Ratios for profitability, liquidity and efficiency

Question 1

What does ratio analysis do?

Answer 1

ration analysis allows for a more meaningful interpretation of published accounts by comparing one figure with another.
Ratio analysis allows for both interfirm and intrafirm comparisons.

Question 2

What is profitability?

Answer 2

measure of a firm in relation to another factor. Allows for a more comprehensive assessment of performance of a firm.

Question 3

Gross profit margin calculation

Answer 3

(gross profit/revenue) x 100

Question 4

What gross profit margin shows

Answer 4

Ratio looks at gross profit as a percentage of sales turnover.
if gross profit margin fall from year to year or it thought to be too low a firm may reduce costs of its purchases. e.g. looking for a cheaper supplier(without affecting quality of products)
or it may try to increase sales without increasing cost of goods sold.

Question 5

Mark up calculation

Answer 5

(gross profit/cost of sales) x 100

Question 6

What mark up shows

Answer 6

Ratio looks at profit as a percentage of cost of sales. Shows what percentage a cost of sales is added to reach selling price.

Question 7

Net profit margin calculation

Answer 7

(net profit/ revenue) x 100

Question 8

What net profit margin shows

Answer 8

Ratio looks a net profit as a percentage of sales turnover.
Shows for every £1 made in sales, how much of it is left as net profit after all expenses have been deducted.
If net profit margin falls from year to year it is thought to be too low, a firm may look to reduce its expenses e.g. moving to cheaper premises or cutting staff costs.
Accountant must try to identify cause of falling figure - whether it is related to sales, cost of goods sold or expenses as all impact net profit margin.

Question 9

Return on capital employed (ROCE) calculation

Answer 9

(net profit before interest and tax/capital employed) x 100

Question 10

What ROCE shows

Answer 10

This ratio shows the percentage return a business is achieving from the capital being used to generate that return.
It shows for every 31 invested into the business in owners capital or retained profits, what percent is being generated in profit.
Investors will often compare ROCE to the interest rate being offered in a bank to see if their investment is working effectively for them in generating a return.

Question 11

What does liquidity mean?

Answer 11

measures how solvent a business is - how able it is to meet short term debts

Question 12

Current ratio calculation

Answer 12

current assets/ current liabilities

Question 13

What current ratio shows

Answer 13

This ratio shows the amount of current assets in relation to current liabilities and is expressed as x:1.
A 2:1 ratio is considered acceptable however a 0.5:1 ratio is bad because if the firms bank demanded that it repaid its overdraft immediately and creditors demanded payments, the firm would not be able to cover these demand from current assets - so its a dangerous position to be in.

Question 14

liquid capital ratio calculation

Answer 14

(current assets - inventory) / current liabilities

Question 15

What liquid capital shows

Answer 15

liquid capital is thought to be a tougher measure of a firm’s liquidity.
Like current ratio it shows the amount of current assets in relation to current liabilities, but does not include inventory.
This is because inventory is considered to be the hardest current asset to turn into cash quickly - expressed as x:1

Question 16

What are efficiency ratios?

Answer 16

efficiency ratio’s tend to be used to assess how well management is controlling key aspects of the business - primarily stock and finances.

Question 17

trade receivable days calculation

Answer 17

(trade receivables/credit sales) x 365

Question 18

What trade receivable days show

Answer 18

The ratio measures on average how long it takes debtors to pay, it is expressed as a number of days.
Trade receivable days will vary firm to firm, depending upon the nature and price of items sold and whether the business deals in business to business of business to consumer sales.

Question 19

trade payable days calculation

Answer 19

(trade payables/credit purchases) x 365

Question 20

What trade payable days show

Answer 20

The ratio measure, on average how long it takes a firm to pay for goods and services bought on credit, is expressed as a number of days.

Question 21

Inventory turnover calculation

Answer 21

(average inventory/cost of sales) x 365
average inventory = (opening inventory + closing inventory) / 2

Question 22

What inventory turnover shows

Answer 22

The ratio measures the average amount of time an item of stock is held by a business, is expressed as a number of days.
If rate of inventory turnover appears high for nature of the product, this might result in stock going out of date or out of fashion.

Question 23

Limitations of ratios

Answer 23

• they are calculated on past data and may no be a true reflection of the business’s current performance
• records may have been manipulated and therefore the ratios will be based on potential misleading data.
• ratios do not consider qualitative factors
• a ratio can indicate that there is a problem in a business but does not directly identify the cause o the problem or the solution.
• interfirm comparisons can be difficult as not all firms report their performance in the same way or generate their accounts in the same way.