Ratio Analysis

Question 1

What is the use of Ratio analysis?

Answer 1

• ratios are used to compare current year results with the previous years
• they are used to compare current year results with those of comparable companies in the same business
  -they are used to compare current performance against the budget or standard or benchmark of performance
• ratios help a business plan for the future

Question 2

What are the five categories of accounting ratios?

Answer 2

• Market Value ratios
• Profit ratios
• Short term liquidity ratios
• long term solvency ratios/Gearing ratios
• Asset Management ratios

Question 3

What are the limitations of using ratio analysis?

Answer 3

• Ratios are based on historical data which may not be relevant for future decision making
• Ratio analysis is not definitive
• Ratios on their own do not make much sense, they require comparable information
• Ratio analysis is a subjective exercise

Question 4

What are Gearing ratios?

Answer 4

These are ratios used to show how a company relies on debt financing versus shareholder equity. Examples include: Debt to equity ratio and Debt to Capital ratio.

Question 5

What is the total debt ratio?

Answer 5

This is a ratio that measures the proportion of a company’s assets that are financed through debt.

It’s formula is Debt ratio = Total debt / Total assets

Question 6

What are the formulas for the debt to capital ratio and debt to equity ratio?

Answer 6

• Debt to Capital ratio = Total debt / Total debt + Total equity
• Debt to equity ratio = Total debt / Total equity

Question 7

What is the difference between Total Prior charge capital and Total debt?

Answer 7

Total debt includes: long-term debt (e.g. bonds and bank loans, short-term debt (e.g. overdrafts and commercial paper)

Total prior charge capital includes: Total debt and Preference shares (preference shares because they are paid before equity shareholders)

Question 8

Between Total debt and Total prior charge capital which one should you use for debt to capital ratio analysis?

Answer 8

• For a traditional ratio, use total debt because it focuses only on financial risk from borrowing.
• For a more comprehensive risk assessment use total prior charge capital if preference shares form a significant part of the company’s capital structure

Question 9

What is the total prior charged capital?

Answer 9

Prior charge capital includes all sources of capital which rank ahead of equity shareholders
in dividend and liquidation distribution.

Question 10

What are the ratios under the short-term liquidity ratios?

Answer 10

• Current ratio (this measures how well a company can pay off its liabilities)
• Quick ratio (acid test ratio) (this assesses how well a company can pay off its liabilities by looking at only their most liquid assets, excluding inventory)

Inventory is excluded because it can take long to convert to cash so therefore a quick ratio gives a more realistic position of the company’s ability to pay off their liabilities