Topic 10: Ratios Flashcards
What is the definition of Profitability?
The ability of a business to control its expenses to earn a profit.
What is the definition of the Profit (Margin) Ratio?
The percentage of profit (after tax) that is contained in each dollar of sales.
What is the trend in the Profit (Margin) Ratio when it Increases?
An increase in profit in proportion to sales.
What is the trend in the Profit (Margin) Ratio when it Decreases?
A decrease in profit in proportion to sales.
What are some reasons behind an Increase in the Profit (Margin) Ratio?
- decrease in expenses
- increase in selling price
- decrease in cost of sales
What are some reasons behind a Decrease in the Profit (Margin) Ratio?
- increase in expenses
- decrease in selling price
- increase in cost of sales
What are some suggested strategies for improving the Profit (Margin) Ratio?
- decrease expenses
- increase selling price
- decrease cost of sales / find cheaper suppliers
What is the definition of the Gross Profit Ratio?
The percentage of profit the business has earned from its inventory.
What is the trend in the Gross Profit Ratio when it Increases?
An increase in gross profit in proportion to sales.
What is the trend in the Gross Profit Ratio when it Decreases?
A decrease in gross profit in proportion to sales.
What are some reasons behind an Increase in the Gross Profit Ratio?
- increase in selling price
- selling more high profit items
- decrease in cost of sales
What are some reasons behind an Decrease in the Gross Profit Ratio?
- decrease in selling price
- selling more low profit items
- increase in cost of sales
What are some suggested strategies for improving the Gross Profit Ratio?
- increase selling price
- decrease cost of sales / find cheaper suppliers
What is the definition of the Expense Ratio?
The percentage of expenses (exc. cost of sales) that is contained with each dollar of sales.
What is the trend in the Expense Ratio when it Increases?
An increase in expenses in proportion to sales.
What is the trend in the Expense Ratio when it Decreases?
A decrease in expenses in proportion to sales.
What are some reasons behind an Increase in the Expense Ratio?
- increase in expenses
- inclusion of an extra-ordinary expense
What are some reasons behind a Decrease in the Expense Ratio?
- decrease in expenses
What are some suggested strategies for improving the Expense Ratio?
- increase profit through increasing sales while maintaining expenses
- decrease expenses
What is the definition of the Rate of Return on Assets Ratio?
How efficiently a business has used its assets to generate a profit.
What is the trend in the Rate of Return on Assets Ratio when it’s High?
Good performance of assets or effective use of assets to generate profit.
What is the trend in the Rate of Return on Assets Ratio when it’s Low?
Poor performance of assets/non-effective use of assets to generate profit.
What are some reasons behind an Increase in the Rate of Return on Assets Ratio?
- increase in sales
- decrease in expenses
- decrease in total assets
What are some reasons behind a Decrease in the Rate of Return on Assets Ratio?
- decrease in sales
- increase in expenses
- increase in total assets
What are some suggested strategies for improving the Rate of Return on Assets Ratio?
- increase profitability by better control of expenses
- better use of assets
What is the definition of Liquidity?
How easy it is to turn assets into cash in order to pay debts as they fall due.
What is the definition of the Current Ratio?
The ability to pay off short term debts (less than 12 months) using current assets.
What is the trend in the Current Ratio when it is below 100%?
It will be difficult to pay off debts.
What is the trend in the Current Ratio when it is between 100% and 200%?
Should be easy to pay off debts (ideal/safe).
What is the trend in the Current Ratio when it is above 200%?
It is easy to pay off but current assets are not being used efficiently.
What are some suggested strategies for improving the Current Ratio?
- better credit policy (improve acc. rec.)
- improve stock turn-over (decrease inventory)
- monitor expenses
- pay back acc. payable
- reduce short term loans
What is the definition of the Quick Asset Ratio?
The ability to meet immediate debts using very liquid assets.
What is the trend in the Quick Asset Ratio when it is below 100%?
Should be able to pay off debts.
What is the trend in the Quick Asset Ratio when it is above 100%?
Will find it difficult to pay off debts.
What are some suggested strategies for improving the Quick Asset Ratio?
- better credit policy (improve acc. rec.)
- improve stock turn-over (decrease inventory)
- monitor expenses
- pay back acc. payable
- reduce short term loans
What is the definition of Leverage?
The amount of borrowings of a business.
What is the definition of the Debt to Equity Ratio?
Compares how much a company borrows externally compared to how much they borrow internally.
What is the trend in the Debt to Equity Ratio when it is above 100% (high)?
Reliant on external finance which can cause concern as we have to pay interest payments.
What is the trend in the Debt to Equity Ratio when it is below 100% (low)?
Not too reliant on external finance so will be able to pay off easily.
What are some reasons behind an Increase in the Debt to Equity Ratio?
Not necessarily bad because even though we pay interest, the borrowed funds can be used to expand operations (higher growth and sales).
What are some reasons behind a Decrease in the Debt to Equity Ratio?
Typically a good sign because less risk (manage interest payments) but the future growth of the business can slow down because there is a lack of expansion.
What are some suggested strategies for improving the Debt to Equity Ratio?
- increase capital contributions
- decrease drawings
- refinance or find loans with lower interest rates
- reinvest profits
What are three different limitations to ratio analysis?
Historic Focus not Future Focus: ratios reflect historic performance and do not predict future performance
Need for Comparison: ratios need to be compared with other information to be most useful
Data Manipulation: data could me manipulated to make data appear more desirable. This will impact ratio calculations & comparisons.
What are some things Ratios can be compared with?
- budgeted/predicted results
- previous years results
- industry averages
- other businesses
