L6 - Ratio Analysis

Question 1

To understand more about a firm from its accounts, what questions need answering?

Answer 1

• Is the company being run efficiently and effectively? –> How good are the managers, in comparison with other firms and other years
• Will other firms supply goods on credit? –> is the company able to continue trading and paying its bills (payables)?
• Does the business require further funds? would investors/lenders see it as safe in terms of the return of their money and attractive in terms of return on their money
• How is the capital structured? –> e.g. cheap debt or more costly equity capital, what are the risks

Question 2

What are ratios useful for?

Answer 2

• they help us to identify which questions to ask, rather than provide the answer
• They help to highlight the financial strengths and weaknesses of a business, but cannot explain why those strengths or weaknesses have occurred-
• They provide a starting point for further analysis
• Only a detailed investigation will reveal the underlying reasons

Question 3

How are the financial ratio classified?

Answer 3

MANAGEMENT OF THE ORGANISATION –> how well are management using the available resources

• Profitability
• Efficiency
• Liquidity

CAPITAL STRUCTURE –> does the company have the right balance between ‘cheap’ debt & equity
- Gearing

RETURNS TO OWNERS –> how does the return compare to other investment opportunities
-Investment

Question 4

What are the Profitability ratio?

Answer 4

• Businesses generally exist with the primary purpose of creating wealth for their owners,
• Profitability ratio provide some indication of the degree of success in achieving this purpose
• They normally express the profit made in relation to other key figures in the financial statements or to some business resource
• The 6 profitability ratios are:
• Gross profit margin
• Operating profit margin
• ROCE - Return on Capital Employed
• ROSF- Return on Shareholders’ Fund
• Overheads
• Trend

Question 5

Why is there a need for comparison of ratios?

Answer 5

• Merely calculating a ratio will not tell us very much about the position or performance of a business
• if a ratio is worked out there need to be a benchmark for comparison so it can be interpreted and evaluated
• The areas of comparisons are as follows:
• Past Periods
• Similar businesses
• Planned performance

Question 6

How can ratios be compared to Past Periods?

Answer 6

• By comparing the ratio that have calculated with the same ratio, but for a previous period, it is possible to detect whether there has been an improvement or deterioration in performance
• It is often useful to track particular ratios over time (e.g. 5-10 years) to see whether it is possible to detect trends
• the comparison of ratios from different periods brings certain problems, however, In particular there is always the possibility that trading condition were quite different in the period being compared
• There is the further problem that, when comparing the performance of a single business over time, operating inefficiencies may bot be clearly exposed
• Finally, there is the problem that inflation may have distorted the figure on which the ratios are based
• Inflation can lead to an overstatement of profit and an understatement of asset values

Question 7

How can ratios be compared to Similar Businesses?

Answer 7

• In a competitive environment, a business must consider its performance in relation to that of other businesses operating in the same industry
• Survival may depend on its ability to achieve comparable levels of performance
• A useful basis for comparing a particular ratio, therefore, is the ratio achieved by similar businesses during the same period
• This basis is not, however, without its problems, competitors may have different year-ends and so trading condition may not be identical
• They may also have different accounting policies which can have a significant effect on reporting profits adn asset values (e.g. different methods of calculating depreciation or valuing inventories )
• Finally, it may be difficult to obtain the financial statement of competitor businesses
• Sole proprietorship and partnerships, for example, are not obliged to make their financial statements available to the public in the case of limited companies, there is a legal obligation to do so
• However, a diversified business may no provide a breakdown of activities that is sufficiently detail to enable comparisons with other businesses

Question 8

How can ratios be compared to Planned performance?

