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A - accounting spring > Ratio Analysis (PART A) > Flashcards

Ratio Analysis (PART A) Flashcards

1
Q

what is a ratio?

A

mathematical expression of the relationship between 2 or more variables

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2
Q

what is needed for two variables to have meaning?

A

have a meaningful relationship

some logic behind it

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3
Q

why do we use ratios?

A
  • help build picture of position and performance in a business
  • not difficult to calculate (can be difficult to interpret)
  • identify financial strengths and weaknesses but by themselves
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4
Q

why can ratios be useless?

A
  • there needs to be skill in interpreting what they are saying
  • they don’t explain why there are strengths and weakness (just show that they are there)
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5
Q

what is the importance of ratios?

A

interpretation is key to indepth understanding of performance

  • measure performance against benchmarks
  • understand where performance went wrong
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6
Q

why is a ratio on its own useless?

A
  • they are used for comparison (other departments/businesses)
  • if calculate on its own, doesn’t tell you much about financial health or performance of business
  • if it is in isolation then it must be used in context
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7
Q

what kinds of comparisons can be made using ratios?

A
  • one year to another
    (which year performed better/improvement)
  • performance with planned performance (budget)
    (how much hoping to spend vs ratio)
  • review of trend over number of periods
    (compare different seasons)
  • inter-firm competition / comparisons within industry sectors
    (competitors)
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8
Q

why can it be a disadvantage at looking into the past as a guide to the future?

A

business environment can be uncertain, variable, can change quick

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9
Q

what are the key steps in creating ratios?

A

1) identify users and their information needs
(investors/employees)
2) select and calculate the appropriate ratios
(liquidity/gearing)
3) interpret and evaluate results
(using relevant benchmarks)
4) identify the limitations of the ratio/business

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10
Q

what are the types of ratios?

A

5 main lenses in which we can view the company
each show different things about the company, dependant on what you are interested in and who you are
- profitability
- efficiency
- liquidity
- gearing

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11
Q

what are the profitability ratios?

A

(most common)
how good is the profit in relation to investment made in the business?
- return on capital employed (ROCE)
- return on shareholder funds (ROSE)
how good is the profit in relation to sales made (margins)
- Gross profit margin
- Net profit margin

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12
Q

what is ROCE?

A

return on capital employed

  • fundamental measure of business performance
  • expresses relationship between operating profit and average long term capital invested in business
  • primary ratio
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13
Q

what is meant by capital employed?

A

= all of the long term funding (equity and liabilities)

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14
Q

what is the formula for ROCE?

A

(operating capital(PBIT) / capital employed) x 100 (%)

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15
Q

what is PBIT?

A

profit before interest and tax

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16
Q

what is ROSF?

A

return of shareholder funds

  • measure profit attributable to ordinary shareholders relative to the amount they have invested
  • what is the business earning for shareholders / owners
  • want to be as high as possible
  • how much profit can be given back as profit
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17
Q

what are shareholder funds?

A

= equity, share capital, premium, reserves
not dividends
(same as ROCE minus the long term loan as this is from the bank)

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18
Q

what is the formula for ROSF?

A

(Profit after tax(PAT) / shareholder funds ) x 100

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19
Q

how can ROCE and ROSF be interpreted?

A
  • compares inputs (capital investment) with outputs (operating profit)
  • assesses attractiveness with which finds have been deployed during accounting period
  • could the business / shareholder be getting a better return by investing its finds elsewhere
  • ideally ROCE should be higher than the rate of interest
    (otherwise why not leave the money in the bank)
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20
Q

what is the Gross profit margin ratio?

GPM

A
  • relates gross profit to same periods as sales revenue
  • measure of profitability in buying and selling goods and services before other expenses
  • want this to be as high as possible, bigger the gap between sales and COGS the better
  • gives you profitability on buying activities
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21
Q

what is the formula for GPM?

A

(gross profit / sales) x 100

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22
Q

how can GPM be interpreted?

A
  • how much sales are we retaining as GP
  • represents what a company made after paying off its COGS
  • companies with a higher GPM are more liquid and have more money to spend on indirect spendings
  • if companies raw materials rise then GPM will fall unless selling prices are cut
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23
Q

what is operating profit margin?

A

(profitability)
- relates operating profit for the period to the sales revenue generated in the period
- shows not just margins earned on sales but also forms ability to control its operating costs

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24
Q

what is the operating profit?

A

= GP minus operating expenses
before the deduction of tax and interest
includes all firms income and expenses expect tax and interest

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25
Q

what is the formula for OPM?

A

(operating profit margin / sales) x 100

26
Q

how can OPM be interpreted?

A
  • how much of sales revenue are we retaining as operating profit
  • if GP is remaining stable but OP margin is falling - need to examine our operating costs
  • the higher the better - less than 5% means company is in a very competitive sector or doing badly
  • variations in operating profit margin over time usually due to changes in sales mix (what you are selling, selling prices or indirect costs
27
Q

how do you get full marks on a GPM/OPM questions?

A

you must work them both out and then compare then against each other

28
Q

what are efficiency ratios?

