Ratios and Insolvency

Question 1

purpose of ratio analysis

Answer 1

• assess financial strengths and weaknesses of company and compare with other companies or industry averages
• identify trends in financial position of company
• for investors to decide whether or not business is a good investment when checking whether business is stable or not
• for suppliers to decide whether or not business is a good credit risk when deciding whether to give credit term

Question 2

to interpret ratios, they need to be compared with

Answer 2

• budget from same accounting period with expected figures
• results for same business from previous accounting periods to analyse trends
• results for similar business from same period to compare with competitors
• average ratios for that type of business to compare with industry averages

Question 3

liquidity ratio

Answer 3

• assess short term business survival

- indicates ability of a company to pay its operating costs and debts`

Question 4

stability ratio

Answer 4

• assess long term business survival
• leverage refers to how a company funds its assets
• low leverage ratio indicates capacity to take on more debt
• high leverage ratio indicates that debt is not the best option for source of funds as there already is a high level of debt

Question 5

profitability ratio

Answer 5

• measures performance of a company over a period
• indicates how well a company uses its assets to generate profit
• used as performance targets and to assess performance and potential investments

Question 6

efficiency ratio

Answer 6

• evaluates effectiveness in managing assets to increase profitability and liquidity
• measures how long it takes to sell stock

Question 7

market ratio

Answer 7

• evaluates companies that are listed on the stock exchange

- decisions are made about which companies to invest in and when to buy or sell shares in those companies

Question 8

limitations of ratio analysis

Answer 8

• identifies problems but does not explain the causes
• must be used with reference to other ratios and trends and in comparison with other companies and industry averages
• companies may manipulate policies to get the best ratio results
• ratios are calculates using NCA based on historical cost