Learning Objective 7 - Chapter 9 (2 marks) Flashcards
what are the 5 frequently used ratios?
- Profitability ratio
- Productivity ratio
- Liquidity ratio
- Actiity (or Turnover ratio)
- Gearing ratio
what iare those most interested in a company want to do?:
- Analyse performance of a company in the past
- Draw conclusions from this past performance about what action should be taken now or in the future.
what are profitability ratios useful for?
This is one of the most important measures of a companies success ad its viability.
what are the main three types of profitability ratio?
Gross profit ratio
Net profit ratio
Return on capital employed
what does a decrease in the gross profit ratio usually indicate?
- Greater competition in the market causing lower selling prices and lower gross profit or an increase in the cost of purchases
what does an increase in the gross profit ratio usually indicate?
That the company is in a position to exploit the market and charge higher prices for its products, or that it is abe to source its purchases at a lower cost.
how do you calculate a gross profit ratio?
Gross Profit / Sales (revenue) x 100
How to you calculate a net profit ratio
Net profit / sales (revenue) x 100
what does the relationship between the gross profit and net profit ratios show?
This shows an indication of how well a company is managing its business expenses
if the net profit has decreased over time and the gross profit has remained the same, what might this indicate?
A lack of control over expenses
what is the reason for the multiplication of 100 when looking at ratios?
To express the figure as a percentage rather than a fraction
what does the net profit ratio show?
this shows how effective the management is i.e if it increases over time, or is high compared to competitors, it is often a sign of a skilled management, or vice versa, sign the company might have increasing overheads to cope with a future expansion
what is the calculation for the return on capital employed ratio?
Profit before interest charges and tax / (share capital + reserves + borrowings) x 100
what is a return on capital employed ratio?
This enables investors to see if an insurer is making money for them and make comparisons between companies. It is essentially to show the relationship of profits and capital employed; giving an indication of how effectively resources are financed and used.
regarding return on capital employed ratios, what are shareholders usually looking for?
At least two times the return they would get from putting their money into a low risk investment
why is the Return On Capital Employed (ROCE) an important measure?
- A low return could easily be wiped out in a recession
- When acquiring other businesses or moving into new markets, there should be a high ROCE to make it worthwhile for the capital providers.
- A persistently low ROCE in a business division may signal it is time to cut it.
what is a variation of ROCE?
Return on Equity (ROE)
what does Return On Equity (ROE) look at?
This looks at the return after tax attributable to shareholders as a ratio on equity.
what is the productivity ratio?
This ratio is a measure of production efficiency.
how is the productivity ratio calculated?
business outputs / business inputs
not to be confused with profitability as the two compare output vs input differently
How are profitability ratios and productivity ratios different?
profitability compares money value outputs vs inputs, and can be expressed either as an amount of money or as a ratio, However, productivity ratios use non monetary values, so does not use money as a measuring rod.
how can we measure the success of companies picking up debt owed to them?
They can do the calculation:
Trade receivables/debt owed to them divided by (/) sales x 365
what is the calculation that might show how much goods or services a company is purchasing on credit:
payables/creditors /(divided by) purchase x 365
The inventory/stock turnover period indicates the average number of days that inventory/stock is held?
Inventory/stock / (divided by) cost of sales x 365
what can a change in inventory / stock turnover period indicate?
A lengthening period may indicate that a company is slowing down trading or an unnecessary build up of stock/inventory
what are most bankruptcies a result of?
A lack of liquidity.
why is it that the main reason for bankruptcies is a lack of liquidity rather than lack of profitability?
Because shareholders rarely close down their company even after several years of losses, whereas the first creditor who is not paid on time will take the company to court and spring off the bankruptcy proceedings.
what are deemed liquid assets?
Assets that are either money (cash) or can be turned into money at short notice (like short-term deposits with banks, or short term securities)
what are the two main liquidity ratios?
- Current ratio
- Quick ratio
How is the current ratio calculated?
- Current assets / current liabilities
How is the quick ratio calculated?
Current assets excluding stock / current liabilities
what are the three types of activity / turnover ratios?
- Stock turnover ratio
-Debt turnover ratio
-Credit turnover ratio
How is the stock turnover ratio calculated?
- Cost of sales / average stock
How is the debt turnover ratio calculated?
sales / debtors
How is the credit turnover ratio calculated?
Purchases / creditors
why is the credit turnover ratio based on purchases and not sales like the other activity ratios?
Because creditors are created when the business buys something
what do changes in the stock, debtor and creditor ratios mean?
changes in these ratios affect the liquidity of the business
what is a gearing ratio?
This is one of the best measures of a companies future as it is easy to understand and is a measure of financial leverage - showing the extent to which a company finances its activities from borrowings as opposed to shareholder equity.
What does a high gearing ratio indicate?
The higher the ratio, the more the business relies on debt finance as opposed to shareholder equity.
how to you calculate the gearing ratio?
Long-term borrowings / shareholder equity x 100
do insurance brokers use insurer ratios or general ratios?
