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Accounting-Year 11 ATAR WACE > Ratio Analysis > Flashcards

Ratio Analysis Flashcards

1
Q

Introduction

A

In Accounting and Finance, Profit and Loss statements, Balance Sheets, and Cash Flow statements. All provide an overlook on a Company or Business overall Financial Performance.
Another Method of doing this is through the use of Ratios.

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2
Q

Define Ratios

A

Can be defined as the Relationship that exists between two different quantities.

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3
Q

Define Liquidity

A

The ability of a Business to pay its debts as they fall due.

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4
Q

Define Stability

A

The ability of a Business to survive in the long term.

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5
Q

Define Profitability

A

The ability of a Business to make an acceptable level of profit.

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6
Q

What is Current Ratio used to measure?

A

(USE TO MEASURE LIQUIDITY OF A BUSINESS)

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7
Q

What is Quick Asset Ratio used to measure?

A

(USE TO MEASURE LIQUIDITY OF A BUSINESS)

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8
Q

What is Debt to Equity Ratio used to measure?

A

(USE TO MEASURE STABILITY OF A BUSINESS)
By the way it is also known as a Leverage Ratio

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9
Q

What is Gross Profit Ratio used to measure?

A

(USE TO MEASURE PROFITABILITY OF A BUSINESS)

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10
Q

What is Profit Ratio used to measure?

A

(USE TO MEASURE PROFITABILITY OF A BUSINESS)

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11
Q

What is Expense Ratio used to measure?

A

(USE TO MEASURE PROFITABILITY OF A BUSINESS)

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12
Q

What is Return on Asset Ratio used to measure?

A

(USE TO MEASURE PROFITABILITY OF A BUSINESS)

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13
Q

What two ratios are used to evaluate Liquidity of a business?

A

The Current Ratio and Quick Asset ratio
(Also Known As The Acid Test Ratio)

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14
Q

What is the formula for Current Ratio?

A

(Current Assets / Current Liabilities) MULTIPLIED by 100

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15
Q

What is the interpretation of a Current Ratio of less than 100%?

A

A current ratio of less than 100% means and indicates that either 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.

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16
Q

What is the interpretation of a Current Ratio of between 100% and 200%?

A

A current ratio between 100% and 200% indicates that a business should be able to pay its short term debts.

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17
Q

What is the interpretation of a Current ratio of more than 200%?

A

A current ratio of more than 200% indicates that a business should be able to pay its short term debts and that the business has extra current assets available.

18
Q

Define Quick Asset Ratio (also known as Acid Test Ratio)

A

The quick asset ratio is a measure of the ability of a business to pay its immediate current liabilities using only its most liquid current assets.

19
Q

What is the Formula for Quick Asset Ratio?

A

(Current Assets except for Inventory and prepaid expenses / Current Liabilities except for Bank Overdraft) MULTIPLIED BY 100

20
Q

What is the interpretation of a Quick Asset Ratio of more than 100%?

A

A quick asset ratio of more than 100% indicates that a business should be able to pay its short term debts.

21
Q

What is the interpretation of a Quick Asset Ratio of less than 100%?

A

A quick asset ratio of less than 100% indicates that, in an emergency, a business may not be able to pay its short term debts.

22
Q

What is Gearing (also known as leverage)?

A

Gearing or leverage is the term used to describe the extent of the borrowings of a business.
A highly geared business would have large interest and loan repayments which will increase the business risks of failure.

23
Q

Define Debt to Equity Ratio

A

The debt to equity ratio measures the gearing (leverage) of a business.

24
Q

What is the formula for the Debt to Equity Ratio?

A

(Total Liabilities / Total Equity) MULTIPLIED BY 100

Note: Total Liabilities = current liabilities + non-current liabilities

25
Q

What is the interpretation of a Debt to Equity Ratio?

A

There is no ideal percentage of Debt to Equity Ratio, as it highly depends on the business.
For example a small business might be able to operate successfully with a debt to equity ratio of 70% or less BUT a large business might be able to operate successfully with a debt to equity ratio of 100% to 200% or even higher.

