Ratio Analysis Flashcards

1
Q

Define RATIO ANALYSIS

A

Ratio analysis is an examination of accounting data by relating one figure to another. This allows for more meaningful interpretation of the data and the identification of trends.

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2
Q

What are the three key types of ratio?

A
  1. Liquidity ratios - current ratio and acid test ratio
  2. Profitability margins - gross profit, operating profit, net profit and ROCE.
  3. The gearing ratio
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3
Q

Define RETURN ON CAPITAL EMPLOYED

A

ROCE measure how much profit is made by a business compared to how much capital has been invested.

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4
Q

What is the formula for ROCE?

A

ROCE = (operating profit/capital employed) x 100

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5
Q

How can low ROCE be improved?

A
  • Increasing long term profit, without increasing loans.

- Repaying some long term loans, which then reduces capital employed

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6
Q

What should ROCE be compared to?

A
  • ROCE from previous years
  • ROCE of competitors
  • Current base rate of interest
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7
Q

Define the GEARING RATIO

A

The gearing ratio measures the percentage of total capital employed in a firm that comes from long term loans (non-current liabilities).

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8
Q

What is the formula for gearing?

A

Gearing = (non current liabilities/capital employed) x 100

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9
Q

Define HIGHLY GEARED

A

A business is said to be highly geared if more than 50% of its total capital employed exists in the form of loans.

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10
Q

Define LOWLY GEARED

A

A business is said to be lowly geared if less than 25% of its total capital employed exists in the form of loans.

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11
Q

What are the features of a highly geared business?

A
  • Vulnerable to changes in interest rates
  • Shows that a firm is willing to take risks
  • Difficulty keeping up with loan repayments if profit falls.
  • Risky in a slow economy as payment will still need to be made.
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12
Q

What are the features of a lowly geared business?

A
  • Shows the business may be risk averse and therefore they miss out on growth opportunities.
  • Will have less difficulty repaying loans if profit falls.
  • Can take out additional loans to fund new projects if necessary.
  • Less risky when the economy is slowing down.
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13
Q

What are the limitations of ratios?

A
  • Need to be compared over a period of time to get an idea of trends.
  • Only as reliable as the documents they are based on.
  • Comparison with competitors is needed to get industry context and identify which factors can be controlled by the business and which affect all businesses.
  • Qualitative factors are ignored
  • Product portfolio and product development are ignored.
  • External economic factors or changes in a firm’s competitive environment are not reflected in statements.
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