Unit 7 - Financial Ratios

Question 1

What is current ratio?

Answer 1

A measure of a firms liquidity (how quickly a business can turn assets into cash)
CURRENT ASSETS/ CURRENT LIABILITIES

Question 2

Meanings of current ratios

Answer 2

• less than 1 = bad as firm can’t meet its short term debt
• between 1 and 1.5= firm might get into difficulty if it doesn’t receive all debts or of one off debts suddenly appear
• 1.5 to 2 = liquidity is good
• above 2 = firm is in danger of stockpiling too much money (money isn’t being used productively as its sitting in the bank/ excess stock)
• the value of the current assets has to be more than the value of current liabilities

Question 3

Acid test (quick) ratio

Answer 3

• aims to overcome the problem of inventory
• should be between 1 and 1.5
  (CURRENT ASSETS- INVENTORY)/ CURRENT LIABILITIES

Question 4

What is return on capital employed (ROCE)

Answer 4

• Measures how effectively all the money brought into the company is at generating profit
• the higher the % the better
  CAPITAL EMPLOYED = TOTAL EQUITY + NON CURRENT LIABILITIES
  ROCE= (OPERATING PROFIT/CAPITAL EMPLOYED) X 100

Question 5

Functions of ROCE

Answer 5

• a good indication for how hard their investments are working
• used to compare multiple businesses across any industry (e.g. if ROCE is too low, costs could be too high/ sales aren’t being maximised)

Question 6

What is gearing ratio

Answer 6

• Measures how reliant a business is on long term debt to finance its operations
• gearing less than 50% is good
  (NON CURRENT LIABILITIES/ CAPITAL EMPLOYED) X 100

Question 7

Meanings of gearing ratios

Answer 7

too much gearing can mean you are too reliant on debt to finance your growth so if liquidity falls you could be in danger of not being able to pay off loans

Question 8

How to reduce gearing?

Answer 8

• pay off long term debts
• raise more equity in the form of profits or share capital
• window dressing (re-identifying long term debts on paper so gearing ratio looks better) however this automatically reduces current ratio so could look like liquidity is poor and it’s frowned upon.

Question 9

Debtor/ receivable days

Answer 9

debts owed to a firm by its customers for goods or services used or delivered but not yet paid for.
(RECEIVABLES/ REVENUE) X 365

Question 10

Payable/ creditor days

Answer 10

How long it takes to pay the supplier
(TRADE PAYABLES / COST OF SALES) X 365

Question 11

“Businesses want payable days to be BLANK than receivable days”

Answer 11

LONGER
… so they can improve cash flow as we are paying debts after we receive money

Question 12

Why don’t we want payable days to be TOO long?

Answer 12

• poor reputation
• removal of trade credit (an arrangement to buy goods and/or services on account without making immediate cash or cheque payments)
• interest
  (So stay within the trade credit terms or arrange longer to pay)

Question 13

What is stock / inventory turnover ratio

Answer 13

How many times stock is renewed each year
COST OF SALES / AVERAGE STOCK HELD

Question 14

How to calculate how many days stock is held for on average

Answer 14

DAYS IN YEAR / INVENTORY TURNOVER RATIO
(We want stock days to be short as you want to sell it to turn into cash)