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M92 Business and Finance > Chapter 9 - Financial Ratios > Flashcards

Chapter 9 - Financial Ratios Flashcards

1
Q

The standard ratios fall into which five categories?

A
  • profitability ratios
  • productivity ratios
  • liquidity ratios
  • activity or turnover ratios
  • gearing ratios
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2
Q

What are the three main profitability ratios?

A
  • gross profit percentage
  • net profit percentage
  • return on capital employed
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3
Q

What is the formulae for the gross profit percentage ratio?

A

Gross profit / sales (revenue) x 100

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4
Q

What can a decrease in the gross profit percentage show?

A

May indicate greater competition in the market, causing lower selling prices and a lower gross profit or increase in cost of purchases

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5
Q

What can an increase in the gross profit percentage show?

A

May indicate the company is in a position to exploit the market and charge higher prices for its products, or that is able to source its purchases at a lower cost

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6
Q

The third final change in the gross profit percentage ratio may indicate?

A

A change in the mix of products sold. An increasing volume of. A product with a high gross margin will increase the overall ratio

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7
Q

What is the net profit percentage ratio?

A

Net profit / sales (revenue or turnover) x 100

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8
Q

The relationship between the gross profit and net profit percentage gives an indication as to how well a company is managing its business…

A

Expenses

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9
Q

If net profit has decreased over time, yet gross profit has remained the same, what may this indicate?

A

A lack of control over expenses

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10
Q

As the net profit percentage ratio is shown as a percentage, this may show how effective the m……….

A

Management is

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11
Q

If the net profit percentage margin is low then this could be caused by the business deliberately increasing the overheads to cope with a planned future…

A

Expansion of the business

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12
Q

What is the return on capital employed formulae?

A

ROCE = profit before interest charges and tax / share capital + reserves + borrowings x 100

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13
Q

The ROCE ratio enables an investor to see if…

A

The insurer is making money for them

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14
Q

The ROCE ratio is basically concerned with the relationship of profit to the capital employed and is seen as giving an indication of how efficiently and effectively management have…

A

Deployed resources available to it

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15
Q

As a rough guide to ROCE, a shareholder will want at least two times the return than if they was to…

A

Put their money in a typical bank deposit account

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16
Q

The higher the risk in the company the higher the…

A

Return

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17
Q

A start up company would be expected to produce a high…

A

Return

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18
Q

In regards to the ROCE ratio, a low return could easily be ??????? In a recession

A

Wiped out

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19
Q

When a company is acquiring other businesses or moving into new markets, the ROCE should be ???? To make it worthwhile for capital providers

A

High

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20
Q

A persistent low ROCE In a business division may signal that…

A

It is time to dispose of that business division

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21
Q

A variation on ROCE is ???? This looks at the return after tax attributable to shareholders as a ratio in equity

A

Return on equity (ROE)

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22
Q

Both profitability and productivity compare inputs and …

A

Outputs

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23
Q

Profitability compares the money value of the outputs with the money value of the inputs. The difference between the two is profit. The difference in productivity is that…

A

It does not use money as a measure. It compares inputs and outputs directly

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24
Q

In regards to productivity, what are the inputs and output of say a plane flight?

A

Fuel is the input and the flight is the output. This shows overall efficiency.

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25
Q

Companies will compare their efficiency and productivity with other companies so they can look to Improving…

A

Areas within their business which can be more efficient and productive.

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26
Q

Companies will seek to collect their debts as…

A

Soon as possible

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27
Q

Which ratio shows how efficient debt collection has been? Give the formulae

A

Debtors or trade receivables / sales x 365 days

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28
Q

Which ratio shows how long the company is taking to pay its own creditors?

A

Creditors or payables / purchases x 365 days

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29
Q

It is in a company’s interest to defer payments for as long as possible however, excessive delays in payment may reduce the terms suppliers are willing to offer, and could result in ??????? Damage for the company

A

Reputational

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30
Q

What is the ratio showing the average number of days that inventory/stock is held for?

