Week 5a - Financial Ratios: Solvency and Profitability Flashcards
What are the three main groups of financial ratios?
Financial strength/solvency
Profitability
Stock market (Investment)
What do financial strength/solvency ratios determine?
Is the business likely to survive? Can it pay its liabilities as they fall due?
What do profitability ratios determine?
Is the business sufficiently profitable? Is it making the best use of the resources available to it?
What do stock market (investment) ratios determine?
How are the company’s shares performing on the stock market? Are they likely to be a good investment?
State the different types of solvency ratios
Short term
Long term
State the different types of profitability ratios
Overall Profitability
Profitability on Sales
Utilisation of Assets (Efficiency)
What does a short term solvency ratio determine?
- Can short term liabilities be met as they fall due
- Relationship between current assets and current liabilities
What does a long term solvency ratio determine?
- Can the company service the long term loans?
- Capital gearing
- Interest cover
Give the formula for the current ratio
Current ratio = current assets/current liabilities
What does the current ratio indicate?
The extent to which short-term assets are available to meet short-term liabilities
Why is the underlying trend from a current ratio important?
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
How come some companies can operate on a tight current ratio?
They can plan the timing of cash inflows and outflows quite precisely
Calculate the current ratio given the following information:
Current assets = £19,000
Current liabilities = £10,000
Current ratio = current assets/current liabilities
= 19,000/10,000 = 1.9
Calculate the current ratio given the following information:
Current assets = £22,000
Current liabilities = £17,000
Current ratio = current assets/current liabilities
= 22,000/17,000 = 1.29
Give the formula for the quick ratio (acid test)
Quick ratio = (Current assets-Inventories)/Current Liabilities
Why are inventories excluded from the quick ratio?
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.)
Why, for many companies, is the quick ratio less than 1:1?
As it is unlikely that all creditors will require payment at the same time
Calculate the current ratio given the following information:
Current assets = £19,000
Current liabilities = £10,000
Inventories = £6,000
Quick ratio = (Current assets-Inventories)/Current Liabilities
= (19,000-6,000)/10,000 = 1.3
Calculate the current ratio given the following information:
Current assets = £22,000
Current liabilities = £17,000
Inventories = £5,000
Quick ratio = (Current assets-Inventories)/Current Liabilities
= (22,000-5,000)/17,000 = 1
What is financial structure/gearing?
- The way the business is financed
- The balance between equity and debt
What ratios measure financial structure/gearing?
Capital gearing ratio
Interest cover ratio
Give the formula for capital gearing ratio
Gearing ratio = LT borrowings / (LT borrowings + Equity)
What does a low gearing ratio indicate?
- A low exposure to financial risk
- Little difficulty in paying loan interest and repaying the loans as they fall due
What does a high gearing ratio indicate?
- A high exposure to financial risk
- There are interest charges to be met and a requirement to repay the loans on the due date
Calculate the gearing ratio given the following information:
Total equity = £40,500
Long term borrowings = £20,000
Gearing ratio = LT borrowings / (LT borrowings + Equity)
= 20,000/(40,500+20,000) = 0.331 = 33.1%
Calculate the gearing ratio given the following information:
Total equity = £29,500
Long term borrowings = £15,000
Gearing ratio = LT borrowings / (LT borrowings + Equity)
= 15,000/(29,500+15,000) = 0.337 = 33.7%
Give the formula for interest cover ratio
Interest cover = Operating profit/interest
Give the formula for operating profit
Operating profit = Gross profit - operating costs for distribution and administration
What does the interest cover ratio indicate?
Whether the profit generated before interest and tax is sufficient to give high cover for the interest charges
What does a low interest cover ratio indicate?
If the interest cover is falling or low, there may be increasing cause for concern
Calculate the interest cover ratio given the following information:
Finance costs = -£1,000
Profit before tax = £8,500
Interest cover = Operating profit/interest
= (8,500 + 1,000)/1,000 = 9.5
Calculate the interest cover ratio given the following information:
Finance costs = -£1,000
Profit before tax = £9,000
Interest cover = Operating profit/interest
= (9,000 + 1,000)/1,000 = 10
Outline the effect of financial gearing
- 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
What is an ungeared company?
Debt-equity ratio = 0
What is a geared company?
Debt-equity ratio > 0
When profits are rising, is it preferable to be a shareholder in a geared company or a shareholder in an ungeared company?
When profits are rising, it is preferable to be a shareholder in a geared company (i.e. debt-equity ratio>0)
When profits are falling, is it preferable to be a shareholder in a geared company or a shareholder in an ungeared company?
When profits are falling, it is preferable to be a shareholder in an ungeared company (i.e. debt-equity ratio=0)
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) 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%
What are the different sections in which profitability can be examined?
• Profitability can be examined in three sections:
- Overall profitability
- Profitability on sales
- Utilisation of assets (efficiency)
What does ROCE stand for?
Return on capital employed
Give the formula for the ROCE ratio
ROCE = Net profit before interest and tax (EBIT)/ (Equity + Long Term Debt)
What does ROCE measure?
- 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
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
ROCE = Net profit before interest and tax (EBIT)/ (Equity + Long Term Debt)
= (8,500 + 1,000)/(40,500 + 20,000) = 0.157 = 15.7%
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
ROCE = Net profit before interest and tax (EBIT)/ (Equity + Long Term Debt)
= (9,000 + 1,000)/(29,500 + 15,000) = 0.225 = 22.5%
What are the two ways to increase ROCE?
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
Give the formula for profit growth
Profit growth = (Current profit - Previous profit)/Previous profit
What three important factors must be considered regarding profit growth figures?
