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accounting > Ratio Analysis > Flashcards

Ratio Analysis Flashcards

1
Q

Limitations of Ratio Analysis

A
  • They do not identify the causes of problems
  • They usually have limited value - need to be compared to an industry average
  • Limited disclosure of information makes it impossible to calculate some ratios
  • It is not always possible to compare ratios between businesses as they may have different accounting policies i.e. inventory valuation methods
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2
Q

What is liquity definition

A

Liquidity is defined as the ability of a business to pay its debts as they are due for payment

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3
Q

What are the two ratios of liquidity

A
  • Current Ratio/Working Capital Ratio
  • Quick Asset Ratio
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4
Q

Define Current Ratio/Working Capital Ratio

A

A measure of the ability of a business to pay its short term debts - debts payable within 12 months

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5
Q

Interpreations of Current Ratio/Working Capital Ratio

A
  • Less than 100% - indicates either that a business may find it difficult to pay its short-term debts or that the business is operating in an industry in which money is collected from sales very quickly i.e. QANTAS
  • Between 100% and 200% - indicates that a business should be able to pay its short-term debts
  • More than 200% - indicates that a business should comfortably be able to pay its short-term debts or company has an excessive level of current assets and is not making the best use of its resources to generate revenue
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6
Q

Define Quick Asset Ratio

A

A measure of the ability of a business to pay its short term debts (excluding bank overdraft) using only its more liquid current assets

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7
Q

Why are inventory and prepaid expenses left out of calculation for quick asset ratio

A
  • They both have low levels of liqudity
  • Inventory is likely to be difficult to sell in large quantities at its normal selling price
  • Prepaid expenses are excluded because it may be difficult to recover money paid in advance
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8
Q

Interpretations of Quick Asset Ratio

A
  • More than 100% - Indicates a business should be able to pay its short term debts
  • Less than 100% - Indicates, in an emergency, a business may not be able to pay its short debts
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9
Q

Why are retail companies more likely to have a Quick Asset Ratio under 100%

A

Their inventory makes up a large proportion of its current assets

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10
Q

3 ways in which a business can purchase assets

A

Borrowed money (debt finance), share capital or from the cash generated from the profit (equity finance)

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11
Q

Definition of stability ratios

A

Measures the medium to long term survival prospects of a business based on the extent of the borrowings of that business

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12
Q

What is gearing/leverage and what is the trend of gearing/levarge

A
  • describes the extent of the borrowing of a business
    • A highly geared business has large interest and loan re-payments and has an increased risk of failure
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13
Q

What does the Debt to Equity Ratio measure

A

extent of the gearing (borrowing) of a business

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14
Q

Why is their no one acceptable figure for debt to equity

A

This is because the debt level of a company must be considered in relation to the profit made by the company - how the company has used its debt finance to generate income

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15
Q

Conservative and High debt to equity figures

A
  • Around 40% debt-to-equity however is considered conservative
  • Around 100% debt-to-equity is considered to be high
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16
Q

Times Interest Earned definition

A

The number of times that the interest expense of a company is covered by the profit before tax

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17
Q

Interpretations of Times Interest Earned

A

Ratio of 3-4 times: Widely viewed as a good safety margin for a company

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18
Q

What does Profit Margin Ratio measure

A

Shows the percentage of profit after income tax that is contained in each dollar

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19
Q

How should the Profit Margin ratio be measured

A

compared with the profit margin ratio in previous years or with an industry average

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20
Q

3 reasons for an increase in Profit Margin Ratio

A
  • A reduction in expenses
  • An increase in the selling prices or the products of the company greater than any increase in the COS
  • A cheaper supplier of inventory has been found
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21
Q

2 reasons for a decrease in Profit Margin Ratio

A
  • Expense increases that are not being fully passed on to consumers in the form of increased selling prices
  • Increased competition causing the business to lower its selling prices
22
Q

Rate of Returns on Assets definition

A

Measures how efficiently a business has used assets to generate a profit

23
Q

Explain why Int Expense is added to profit before tax in the Rate of Return on Assets ratio

