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FIN1003 Financial Reporting and Analysis > Week 5a - Financial Ratios: Solvency and Profitability > Flashcards

Week 5a - Financial Ratios: Solvency and Profitability Flashcards

1
Q

What are the three main groups of financial ratios?

A

Financial strength/solvency
Profitability
Stock market (Investment)

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2
Q

What do financial strength/solvency ratios determine?

A

Is the business likely to survive? Can it pay its liabilities as they fall due?

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3
Q

What do profitability ratios determine?

A

Is the business sufficiently profitable? Is it making the best use of the resources available to it?

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4
Q

What do stock market (investment) ratios determine?

A

How are the company’s shares performing on the stock market? Are they likely to be a good investment?

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5
Q

State the different types of solvency ratios

A

Short term

Long term

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6
Q

State the different types of profitability ratios

A

Overall Profitability
Profitability on Sales
Utilisation of Assets (Efficiency)

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7
Q

What does a short term solvency ratio determine?

A
  • Can short term liabilities be met as they fall due

- Relationship between current assets and current liabilities

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8
Q

What does a long term solvency ratio determine?

A
  • Can the company service the long term loans?
  • Capital gearing
  • Interest cover
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9
Q

Give the formula for the current ratio

A

Current ratio = current assets/current liabilities

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10
Q

What does the current ratio indicate?

A

The extent to which short-term assets are available to meet short-term liabilities

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11
Q

Why is the underlying trend from a current ratio important?

A

If the ratio is worsening over time, and especially if it falls to less than 1:1, one would look closely at the cash flow

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12
Q

How come some companies can operate on a tight current ratio?

A

They can plan the timing of cash inflows and outflows quite precisely

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13
Q

Calculate the current ratio given the following information:
Current assets = £19,000
Current liabilities = £10,000

A

Current ratio = current assets/current liabilities

= 19,000/10,000 = 1.9

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14
Q

Calculate the current ratio given the following information:
Current assets = £22,000
Current liabilities = £17,000

A

Current ratio = current assets/current liabilities

= 22,000/17,000 = 1.29

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15
Q

Give the formula for the quick ratio (acid test)

A

Quick ratio = (Current assets-Inventories)/Current Liabilities

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16
Q

Why are inventories excluded from the quick ratio?

A

In a crisis, where short-term creditors are demanding payment, the possibility of selling stocks (inventories) to raise cash may be unrealistic (as inventories are less liquid than other current assets.)

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17
Q

Why, for many companies, is the quick ratio less than 1:1?

A

As it is unlikely that all creditors will require payment at the same time

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18
Q

Calculate the current ratio given the following information:
Current assets = £19,000
Current liabilities = £10,000
Inventories = £6,000

A

Quick ratio = (Current assets-Inventories)/Current Liabilities
= (19,000-6,000)/10,000 = 1.3

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19
Q

Calculate the current ratio given the following information:
Current assets = £22,000
Current liabilities = £17,000
Inventories = £5,000

A

Quick ratio = (Current assets-Inventories)/Current Liabilities
= (22,000-5,000)/17,000 = 1

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20
Q

What is financial structure/gearing?

A
  • The way the business is financed

- The balance between equity and debt

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21
Q

What ratios measure financial structure/gearing?

A

Capital gearing ratio

Interest cover ratio

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22
Q

Give the formula for capital gearing ratio

A

Gearing ratio = LT borrowings / (LT borrowings + Equity)

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23
Q

What does a low gearing ratio indicate?

A
  • A low exposure to financial risk

- Little difficulty in paying loan interest and repaying the loans as they fall due

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24
Q

What does a high gearing ratio indicate?

A
  • A high exposure to financial risk

- There are interest charges to be met and a requirement to repay the loans on the due date

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25
Q

Calculate the gearing ratio given the following information:
Total equity = £40,500
Long term borrowings = £20,000

A

Gearing ratio = LT borrowings / (LT borrowings + Equity)

= 20,000/(40,500+20,000) = 0.331 = 33.1%

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26
Q

Calculate the gearing ratio given the following information:
Total equity = £29,500
Long term borrowings = £15,000

A

Gearing ratio = LT borrowings / (LT borrowings + Equity)

= 15,000/(29,500+15,000) = 0.337 = 33.7%

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27
Q

Give the formula for interest cover ratio

A

Interest cover = Operating profit/interest

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28
Q

Give the formula for operating profit

A

Operating profit = Gross profit - operating costs for distribution and administration

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29
Q

What does the interest cover ratio indicate?