A

Inventory or stock / cost of sales x 365 days

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31
Q

A change in the inventory, stock ratio can be a useful Indicator of how well a company is doing. A lengthening in the inventory/stock turnover period may indicate either…

A

Slowing down of trading or an unnecessary build up of stock/inventory

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32
Q

Most bankruptcies are not caused by poor profitability but by…

A

Inability to pay creditors on time, so lack of liquidity

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33
Q

It is Important for a company to pay its creditors on time, as if a creditor is not payed…

A

They can take the company to court

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34
Q

What are liquid assets?

A

All the assets that are money (cash) or can be turned into cash at short notice

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35
Q

Assets like unsold cars for a car dealer are not very liquid because?

A

These cannot just be sold whenever the dealer wishes

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36
Q

In regards to liquidity ratios, what are the two most important ratios? (Think snappy)

A

Current ratio and the quick ratio

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37
Q

What is the formulae for the current ratio?

A

Current assets / current liabilities

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38
Q

What is the formulae for the quick ratio?

A

Current assets excluding stock / current liabilities

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39
Q

To maintain creditworthiness a current ratio of ? Is seen as prudent. In more recent years a current ratio of ?.? Is more normal

A
  1. Now 1.5 is quite normal
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40
Q

Which businesses can usually survive on a current ratio less than 1? And why? (Think big and practical)

A

Supermarkets because they buy on credit and sell mainly for cash

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41
Q

The quick ratio will usually be below…

A

1

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42
Q

If a company has a quick ratio of below 1, then if the company has paid up all its creditors and collected from all its debtors at once, the company would require an ???? From a bank

A

Overdraft

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43
Q

In regards to the quick ratio. If the company can not get an overdraft and has a quick ratio of less than one, the company…

A

May be in trouble

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44
Q

A company’s assets do not produce cash by themselves. It is from sales of goods and services that allow a company to generate

A

Profit

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45
Q

The profit the company makes will depend on the activity (measured by volume of sales) generated by the company’s assets and…

A

Shareholders equity

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46
Q

Activity ratios compare some aspect of the company’s activities (usually sales of purchases) with a relevant…

A

Balance sheet item

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47
Q

When comparing sales over a long period of time, it may also be advisable to take into account…

A

Inflation

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48
Q

What two types of ratio are useful in regards to activity ratios

A

Stock as well as debtors and creditors.

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49
Q

What is the stock turnover ratio

A

Cost of sales / average stock

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50
Q

What is the stock ratio used for?

A

Investigating a company’s stockholding policy.

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51
Q

If stock is turned over more slowly, less cash is generated and more cash is…

A

Tied up In stock

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52
Q

If a company has an annual cost of sales of120 and holds an average stock of 20. The stock turnover is how many times per year? And once every how many months?

A

6 times per year and once every 2 months

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53
Q

What is the debt turnover ratio?

A

Sales / debtors

54
Q

What is the creditor turnover ratio?

A

Purchases / creditors

55
Q

Sales of 180 per year and average debtors of 30 would produce a debtor turnover of how many times per year?

A

6

56
Q

If the debtors turnover ratio is 6 then this is the same as saying that debtors add turned over once every …

A

Two months. Debtors take on average two months to pay.

57
Q

If a company’s purchases are 120 per year and the a average amount of creditors is 10, then the creditor turnover ratio is either…

A

Twelve times a year or once a month. This means that the company receives one months credit from the suppliers.

58
Q

As creditors are a current liability, an increase in the creditor period increases the ???? Of the company

A

Liquidity

59
Q

Why is the gearing ratio one of the best measures of a company’s future?

A

It shows how much the business relies on debt to finance the business.

60
Q

What is the gearing ratio?

A

Long term borrowings / shareholders equity x 100

61
Q

Depending on the business, what is usually a good figure of gearing?

A

80-110%

62
Q

Explain why a company relying on a lot of debt to finance their business is in a potentially worse position than a company with not as much debt?

A

With debt, interest must be paid on it. The debt must also be paid on the due date, so regardless if the company is doing well or not, it must still repay this debt. If it is unable to pay the debt then it may be the end of the company. A company reliant on less debt will therefore have less risk. If a company without debt has a bad year than it may not pay dividends to its shareholders, a company with debt however still has to pay back their money back regardless of how well they are doing.