A
  • Interest Expense is added back to the profit before tax to cancel out the cost of financing the assets
    • This is because assets can be funded through equity (int-free) or debts (have interest)
24
Q

Interpretations of Rate of Return on Assets

A
  • Ratio should be compared to ratios in previous years or an industry average
    • A ratio above industry average means assets have been used efficiently in generating a profit
    • A ratio below industry average means assets have not been used efficiently in generating a profit
25
Q

Purpose of Market Ratios

A

Used by investors to review the performance of public companies listed on the ASX (Australian Securities Exchange)

26
Q

Earnings per Ordinary Share definition

A

The portion of company’s annual profit after tax and preference dividends allocated to each issued ordinary share

27
Q

Interpretations of Earnings per Ordinary Share

A

Ratios are compared to previous years where an increase in the ratio is strongly approved by shareholders

28
Q

Price Earnings Ratio Definition

A
  • Number of times earnings per ordinary share that an investor is prepared to pay to purchase an ordinary share in the company
    • Stock market’s assessment of the value of an ordinary share
29
Q

Price Earnings Ratio Intepretations

A
  • Compared to industry averages
    • High price earnings ratio indicates that investors believe that the future growth in the profit of the company is likely to be very good
      • However investors may be overconfident about the company’s future
    • Low price earnings ratio indicates that investors believe that the company has poor profit growth prospects
      • However investors may underestimate the profit potential of the company
30
Q

Dividend yield definition and what it allows

A
  • Shows how much a company has paid out in dividends in a year relative to its share price
    • Allows investors to compare the dividend yield of a company with the interest received from investing in a fixed term bank deposit
31
Q

Interpretations of Dividend Yield

A

Compared between investment portfolios to see an optimal investment

32
Q

Limitation of Dividend Yield ratio

A
  • The analysis ignores capital growth or capital loss - future increases or decreases in the market price of the shares
33
Q

Purpose of efficiency ratios

A

Allow for evaluation of the performance of management of a company in key areas such as inventory and accounts receivable

34
Q

Debtors Collection Period definition

A
  • Measures how quickly a business collects money owing from credit sales
    • Use of Gross debtors amount
35
Q

4 Reasons for an increase in debtors collection period

A
  • Poor debt collection procedures - business may not be quickly following up overdue customer accounts
  • Slow processing of sales invoices - business may be taking a long time to send out sales invoices to customers
  • A business may not be checking the credit rating of new customers before selling them products or services on credit
  • A business may be offering longer credit terms to potential customer to increase sales
36
Q

1 Reason for a decrease in Debtor’s Collection Period

A

A decrease in the debtor’s collection period would indicate that the credit control and collection procedures have improved

37
Q

Inventory Turnover Ratio definition

A

Measures how many times each year a business replaces its inventory

38
Q

Why are Cost of Sales and Average Inventory used in the formula for Inventory Turnover

A
  • A COS is used in this ratio because this figure is the actual amount of inventory sold during the period
  • An average inventory amount is used because the figure is more accurately representing the amount of inventory held during the year than the closing inventory figure
39
Q

Interpretations of Inventory Turnover

A
  • Increasing inventory turnover ratio may mean that the inventory sold as products by the company are more popular with customers
  • A decreasing inventory turnover ratio may indicate that the inventory management policy of the company is inefficient - business has ordered too much inventory and is left with excessive slow moving or obsolete (out of date) inventory
40
Q

Unit for current ratio

A

%

41
Q

Unit for quick ratio

A

%

42
Q

Unit for debt to equity ratio

A

%

43
Q

Unit for times interest earned

A

times

44
Q

Unit for profit margin

A

%

45
Q

Unit for rate of return on asset

A

%

46
Q

Unit for earnings per ordinary share

A

$

47
Q

Unit for price earnings ratio

A

times

48
Q

Unit for dividend yield

A

%

49
Q

Unit for debtors collection

A

days

50
Q

Unit for inventory turnover

A

times

accounting (12 decks)

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