- 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
Calculate the profit growth using the following information:
Profit for the period (2007) = £7,000
Profit for the period (2006) = £6,200
Profit growth = (Current profit - Previous profit)/Previous profit
= (7,000 - 6,200)/6,200 = 0.1290 = 12.9%
Give the formula for gross profit margin
Gross profit margin = Gross profit/Sales
What does the gross profit margin ratio concentrate on?
This ratio concentrates on costs of making goods and services ready for sale
What do companies keep secret regarding gross profit margins?
Companies try to keep secret from their competitors and customers the detailed breakdown of gross profit for each product line or area of activity
Calculate the gross profit margin using the following information:
Revenue = £50,000
Gross profit = £20,000
Gross profit margin = Gross profit/Sales
= 20,000/50,000 = 0.4 = 40%
Calculate the gross profit margin using the following information:
Revenue = £45,000
Gross profit = £17,000
Gross profit margin = Gross profit/Sales
= 17,000/45,000 = 0.378 = 37.8%
Comment on the nature of growth profit margins between companies in the same industry
The gross profit margin varies between companies, though should be reasonably similar within specific industries
What are some of the reasons as to why gross profit margins within a company might change from year to year?
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
Give the formula for Operating (Net) Profit Margin
Operating (Net) Profit Margin = Net profit before interest and tax / Sales
What does the operating margin reflect?
- The degree of competitiveness in the market
- The economic situation
- The ability to differentiate products
- The ability to control expenses
Why are companies not necessarily obliged to seek high operating margins?
Some companies can still make a satisfactory ROCE by making efficient use of their non-current assets
Calculate the operating profit margin using the following information:
Revenue = £50,000
Finance costs = -£1,000
Profit before tax = £8,500
Operating (Net) Profit Margin = Net profit before interest and tax / Sales
= (8,500 + 1,000)/50,000 = 0.190 = 19%
Calculate the operating profit margin using the following information:
Revenue = £45,000
Finance costs = -£1,000
Profit before tax = £9,000
Operating (Net) Profit Margin = Net profit before interest and tax / Sales
= (9,000 + 1,000)/45,000 = 0.222 = 22.2%
State some utilisation of asset (efficiency) ratios
Sales/non-current assets Ratio Sales/current assets Ratio Inventories Turnover Ratio Trade Receivables Ratio Trade Payables Ratio
What does the sales/non-current assets ratio show?
How many £s of sales have been generated by each £ of non-current assets
What does the sales/current assets ratio indicate?
How well a company has used its current assets to generate sales
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
Sales/non-current assets ratio = 50,000/56,000 = 0.893 = 89.3%
Sales/current assets ratio = 50,000/19,000 = 2.63
State the formula for Inventories Turnover Ratio
Inventories Turnover Ratio = (Inventories/Cost of sales)*365
What does the inventories turnover ratio measure?
The average period during which stocks (inventories) of goods are held before being sold or used in the operations of the business
What is the optimal period of time regarding inventory turnover?
- 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
Calculate the inventories turnover ratio using the following information:
Cost of sales = -£30,000
Inventories = £6,000
Inventories Turnover Ratio = (Inventories/Cost of sales)*365
= (6,000/30,000)*365 = 73 days
Calculate the inventories turnover ratio using the following information:
Cost of sales = -£28,000
Inventories = £5,000
Inventories Turnover Ratio = (Inventories/Cost of sales)*365
= (5,000/28,000)*365 = 65.2 days
State the formula for the trade receivables ratio
Trade receivables ratio = (Trade receivables/Sales revenue)*365
What does the trade receivables ratio measure?
The average period of credit allowed to credit customers
What would an increase in the trade receivables ratio indicate for a business?
- 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
Calculate the trade receivables ratio using the following information:
Revenue = £50,000
Trade receivables = £8,000
Trade receivables ratio = (Trade receivables/Sales revenue)365
= (8,000/50,000)365 = 58.4 days
Calculate the trade receivables ratio using the following information:
Revenue = £45,000
Trade receivables = £6,000
Trade receivables ratio = (Trade receivables/Sales revenue)365
= (6,000/45,000)365 = 48.7 days
State the formula for the trade payables ratio
Trade payables ratio = (Trade payables/Cost of sales)*365
What does the trade payables ratio measure?
The average period of credit taken from suppliers of goods and services
What would an increase in the trade payables ratio indicate for a business?
- 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
Calculate the trade payables ratio using the following information:
Cost of sales = -£30,000
Trade and other payables = £5,500
Trade payables ratio = (Trade payables/Cost of sales)*365
= (5,500/30,000)*365 = 66.92 days
Calculate the trade payables ratio using the following information:
Cost of sales = -£28,000
Trade and other payables = £10,000
Trade payables ratio = (Trade payables/Cost of sales)*365
= (10,000/28,000)*365 = 130.36 days
What two pressures must be considered when dealing with working capital management
• 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
What are the two main groups of relevant ratios concerned with working capital management?
Maximising solvency
Maximising profitability
State the relevant maximising solvency ratios associated with working capital management
• 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?
State the relevant maximising profitability ratios associated with working capital management
• 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?
What does the OCC stand for?
The operating cash cycle
What is the operating cash cycle?
The OCC is the time lapse between paying for goods and receiving cash from the sale of goods.
What are the risks associated with a longer OCC?
The longer the cycle, the greater will be the financing requirements and the greater the financial risks
Draw a flow diagram illustrating the operating cash cycle (OCC)
Week 5 page 61
How does one calculate the operating cash cycle (OCC) for a business?
Average inventories holding period
plus
Average settlement period for trade receivables
plus
Average payment period for trade payables
equals
Operating cash cycle
