Ratios Flashcards
What is the purpose of ratio analysis in business?
To compare a firm’s performance or different organizations’ performance over a number of years.
What are the three main types of ratios used in business analysis?
- Profitability ratios
- Liquidity ratios
- Efficiency ratios
Who uses ratios as a decision-making tool?
Managers of a business and outsiders interested in the performance of the business.
What is a limitation of using ratios for business analysis?
Information is historical and may not be relevant to the current or future position.
What do profitability ratios measure?
How much profit an organization makes.
What is the formula for calculating the gross profit margin?
GROSS PROFIT / SALES REVENUE x 100
What factors can cause changes in the gross profit margin ratio?
- An increase or decrease in selling price
- A change in the cost of goods sold
What does the profit for the year margin measure?
Overall profit of the business after all expenses have been taken into account.
What is the formula for calculating the profit for the year margin?
PROFIT FOR THE YEAR / SALES REVENUEx 100
How can an organization improve the profit for the year margin?
- Reduce expenses
- Increase gross profit
What is return on equity employed used for?
To calculate how much money an investor will get back after a period of time.
What is the formula for calculating return on equity employed?
PROFIT FOR THE YEAR / OPENING EQUITY x 100
What are two ways to improve the return on equity employed ratio?
- Increase sales
- Reduce expenses
What do liquidity ratios measure?
The ability of a business to pay back short-term debts.
What is the commonly accepted liquidity ratio?
2:1 (twice as many current assets as current liabilities).
What is the formula for calculating the liquidity ratio?
CURRENT ASSETS / CURRENT LIABILITIES
What does a liquidity ratio of less than 2:1 indicate?
The business must try to secure more current assets and reduce current liabilities.
What is an acceptable liquidity ratio in a crisis situation?
1:1
What is the formula for calculating the quick ratio?
(CURRENT ASSETS - CLOSING INVENTORY) / CURRENT LIABILITIES
How can liquidity ratios be improved?
By using an efficient stock control system (e.g., JIT).
What do efficiency ratios measure?
The amount of times a business re-stocks their inventory during the year.
What does a higher inventory turnover rate indicate?
The business is earning profits more quickly.
What is the formula for calculating inventory turnover?
COST OF SALES / AVERAGE INVENTORY
How is average inventory calculated?
(OPENING INVENTORY + CLOSING INVENTORY) / 2
What should a business do if the inventory turnover rate is too low?
- Use JIT to avoid overstocking
- Sell off excess stock
- Negotiate sale or return with suppliers