63
Q

If borrowing and gearing is potentially more risky, why do companies bother borrowing money At all?

A

The borrowing option may be more profitable to shareholders, if the company can borrow money, it may be able to for example, build a new plant and sell more goods on a decent margin, which will therefore make more money for the company, despite it having to pay interest on the debt.

64
Q

What is a risk of a company borrowing in to increase profit, even if the company was not needing to borrow?

A

Recessions can occur which can make their borrowing look foolish. If a factory has to stop production in a recession, the debt due will still need to be paid. Companies can therefore risk over stretching themselves and borrowing too much money in the good times and not having the reserves to pay the interest in the lean times.

65
Q

The general ratios will apply to insurance companies, as well as other insurance specific…

A

Ratios

66
Q

What are the ratios in the insurance industry?

A
  • solvency
  • liquidity
  • capital adequacy
  • profitability
  • claims
67
Q

What is the solvency ratio?

A

Net assets / earned premium net of reinsurance

68
Q

The higher the solvency ratio the better or worse the company’s position?

A

Better

69
Q

What is an issue with the solvency ratio in regards to a hard market?

A

Premium rates increase so solvency ratio shows appearing deterioration whereas the economic position is an improvement.

70
Q

A company that has a high level of capital to support the premiums written will often be seen as overcapitalised and will have a lower…

A

Return on equity than a company that has a lower level of capital

71
Q

Another way to asses solvency is to compare the surplus regulatory capital available to the regulatory capital required. This can be calculated as…

A

Surplus regulatory capital / regulatory capital available

72
Q

In what way do insurance companies have an advantage to manufacturing companies in terms of liquidity?

A

Premiums are received before claims need to be paid so often positive cash flow.

73
Q

A generalised formulae for liquidity for an insurance company is?

A

Total liabilities / cash + investments

74
Q

In regards to the liquidity in insurance companies, some companies include quoted investments, while others include a proportion of …

A

Non quoted investments

75
Q

Firms must be consistent year and year on calculating their liquidity ratios and in all cases, common definitions of ? And ? Must be used.

A

Assess and liabilities

76
Q

Why is there a different liquidity ratio used for insurance companies as oppose to regular companies?

A

Insurers liquidity can easily come from freely marketable investments as these are mainly held to fund claims. Few trading or service companies hold substantial investments that need to potentially be available to finance long term non current liabilities such as claims.

77
Q

As there is uncertainty over the amount to set aside for claims for insurance companies, consequently there is uncertainty over the profit for the year. For this reason insurance companies often look at profitability ratios for a number…

A

Of years at a time

78
Q

What is the return on equity ratio for an insurance company?

A

Profit after tax / shareholders equity (capital) x 100

79
Q

The ROE quite simply shows how efficiently…

A

That capital is employed

80
Q

The higher the ROE figure the better the…

A

Rate of return

81
Q

In an insurance company, the ROE ratio for an inventory would generally want to be…

A

2.5 times the amount that they would earn in a bank deposit account over a five year period. ( the hard and soft market cycle will distort the figures )

82
Q

In an insurance company, with regards to gearing, the sources of finance can be…

A

Equity capital or long term borrowings carrying s fixed interest (unsecured loans, debentures, preference shares)

83
Q

What percentage in regards to an insurance company is considered to be high in regards to gearing?

A

Over 120% of fixed interest finance

84
Q

In an insurance company, what would be a low gearing percentage?

A

Below 60%

85
Q

It can be a detriment to shareholders if an insurance company is geared to high, as it will have a large…

A

Interest bill, which means that there will be lower profits for shareholders

86
Q

In regards to gearing in an insurance company, why might a high gearing ratio be preferred in relation to shares?

A

If a company issues too many shares it will lose control. There are also with fewer shares, fewer shareholders to participate in the profit, so a small increase in pre-interest profit could lead to a large increase in dividends.

87
Q

The combined ratio measures the underwriting performance by combining the…

A

Loss ratio, expense ratio and the commission ratio.

