Using Financial Ratios 3.7.2 Flashcards
What are financial ratios and what they they provide for managers
They compare two pieces of information e.g profit as a percentage of revenue.
They give managers a more in depth understanding of the financial performance of a business
What are the four types of finanacial ratios
Profitability ratios
Liquidity ratios
Efficiency ratios
Gearing ratios
What do profitability ratios provide for a business
A key measure of success for a business comparing profit to revenue and investment
What do efficiency ratios provide for a business
An indication of how well an aspect of business has been managed
What do liquidity ratios assess
The ability a business has to pay its debts
What do gearing ratios assess
The extent to which a business is based on borrowed finance
What do profit margin ratios compare
They compare a type of profit to the revenue that it was generated from over a trading period.
How can gross profit margin, operating profit margin and net profit margin be calculate
Gross profit / revenue x 100
Operating profit / revenue x 100
Net profit / revenue x 100
How may managers use profit margin ratios to asses their business
They may compare these ratios as doing so will give them an indication of the quality of profit and how well the business is managing various aspects of the business such as its direct and indirect costs
What does ROCE ratio do
Compares operating profit earned with the amount of capital employed by a business
What is capital employed
Capital employed is its total equity plus any non current liabilities
ROCE calculation
Operating profit / capital employed (total equity + non current liabilities)
What does ROCE show for a business
How effective a business is at generating profit from the investment placed within the business
What can ROCE be compared to
Can be compared to previous years and the general rate of interest
How can a business improve ROCE
Increasing operating profit or reducing capital employed
Current ratios is a key ……….. ………..
Current ratios are a key liquidity ratio
What do current ratios compare and what does it enable a business to understand
Compare the current assets with current liabilities. It assesses whether a business has sufficient working capital to pay off its short term debts
How is current ratio calculated
Current assets / current liabilities
What does a current ratio of 2:1 suggest
Suggest that a business has £2 of current assets for every £1 of current liabilities
What is meant when a current ratio is less than 1 e.g 0.5 : 1
The business may struggle to pay off its short term debts
What does gearing ratios analyse
Analyses how a business has raised its long term finance
What does the gearing ratio represent and how is it calculated
Represents the proportion of a firms equity that is borrowed.
Calculated by :
Non current liabilities / (total equity + non current liabilities) x 100
What is meant by a highly geared business and how may it affect a business
A highly geared business has more than 50% of its capital in the form of loans. They may be vulnerable to increases in interest rates (they have to pay more back)
What benefits may a low geared business have
Have the opportunity to borrow funds in order to expand. These may be business with secure cash flow or considerable assets
Why may being highly geared not always be bad for a business
Some shareholders may want a business to be financed through loan capital as long term borrowing can sometimes be cheaper than annual return shareholders require. E.g interests om a ten year loan may only require 6% whereas shareholders might expect an annual return of 20%
What is meant by liquidity
The ability for a business to pay off its short term liabilities
What do inventory turnover ratios measure and what does it compare
Measures the success of a company at converting inventories into revenue. It compares the value of inventories (at cost - cost of goods sold) with the sales achieved. The faster a business can sell its inventories the faster it achieves a profit
How are inventory turnover ratios calculated
Costs of goods sold / average inventories held
What is meant when inventory turnover rate is low
The lower the number the more efficient a business is.
What are turnover rates determined by (give examples)
They are dependant on the nature of a product. Perishable goods such as foods will have a much faster turnover than manufactured foods e.g blu-ray players/
How to determine average number of days inventory is held
(Costs of goods sold / average inventories held) / 365
What do receivable days ratio calculate
The amount of time it takes for a business to collect debts that it is owed. The shorter the period, the faster cash is flowing into the business
How is receivable day ratios calculated
Receivables / revenues x 365
Shorter receivable period means
The firm will find it easier to meet its short term cash needs
When may a firm experience long payment periods
When firms offer trade credit to customers - this can cause cash flow problems
What do payable days ratio calculate
Calculates the time it takes for a business to pay its creditors - the longer the period the long the business is retaining cash within the business
How is payable ratio calculated
Payables / costs of sales x 365
Why may long payable periods benefit a business and how can it also damage a business
The longer the period the easier it may be for a business to pay off short term debts
However,
Business that delay payments to suppliers/creditors may damage relationships and cause future problems when making deals
When might a business want to calculate its inventory turnover
When it holds large inventories - business will be interested in how quickly these inventories will be turned over as this will help free up working capital
Difference between receivables and payables
Receivables are the monies owed to a business from its debtors
Payables are expenses that a business must make to its creditors
What is the link between receivables and liquidity of a firm
The faster a business is able to retrieve debts from its debtors (receivables) the quicker cash will flow into a business, improving its liquidity position
Who may use financial accounts and how may they be used
Managers - assess performance of the business and whether resources are being used efficiently
Potential investors and lenders - assess security and liquidity of a business
Shareholders - assess return they may receive on their investment
Government - calculate the tax liability of the business
3 benefits of ratio analysis
- allows business to calculate and compare trends over a period of time
- shows greater insights than financial accounts on their own
- information can be used against benchmark data e.g industry average
3 limitations of financial ratio analysis
- doesn’t take into account qualitative issues such as brand image or customer service performance
- does not take into account the impact of long term decisions such as investment today may lower profitability but boost it in the long term
- ratios do not take into account economic conditions or the performance of other business
What does window dressing involve and give an example
Manipulating its financial accounts to make them look more favourable to stakeholders. E.g delaying payments to a later period to boost short term profit this may boost morale and attract potential shareholders.