Answer 8

• Ratios may be compared with targets that management developed before the start of the period under review
• The comparison of actual performance with planned performance can be useful way of assessing the level of achievement attained
• Indeed, planned performance often provides the most valuable benchmark against which managers may assess their own business
• However, planned performance must be based on realistic assumption if it is to be worthwhile for comparison purposes
• Planned , or target, ratios may be prepared for each aspect of the business’s activities. When developing these ratios, account will normally be taken of past performance and the performance of other businesses
• This does not mean, however, that the business should seek to achieve either of these levels of performance, Neither of them may provide an appropriate target
• We should bear in mind that those outside the business do not normally have access to the business’s plan
• For such people, past performance and the performance of other, similar, business may provide the only practical benchmarks

Question 9

What is the Gross profit margin and how do you calculate it?

Answer 9

• The gross profit margin ratio relates the gross profit of the business to the sale revenue generated for the same period
• gross profit represents the difference between sales revenue and the cost of sales
• the ratio is therefore measure of profitability in buying (or producing) and selling goods or services before any other expenses are taken into account
• As cost of sales represents a major expense for many businesses, a change in this ratio can have a significant effect on the ‘bottom line’ (that is, the profit for the year)
• The calculation for Gross Profit margin is:
• Gross profit margin = (gross profit/ Sales revenue) x 100

Question 10

What can the Gross Profit Margin tell you?

Answer 10

• An investigation is needed to discover what caused the increases in both cost of sales and operating expenses, relative to sales revenue
• this will involve checking on what has happened with sales and inventories prices over the two years
• Similarly, it will involves looking at each of the individual areas that make up operating expenses to discover which ones were responsible for the increase, relative to sales revenue
• It involves looking at each of the individual areas that make up operating expenses to discover which ones were responsible for the increase, relative to sales revenue

Question 11

What is the Operating Profit Margin and how do you calculate it?-

Answer 11

• Operating profit (that is, profit before interest and taxation) is used in this ratio as it represents the profit from trading operations before interest payable is taken into account
• It is normally measure of operational performance, when making comparisons. This is because differences arising from the way in the business is financed will not influence the measure
• the calculation of Operating Profit Margin is:
• Operating profit margin = (operating profit/ Sales revenue) x 100

Question 12

What can the operating profit tell you?

Answer 12

• The ratio compares one output of the business (operating profit) with another output (sales revenue). It can vary considerably between types of business. Supermarkets for example tend to operate on low prices and therefore low operating profit margin –> this is done in an attempt to stimulate sales and thereby increase the total amount of operating profit generated
• Jewellers, on the other hand, tend to have high operating profit margins but have much lower levels of sales
• Factors such has the degree of competition the type of customer, the economic climate and industry characteristics (such as the level of risk) will influence the operating profit margin of a business

Question 13

What is Return of Capital Employed (ROCE) and how do you calculate it?

Answer 13

• The return on capital employed ratio is a fundamental measure of business performance
• This ratio expresses the relationship between the operating profit generated during a period and the average long-term capital invested in the business
• The calculation of Return of Capital Employed is:
• ROCE = ((Operating Profit)/(Share Capital + Reserves + Non-current Liabilities) x 100

Question 14

What can Return of Capital Employed (ROCE) tell you?

Answer 14

• Note, in this case, that the profit figure used in the operating profit (that is, the profit before interest and taxation) because the ratio attempts to measure the returns to all suppliers of long-term finance before any deduction for interest payable on borrowings, or payments of dividends to shareholders
• ROCE is considered by by many to be a primary measure of profitability,
• It compares inputs (capital invested) with outputs ( operating profit) so as to reveal the effectiveness with which funds have been deployed
• Once again an average figure for capital employed should be used where the information is available
• This ratio tells much the same story as ROSF, namely a poor performance, with the return on the assets being less that the rate that the business pays for most of its borrowed funds

Question 15

What is Return on Ordinary Shareholders’ Funds (ROSF) and how do you calculate it?

Answer 15

• The return on ordinary shareholders’ funds ratio (ROSF) compares the amount of profit for the period available to owners, with their average investment in the business during the same period
• the profit for the year (less any preference dividend) is used in calculating the ratio, because this figure represents the amount of profit that is attributable to the owners
• the Calculation of Return on Ordinary Shareholder’s Funds (ROSF) is:
• ROSF = ((Profit for the Year (less any preference dividend))/(Ordinary share capital + Reserves)) x 100
• Profit for the year can also be Profit after tax

Question 16

Why do we use an average figure for Return on Ordinary Shareholder’s Fund (ROSF) ?