General ratios
what are stakeholders and analysts for insurance companies mainly concerned with?
- Solvency
- Liquidity
- Capital adequacy
- Profitability
- Outstanding claims
what is the solvency capital ratio and why is this commonly used within insurance company ratios?
- The solvency capital ratio compares the total eligible capital to the solvency capital requirement:
Total eligible capital / solvency capital requirement
in 2019 RSA stated that they prefer to operate above the top end of its target solvency 2 coverage ratio, what was this as a percentage?
130% - 160%
what is another ratio of measuring solvency in insurance companies?
The solvency ratio - this is
net assets / earned premium net of reinsurance
in general terms, what do solvency ratios indicate within insurance companies?
The higher the figure, the stronger the company.
However, in a hard market, the figures might drop as premium rates increase , making it look like a deterioration, however it is actually an economic improvement
what is an issue with using solvency ratios within insurance?
A company with a high level of capital to support the premiums written is usually seen as being ‘overcapitalised’ and will have a lower return on equity than a company with a lower level of capital
why do insurance companies usually have a high cash flow?
As premiums are usually paid before claims are paid, if any.
what is a general formula for insurer liquidity ratios?
Total Liabilities / (Cash + Investments)
how are profitability ratios looked at regarding insurance companies?
These are usually looked at for a number of years at a time as there is uncertainty around the appropriate amount which is set aside for claims, this uncertainty over the accuracy of each years profit
why is ROE (Return on Equity) a primary measure of finances for insurers?
Because it enables investors to see if the insurer is making money for them & can compare them with other insurers.
The higher the figure emerging the better the return, but as a rough guide the investor should be making 2.5 times the amount that they would earn in a bank deposit account over a five year period (the hard and soft market cycle will distort the figures).
what is the calculation for liquidity ratios in insurance?
Profit after tax / shareholder equity (capital) x 100
why is it common for an insurer that chooses to use debt capital to have a gearing ratio in the range 10%-25%?
Because there are restrictions in place i.e debt capital for an insurance company is subject to special requirements, as, to be effective the debt capital has to comply with the rules laid down by the regulator.
what does it indicate when an insurance company has a gearing ratio below 10%?
That they have a low level of gearing
what does it indicate when an insurance company has a gearing ratio above 40%
that they have a high level of gearing - which would suggest that a company cannot finance its own activities. Generally it is not a good thing for companies to borrow a high percentage of its sources of finance for long term investment, as the interest bill will be large
what is the gearing ratio calculation for an insurer?
long-term borrowings / shareholder equity x 100
when might a high gearing ratio be accepted for an insurer?
i.e when it is preferred to have a higher gearing ratio as opposed to:
- losing control by having too many issued shares
- with fewer shares, fewer shareholders to participate in the profit, so a small increase in pre-interest profit could lead to larger dividends
what does a combined ratio measure for an insurer?
The underwriting performance by combining the claims ratio with the expense ratio and the commission ratio. i.e is there sufficient premium to cover the costs of reinsurance, claims handling, other staff.
what are the three ratios that drive the combined ratio for an insurer?
- the claims ratio
- the expense ratio
- the commission ratio
how is the claims ratio calculated (under combined ratios for an insurer)
claims incurred net of reinsurance / earned premiums net of reinsurance x 100
how is the expense ratio calculated (under combined ratios for an insurer)
Administrative expenses / earned premium net of reinsurance x 100
how is the commission ratio calculated (under combined ratios for an insurer)
acquisition costs / earned premium net of reinsurance x 100
how is the combined ratio calculated (under combined ratios for an insurer)
(claims + expenses + Acquisition costs) / (earned premium net of reinsurance) x 100
what is another name for combined ratio?
Operating ratio
why is it important that insurers do not overpay commission to brokers, but still pay well?
as it will erode profits for the shareholders,
but as a counter argument, the most profitable business will
often have the highest commission.
what is a good commission ratio for insurers?
between 10-20%, although this could be alot higher if they have brokers using delegated authority schemes.
what is the most major liability for an insurance company?
Outstanding claims
how do we calculate the outstanding claims ratio for insurers?
Outstanding claims net of reinsurance / net assets
what does the outstanding claims ratio indicate?
The lower the ratio, the more secure the position. but,
paradoxically, a company which is under-reserved will show a
better result and this will create problems for the future,
maybe even leading to failure
how many ratios should be taken into account when analysing an insurance companies accounts and what are they?
6
1- claims ratio
2-expenses ratio
3 - commission ratio
4- combined ratio
5-ROE (Return on Equity)
6- Solvency coverage ratio
summarise 3 ways that ratios can be used?
- to analyse the performance of a business
- to compare performance of a company overtime or with competitors
summarise 4 limitations of using ratios?
- Comparative information is essential for any meaningful ratio analysis
-Accounting ratios are based on income statements and balance sheets which are subject to judgements and limitations
-Ratio analysis helps to build a picture of a company however this depends on the quality of the financial information available and relies heavily on accounts being pristine.
-Past company performance is not always the best indicator of future performance.
