratio indicates a stronger liquidity position and suggests that the company has a sufficient buffer of liquid assets to meet its short-term obligations.
11
Q
What are the 4 Use of Resources ratios?
A
- Inventory holding period and turnover
- Receivable’s collection period
- Payable’s payment period
- Working capital cycle
12
Q
What are the 2 Financial position ratios?
A
- Gearing
- Interest cover
13
Q
Explain Gearing?
A
- Shows the percentage of a company’s capital structure that is funded by debt compared to equity
- Indicates the reliance on borrowing to finance operations.
- Financial Risk Assessment: Gearing helps assess the company’s financial risk and solvency by evaluating its debt levels relative to equity. High Gearing means a reliance on debt financing, which can increase returns and financial risk
- Investment Decision Making: Investors, creditors, and management use gearing ratios to evaluate the company’s risk profile, financial health, and strategic decision-making.
- Capital Structure Management: Gearing influences decisions regarding capital structure, dividend policy, and investment priorities. High Gearing results in greater interest charges and less profits for shareholders.
14
Q
What does the Interest Cover show?
A
- A company’s ability to meet its interest charges from its operating profit.
- Risk of Default: A higher Interest Cover ratio signifies a lower risk of default on debt payments
- Lender Confidence: Lenders and creditors use the Interest Cover ratio to assess the company’s creditworthiness and ability to repay its debts.
- Operating Performance: The Interest Cover ratio provides insights into the company’s operating performance and profitability.
15
Q
What are the 5 limitations of ratio analysis?
A
- Hisorical information - all financial statements are based on historical information
- Comparison to other companies - you aren’t comaparing on a like for like basis
- Window dressing - a comapny can acomplish things at the year end or at the start of the new year, which can skew the ratios.
- Non financial information - no consideration of the qualitative impacts of the business.
- Markets and Size - similar companies have different market sizes making their ratios harder to compare.