Answer 16

• Note that when calculating the ROSF, the average of the figures for ordinary shareholders funds as at the beginning and at the end of the year has been used –> This is because an average figure is normally more representative
• The amount of shareholder’s funds was not constant throughout the year, yet we want to compare it with the profit earned during the whole period
• the easiest approach to calculating the average amount of shareholders’ funds is to take a simple average based on the opening and closing figures for the year
• This is often the only information available
• Averaging is normally appropriate for all ratios that combine a figure for a period (such as profit for the year) with one taken at a point in time (such as shareholders’ funds)
• Where not even the beginning-of-year figure is available, it will be necessary to rely on just the year-end figure
• This is not ideal but, when this approach is consistently applied it can still produce useful ratios

Question 17

What can the Return on Ordinary Shareholder’s Fund (ROSF) tell us?

Answer 17

• Broadly, businesses seek to generate as high a value as possible for this ratio
• This is provided that it is not achieved at the expense of jeopardising future returns by, for example taking on more risky activities
• Return on total equity (ROE) is used to measure the overall profitability of the company from preference and common stockholders’ point of view. The ratio also indicates the efficiency of the management in using the resources of the business.
• Higher ratio means higher return on shareholders’ investment and a lower ratio indicates otherwise. Investors always search for the highest return on their investment and a company that has higher ROE ratio than others in the industry attracts more investors.

Question 18

How do you calculate overheads Profitability Ratio?

Answer 18

• the ratio of Overheads (expenses to Revenue’ shows management’s ability to control costs in the business
• the calculation for Overheads is:
• Overheads = ((Operating/Admin Cost)/(Revenue)) x 100

Question 19

How do you calculate Trend Profitability Ratio?

Answer 19

• this involves looking at the performance trend of the business, are things are improving ,stable, stagnant, or declining?
• the calculation for Trends is:
• ((increase/Decrease in Operating Profit)/(Last year’s Operating Profit)) x 100

Question 20

Why could the the interpretation of the ratios of Overheads and Trends be subjective?

Answer 20

• For example, Shareholders might think profit have stagnated and that management need replacing
• Alternatively, managers might prefer to describe performance as ‘solid’ or ‘stable’, say, during a period of industry consolidation, and their strategy as deliberately ‘pausing for breath’ before, say, their next big marketing push
• For example, Compass changed its strategy after a period of expansion by acquisition in 2002

Question 21

What are the Efficiency ratios?

Answer 21

Efficiency ratios are used to try to assess how successfully the various resources of the business are managed

• How good are we at using our working capital
• The 5 efficiency ratios are:
• Average inventory turnover period
• Average Settlement period receivables
• Average Settlement period for payables
• (Asset Turnover) Sales Revenue to Capital Employed Ratio
• Revenue per employee

Question 22

What is Average Inventories’ Turnover period and how do you calculate it?

Answer 22

• Inventories often represent a significant investment for a business
• The average inventories turnover period ratio measure the average period for which inventories are being held
• the Calculation for Average Inventories’ Turnover period is:
• ((Average Inventories held)/(Cost of Sales)) x 365
• the average inventories for the period can be calculated as a simple average of the opening and closing inventories levels for the year
• In case of a highly seasonal business, however, where inventories levels vary considerable over the year, a monthly average would be more appropriate
• Such information may not be available, this point about monthly average is equally relevant to any asset or claim that tends to vary over the reporting period., including receivables and trade payables

Question 23

What can the Average Inventories’ Turnover Period tell you?

