Ratios

Question 1

Gross profit ratio (%)

Answer 1

Gross profit x 100%
Revenue

Assesses the profitability of a company’s core activity

Question 2

Operating profit ratio (%)

Answer 2

Operating profit x 100%
Revenue

Shows operating profit generates ad a percentage of sales

Question 3

Return on capital employed ratio (%)

Answer 3

Operating profit x 100%
Capital employed

Where capital employed is Equity + Non-current Liabilities

Expresses a company’s profit as a percentage of the amount of capital invested in the company

Question 4

Current ratio

Answer 4

Current Assets
Current Liabilities

Usually 2:1

Measures a company’s ability to pay short-term obligations

Question 5

Quick ratio (acid test)

Answer 5

Current Assets - Inventory
Current liabilities

Usually 1:1

Measures a company’s ability to meet short-term obligations using it’s MOST LIQUID assets

Question 6

Trade receivables collection period (days)

Answer 6

Trade receivables x 365
Revenue

Measures how quickly cash is being collected from debtors

Question 7

Trade payables payment period (days)

Answer 7

Trade payables x 365
Cost of sales

Measures how long it takes a company to pay it’s trade payables

Question 8

Inventory holding period (days)

Answer 8

Inventory x 365
Cost of sales

Measures the number of days inventories are held (on average)

Question 9

Asset turnover ratio

Answer 9

Revenue
Capital employed

Where capital employed is Equity + Non-current Liabilities

x:1

Measures the level of efficiency of the company’s assessed to generate sales

Question 10

Interest cover ratio

Answer 10

Operating profit
Interest expense

Measures the number of times that the interest payable for an accounting period could have been paid out of available profits

Question 11

Gearing ratio

Answer 11

Non-current liabilities
Equity + Non-current liabilities

Measures the extent to which a company’s long term funds have been provided by lenders

Question 12

What should a firm do if either:
The current ratio is not 2:1 or
The quick ratio is not 1:1

Answer 12

If the current ratio and quick ratio is outside of this range then further investigation should be made by looking at the operating cycle

Question 13

What are low, normal and high levels of gearing?

Answer 13

Low gearing - less than 25%
Normal gearing - 25% to 50%
High gearing - more than 50%

Question 14

What are some issues with highly geared firms?

Answer 14

The higher the borrowing (gearing), the higher the financial risk

If a company has too much debt:

• May not be able to meet their interest payments when they are due
• May not be able to make the repayments when they are due
• May be spending too much on interest that there is nothing left to give back to the shareholders as dividends
• The company will find it hard to borrow any more money if gearing is too high

Question 15

What is the main limitation of ratio analysis?

Answer 15

They are based on financial statements and are therefore only as good as the financial statements they derive from

Question 16

What are other limitations of ratio analysis

Answer 16

• They don’t provide answers - the analysis is based on assumptions. They only highlight unusual information that needs to be further investigated
• Can be difficult to find a suitable company to compare to
• The ratios need to be looked at as a whole rather than individually when analysing
• Directors may manipulate the figures in financial statements