A

Whether the profit generated before interest and tax is sufficient to give high cover for the interest charges

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30
Q

What does a low interest cover ratio indicate?

A

If the interest cover is falling or low, there may be increasing cause for concern

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31
Q

Calculate the interest cover ratio given the following information:
Finance costs = -£1,000
Profit before tax = £8,500

A

Interest cover = Operating profit/interest

= (8,500 + 1,000)/1,000 = 9.5

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32
Q

Calculate the interest cover ratio given the following information:
Finance costs = -£1,000
Profit before tax = £9,000

A

Interest cover = Operating profit/interest

= (9,000 + 1,000)/1,000 = 10

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33
Q

Outline the effect of financial gearing

A
  • The movement in the larger cog (operating profit) causes a more than proportionate movement in the smaller cog (returns to ordinary shareholders)
  • In other words, returns to shareholders
    become more sensitive to changes in operating profits
  • Diagram available on page 23 week 5 notes
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34
Q

What is an ungeared company?

A

Debt-equity ratio = 0

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35
Q

What is a geared company?

A

Debt-equity ratio > 0

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36
Q

When profits are rising, is it preferable to be a shareholder in a geared company or a shareholder in an ungeared company?

A

When profits are rising, it is preferable to be a shareholder in a geared company (i.e. debt-equity ratio>0)

37
Q

When profits are falling, is it preferable to be a shareholder in a geared company or a shareholder in an ungeared company?

A

When profits are falling, it is preferable to be a shareholder in an ungeared company (i.e. debt-equity ratio=0)

38
Q

What is the effect of a 20% increase/decrease in operating profit on the net profit of shareholders for company X plc and company Y plc? Assume operating profit before the change to be constant at 100.
Interest (X plc) = 0
Interest (Y plc) = 50

A

(a) Effect of 20% decrease in operating profit
X plc Y plc
Operating profit 80 80
Interest 0 (50)
Net profit for ordinary shareholders 80 30
Percentage decrease 20% 40%

(a) Effect of 20% increase in operating profit
X plc Y plc
Operating profit 120 120
Interest 0 (50)
Net profit for ordinary shareholders 120 70
Percentage increase 20% 40%

39
Q

What are the different sections in which profitability can be examined?

A

• Profitability can be examined in three sections:

  1. Overall profitability
  2. Profitability on sales
  3. Utilisation of assets (efficiency)
40
Q

What does ROCE stand for?

A

Return on capital employed

41
Q

Give the formula for the ROCE ratio

A

ROCE = Net profit before interest and tax (EBIT)/ (Equity + Long Term Debt)

42
Q

What does ROCE measure?

A
  • The performance of a company as a whole in using all sources of long-term finance
  • It is often seen as a measure of management efficiency
43
Q 
Calculate the ROCE ratio given the following information:
Finance costs = -£1,000
Profit before tax = £8,500
Total equity = £40,500
Long term borrowings = £20,000
A

ROCE = Net profit before interest and tax (EBIT)/ (Equity + Long Term Debt)
= (8,500 + 1,000)/(40,500 + 20,000) = 0.157 = 15.7%

44
Q 
Calculate the ROCE ratio given the following information:
Finance costs = -£1,000
Profit before tax = £9,000
Total equity = £29,500
Long term borrowings = £15,000
A

ROCE = Net profit before interest and tax (EBIT)/ (Equity + Long Term Debt)
= (9,000 + 1,000)/(29,500 + 15,000) = 0.225 = 22.5%

45
Q

What are the two ways to increase ROCE?

A

By increasing the numerator, return

  • Reducing costs
  • Increasing sales
  • Increase the difference between costs and sales

By reducing the denominator, capital employed
- Making more intensive use of assets or capital employed

46
Q

Give the formula for profit growth

A

Profit growth = (Current profit - Previous profit)/Previous profit

47
Q

What three important factors must be considered regarding profit growth figures?