Answer 23

• A business will normally prefer a short inventories’ turnover period to a long one, because holding inventories has costs, for example, the opportunity cost of the funds tied up
• When judging the amount of inventories to carry, the business must consider such things as the likely demand for them, the possibility of supply shortages, the likeihood of price rises, the amount of storage space available and their perishability or susceptibility to obsolescence
• the question is ‘How good are management at moving inventory through the system? we might question whether customers want to buy our goods given the inventory holding time?
• If it’s too long, perishable goods might decay,fashion goods go out of style and technology products become obsolete
• too short and sufficient inventory may comprise customer and choice and instant delivery

Question 24

What is the Average Settlement Period for Trade Receivables and how do you calculate it?

Answer 24

• Selling on credit is the norm for most businesses, expect for retailers
• trade receivables are a necessary evil
• A business will naturally be concerned with the amount of funds tied up in trade receivables and try to keep this to a minimum
• The speed of payment can have significant effect on the business’s cash flow
• The average settle period for trade receivables ratio calculates how long, on average, credit customers take to pay amounts that they owe the business
• The calculation for the Average Settlement Period for Trade Receivables is:
• ((Average Trade Receivables)/(Credit Sales Revenue)) x 365
• Assume all sales are credit unless told otherwise

Question 25

What can the Average Settlement Period for Trade Receivables tell you?

Answer 25

• How good are we at collecting debts from out customers/receivables?
• A business will normally prefer a shorter average settlement period to a longer one as, once again, funds are being tied up that may be used for more profitable purposes
• Although this ratio can be useful, it is important to remember that it produces an average figure for the number of days for which debts are outstanding
• This average may be badly distorted by for example, a few large customers who are very slow or very fast payers
• the only time a reduction in Settlement period be undesirable` if the reduction were achieved at the expense of customer goodwill or through high out-of-pocket cost

Question 26

What is Average Settlement Period for Trade Payables and how do you calculate it?

Answer 26

• The average settlement period for trade payables ratio measures how long, on average the business takes to pay those who have supplied goods and services to it on credit
• The calculation for the Average settlement period for trade payables is:
• ((Average Trade Payables)/(Credit Purchases)) x 365
• This ratio provides an average figure, which, like the average settlement period for trade receivables ratios, can be distorted by the payment period for one or two large suppliers
• Note: cost of revenue is a substitute for credit purchases if there is no other information available. In other words we assume that everything has been purchased on credit

Question 27

What can the Average Settlement Period for Trade Payables tell you?

Answer 27

• To what extent do out suppliers subsidise our working capital funding?
• A more direct question might be, how ‘mean’ are we at settling our bills?
• As trade payables provide a free source of finance for the business, it is perhaps not surprising that some businesses attempt to increase their average settlement period for trade payables
• Such a policy can be taken too far, however, and can result in a loss of goodwill of suppliers
• Small businesses often suffer acute cash flow problems because large business customers refuse to pay within a reasonable period
• This has led the UK government to introduce the Prompt Payment Code to help small businesses
• Large businesses do not have to sign up to this Code, which sets standards for payment practices, but they are actively encourage to do so –> To date, however, the Code has achieved only limited success,

Question 28

What is Asset Turnover (Sales Revenue to Capital Employed) and how is it calculated?

Answer 28

• THE sales revenue to capital employed ratio examines how effectively the assets of the business are being used to generate sales revenue
• the calculation for Asset Turnover is:
• ((Sales Revenue)/(Share Capital+Reserves+ Non-Current Liabilities))
• A variation of this formula is to use the total assets less current liabilities (which is equivalent to long-term capital employed) in the denominator

Question 29

What can Asset turnover (Sales Revenue to Capital Employed) tell you?

Answer 29

• How hard are management working (using the assets? In other words, for every £1 that is invested in assets, how many £s’ worth of sales)
• Generally speaking, a higher sales revenue to capital employed ratio is preferred to a lower one
• A higher ratio will normally suggest that assets are being used more productively in the generation of revenue
• However, a very high ratio may suggest that the business is overtrading on its assets.
• in other words, it has insufficient assets to sustain the level of sales revenue achieved
• When comparing the sales revenue to capital employed ratio for different businesses, factors such as the age and condition of assets held, the valuation bases for assets and whether assets are leased or owning outright can complicate interpretation

Question 30

What is Sales Revenue per Employee and how do you calculate it?

