Accounting Ratios

Question 1

What is the primary purpose of accounting ratios?

Answer 1

To better assess:
Returns Received
&
Risks Faced

Question 2

What are the four types of accounting ratio?

Answer 2

1) Profitability
2) Liquidity
3) Gearing
4) Investor Ratios

Question 3

Define the four types of accounting ratio

Answer 3

1) Profitability - Asseses the trading or operating performance of the business
2) Liquidity - Assess the trading risk of the business - the risk that through the course of business the firm will be unable to pay its suppliers and cease to be a going concern
3) Gearing Ratios - The companies ability to pay long term debt & the risk to those providing financing for the company
4) Investor Ratios - The returns recieved by those financing the business.

Question 4

What are the three profitability margin ratios?

Answer 4

Gross Profit Margin - The amount of profit that goes towards COGS and therefore the amount remaining for operating expenses.
Net Profit Margin - The amount of actual profit after all costs are deducted - e.g 4.4% means £4.40 profit for every £100 sold.
Operating Profit Margin - The amount of profit spent on COGS and operating expenses

These operating expenses can include: Research and Development, Marketing & Financing Costs.

Question 5

What are the benefits of the three profitability margin ratios?

Answer 5

Gross Profit - Compare performance to industry peers - It’s an important starting point

Net Profit - Final picture of companies health - enables an investor to see are management generating enough profits from sales

Operating Profit - Measures how efficiently a company can manage its expenses

Question 6

What are the limitations of the three profitability margin ratios?

Answer 6

Gross - Does not take into acount any costs - can’t analyse changes in cost of production

Net - Can be influened by a one off sale and does not provide insight into cost management

Operating - Comparisons are hard due to lack of consistency in accounting standards - e.g method of depreciation.

Question 7

What does return on equity measure?
How is it calculated?

Answer 7

The return on the amount of capital provided by shareholders.

It is calculated as Net Income / Shareholder Equity

The ratio outcome depends on: Industry, State in companies lifecycle & broader economic situation

Question 8

What are the limitations of using RoE?

Answer 8

1) It does not show the risk associated with generating that level of return
2) It can be manipulated by deflating shareholder equity or inflating net income
3) Misleading for new companies as capital requirement is high and will lower RoE.

Question 9

Asset Turnover
1) What does it show
2) How is it calculated
3) What kind of companies have high or lower ratios

Answer 9

1) How efficiently a company use their assets to generate revenue
2) Revenue / Capital Employed (or average total assets)
3) Supermarkets / Retail = High & Capital Intensive (e.g. Telecoms) = Low

One drawback is that it cannot be used to compare companies that operate in different industrial sectors.

Question 10

What is equity multiplier & how is it calculated?

Answer 10

A gearing ratio that shows what portion of RoE is debt
Total Assets / Shareholder Funds

Makes up part of the DuPont Analysis to analyse the level of gearing in RoE.

Question 11

What is ROCE?
How is it calculated?

Answer 11

Measures how effectively you use your long term capital to generate a profit.

Operating Profit / Capital Employed

Capital Employed = Assets - Current Liabilities or (Equity + Non-current liabilities)

Question 12

What is ROCE useful for?

Answer 12

Analysing companies in the same sector. Particuarly capital intensive sectors.

However, it also does not capture risk through things like borrowing to gauge how returns are made.

It also cannot be used to compare companies in different sectors.

It should be used alongside other profitability ratios and liquidity ratios to better understand how the profits are generated and the risks / changes to profitiability.

Question 13

What is the difference between solvency and liquidity?

Answer 13

Solvency is long term ability to pay long-term liabilities

Liquidity is concerned with short-term operations and the ability to meet cash requirements.

Question 14

What does the current ratio show and how is it calculated?

Answer 14

How easil current assets can cover our current liabilities

Current Assets / Current Liabilities

Higher is better - but too high can show a problem e.g. too much cash on hand.

Question 15

What is the desired level of the current ratio?

Answer 15

Between 1.5 - 2

Question 16

What are some shortcomings of the Current Ratio?

Answer 16

• Overdraft included - Could realistically be a long term source of financing though.
• Balance sheet is a snapshot - not indicative
• Different industries cannot be compared e.g (manufacturing ratio is high and supermarkets low)
• A liability may be due immediately but inventory cannot be sold instantly (especially not at book price)

Supermarkets have little to no trade receievables and therefore low ratios

Question 17

What is the working capital turnover ratio?

Answer 17

Average Annual Sales / Working Capital
Where working capital = Current Assets - Current Liabilities

This is the remedy to the current ratio being a static snapshot in time.

Question 18

What is the acid test (quick ratio)

Answer 18

Current Assets - Inventory / Liabilities

Retail companies often have lower quick ratios and as such fall victim to recessions more often than other industries.

Supermarkets operate with very very low ratios

The quick ratio should be 1:1 or better

Question 19

What is the working capital cycle?

Answer 19

Measures the velocity of cash flow.
I.e. how long it takes to purchase materials and then how long it takes to sell the goods.

Question 20

How can the working capital cycle be improved?

Answer 20

1) Minimise inventory levels
2) Ensuring debtors pay quickly
3) Delaying payments to creditors

Question 21

What are the three working capital cycle ratios?

Answer 21

1) Receivables Collection Period
2) Payables Collection Period
3) Inventory Holding Days

Question 22

What is Receivables Collection Period?

Answer 22

Receivables / Revenue * 365
Shows how many days it takes you to get paid - therefore lower is better.

The number is only an average, some payments will be shorter / longer (if larger payments take longer this isn’t shown by the ratio)

Question 23

What is Payables Collection Period?

Answer 23

Payables / Cost of Goods Sold * 365
Shows how long you take to pay your payables.
Longer is better but there is a fine balance - you don’t want to spread liquidity fears or upset suppliers.

If you upset suppliers you could lose out on trade discounts

Question 24

What is inventory holding days?

Answer 24

How quickly a company is selling its inventory
Too low and you can’t keep up with a surge in demand
Too high and the cost of holding inventory is too much
Supermarkets will have lower days as their stock is often perishable.

Question 25

What is debt to equity ratio?

Answer 25

Debt + Preference Share Capital / Shareholder Equity

Measures to what extent a company is funded by borrowing compared to shareholder funds.

If the ratio is too high, then growth is being delivered by too much borrowing. Too low and it shows an over reliance on expensive and ineffective equity.

Question 26

What is net debt to equity?

Answer 26

Debt - Cash / Shareholder Equity

Same as debt to equity but includes how much debt could be offset by cash.

Question 27

What is interest cover?

Answer 27

Operating Profit + Interest Receivable + Other Income Receivable / Interest Payable

Measures how well a company can afford to pay its interest on borrowings

Higher is better for lenders as it indicates less risk

Does not include trade receivables as this is already included in operating profit

Question 28

What is asset cover?

Answer 28

Total Assets - Current liabilities / Debt
- the ratio between loans granted and the assets available to repay them.

• Some loans have a different priority than others – the asset cover ratio should be calculated for each in priority order.