Ratios Flashcards
Current ratio
current assets/ current liabilities.
Current ratio is a measure ofthe ability of a business to pay its short term debts, that is, debts payable within 12 months.
Interpretation of Current ratio
Current ratio of less than 100%
* indicates a business may find it difficult to pay its short term debts or that a business is operating in an industry where money is collected from sales very quickly
Current ratio between 100% and 200%
* indicated that a business should be able to pay its short term debts
Current ratio of more than 200%
* Indicates that a company should be able to comfortable pay its short term debts or that a company has an excessive level of current assets and is not making best use of its resources to generate revenue.
Gross profit ratio
gross profit/ net sales
Gross profit ratio measures a company’s profitability by comparing gross profit to net sales. It indicates the percentage of each sales dollar remaining after deducting the cost of goods sold.
Interpretation of Gross profit ratio
A higher gross profit ratio suggests better profitability, indicating that the company is efficient in managing its production costs and generating revenue. Conversely, a lower gross profit ratio indicates a smaller portion of sales revenue is available to cover operating expenses and generate profit. This could be due to high production costs, intense competition, or pricing pressures.
Profit ratio
profit/ net sales
profit ratio shows the percentage of profits after income tax that is contained in each dollar of sales.
Interpretation of Profit ratio
Increase in the profit ratio may be caused by:
* a reduction in expenses
* an increase in the selling prices of the products of the company greater than the cost of sales
* a cheaper supplier of inventory has been found
A decrease in the profit margin ratio may be caused by
* expenses increasing that are not directly passed on to consumers in the form of increased selling prices
* Increase in competition causing the business to lower its selling price
Expense ratio
operating expenses/ net sales
Expense Ratio is a financial metric that measures the proportion of operating expenses to net sales. It indicates how efficiently a company manages its costs relative to revenue.
Interpretation of Expense ratio
A lower ratio signifies better cost control, meaning the company is generating more profit for each dollar of revenue. Conversely, a higher ratio indicates that a larger portion of revenue is being used to cover operating expenses, potentially impacting profitability.
Return on equity ratio
Profit/ Equity at end of period
Return on Equity (ROE) is a financial ratio that measures the profitability of a company in relation to its shareholders’ equity. It shows how efficiently a company generates profits from the money invested by shareholders.
Interpretation of Return on equity ratio
a higher ROE indicates better management in generating returns for investors. However, it’s crucial to compare ROE within the same industry as performance can vary significantly across sectors. A consistently high ROE might signal a company’s ability to generate sustainable profits, while a declining ROE could indicate potential issues with profitability or efficiency.
Debt to equity ratio
Extent of gearing in a business
Interpretation of Debt to equity ratio
There is no one acceptable figure for the debt to equity ratio. A debt to equity ratio of 40% would be considered by many investors to be conservative and a debt to equity ratio of 100% would be considered to be high.
It should be noted that the debt level of a company must be consider in relation to the profit made by the company, this is, how the company has used its debt finance to generate income.