Answer 30

• The Sales Revenue per Employee Ratio relates sales revenue generated during a reporting period to a particular business resource - labour, It provide a measure of the productivity of the workforce
• The calculation for Sales Revenue per Employee is:
• ((Sales Revenue)/(Number of Employees))

Question 31

What can the Sales Revenue per Employee tell you?

Answer 31

• Generally businesses would prefer a high value for this ratio, implying that they are deploying their staff efficiently

Question 32

What is the working capital cycle?

Answer 32

• Organisations have a circular cash flow cycle and this can be used to illustrate the cumulative effect of the individual working capital ratio in days
• the significance of working capital is that its rate of turnover drives the profitability of the business and imbalances can lead to cash shortages or a lack of inventory with which to trade
• during any period of operation it is likely that imbalances between cash inflows and outflows will arise
• Seasonal Deficits and surpluses have to be managed and the first step in the process is to look ahead and prepared a cash budget for:
• Each day of the next week, Each week of the next month, Each month of the next year

Question 33

How do you work out the total cycle time?

Answer 33

- The cycle contains 6 points:
1 - Bank Account
2- Payables
3- Purchases
4- Inventory days
5- Revenue
6- Receivables days
- add up all the day it takes to go through this cycle ( with Payables being a negative number)
- If the number is negative the supplier is providing those days of net financing, they are borrowing money to fund the business

Question 34

what is the relationship between Profitability and Efficiency?

Answer 34

• We can view ratio analysis as a pyramid of ratios
• ROCE at the top, can be split into the two secondary ratios of Operating Profit Margin and Asset, For example, a company may have a satisfactory ROCE, despite a low Operating Profit margin IF its Asset Turnover is High e.g. the Ryanair business model
• and similarly low asset turnover can be overcome by a relatively high operating profit margin
• In many areas of retail and distribution e.g. supermarkets and delivery services), operating profit margins are quite low, but the ROCE can be high , provided that assets are used productively ( that is, low margin ,high sales revenue to capital employed)
• Operating Profit can be broken further down to Overhead/Revenue –> which can be further be broken down into Property costs/Revenue and Admin. Costs/Revenue
• Asset Turnover can be broken down further to Working Capital –> which can further be broken down into Inventory turnover, Receivables and Payables

Question 35

How is ROCE related to Profitability and Efficiency?

Answer 35

• We can get ROCE from operating profit margin (Operating profit/Sales Revenue) multiplied by Asset Turnover (Sales Revenue/Long-term capital employed)
• By breaking down the ROCE ratio in the manner, we highlighted the fact that the overall return on funds employed within the business will be determined both by profitability of sales by efficiency in the use of capital

Question 36

What are the Liquidity Ratios?

Answer 36

• Liquidity ratios are concerned with the ability of the business to meet its short-term financial obligations
• the three Liquidity ratios are:
• the Current ratio
• the acid test/ quick ratio
• Operating cash flows to maturing obligations

Question 37

What is the Current Ratio and how do you calculated it?

Answer 37

• the current ratio compares the ‘liquid assets’ ( that is, cash and those assets held that will soon be turned into cash) of the business with the current liabilities
• the calculation for the Current Ratio is:
• Current Assets/Current Liabilities

Question 38

What can the Current Ratio tell you?

