Ratio Analysis (8) Flashcards
Define Gearing?
The extent to which an entity is funded by debt as compared to equity.
Interest bearing debt
Liabilities of an entity which require the payment of interest on top of the capital amount.
Apply ratio analysis in businesses to determine the?
position and potential of the company in which they have an interest
There are various benefits to using ratio analysis?
- Measuring performance of the entity: Ratios provide an indication of an entity’s profitability, liquidity and solvency.
- Making comparisons: The ratios can be compared to those of companies in the industry in which the company operates, or with its own prior year ratios.
- Establishing future trends: Ratios calculated over many years can be used to establish trends.
- Identifying strengths and weaknesses: An entity’s strengths and weaknesses can be established through ratio analysis and interpretation
- Measuring performance of the entity: Ratios provide an indication of an entity’s profitability, liquidity and solvency. This information is a guide with regard to the entity’s performance in terms of generating profits, paying off debts and managing risk associated with borrowing. The financial and operational needs of the entity can also be determined. For example, the senior management of a company can decide to shut down a low-performing department if it continuously records low profits, is heavily in debt, or incurs significant expenses.
- Making comparisons: The ratios can be compared to those of companies in the industry in which the company operates, or with its own prior year ratios. This information can be used to measure performance against industry benchmarks, and improve the entity’s plans and policies accordingly.
- Establishing future trends: Ratios calculated over many years can be used to establish trends. For example, gross profit as a percentage of sales can be easily forecast based on previous years’ figures. This helps in planning and forecasting processes like budgeting.
- Identifying strengths and weaknesses: An entity’s strengths and weaknesses can be established through ratio analysis and interpretation. For example, low profit margins and increased expenses may be an indication of operational inefficiencies, on which the entity needs to improve. On the other hand, improved profit margins might indicate efficient marketing efforts and cost control, strengths that the entity should maintain.
Explain Current ratio?
This indicates the entity’s ability to repay its current liabilities using current assets.
Explain Quick ratio?
This indicates the entity’s ability to pay its current liabilities using assets that are quickly convertible into cash (excluding trading inventory, which is not easily convertible)
Explain Trade receivables collection period (days)?
This indicates the time it takes an entity to collect amounts owed to it by debtors, which is the time between the sale of trading inventory and the receipt of payment. Generally, a shorter collection period is preferred as it improves the cash flow of the business.
Explain Trade payables settlement period (days)?
This indicates the time it takes an entity to pay amounts owed to its creditors, which is the time between the purchase of goods and payment to the supplier. Businesses generally prefer taking longer to pay their creditors so that the cash can be used for internal operations. Taking too long, however, would incur penalties in the form of interest on overdue accounts.
Explain Asset turnover? T
*Asset turnover = Total sales ÷ Total assets
his indicates how productively the entity’s assets are being used to generate sales. A high asset turnover indicates that assets are being used effectively to generate sales. A low ratio indicates low effectiveness where sales income generation could be improved. The ratio must be compared with industry averages.
Explain Trading inventory turnover rate (times)?
- Trading inventory turnover rate (times) = Cost of sales ÷ Trading inventory
- This indicates the number of times in a period trading inventory is sold and replaced. A high trading inventory turnover indicates that sales are being made quickly. A low trading inventory turnover indicates that trading inventory is being kept for longer periods before being sold.
Explain Trading inventory turnover (days)?
*Trading inventory turnover = (Trading inventory ÷ Cost of sales) × 365 days
- This indicates the number of days it takes an entity to convert its trading inventory into sales. The lower the number of days, the more efficient the entity is in selling its trading inventory, and vice versa.
What do liquidity ratios measure?
An entity’s ability to pay off short-term debts using current assets
Which of the following current ratio values represents the worst result for the business?
08:1
What do Asset Management ratios measure?
The business’s success in managing its assets to generate sales
A business’s revenue is equal to R500,000 and it has a total asset figure of R900,000.
What is the value of its asset turnover ratio?
0.55
A business’s current assets are equal to R350.000 and its current liabilities are equal to
R200,000. What is the value of its current ratio?
175:1
Debt financing creates an obligation for the business to repay both?
interest and the principal amount.
Ratio analysis can be used to establish the entity’s ability to repay both?
the interest expense and the capital portion of financing.
Debt management ratios are also known as?
solvency ratios.
Generally, financing an entity through equity is more?
expensive than financing through debt
Explain Debt to equity ratio?
- Debt to equity ratio = (Total debt ÷ Total equity) × 100
- This indicates the extent to which the owner’s equity is exposed to the finance risk that is associated with debt financing. A higher ratio indicates more debt financing, and more finance costs.
Explain Total debt ratio (%)?
- Total debt ratio (%) = (Total debt ÷ Total assets) × 100
- This indicates the percentage of assets financed by borrowing (loans, mortgage bonds etc). A high ratio indicates too much debt and, therefore, a low ratio is preferred.
Explain Capital gearing ratio?
This indicates the degree to which the business’s operations are financed by debt as compared to owner’s equity. A high gearing ratio indicates that an entity is heavily financed by debt, which is a concern as this also leads to high finance costs. Thus, a low gearing ratio is preferred. However, the ratio also needs to be compared to industry averages before a definitive conclusion is made.
Management must always be concerned about the business‘s ability to?
generate profits.
Explain Gross profit Percentage?
- Gross profit Percentage = (Gross profit ÷ Total sales) × 100
- This indicates the percentage of sales that is left to cover other expenses after deducting cost of sales. A high gross profit percentage is preferred, as it indicates that the entity has retained more sales income to pay other expenses. This percentage should be compared with industry averages.
