RATIOS

Question 1

RETURN ON ORDINARY SHAREHOLDER’S FUNDS; RETURN ON EQUITY

Answer 1

Compares the amount of profit for the period available to the owners with their average investment in the business

Question 2

RETURN ON CAPITAL EMPLOYED

Answer 2

Measures business performance by expressing the relationship between operating profit and the average long-term capital investment.

Reveals the effectiveness with which funds are being used

Question 3

OPERATING PROFIT MARGIN

Answer 3

Most appropriate measure of operational performance because financing decisions do not influence this measure

Question 4

GROSS PROFIT MARGIN

Answer 4

the difference between sales revenue and the cost of sales

a measure of profitability in buying and selling goods or services (before any other expenses are considered)

Question 5

AVERAGE INVENTORIES TURNOVER PERIOD

Answer 5

average period for which inventories are held before they are sold

Question 6

AVERAGE SETTLEMENT PERIOD FOR TRADE RECEIVABLES

Answer 6

average time it takes for credit customers to pay the amount they owe (the use of an average may give a distorted representation)

Question 7

AVERAGE SETTLEMENT PERIOD FOR TRADE PAYABLES

Answer 7

How long it takes to pay for goods and services

High levels can provide the business with a free source of financing, but may decrease faith in the company (decrease in goodwill)

Question 8

SALES REVENUE TO CAPITAL EMPLOYED

Answer 8

examines how effectively the assets of the business are being used to generate sales revenue

too high may indicate the business is over trading an asset

Question 9

SALES REVENUE PER EMPLOYEE

Answer 9

measures the productivity of the workforce

Question 10

What does the cash conversion cycle tell us?

Answer 10

the overall return on funds employed within the business will be determined both by the profitability of sales and by efficiency in the use of capital

Question 11

CURRENT RATIO
v
ACID-TEST / QUICK RATIO

Answer 11

current: comparing liquid assets to current liabilities (higher number, more liquid business)

quick: more stringent test of liquidity because inventories cannot always be quickly converted to cash

Question 12

CASH GENERATED FROM OPERATIONS TO MATURING OBLIGATIONS RATIO
(CASH RATIO)

Answer 12

Provides a view of the business’ ability to meet its maturing obligations (view of its liquidity)

Question 13

GEARING RATIO

Answer 13

debt:equity
measures the contribution of long-term lenders to the long-term capital structure of the business (how geared the business is)

Question 14

INTEREST COVER RATIO
(TIMES-INTEREST-EARNED)

Answer 14

measuring the amount of operating profit available to cover interest payable

the lower the ratio,the greater the risk to lenders that interest payments will not be met

Question 15

DEBT RATIO

Answer 15

measures ability to pay all liabilities (lower is safer)

Question 16

red flags in financial statements

Answer 16

earnings problems
decreased cash flow
too much debt
inability to collect receivables
buildup of inventories
downward facing trends of sales, inventory and receivables

Question 17

overtrading

Answer 17

occurs when a business is operating at a level that cannot be sustained by the amount of finance that has been committed (causing liquidity problems)

• (often with young expanding businesses) managers did not anticipate the rapid increase in demand
• inflation causes more finance to be committed to inventories without an expansion of trade volumes

Question 18

limitations of ratio analysis

Answer 18

ratios inherit the limitations of financial statements (cannot include all resources, manipulation)

can only give a snapshot, and not a complete understanding

the reported value of assets do not always reflect their current value; inflation can cause expenses to mismatch the price at the time of sale