Week 5

Question 1

What is the purpose of ratio analysis?

Answer 1

• evaluates + interprets financial info
• assesses profitability used for trend analysis + comparisons
• can identify items requiring further investigation
• helps understand business (investors + other stakeholders)

Question 2

Advantages of ratios:

Answer 2

• easy to calculate
• simplify data to highlight trends
• express relationships between different figures
• enables comparisons between different sized businesses
• can understand business operations

Question 3

Limitations to ratios:

Answer 3

• comparisons misleading if different accounting policies are used
• historical comparatives distorted by inflation
• aggregate nature = some data needed is not disclosed
• some benchmarks N/A for all types of industry
• different industry / circumstances distort comparatives
• multiple ratios needed for good indication of performance
• doesn’t consider non-financial info

Question 4

Return on capital employed (ROCE):

Answer 4

(Profit before tax, interest and preference dividends/
Net capital employed)
X100

:) how effectively assets are used
:) key ratio in annual reports
:) guides investors: highest returns

:( SFP figures don’t represent current values
:( encourages retention of older, less efficient assets
:( not all assets used to generate profit included in SFP

Question 5

Gross Profit Margin:

Answer 5

(Gross profit/
Revenue)
X100

:) shows percentage of sales revenue is gross profit
:) big variation between certain industries
:) changes due to unit selling price, costs, product mix and productivity.

:( product mix variation between businesses even in same sector distorts comparison

Question 6

Operating profit margin:

Answer 6

(Operating profit/
Revenue)
X100

:) what percentage of sales revenue is operating profit
:) changes due to gross profit margin + changes in overheads
:) big variation in profit margins between diff industries due to variations in expenses

:( product mix between businesses distorts comparisons

Question 7

Asset turnover ratio:

Answer 7

(Revenue/
Net capital employed)
X100

:) measures activity + productivity
:) changes due to production efficiency + capacity
:) variation in tech varies by industry

:( denominator can be distorted by age old assets (encourage retention of older/less efficient assets)

Question 8

(L)
Current ratio:

Answer 8

Current assets/
Current liabilities

:) sees if assets cover liabilities
:) should be in region of 1.5 - 2 but can vary significantly by industry

:( ignores significant variation in liquidity of assets

Question 9

(L)
Quick Ratio:

Answer 9

Current assets - inventories /
Current liabilities

:) extent current liabilities are covered by more liquid assets
:) should be at leat 1 but can vary by industry

:( very simple measure of liquidity, not reliable to predict insolvency

Question 10

(E)
Trade receivables (days)

Answer 10

Trade receivables/
Revenue
X365 days

:) average no. of days credit taken by trade receivables