POFM - introducing ratios - the current ratio and debt to equity ratio

Question 1

what is the purpose of financial ratio

Answer 1

highlights relationships between variables and allow the business financial position to be assessed.

Question 2

types of financial ratio

Answer 2

Liquidity – ability to pay debts in the short term
Profitability – how much money the business is making
Solvency – ability to pay debts in the longer term Efficiency – how well the business is using its resources

Question 3

Liquidity

Answer 3

business ability’s to pay its debts in the short term
Ie measures the resources available to pay debts when they fall due

Liquidity is measured in the current ratio

Question 4

current ratio =

Answer 4

Current Assets/Current liabilities

it is written as a ratio of x: 1 and means the business has $x of current assets for every $1 of current liabilities.

Question 5

what does a current ratio mean???

Answer 5

allows financial managers to gauge whether the business is in a position to pay off its current liabilities using its current assets alone

Question 6

Large ratio

Answer 6

(1.5:1 or higher) the more liquid a business is and can easily meet its short term financial obligations

Question 7

smaller ratio

Answer 7

(less than 1.5:1) the less liquid a business is and that harder it is for the business to meet these short term obligations.

Question 8

(2.5:1 and higher)

Answer 8

a business can be too liquid, cash can be sitting on the balance not working for the business.

Question 9

solvency or gearing

Answer 9

Solvency is a measure of long term financial stability and refers to a business’s ability to pay their debts in the longer term

Gearing measures that mix of debt and equity as forms of funding within a business

Question 10

Solvency is measured by the debt to equity ratio

debt to equity ratio=

Answer 10

debt(total liabilities)/Equity(OE)

It is always written as a ratio i.e. x:1 and means the business has $x of debt for every dollar of equity

Question 11

but what does this mean?

Answer 11

the mix of debt and equity used by the business and is a measure of long term financial risk depending on the level of debt used

Question 12

The greater the ratio (DTER)

Answer 12

the more debt that is used for finance and the higher the potential risk.

Question 13

The lower the ratio (DTER)

Answer 13

the more equity that is being used and the lower the potential risk