Note: Despite these nuances it is generally considered better for any business to have less debt to equity ratio.

While higher debt to equity ratio can offer growth opportunities by leveraging additional funds, a lower debt-to-equity ratio is generally preferred.

This is because lower debt to equity ratio reduces the risk of financial strain from interest obligations, especially in downturns or periods of rising interest rates.

So, a lower debt to equity ratio often indicates greater financial stability and flexibility, which is generally beneficial for any business.

26
Q

What are the 4 ratios that can be used to measure Profitability?

A

The four ratios that can be used to measure Profitability are the:
- Gross Profit Ratio
- Profit Ratio
- Expense Ratio
- Return On Asset Ratio

27
Q

Define Gross Profit Ratio

A

The gross profit ratio shows the percentage of gross profit that is contained in each dollar of sales.
Note: Gross Profit = (Sales - Less cost of sales)

28
Q

What is the formula for Gross Profit Ratio?

A

(Gross Profit / Net Sales) MULTIPLIED BY 100

29
Q

What is the interpretation of the Gross Profit Ratio?

A

The gross profit ratio of a business will be compared to its previous years ratio or with an industry average ratio.

An increase in the gross profit ratio compared to previous or industry average could mean:
1. An increase in the selling price of the inventory which is greater than any increase in the purchase price of the inventory.
2. The purchasing of inventory is now at a lower price (Cost of inventory has decreased).

A decrease in the gross profit ratio compared to previous or industry average could mean:
1. A decrease in the selling price of the inventory due to:
a) new competitors entering the market.
b) a price war between competing businesses.
c) a plan to increase market share by selling inventory at a
cheaper price.
2. An increase in the purchase price of the inventory greater than any increase in the selling price of the inventory (Cost of inventory has increased).

30
Q

Define Profit Ratio

A

The profit ratio shows the percentage of profit that is contained in each dollar of sales.
Note: Profit = (Gross Profit - Less other expenses)

31
Q

What is the formula for Profit Ratio?

A

(Profit / Net Sales) MULTIPLIED BY 100

32
Q

What is the interpretation of the Profit Ratio?

A

An Increase in the profit ratio:
- Could be caused by an increase in the gross profit or a reduction
in expenses.

A decrease in the profit ratio:
- Could be caused by an increase in expenses.

33
Q

Define Expense Ratio

A

The expense ratio compares the sales of a business to the total of the selling and distribution, general and administration and financial expenses.

34
Q

What is the Expense Ratio Formula?

A

( Expenses, other than cost of sales / Net sales )MULTIPLIED BY 100

35
Q

What is the interpretation of the Expense Ratio?

A

From this ratio the owner of a business can see the extent to which the expenses ( other than cost of sales) have affected the profit and can compare this year’s expense ratio to the expense ratios of previous years and investigate any large, negative differences.

36
Q

Define Return on Assets Ratio

A

The return on assets measures how efficiently a business has used its assets to generate a profit.

37
Q

What is the formula for Return on Assets?

A

( Profit / Average Assets ) MULTIPLIED BY 100
Note: You can calculate Average Assets by adding the current year total asset with the previous year total asset then finding the average.
Which will be:
Average assets =
(previous year Total Asset + current year Total Assets / 2)

38
Q

What is the interpretation of Return on Asset Ratio?

A

This ratio should be compared to the return on asset ratio achieved in previous years or to an industry average.
Which will measure how efficiently a business has used its assets to generate profit compared to previous years or the industry average.
This is a valuable insight for the owner of the business as well as investors.

39
Q

How is it possible for a business to have high profitability, but low liquidity?

A

Profitable businesses are to do with income and expenses, and it is possible for this to be high with high income and low expenses. But low liquidity looks at a high level of immediate current liabilities in comparison to low liquid current assets.

40
Q

What is an ideal ratio for the working capital and quick ratio? Explain.

A

An ideal ratio is 2:1 ratio. This means that you have double the current assets for every amount of current liability.

Accounting-Year 11 ATAR WACE (3 decks)

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