Answer 38

• it seems to be believed by some that there is an ‘ideal’ current ratio (usually 2 times or 2:1) for all businesses
• However, this is not the case, different types of business require different current ratios
• A manufacturing business, for example, will normally have a relatively high current ratio because it will hold inventories of finished goods, raw materials and work-in-progress
• It will also sell goods on credit, thereby giving rise to trade receivables
• A supermarket chain ,on the other hand, will have relatively low ratio, as it will hold only fast-moving inventories of finished goods and its sales will be for cash rather than on credit
• the higher the current ratio, the more liquid the business is considered to be
• As liquidity is vital to the survival of a business, a higher current ratio might be thought to be preferable to a lower one
• If a business has a very high ratio, however, it may be that excessive funds are tied up in cash or other liquid assets and are not, therefore, being used as productively as they might otherwise be
• also only a proportion of the value of those assets might be turned into cash fast enough to satisfy the total payables

Question 39

What is the Acid Test/Quick Ratio and how can you calculate it?

Answer 39

• similar to the current ratio, but it represents a more stringent test of liquidity
• For many businesses, inventories cannot be converted into cash quickly, as a result it is usually better to exclude this particular asset from this measure of liquidity
• the calculation for the acid test/quick ratio is:
• Acid Test Ratio= (Current assets - inventories)/(Current Liabilities)

Question 40

What can the Acid Test/Quick Ratio tell you?

Answer 40

• The ratio reflects the progressive difficulty of selling inventories of raw materials, work in progress and finished goods quickly to pay the total liabilities
• Unless sold at a bargain price for cash, such sales will likely become ‘ receivables’ for further periods of time and that will do little to alleviate an immediate liquidity problem
• The minimum level for this ratio is often stated as 1 times ( or 1:1; that is, current assets ( excluding inventories) equal current liabilities)
• However, for many highly successful businesses, it is not unusual for the acid test ratio to be below 1 without causing liquidity problems

Question 41

What is Operating Cash Flows to Maturing Obligations ratio and how do you calculate it?

Answer 41

• The operating cash flow ratio is a measure of how well current liabilities are covered by the cash flows generated from a company’s operations.
• The operating cash flow ratio can gauge a company’s liquidity in the short term. Using cash flow as opposed to income is considered a cleaner, or more accurate, measure since earnings can be manipulated.
• The calculation for Operating Cash Flows to Maturing Obligations is;
• (Operating Cash flows)/ (current Liabilities)

Question 42

what does the Operating Cash Flows to Maturing Obligations Ratio tell you?

Answer 42

• The operating cash flow ratio is a measure of the number of times a company can pay off current debts with cash generated within the same period.
• A high number (>1) indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities.
• A ratio less than one indicates the opposite: The firm has not generated enough cash to cover its current liabilities.
• To investors and analysts, a low ratio could mean that the firm needs more capital.
• However, there could be many interpretations, and not all are indications of poor financial health. For example, a firm may embark on a project that compromises cash flows temporarily but renders great reward in the future.

Question 43

What are the Gearing?

Answer 43

• Financial gearing occurs when a business is financed, at least in part, by borrowing rather than by owners’ equity
• The extent to which a business is geared ( that is, financed from borrowing) is an important factor in assessing risk
• Borrowing involves taking on commitment to pay interest charges and to make capital repayments
• Where the borrowing is heavy, this can be a significant financial burden; it can increase the risk of the business becoming insolvent
• Nevertheless, most businesses are geared to some extent
• Given the risks involved, we may wonder why a business would want to take on gearing
• One reason is that the owners have insufficient funds , so the only way to finance the business adequately is to borrow
• Another reason is that gearing can be used to increase the returns to owners
• This is possible provided the returns generated from borrowed funds exceed the cost of paying interest
• An effect of gearing is that returns to shareholders become more sensitive to changes in operating profit
• For a highly geared business, a change in operating profit will lead to a proportionately greater change in the ROSF ratio
• The two gearing ratios are:
• gearing ratio
• interest cover ratio

Question 44

What is an issue with high gearing?

Answer 44

• The higher a company’s leverage, the more the company is considered to be a risk
• A company with high gearing will be more vulnerable to downturns in the business cycle because the company must continue to service its debts regardless of how bad sales might be
• A greater proportion of equity provides a margin of safety and is seen as a measure of financial strength in uncertain times

Question 45

Which is best - Debt or equity?

