Ratios Flashcards
Liquidity ratios
Current ratio, quick asset ratio
Current ratio
Measures the ability of a business to pay its short term debts.
Current ratio less than 100% = business may have difficult paying short term debts OR is in an industry where money is collected from sales very quickly.
Between 100% and 200% = should be able to pay back short term debts.
More than 200% = should be able to comfortably pay its short term debts or that a company has an excessive level of current assets and is not making the best use of its resources to generate revenue.
Quick asset ratio
Measures the ability of a business to pay its short term debts using only its more liquid current assets.
100% or more = should be able to pay back.
Less than 100% = business may not be able to pay back debts IN AN EMERGENCY.
Stability ratios
Measures the long term survival prospects of a business based on the extent of borrowings of the business. Highly geared = large interest and loan re-payments = increased failure risk.
Debt to equity ratios and times interest earned.
Debt to equity ratios
Measures the extent of gearing of a business.
No acceptable figure.
Below 40% may be conservative and more than 100% may be too high.
Needs to be considered in relation to profit made by company (how has company used its debt finance to generate income?)
Times interest earned
Number of times interest can be covered by profit before tax.
Between 3 and 4 is a good safety margin for the company.
Profitability ratios
Profit margin ratio and rate of return on assets.
Profit margin ratio
Shows the percentage of profit after income tax that is contained in each dollar of sales.
Increase because of:
- reduction in expenses
- increase in selling prices of products of company greater than increase in cost of sales
- cheaper supplier of inventory is found
Decrease because of:
- expense increases not being fully passed onto consumers in form of increased selling prices.
- increased competition causing business to lower its selling prices.
Rate of return on assets
Measures how efficiently a business has used its assets to generate a profit.
Should be compared to previous years or industry average.
Market ratios
Used by investors to review performance of public companies listed on the ASX.
Earnings per ordinary share, price earnings ratio and dividend yield.
Earnings per ordinary share
Measures the profit available to shareholders expressed as an amount per share. Determines the likelihood of a higher dividend payout.
Shareholder wants to see an increase each year.
Price earnings ratio
Measures the amount investors are willing to pay for every dollar of profit to own ordinary shares.
High ratio = investors believe future profit growths are good OR are over-confident.
Low ratio = investors believe future profit growths are poor OR are under-estimating.
Dividend yield
Measures the current return to an investor on buying a share on the stock exchange.
IGNORES CAPITAL GROWTH OR CAPITAL LOSS.
Efficiency ratios
Evaluate the performance of the management of a company in areas of inventory and accounts receivable.
Debtors collection period and inventory turnover.
Debtors collection period
Measures how quickly a business collects the money owing from credit sales.
Uses the debtors total before subtracting allowance for doubtful debts.
Increase:
- Poor debt collection procedures.
- Slow processing of sales invoices.
- May not be checking credit rating of new customers.
- May offer longer credit terms to potential customers to increase sales.
Decrease: credit control and collection procedures have improved.
Inventory turnover
Measures how many times each year a business replaces its inventory.
Increase: products sold by company are more popular with consumers.
Decrease: business has ordered too much inventory and may be left with excessive amount of slow moving/obsolete inventory.
Limitations on ratio analysis
Ratios do not identify the cause of the problem.
Ratios are of limited value by themselves.
Limited disclosure information makes it impossible to calculate some ratios.
Not always possible to compare ratios between businesses as different accounting policies may have been chosen that will affect ratio calculations.
Diversification of investments
Best to invest in a number of companies across a range of industries. A profit downturn in one industry may be overset by profit growth in another industry. Diversification will reduce the risk of making a loss on investments.
What does a decrease in dividend yield show to investors?
The dividend yield has declined slightly over the two years which is not positive. This indicates that dividends have fallen slightly compared to its share price. Investors would be concerned with such a low dividend yield but may indicate profit retention for future expansion. Reflective of the company’s lower profitability or recent improvement in market share price.
Decline in profit ratio
The company performance could be worse because of higher expenses or lower sales or gross profit.
Debtors Collection Period Analysis
This measures the efficiency of management to collect amounts owing by debtors from credit sales within a reasonable period of time. It is an average over the year. The ratio is used by management to check efficiencies in the credit sales processing and the credit department. The shortest possible collection period, within normal trading terms, is considered best. Collection times may be influenced by the business’ normal trading terms and conditions, general economic conditions, and comparison
with competitors. Financially, holding too much in debtors is an undesirable use of
capital.
Inventory Turnover Analysis
This measures the efficiency of management to effectively manage inventory levels. It is an average over the year and across all stock for sale. The ratio is used by management to check efficiencies in inventory and the supply chain. It is desirable to have an adequate stock level to ensure prompt supply to customers, without carrying too much stock that may deteriorate if unsold. Financially, holding too much stock is an undesirable use of capital.
Discuss how the debtors collection ratio can be used as target key performance indicators by
directors for decision-making purposes.
The KPI for the debtor’s collection rates may be set, for example, at 30 days. If the
KPI was reasonable and the actual ratio exceeds 30 days, then this indicates there
is a problem with collecting amounts owing from debtors. The directors will ask
management to look at ways to improve this ratio in the future. However, if it is
unreasonable to expect to collect debts within 30 days, due to industry averages
being much longer, then the KPI will need to be reviewed.
Discuss how the inventory turnover ratio can be used as target key performance indicators by
directors for decision-making purposes.
The inventory/stock turnover ratio may be set, for example, at 24 times per year,
which means that inventory is replaced 24 times over the year. If the ratio is
15 times per year, then management will be very concerned as inventory is moving
too slowly. If 24 times per year is a reasonable KPI, the directors will be wanting
management to investigate why inventory is not being sold more quickly and
investigate ways to improve turnover. However, if 24 times per year is
unreasonable then the KPI will need to be reviewed.
Purpose of ratio analysis
To evaluate profitability, liquidity and leverage.
Liquidity defintion
The ability of a company to pay back its debts when they fall due.
Profitability definition
The company’s ability to generate a return from its investment in assets or equity,
How can a business have both high profitability and low leverage?
Profit may be high due to non-cash items such as high credit sales - cash flow can still be low thus liquidity might be poor.
What results are most likely to occur for a highly geared company over a long period of time?
If a business is highly geared, then it has a high proportion of externally generated debt, resulting in the requirement to pay high levels of interest to external stakeholders.
