Researching a business - evaluating financial information

Question 1

Uses of ratio analysis

Answer 1

• compare a business performance over two time periods
• compare business performance to competitor
• compare budgeted and actual performance
• investigate areas where business is not performing

Question 2

Two main ratios studied

Answer 2

• gross profit as a percentage of sales
• net profit as a percentage of sales

Question 3

Gross profit as a percentage of sales - what it suggests and factors that may change it

Answer 3

• high percentage indicates that business have efficient buying policy or high selling price
• an increase or decrease in selling prices (deliberate decision)
• change in cost of goods sold (outwith control)

Question 4

Gross profit as a percentage of sales - formula

Answer 4

(gross profit / sales) x 100%

Question 5

Net profit as a percentage of sales - what it suggests and use

Answer 5

• low figure shows expenses are high and should be further investigated
• used to highlight efficiency and control costs

Question 6

Net profit as a percentage of sales - formula

Answer 6

(net profit / sales) × 100%

Question 7

Limitations of ratio analysis

Answer 7

• information is historical, too late to do anything about it
• only considers financial info not PESTEC etc.
• comparisons are difficult - different conditions apply in different years and no two companies are exactly the same

Question 8

Other 5 ratios

Answer 8

• return on capital employed
• mark-up ratio
• current or working capital ratio
• acid test ratio
• rate of stock turnover

Question 9

Return on capital employed - expansion

Answer 9

• higher ROCE, better
• low number due to low sales, high costs, high expenses, PESTEC
• solutions, increase sales, lower costs

Question 10

Mark-up ratio - expansion

Answer 10

• higher = better
• low number due to cost of sales increasing, selling price too low
• solutions, find cheaper supplier, increase selling price

Question 11

Current/working capital ratio - explanation

Answer 11

• optimum is 2:1
• indicates ability to pay short term debts
• takes into account stock figure
• formula is current assets/current liabilities

Question 12

Current/working capital ratio - problems and solutions

Answer 12

Problems
- increasing current liabilities, too many credits
- decreasing current assets, decreasing stock or cash

Solutions
- decrease current liability
- increase current assets

Question 13

Acid-test (liquidity ratio) - explanation

Answer 13

• the optimum is 1:1
• this would mean being able to pay off debts without having to sell any stock
• formula: current assets - stock/current liabilities

Question 14

Acid-test ratio - problems and solutions

Answer 14

problems
- increasing current liabilities - too many creditors
- decreasing current assets (low cash flow)

solutions
- decrease current liabilities (pay off creditors or work to reduce the amount owed to creditors)
- increase current assets (increase cash available by selling fixed assets or invest more money)

Question 15

Rate of stock turnover (efficiency ratio) - explanation

Answer 15

• higher number is better
• tells us how many times in a period stock is being completely sold
• indicates successful products/sales team

Question 16

Rate of stock turnover (efficiency ratio) - formula

Answer 16

• cost of goods sold/average stock
• average stock = (opening stock + closing)/2

Question 17

Current/fixed

Answer 17

• current = within a year
• fixed = more than a year

Question 18

Return on capital employed - formula

Answer 18

• net profit/capital employed x 100

Question 19

Net profit ratio - formula

Answer 19

• net profit/sales x 100

Question 20

Ways to increase current assets

Answer 20

• cash discounts
• debt collectors

Question 21

Ways to decrease current liabilities

Answer 21

• negotiate better terms with creditors
• avoid cash payments (hire purchase)