Ratio Analysis Flashcards
What is the importance of ratio analysis? What does context mean in this aspect?
- Time and Effort spent on financial statement
- This means that you should do something using it
- Interpretation is key to decision of financial improvement
- Ratios on their own mean very little
- Have to be used for comparison
Name the 5 types of ratios
- Profitability
- Efficiency
- Liquidity
- Gearing
- Investor
What are the 3 types of Profitability ratios?
- Return on Capital Employed (ROCE)
- Gross Profit Margins (GPM)
- Operating Profit Margins (OPM)
What is the Return on Capital Employed ratio? Give the formula for it
- The fundamental measure of a firm’s performance
- Operating Profit Vs Average Long-Term Capital Investment
- Formula:
(Operating Profit)/Capital Employed X 100% - Capital Employed: Retained Profit, Reserves, SC, SP and Non-Current Liabilities
How can the Return on Capital Employed be interpreted?
- Inputs and Outputs
- Tells us how well-used funds are
- Can they get a better return elsewhere?
- ROCE should be greater than competitors, interest rate and last years
What is the Gross Profit Margin ratio? Give the formula for it
- Measures the percentage of sales that a firm keeps
- Formula:
(Gross Profits)/Sales x 100%
How can the Gross Profit Margin be interpreted?
- How much Profit is retained?
- Represents what a company keeps (- COGS)
- Compared to the industry average or last year
- If CoP increases, GPM will generally fall (ceteris paribus)
What is the Operating Profit Margin ratio? Give the formula for it
- Measures Operating Profit Vs Sales
- Formula:
(Operating Profits)/Sales x 100%
How can the Operating Profit Margin be interpreted?
- Very similar to GPM, so are looked at together
- The higher the better, <5% is poor
- A lot of changes over time generally
What are the 4 types of Efficiency ratios?
- Non-Current Asset Turnover Ratio
- Average Receivables Collection Period
- Inventory Holding Period
- Average Payables Collection Period
What is the Non-Current Asset Turnover ratio? Give the formula for it
- Measures how efficiently the firm is using its Long-Term assets to generate sales
- Formula:
Sales / Non-Current Assets
How can the Non-Current Asset Turnover be interpreted?
- If assets aren’t producing sales, they represent a ‘drain on resources’
- This however may be distorted by failure to replace assets
What is the Average Receivables Collection Period ratio? Give the formula for it
- Measures the average time to collect TR
- Assume all sales are credit sales unless explicitly stated
- Formula:
TR / Credit Sales X 365 Days
How can the Average Receivables Collection Periods be interpreted?
- Firms will prefer shorter settlement periods
- Can result in lower sales
- When this is high, shows poor control; if this happens, you need an ID firm or Factoring
- Best period would be 45-75 days
What is the Inventory Holding Period ratio? Give the formula for it
- Measures the time taken to turn inventory into sales
- Formula:
Inventory / Cost of Sales X 365 Days
How can the Inventory Holding Period be interpreted?
- Don’t want it held for too long
- Might be distorted by seasonality
- Too Long? Need a marketing system
What is the Average Payables Collection Period ratio? Give the formula for it
- Measures the average time to pay back supplies
- Use COGS if cannot find Credit Payables
- Formula:
TP / Credit Purchases X 365 Days
How can the Average Payables Collection Periods be interpreted?
- Can be distorted based on different deals from suppliers
- ‘Free’ source of finance so businesses would like to leave this as long as possible
- But, leaving it too long will annoy suppliers
What is the Net Trade Cycle? Give the formula
- Measures time between when you pay suppliers and when you receive the TR
- NTC = IHP + RCP - PCP
What are the 2 Types of Liquidity Ratios?
- Current Assets
- Quick Assets
What is the Current Asset ratio? Give the formula for it
- How many £ of Current Assets for each Current Liabilities
- Formula:
Current Assets / Current Liabilities
How can the Current Asset Ratio be interpreted?
- Increased ratio, more liquidity
- Ideal = 2:1, but this depends on the industry
- Too high; too much tied up in CA
- Too low; CL becomes worrying
What is the Quick Asset ratio? Give the formula for it
- Excludes the least liquid of CA
- Formula:
(Current Assets - Inventory) / Current Liabilities
How can the Quick Asset Ratio be interpreted?
- Ideal = 1:1, but this depends on the industry
What are the 2 Types of Gearing Ratios?
- Gearing
- Interest Cover Ratio
What is the Gearing ratio? Give the formula for it
- The Ratio between external (debt) and internal (equity) long-term finance
- Measures the risk of an organisation
- Formula:
Long-Term Debt / Capital Employed x 100
How can the Gearing Ratio be interpreted?
- Should be low if the industry is susceptible to volatile demand and profits
- Over 50% is risky- debt>equity
What is the Interest Cover ratio? Give the formula for it
- Indicates how well interest can be afforded
- Formula:
PBIT / Interest
How can the Interest Cover Ratio be interpreted?
- High-interest cover suggests that lenders payments are secure
- BUT, if too high, it could be good to take on more things
What are the 2 Types of Investor Ratios?
- Earnings Per Share (EPS)
- Dividends Cover Ratio
What is the Earnings Per Share ratio? Give the formula for it
- Measures for each share, relative earnings
- Formula:
Profits After Tax / Total Share in Issue
How can the Earnings Per Share Ratio be interpreted?
- Want it as high as possible
- The go-to investor information
What is the Dividends Cover ratio? Give the formula for it
- Measures how affordable dividends is
- Formula:
Profit After Tax / Dividends
How can the Dividends Cover Ratio be interpreted?
- If it is high, Dividends are low
- BUT, they could be looking to spend in the future
Name the limitations of ratios
- Highlights change- does not explain it
- Deterioration isn’t bad management
- Broad Picture: Use a lot of ratios
- Comparability/ Choices of accounting
- Seasonality
- Quality of financial statement - “Window Dressing”
- Restricted vision of ratios
- Ratios relating to SOFP; snapshot
