unit 7.2 - financial ratio analysis

Question 1

what is the balance sheet

Answer 1

-document describing the financial position of a company at a particular point in time
-historical data
- measures liquidity ( ability to pay bills on time)
- shows source of capital invested & in what form that capital is in

Question 2

what is the income statement

Answer 2

• describes income or expenditure of a business over a period of time
• also known as the profit and loss account ( shows profit /loss business has made over a year)
• helps assess profitability ( how effectively the business coverts its sales revenue into profit & how well it controls costs)

Question 3

non current assets

Answer 3

what the business owns with a lifespan of more than one year
- used repeatedly in the production process and allow a business to operate
- should not be sold
- machinery, land, vehicles, premises,
-lose their value through use ( depreciation)

Question 4

current assets

Answer 4

• assets owned by a business that are likely to be turned into cash within a year
  -constantly change form
• used to pay for current liabilities
  1. cash
  2. receivables - money owed from customers from purchases on credit, may become bad debt if they are unlikely to be able to pay back and so it is written off. - can use debt factoring
  3. inventories - stock, work in progress, finished goods. - value may reduce if it goes out of fashion or is damaged - stock control methods ( slowest to convert to cash)

Question 5

non current liabilities

Answer 5

debts due for repayment after more than a year
-e.g. mortgages, loans w fixed interest + long repayment date

Question 6

current liabilities

Answer 6

debts due for repayment within a year (short term debt)
- e.g. payables (owed to suppliers), overdrafts
- ideally business has £2 in CA to be able to pay every £1 in CL but this depends on whether they operate JIT & B2B

Question 7

working capital

Answer 7

-also known as net current assets + / net current liabilities -
formula : Current Assets - Current Liabilities
- money left over to be used for day 2 day operations
- gives an idea of a businesses liquidity

Question 8

net assets

Answer 8

• also known as net worth
• total assets ( NCA + CA) - total liabilities (NCL + CL)
• should be the same as the total equity

Question 9

total equity

Answer 9

• also known as shareholder’s funds ( funds provided by shareholders to set up business, fund expansions etc)
• total equity = retained profits + share capital
• capital & reserves shows how the business has been financed

Question 10

capital employed &
ROCE (profitability ratio)

Answer 10

CE = total equity + non current liabilities
- the amount of capital investment a business uses to operate & indicates how it is using its money

ROCE - operating profit/CE x 100
- shows how efficient business is at producing profit based on the capital invested

Question 11

liquidity

Answer 11

the ability to pay short term debts on time e.g. operating costs

Question 12

reserves + retained profit

Answer 12

• profit reinvested into the business that hasn’t been paid as dividends

Question 13

purposes x users of company accounts

Answer 13

• stakeholders
• shows value x size of business
• indication of firms liquidity
• helps bank identify collateral for loan requests
• shows current borrowing levels

Question 14

liquidity ratios

Answer 14

• measure whether a business can pay its short-term liabilities + how easily they can do this (how solvent they r)
  1. current ratio
  = CA / CL –> between 1.5 to 2:1 desirable ratio ~ between bcos firms can use JIT & suppliers to hold stock meaning they can operate at lower level

2. Gearing ratio - shows how reliant a firm is on borrowing & what proportion of capital invested is borrowed ( firm’s long-term liquidity)
   = NCL / ( TE + NCL) ~ aka capital employed –> above 50% highly geared & 25% lowly geared

Question 15

profitability ratios

Answer 15

• compares profits made with the size of the business ( show a firms efficiency at producing profit)
  1. gross profit margin, operating profit margin etc
  2. return on capital employed ( ROCE)

Question 16

efficiency ratios

Answer 16

inventory turnover - how quickly stock is converted into sales (number of times a year you sell off all your stock)
(cost of sales/ average inventory held)

receivables days - the number of days it takes to convert receivables into cash ( how long it takes to receive payment from customers)
(receivables/ revenue x 365) in days

payables days - the number of days it takes to pay any payables owed ( how long it takes to pay suppliers)
(payables/ cost of sales x 365) in days

Question 17

current ratio

Answer 17

• dependant on size of firm x industry
• firms w higher ratio may not be investing enough cash in NCA to expand business to generate profit or may be holding too much stock
• sources of finance e.g. sale x leaseback & long term borrowing used to improve cash level and therefore C ratio
• experience poor liquidity when growing due to extra costs so need healthy C ratio before expansion

Question 18

Gearing ratio

Answer 18

NCL/CE x 100
CE = NCL + total equity (shares + retained profit)

Question 19

-gross profit margin
- operating profit margin
- profit for the year margin

Answer 19

1. gross profit/ revenue x 100
2. operating profit/ rev x 100
3. profit for the year/ rev x 100

Question 20

efficiency ratios

Answer 20

• payables days should be higher than receivables days to be solvent
• firms that offer credit may use overdrafts/ debt factoring to fund their business

Question 21

issues with ratio analysis

Answer 21

• data may be window dressed ( made to look better) for various reasons e.g. attract investors
• economic factors + external factors may have impacted the results
• exceptional items may distort costs/profit e.g. one off costs like sold property
• firms may not always pursue profit maximisation but other objectives e.g. social enterprises ~ people, profit, planet