Topic 17: Ratio Analysis Flashcards
Evaluate the usefulness of ratio analysis.
Advanatages
Allows users to easily interpret the firms financial statements using the main performance indicators (profitability and liquidity).
Allows easy comparison over time between similar businesses
Collecting data on systematic basis enables trends to emererge and predictions to be made about the future
Disadvantages
Data is based on historic costs nad is questionable whether this is an indicator of futur eprefromance
Non-Financial information connot be shown e.g managment and labour problems
What is Liquidity?
it is the firms ability to generate cash needed to pay its current liabilities in the short run
What is Profitability?
it is the ability of firm to trade and operate at a profit that is sufficient to justify the risk of capital
How do we improve Liquidity?
Attract more sales and get the trade receivables to pay faster
Reduce drawings
Get a loan
Sell unwanted non-current assets
Invite more investors in the business (partners, shareholders)
How to improve Profitability?
Reduce expenses
Buy at cheaper prices
Sell at higher prices
Make production more efficient (if manufacturing)
What does GROSS PROFIT MARK UP tell us?
Gives us the % by which the cost of sales is ‘marked up’ to find the selling price
Cost of sales + Gross Profit = Sales
The above relationship is used to find missing figures in the trading a/c
What does GROSS PROFIT MARGIN tell us?
Tells us the % of gross profit we have been able to generate from our sales
What does PROFIT FOR THE YEAR MARGIN tell us?
Tells us the % of profit of the year we have been able to generate from our sales revenue
What does RETURN ON CAPITAL EMPLOYED tell us?
Compares the profit earned to the funds used to generate that profit
What does CURRENT RATIO tell us?
It indicates whether there are sufficient short-term assets to need short-term liabilities
What Current ratio is considered ‘ideal’? why is anything lower or higher considered bad?
around 2:1, any results around 1.4-2:1
A higher current ratio inefficient use of resources and
Anything lower would leave the firm vulnerable to trade payables
What does LIQUID RATIO tell us?
Shows whether the company has enough Liquid resources (quick assets to meet CL)
What are other names given to the LIQUID RATIO?
ACID TEST RATIO
QUICK ASSETS RATIO
What Liquid ratio is considered ‘ideal’?
Any result within the boundary 0.70-1:1 is accepted
What does a large difference between the Current and Liquid ratio mean?
A Large difference between the current ratio and the acid test ratio implies that a large amount of CA Is tied up in unproductive assets(inventory) so the company may struggle to raise money in the short run