A
  • A positive growth figure is a good sign
  • Growth rates should exceed inflation
  • Growth rates should be benchmarked to other companies in the same industry
48
Q

Calculate the profit growth using the following information:
Profit for the period (2007) = £7,000
Profit for the period (2006) = £6,200

A

Profit growth = (Current profit - Previous profit)/Previous profit
= (7,000 - 6,200)/6,200 = 0.1290 = 12.9%

49
Q

Give the formula for gross profit margin

A

Gross profit margin = Gross profit/Sales

50
Q

What does the gross profit margin ratio concentrate on?

A

This ratio concentrates on costs of making goods and services ready for sale

51
Q

What do companies keep secret regarding gross profit margins?

A

Companies try to keep secret from their competitors and customers the detailed breakdown of gross profit for each product line or area of activity

52
Q

Calculate the gross profit margin using the following information:
Revenue = £50,000
Gross profit = £20,000

A

Gross profit margin = Gross profit/Sales

= 20,000/50,000 = 0.4 = 40%

53
Q

Calculate the gross profit margin using the following information:
Revenue = £45,000
Gross profit = £17,000

A

Gross profit margin = Gross profit/Sales

= 17,000/45,000 = 0.378 = 37.8%

54
Q

Comment on the nature of growth profit margins between companies in the same industry

A

The gross profit margin varies between companies, though should be reasonably similar within specific industries

55
Q

What are some of the reasons as to why gross profit margins within a company might change from year to year?

A

Changes in the gross profit margin from year to year within the one company should not be common and is likely to be as a result of:

  • Inflation
  • A change in the selling price of the product;
  • A change in the purchase price of supplies;
  • Wastage, theft, obsolescence of inventories; or
  • A change in sales product mix
56
Q

Give the formula for Operating (Net) Profit Margin

A

Operating (Net) Profit Margin = Net profit before interest and tax / Sales

57
Q

What does the operating margin reflect?

A
  • The degree of competitiveness in the market
  • The economic situation
  • The ability to differentiate products
  • The ability to control expenses
58
Q

Why are companies not necessarily obliged to seek high operating margins?

A

Some companies can still make a satisfactory ROCE by making efficient use of their non-current assets

59
Q

Calculate the operating profit margin using the following information:
Revenue = £50,000
Finance costs = -£1,000
Profit before tax = £8,500

A

Operating (Net) Profit Margin = Net profit before interest and tax / Sales
= (8,500 + 1,000)/50,000 = 0.190 = 19%

60
Q

Calculate the operating profit margin using the following information:
Revenue = £45,000
Finance costs = -£1,000
Profit before tax = £9,000

A

Operating (Net) Profit Margin = Net profit before interest and tax / Sales
= (9,000 + 1,000)/45,000 = 0.222 = 22.2%

61
Q

State some utilisation of asset (efficiency) ratios

A 
Sales/non-current assets Ratio
Sales/current assets Ratio
Inventories Turnover Ratio
Trade Receivables Ratio
Trade Payables Ratio
62
Q

What does the sales/non-current assets ratio show?

A

How many £s of sales have been generated by each £ of non-current assets

63
Q

What does the sales/current assets ratio indicate?

A

How well a company has used its current assets to generate sales

64
Q

Calculate the sales/non-current assets ratio and the sales/current assets ratio using the following information:
Revenue = £50,000
Non-current assets = £56,500
Current assets = £19,000

A

Sales/non-current assets ratio = 50,000/56,000 = 0.893 = 89.3%
Sales/current assets ratio = 50,000/19,000 = 2.63

65
Q

State the formula for Inventories Turnover Ratio

A

Inventories Turnover Ratio = (Inventories/Cost of sales)*365

66
Q

What does the inventories turnover ratio measure?

A

The average period during which stocks (inventories) of goods are held before being sold or used in the operations of the business

67
Q

What is the optimal period of time regarding inventory turnover?