Explain Net profit Percentage?
- Net profit Percentage = (Net profit after tax ÷ Total sales) × 100
- This indicates the percentage of sales that is left after all expenses have been deducted. A high net profit percentage indicates the entity’s ability to effectively control expenses and generate sales. This percentage should be compared with industry averages.
Explain Return on owner’s equity (%)?
Explain Return on owner’s equity (%) = (Net profit after tax ÷ Owner’s equity) × 100
- This indicates the percentage return earned on funds invested by owners of the business. A high return is favourable, while a low return is unfavourable as it indicates that shareholders are receiving a low return on their investment.
The statement of cash flows is used together with other financial statements to calculate
the cash flow ratios.
These ratios enable users to make conclusive decisions about business processes, as profits alone may not be an accurate?
overall cash flows.
Explain Cash flow to total debt ratio (%)?
- Cash flow to total debt ratio (%) = (Cash flow from operations ÷ Total debt) × 100
- This indicates the ability of the business to pay its debt using the cash generated from its operations. A high ratio shows that the entity will be able to cover its debt. The ratio should be compared to previous year’s ratios to determine whether it has improved or declined.
Explain Cash flow margin ratio (%)?
8 Cash flow margin ratio (%) = (Cash flow from operations ÷ Total sales) × 100
- This indicates the amount of cash generated per rand of sales. A high ratio indicates that more cash was generated from sales, and is preferred over a low ratio.
Market value ratios reflect an entity’s?
value relative to perceptions in the market.
Briefly explain Market value ratios?
reflect an entity’s value relative to perceptions in the market. Market value ratios provide information on how investors view the potential return and risk associated with owning a company’s shares. ‘Market price’ refers to the price at which investors are willing to buy or sell their shares.
Explain Earnings per share (EPS)?
- Earnings per share (EPS) = Net profit after tax ÷ Number of ordinary shares issued
- Earnings are profits for the year available to ordinary shareholders, which can either be paid out as dividends to the shareholders or retained in the business. EPS measures the profit earned per share.
Explain Price/Earnings (P/E) ratio? Market price per share in issue ÷ Earnings per share This indicates the amount that investors are prepared to pay for shares per rand of reported profits. It also indicates investors’ confidence in a company.
- Price/Earnings (P/E) ratio = Market price per share in issue ÷ Earnings per share
- This indicates the amount that investors are prepared to pay for shares per rand of reported profits. It also indicates investors’ confidence in a company.
Explain Dividend yield (%)?
- Dividend yield (%) = (Dividend per share ÷ Market price per share) × 100
- This indicates an investor’s return. Investors prefer a high dividend yield. However, a high dividend yield may also be considered risky, as it may imply that the company is returning a huge portion of profit back to the shareholders as dividends. This leaves less profit for future development and growth.
Explain Dividend cover (times)?
- Dividend cover (times) =(Earnings per share ÷ Dividend per share)
- This indicates how easily dividends can be covered by earnings. A high dividend cover indicates that more earnings have been retained and reinvested in the entity. A low dividend cover shows that most of an entity’s earnings have been paid out as dividends.
List any two profitability ratios?
Any of the following profitability ratios may be listed:
- Gross profit percentage
- Net profit percentage
- Return on owners’ equity
A newly qualified investment analyst has been tasked with assessing the ability of a company to pay its debts when they fall due. They are unsure of which ratios to use. Explain to them which type of ratios are most appropriate, and give any two examples of such ratios?
The new investment analyst should be advised to use liquidity ratios. Liquidity ratios measure an entity’s ability to pay its short-term obligations (current liabilities), using current assets.
*Any of the following liquidity ratios may be listed as examples:
- Current ratio
- Quick (Acid test) ratio
- Trade receivables collection period
- Trade payables settlement period
After going through the current financial statements and calculating the ratios, the management accountant has concluded that the company is highly geared. Explain what this means?
Gearing refers to the extent to which an entity is funded by debt as compared to equity. If an entity is highly geared, it means that its financing is mainly composed of debt as compared to equity.
Rufus Traders are putting together a credit policy. What would you advise them in relation to trade receivables collection and trade payables settlement periods?
- Trade receivables collection period is a measure of how long it takes an entity to collect amounts owed to it by debtors. Rufus Traders should set up a trade receivables collection period that ensures that the days are kept as short as possible. Longer collection periods may result in credit losses and cash flow challenges.
- Trade payables settlement period is a measure of how long it takes an entity to pay amounts that it owes to its creditors. Ideally, Rufus Traders should allow longer settlement periods so that it has cash available for use in operations. However, it should be careful not to default, as this may attract penalties.
In considering an appropriate policy, Rufus Traders should also consider the industry averages and use them as a benchmark.
Define Current ratio?
When compared to the industry average of 5:1, the ratios for 20.17 and 20.16 are both high.
Explain Trade receivables collection period?
The collection period is much higher than the industry average of 45 days for both years. The collection period increased from 86 days in 20.16 to 97 days in 20.17.
Explain Trading inventory turnover (days)?
The number of days that Tuks Ltd takes to convert its trading inventory into sales decreased from 145 days in 20.16 to 108 days in 20.17.
Explain Capital gearing ratio?
The degree to which Tuks Ltd is funded by debt as compared to equity increased from 0.22:1 in 20.16 to 0.29:1 in 20.17.
Explain Gross profit percentage?
The company’s gross profit percentage declined from 74.94% in 20.16 to 65.24% in 20.17.