Answer 45

• It may seem attractive to borrow from a bank at 5% when shareholders want 15% –>interest bearing debt is only attractive when interest rates and economic risks are low, but debt becomes high risk when interest rates rise and/or business conditions are uncertain
• However bank debts will likely be secured on assets and thus, will consequently increase the risk to shareholders of getting their money back - In which case shareholders will expect an even higher return on their investment e.g. 20%
• Its difficult to be prescriptive about gearing, most companies try to maintain a balance but the pendulum of preference tends to seeing between debt and equity over the course of each economic cycle
• When recession bites there tends to be a switch back to equity which does not carry contractual obligation to pay dividends to shareholders ever year
• There is no such thing as an ideal level as investors will have different perceptions of risk and their propensity to take risk across the economic cycle
• However, there is usually a benchmark to compare against using the ratios of companies in the same/similar industries

Question 46

Why is equity funding better for long-term investment?

Answer 46

• generally equity funding is best suited to funding long-term investments because a court order is required to pay back issued ordinary share capital - only profits can be paid out, and at the directors’ discretion
• This means that potential creditors and lenders can be assured that at least the ordinary share capital must remain in the company to offer a base line of protection against liabilities

Question 47

What issues need to be taken into account with Long-term vs. Short-term borrowing?

Answer 47

• Matching –> matching to asset type e.g. an oil refinery would require very long-term finance, a motor vehicle short term
• Flexibility –> Might require change? Say disposal of a vehicle sooner than anticipated
• Refunding risk –> The refunding risk increases interest rates
• Interest Rates –> Are rates likely to fall or rise? Are fixed rates preferable to variable rates? Which is cheaper at the time?

Question 48

What will the capital structure a firm choices at a time depend on?

Answer 48

• Types of investment that is proposed
• Expectations of shareholders and their attitudes to risk
• Existing and projected cost of debt (interest rate)
• Existing and proposed assets (value and saleability)

Debt and equity each have advantages and disadvantages; management’s task is to optimise the overall cost against risk, whilst preserving flexibility of action for the future

Question 49

What is the Gearing Ratio and how do you calculate it?

Answer 49

• The gearing ratio measures the contribution of long-term lenders to the long-term capital structure of a business
• We are essentially interested in what proportion of total long-term funding is interest bearing loan capital rather than equity
• there is no obligation to pay a return to shareholders in bad times
• However, a high proportion of debt can be good IF interest rates are low and profits are high and both states are expected to continue
• The Calculations for the Gearing ratio are:
  (( Non-current Liabilities)/(Share capital + Reserves + Non-current Liabilities)) x 100
  OR
  Debt/equity –> ((Non-current liabilities/( share capital + reserves))

Question 50

What is the Interest Cover Ratio and how do you calculate it?

Answer 50

• The interest cover ratio measure the amount of operating profit available to cover interest payables
• The calculation for the Interest Cover Ratio is:
• (Operating Profit)/(interest payable)

Question 51

What can the Interest Cover Ratio tell you?

Answer 51

• The higher the number means the more operating profit could fall before operating profit levels fail to cover payables
• The lower the level of operating profits coverage the greater the risk to lenders that interest payments will not be met
• There will also be a greater risk to the shareholders that the lenders will take action against
  the business to recover the interest due This is a somewhat crude, and potentially misleading, measure as we know form earlier topics that profits do not equal cash
• An alternative, and probably a more meaningful way is to use Operating Cash Flow instead of profit compared against interest payments

Question 52

What is a general overview of Ratio Analysis?

Answer 52

• Ratio analysis is:
• Only as good as the original information
• based upon historical data and thereby out of date
• possible biased (prepared by some else). Objectivity? Independence?
• Subject to problems with ‘creative’ accounting

Question 53

What are some limitation of Ratio Analysis?

Answer 53

• Quality of financial statements
• Inflation
• The restricted view given by ratios
• The basis for comparison
• Statement of financial position ratios

Question 54

How is Quality of Financial Statements a limitation of ratio analysis?