A
  • One view is that the shorter the period, the better

* However, too short a period may create a greater risk of finding the business is short of a stock of item

68
Q

Calculate the inventories turnover ratio using the following information:
Cost of sales = -£30,000
Inventories = £6,000

A

Inventories Turnover Ratio = (Inventories/Cost of sales)*365

= (6,000/30,000)*365 = 73 days

69
Q

Calculate the inventories turnover ratio using the following information:
Cost of sales = -£28,000
Inventories = £5,000

A

Inventories Turnover Ratio = (Inventories/Cost of sales)*365

= (5,000/28,000)*365 = 65.2 days

70
Q

State the formula for the trade receivables ratio

A

Trade receivables ratio = (Trade receivables/Sales revenue)*365

71
Q

What does the trade receivables ratio measure?

A

The average period of credit allowed to credit customers

72
Q

What would an increase in the trade receivables ratio indicate for a business?

A
  • An increase in this ratio may indicate that a company is building up cash flow problems
  • However, an attempt to decrease the period of credit allowed might deter customers and cause them to seek a competitor who gives a longer period of credit
73
Q

Calculate the trade receivables ratio using the following information:
Revenue = £50,000
Trade receivables = £8,000

A

Trade receivables ratio = (Trade receivables/Sales revenue)365
= (8,000/50,000)365 = 58.4 days

74
Q

Calculate the trade receivables ratio using the following information:
Revenue = £45,000
Trade receivables = £6,000

A

Trade receivables ratio = (Trade receivables/Sales revenue)365
= (6,000/45,000)365 = 48.7 days

75
Q

State the formula for the trade payables ratio

A

Trade payables ratio = (Trade payables/Cost of sales)*365

76
Q

What does the trade payables ratio measure?

A

The average period of credit taken from suppliers of goods and services

77
Q

What would an increase in the trade payables ratio indicate for a business?

A
  • An increase in this ratio may indicate that the supplier has allowed a longer period to pay
  • It could also indicate that the company has cash flow problems, so that it takes longer to pay
78
Q

Calculate the trade payables ratio using the following information:
Cost of sales = -£30,000
Trade and other payables = £5,500

A

Trade payables ratio = (Trade payables/Cost of sales)*365

= (5,500/30,000)*365 = 66.92 days

79
Q

Calculate the trade payables ratio using the following information:
Cost of sales = -£28,000
Trade and other payables = £10,000

A

Trade payables ratio = (Trade payables/Cost of sales)*365

= (10,000/28,000)*365 = 130.36 days

80
Q

What two pressures must be considered when dealing with working capital management

A

• Have to balance two contradictory pressures:

  • The need to ensure that there are sufficient funds to pay liabilities as they fall due
  • The need to ensure the profitable use of capital employed
81
Q

What are the two main groups of relevant ratios concerned with working capital management?

A

Maximising solvency

Maximising profitability

82
Q

State the relevant maximising solvency ratios associated with working capital management

A

• Maximising solvency
-Current ratio: are there enough current assets to
cover current liability?
-Quick ratio: are there enough liquid assets to
cover current liability?
-Trade payables ratio: how long does it take to
pay creditors?

83
Q

State the relevant maximising profitability ratios associated with working capital management

A

• Maximising profitability
- Sales/current assets: are current assets excessive in
relation to turnover?
- Inventory turnover ratio: is inventory excessive in
relation to turnover?
- Trade receivables ratio: are customers taking too long
to pay?
- Trade payables ratio: are we paying suppliers too
quickly to maximise profitability?

84
Q

What does the OCC stand for?

A

The operating cash cycle

85
Q

What is the operating cash cycle?

A

The OCC is the time lapse between paying for goods and receiving cash from the sale of goods.

86
Q

What are the risks associated with a longer OCC?

A

The longer the cycle, the greater will be the financing requirements and the greater the financial risks

87
Q

Draw a flow diagram illustrating the operating cash cycle (OCC)

A

Week 5 page 61

88
Q

How does one calculate the operating cash cycle (OCC) for a business?

A

Average inventories holding period
plus
Average settlement period for trade receivables
plus
Average payment period for trade payables
equals
Operating cash cycle

FIN1003 Financial Reporting and Analysis (22 decks)

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