A
  • measures whether the firm is using its resources effectively
  • long term (use of asset base to generate sales
    (non current asset turnover ratio)
  • short term (effective management of working capital)
    (average receivable collection period)
    (inventory holding period)
    (average payable payment period)
29
Q

what is non current turnover ratio?

NCTR

A

(long term efficiency ratio)

  • measure of how efficiently firm is using its LT asset base to generate sales
  • how much money of sales is generated from non current assets
30
Q

what is the formula for NCTR?

A

sales / non current assets

sales = income state
non current assets = SOFP

31
Q

how can NCTR be interpreted?

A
  • amount of sales revenue generated per £ of non current assets
  • measure of level of activity and productivity
    (ability to generate sales revenue from asset base)
  • if assets not producing sales, they represent a drain on company resources/efficiency
  • can be distorted by failure to replace assets (if you don’t replace NCA value depreciates and ratio is higher and not because of efficiency
  • if it is low then not using NCA to produce sales
32
Q

why can NCTR be distorted?

A

if NCA are not replaced over time, ratio can be higher than the value as they deprecates
this doesn’t show efficiency

33
Q

what is average receivables (debtor) collection period?

A

short term efficiency ratio
- measure amount of time it takes to collect money from receivables
- assume all sales are credit (unless told otherwise)
(credit sales / sales revenue)
- measured in days, when customers give money back

34
Q

what is the formula for average debtor collection period?

A

(trade receivables / credit sales) x 365

35
Q

how can the TR period be interpreted?

A
  • businesses will usually prefer shorter settlement period
    (but may result in reduced sales)
  • if period is higher vs other businesses = inadequate credit control
  • normal average = 45 - 75 days
  • credit is more attractive to customers
  • org needs money to remain liquid (if TR period is high then they are less liquid)
36
Q

what is the inventory holding period?

A
  • average time taken to turn inventory into sales

time inventory is held

37
Q

what is the formula for inventory holding period?

A

inventory / cost of sales x 365

38
Q

how can inventory holding period be interpreted?

A
  • shouldn’t be holding inventory for too long

- can be distorted by seasonal factors or major uptake in sales

39
Q

what is the payables (creditor) payment period?

A
  • time taken to payback suppliers

- if credit purchase not available use COGS

40
Q

what is the formula for payables payment period?

A

trade payable / credit purchases (COGS) x 365

41
Q

how can payables payment period be interpreted?

A
  • distorted by special treatment of a few large suppliers
  • free source of finance, try to extend as long as possible
    (but too long affects credit/prompt payment)
42
Q

what is the Net trade (operating cycle)?

A

average period it takes business to make initial outlay cash to produce goods, sell the goods, and receive the cash in exchange for cash

(want it to be as low as possible)

43
Q

what is the formula for operating cycle?

A

NTC = inventory holding period + receivable collection period + payable payment period

44
Q

what are liquidity ratios?

A

can firm pay its obligations when and as they fall due in the short time

  • current ratio
  • quick ratio
45
Q

what is the current ratio?

A

liquidity
measures whether or not a firm can meet its short term obligations (within a year)
how much £ of CA do you have to pay each £ of current liabilities

46
Q

what is the formula for current ratio?

A

current assets / current liabilities

47
Q

what is the quick ratio

A

liquidity
an indicator of companies short term liquidity position, ability to meet short term obligations with most liquid assets
(exclude least liquid assets)
exclude inventory - takes time to turn this into cash

48
Q

what is the formula for quick ratio?

A

current assets less inventory / current liabilities

49
Q

what is the interpretation of current ratio?

A
  • higher = more liquid
  • ideal would be 2:1
  • higher = too much finance tied into CA (might be better investing in NCA)
  • lower = too much concern about meeting CA
50
Q

what is the interpretation for quick ratio?

A

-ideal approx 1:1

51
Q

what is the gearing ratio?

A
  • the financial structure sensible?
  • how stable are you in the long term
  • ratio of external (borrowed) to internal (equity) LT finance
  • should be low where demand is volatile and profit fluctuates
52
Q

what is the formula for gearing?

A

Long term debt / total capital employed x 100

53
Q

what is the interest cover ratio?

A
  • how well the interest bill can be afforded

how well can business service its debt from PBIT

54
Q

what is the formula for interest cover ratio?

A

PBIT (op P) / interest

55
Q

what is the interpretation of interest cover ratio?

A
  • high cover may suggest they are under-borrowed, not taking advantage of full debt
  • high = repayments are secure
  • number of times profits
56
Q

what are investor ratios?

A

is it attractive to a potential shareholder

  • earnings per share
  • dividend cover
57
Q

what is earnings per share?

A

how much does investing in one share buy

58
Q

what is the formula for earnings per share?

A

shareholders profit (PAT) / total shares in issue

59
Q

what is the interpretation of earnings per share?

A
  • EPS indicator of earning ability of shares in common
  • for each share, how much is business earning
  • want this to be as high as possible
60
Q

what is dividend cover?

A

like interest cover: how affordable is the dividend?

61
Q

what is the formula for dividend cover?

A

profit after tax / dividends

62
Q

what is the interpretation for dividend cover?

A
  • expanding companies with new projects to invest in may pay out proportionally less in dividends
  • safety of future dividends may depend on a relatively cautious payout now

A - accounting spring (7 decks)

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