Answer 54

• Ratios will inherit the limitations of the financial statements on which they are based
• One limitation of financial statements is their failure to include all resources controlled by the business
• internally- generated goodwill and brands for example are excluded from the statement of financial position because they fail to meet the strict definition of an asset
• This means that, even though these resources may be considerable value, key ratios such as ROSF, ROCE and the gearing ratio will fail to acknowledge their presence

Question 55

How is Inflation a limitation of ratio analysis in terms of value of assets?

Answer 55

• A persistent, though recently less severe, problem, in most countries is that the financial results of businesses can be distorted as a result of inflation
• One effect of inflation is that the reported value of assets held for any length of time may bear little relation to current values
• Generally speaking the reported value of assets will be understated relative to current prices during a period of inflation
• This occurs because they are usually reported at their original cost (less any amounts written off for depreciation)
• A difference in, say, ROCE may simply be owing to the fact that assets shown in one of the statements of financial position being compared were acquired more recently

Question 56

How is inflation a limitation of ratio analysis in terms of profits?

Answer 56

• Another effect of inflation is to distort the measurement of profit
• In the calculation of profit, sales revenue is often matched with costs incurred at an earlier time
• This is because there is often a time lag between acquiring a particular resource and using it to help generate sales revenue
• For example. inventories may well be acquired several months before they are sold
• During a period of inflation, this will mean that the time of the sale
• The cost of sales figure is usually based on the historic cost of the inventories concerned
• As a result expenses will be understated in the income statement and this, in turn, means that profit will be overstated
• One effect of this will be to distort the profitability ratio discussed eariier

Question 57

How is The restricted view given by ratio a limitation of ratio analysis?

Answer 57

• It is important not to rely exclusively on ratios, thereby losing sight of information contained in the underlying financial statements
• some items reported in these statements can be vital in assessing position and performance
• For example the total sales revenue , capital employed and profit figures may be useful in assessing changes in absolute size that occur over time, or in assessing differences in scale between businesses,
• Ratio do not provide such information, When comparing one figure with another, ratios measure relative performance and position and, therefore provide only part
  of the picture
• When comparing two businesses, therefore, it will often be useful to assess the absolute size of profits, as well as the relative profitability of each business
• e.g. if Business A generates £1 mil operating profit and has a ROCE of 15% and Business B may generate £100,00 operating profit and have ROCE of 20%
  -Although \business B has a higher level of profitability, as measured by ROCE, it generates lower total operating profits and that fact should not be overlooked

Question 58

How is the Basis for Comparison a Limitation of Ratio Analysis?

Answer 58

• ratios are to be useful they require a basis for comparison
• Moreover, it is important that we compare like with like
• When comparison is with another business there can be difficulties
• No two businesses are identical: the greater differences between the businesses being compared, the greater the limitations of ratio analysis
• Furthermore, any differences in accounting policies, financing methods (gearing levels) and financial year-ends will add to the problems of making comparisons between business

Question 59

How is Statement of Financial Position Ratios a Limitation of Ratio Analysis?

Answer 59

• Because the statement of financial position is only a ‘snapshot’ of the business at a particular moment in time, any ratios based on statement of financial position figures, such as the liquidity ratios, may not be representative of the financial position of the business for the year as a whole
• it is common, for example. for a seasonal business to have a financial year-end that coincides with a low point in business activity
• Inventories and trade receivables may therefore be low at the year-end-
• As a result, the liquidity ratios may also be low
• A more representative picture of liquidity can only really be gained by taking additional measurements at the other points in the year

Question 60

When may a User comprehension of the Financial Statements and Ratio Analysis be compromised?

Answer 60

• different year ending between companies
• different accounting policies - maybe even changed between years
• untypical accounting period end dates e.g. Sparklers (fireworks ) where working capital levels will have seasonal sales and inventory cycles, such as New Year’s Eve and Bonfire Night (5th November)