Week 8 Ratios Flashcards
What are lenders interested in
liquidity and solvency ratios
what are shareholders interested in
profitability ratios and future share prices
What are the types of profitability ratios
ROCE
ROE
Operating profit margin, net profit margin
Gross profit margin
ROCE Formula and what is assesses
ROCE = operating profit (profit before interest) / share capital+ non current liabilities + reserves
assesses effectiveness of the total capital employed
ROE formula and what it assesses
ROE = profit for year less dividends / share capital + reserves
assesses return to shareholders
Operating profit margin formula and what it assesses
OPM = operating profit / sales revenue
measures operational performance
Gross profit margin formula and what measures
GPM = gross profit/sales revenue
measures directly trading performance
mark up formula and what it shows
mark up = gross profit / cost of sales
shows how much more a company’s selling price is than the amount the item costs the company
how to interpret profitability ratios
how do company’s returns compare to industry benchmarks?
Are margins consistent with the stated strategy?
Are the margins changing? Why?
What do efficiency ratios show
How long is inventory held
how long does it take customers to pay
how long does it take for the company to pay
how effectively does the company use its assets
Inventory days formula and measures what
inventory days = average inventories held/cost of sales x365 days
measures how long it takes on average for inventory to be sold (you want it to be as low as possible)
reasons as to why inventory days could be decreasing
sudden increase in demand
stocking up on inventory for holiday selling season or take advantage of trade discounts
receivables days formula and meaning
receivables days = average trade receivables/credit sales x365 days
shows how long on average credit customers take to pay the amount they owe to the business
payables days formula and meaning
payables days = average trade payables/creditpurchases x 365 days
shows how long the company takes to pay creditora
net asset turnover formula and meaning
NAT = sales revenue / share capital + reserves + concurrent liabilities
shows how effectively the entity uses its resources to generate sales
why does a business need working capital
retail - needs to buy and hold inventories
manufacturing - holds inventories of raw materials and part finished goods
what should be the aim of a company in terms of working capital
avoid excessive working capital which creates unnecessary cost
avoid having insufficient amounts of working capital as it can lead to difficulties with cash flow and liquidity
how to calculate operating cash cycle
average inventories holding period
+ average settlement period for receivables
- average payment period for payables
= operating cash cycle
problems with low receivables days
customers could go elsewhere to buy on credit since they don’t have a very long period of credit
what are liquidity and solvency ratios used for
credit risk analysis
what does liquidity show
short term ability to generate cash for working capital needs and immediate debt repayments
what do solvency ratios show
long term ability to generate cash internally or externally to satisfy capacity needs, fuel growth and repay debts
current ratio formula and measures
current ratio = current assets/current liabilities
you want this to be high
compares liquid assets of the company with its current liabilities
what is the acid test ratio formula and measures
acid test ratio = current assets - inventory / current liabilities
want this to be high
more rigorous measure of liquidity that excludes inventory
what is cash ratio formula and what does it show
cash ratio = operating cash flows / current liabilities
want this to be high
most rigorous measure of liquidity
what is financial gearing
occurs when a business is financed partly by debt to finance growth and exploit tax advantages
dangers of high financial gearing
less control over financing decisions
risk of bankruptcy
high volatility profits available to shareholders
limited flexibility due to restrictions imposed on loan agreements
gearing ratio formula and measure
gearing ratio = concurrent liabilities / share capital+reserves+noncurrent liabilities
measures contribution of long term debt to capital structure of the company
interest coverage ratio formula and meaning
interest cover = operating profit / interest payable
shows the amount of profit available to cover interest
want to be high
how to interpret liquidity and gearing ratios
does company have enough liquid funds
does company have enough debt ie is it exploiting the potential benefits of debt interest tax shields
does company have too much debt
what is the company doing with borrowed funds
what are the four investment ratios
dividend payout ratio
dividend yield ratio
earnings per share
price/earnings ratio
dividend payout ratio formula and meaning
dividend payout ratio = dividends announced for year / profit after tax less preference dividend
want it to be high
shows what proportion of profits is paid out as dividends to shareholders
dividend yield formula and measure
dividend yield = dividend per share / share price
want to be high
shows cash return to a share relative to its current market value
EPS formula and meaning
EPS = profit after tax less preference dividend / number of ordinary shares in issue
want to be high
represents the earnings available to shareholders per share issued
P/E ratio formulaa and meaning
P/E ratio = market cap/net income ie market value per share / earnings per share
want to be high
measures market confidence in future earnings power of a business
