Ratio Analysis

Question 1

Describe the 4 steps of ratio analysis?

Answer 1

1. Identification-identifying the relevant information from the total figures.
2. Compilation & presentation-once the data has been identified it can be presented in a useful or easy to understand manner e.g. On a graph or as a percentage.
3. Interpretation-to interpret ratios you must have a solid understanding of what the ratio means and how applicable it is to the business.
4. Compare-ratios can now be compared to previous ratios or competition.

Question 2

Who may be interested in using ratio analysis & why?

Answer 2

ALL stakeholders.

Shareholders-look at the return on investment and health of the business.

Managers-to judge how the business is performing and to make decisions from this information.

Question 3

What do liquidity ratios measure?

Answer 3

Liquidity ratios illustrate the solvency of a business-whether it’s in a position to pay its debts or not. They focus on short-term assets and liabilities.

Question 4

Who will be interested in liquidity ratios?

Answer 4

Creditors are likely to be interested in liquidity ratios to assess whether they will receive money they are owed.

Question 5

Name 2 liquidity ratios. What do they focus on?

Answer 5

Current ratio-current assets and current liabilities.

Acid test ratio-current assets (not including stocks) and current liabilities.

Question 6

State the formula for the current ratio. What do the results suggest?

Answer 6

Current ratio= current assets / current liabilities

• sufficient liquid resources if the current ratio is between 1.5:1 and 2:1
• below 1.5:1 it might be argued that a business does not have enough working capital.
• Operating above a ratio of 2:1 may suggest that too much money is tied up unproductively.

Question 7

Why is the acid test a more stringent test of liquidity than the current ratio?

Answer 7

Stocks are not treated as liquid resources. Stocks are not guaranteed to be sold and they may become obsolete or deteriorate. Therefore they are not included in the acid test.

Question 8

What are profitability ratios?

Answer 8

Profitability or performance ratios simply show how well the business is performing. They tend to focus on: profit, turnover and capital employed.

Question 9

What are the 4 steps of ratio analysis?

Answer 9

1. Identification
2. Compilation and presentation
3. Interpret
4. Compare

Question 10

What is the formula for the gross profit margin? What do the results show/suggest?

Answer 10

Gross profit margin (%) = gross profit / turnover (sales) X 100
-results suggest higher is better although must always be compared to the industry

Question 11

Give the formula for the net or operating profit margin and explain the results.

Answer 11

Net or operating profit margin (%) = net profit / turnover (sales) X 100

• measures whether the firm is efficient in controlling expenses
• higher % is better but always compare with industry results & previous years
• should be compared to the gross profit margin. If the gross profit margin has improved but the net profit margin declined then profits on trading have increased but expenses are increasing at a faster rate than profits

Question 12

What does turnover mean?

Answer 12

No. Of sales

Question 13

What is operating profit?

Answer 13

Same as net profit (TR-TC).

Question 14

What is the ROCE & what is the formula used for it?

Answer 14

-Return On Capital Employed; considered to be one of the most important financial ratios it measures the efficiency of the firm to have funds invested & its return on these funds

ROCE (%)=operating profit / total equity + non current liabilities X 100

-higher is better (should be compared with previous results)

Question 15

What are financial efficiency ratios?

Answer 15

Ratios such as the asset turnover ratio which measure how efficiently an organisation uses its resources.

Question 16

Give the formula for the asset turnover ratio. What does it mean?

Answer 16

Asset turnover = sales revenue / net assets employed

• measures the firms ability to use assets to generate sales
• increasing ratio is better

Question 17

State the formula for the inventory turnover ratio. What does this mean?

Answer 17

Inventory turnover = cost of goods sold / average stock held

• this calculates the number of times inventories are sold and replaced
• general rule is higher the better but it is dependent upon the industry. For example, a car salesman will have a lower inventory turnover than a green grocers

Question 18

What are debtors? Give the debtors ratio and explain the results.

Answer 18

Debtors are individuals, groups, organisations or firms which owe money to the business.

Debtors collection period (DAYS) = debtors / sales revenue X 365

• shows how long it takes (DAYS) for the firm to collect debts owed by customers
• on balance sheets for PLC this customers given credit are called trade receivables
• shorter periods are preferable to maintain working capital

Question 19

State the ratio for the creditors collection period and briefly explain the results.

Answer 19

Creditors collection period (DAYS) = creditors / sales revenue X 365

• designed to show how many (DAYS) the firm takes to pay suppliers
• on PLC balance sheet, those who are owed money are called trade payables
• best to delay payment (higher ratio) for liquidity purposes but must not damage supplier relationship

Question 20

State the 2 shareholders ratios.

Answer 20

Dividend per share (PENCE) = total dividends / number of ordinary shares issued

Dividend yield (%) = dividend per share (PENCE) / market price (PENCE) X 100

Question 21

Give the gearing ratio and what does it mean?

Answer 21

Gearing (%) = non current assets / capital employed X 100

• compares long term financial stability and amount raised through sales of shares (internal) and amount raised through loans (external)
• if borrowed funds are more than 50% of capital employed the firm is highly geared
• firms like this must pay interest before dividend payments or reinvesting profits. Can cause problems borrowing money in the future