88
Q

The combined ratio in simple terms asks…

A

Is there enough premium to cover the cost of claims and expenses?

89
Q

Expenses In the combined ratio will include…

A

Costs of reinsurance, claims handling, underwriting and administration

90
Q

The combined ratio will be useful to underwriters to see…

A

How effectively the limes of business are performing

91
Q

The combined ratio will be of interest to competitiors because…

A

They will want to see how effectively the competition is underwriting

92
Q

Why will senior executives want to know the combined ratio?

A

To see how effective the underwriting divisions are performing.

93
Q

The combined ratio does not take into account what income?

A

Investment

94
Q

The combined ratio tracks what rather profitability?

A

Underwriting performance

95
Q

A combined ratio of below 100% will generally indicate …

A

Good underwriting performance

96
Q

A combined ratio over 110% generally indicates…

A

Poor underwriting or catastrophe loses

97
Q

In the past insurance companies would boost poor underwriting performances with investment income. Recently the fundamentals in the investment markets have forced all insurance companies to rethink their strategies and focus on…

A

Driving the combined ratio below 100%

98
Q

What are the three ratios that drive the combined ratio?

A

The claims ratio, the expenses ratio and the commissions ratio.

99
Q

What is the formulae for the claims ratio?

A

Claims incurred net of reinsurance / earned premium net of reinsurance x 100

100
Q

What is the expenses ratio?

A

Administrative expenses / earned premium net of reinsurance x 100

101
Q

What is the commissions ratio?

A

Acquisition costs / earned premium net of reinsurance x 100

102
Q

The three ratios, claims, expenses and commissions combine to form the combined ratio which is…

A

Claims + expenses + acquisition costs / earned premium net of reinsurance x 100

103
Q

It is important to note that their are variations on how a combined ratio…

A

Is calculated

104
Q

It is important that insurance companies do not pay too high commissions or acquisition costs to brokers. A counter argument to this however is that most…

A

Profitable business will often pay the highest commissions.

105
Q

The ratio in regards to commission is usually between?

A

10-20%

106
Q

Premiums in the ratios (concerning the combined ratio) are taken to mean either written premiums or earned premiums, but students should use earned premiums net of reinsurance in their calculations. Reasons can be found however for an against this, it can be argued earned premium is more consistent however it can be argued that commissions and expenses arise at the time when premiums are written, no matter…

A

When they are earned

107
Q

Ratios are usually used to compare either…

A

Performance of two or more companies in one particular year or to compare the performance of a company over a number of years.

108
Q

In regards to the combined ratio and other concerning ratios, these are used to compare underlying performance, to discover any trends for the better or for worse, and to spot performance areas that require more attention from management. The ???? these ratios the better As if you have ???? Claims or expenses in relation to premiums, you make a bigger profit.

A

Lower

109
Q

The fact a company’s combined ratio exceeds 100% shows the company is making…

A

An underwriting loss

110
Q

Underwriting result is only part of the story in an insurance company, to get the total profit or loss we have to add…

A

Investment income and any other income the company might earn.

111
Q

If the investment income of a company is greater than the underwriting loss than the company makes a ???? Overall

A

Profits

112
Q

Outstanding claims are a major liability for an insurance company. Changes in valuation can affect both surplus and…

A

Profit

113
Q

There is a risk in regards to outstanding claims that…

A

Undervaluation

114
Q

The outstanding claims ratio is?

A

Outstanding claims net of reinsurance / net assets

115
Q

The lower the outstanding claims ratio the more…

A

Secure the position

116
Q

It is important in regards to the outstanding claims ratio that a company which is under reserved will show a better result however this will…

A

Create problems for the company in the future, possibly failure.

117
Q

After considering all of the different ratios, when analysing an insurance companies accounts you should use around six ratios. A good mix of these is…

A
  1. Claims ratio
  2. Expenses ratio
  3. Commission ratio
  4. Combined ratio
  5. Return on equity
  6. Solvency margin
118
Q

Ratios can be used in the following ways:

A
  • to analyse the performance of a business
  • compare performance of a company over time
  • compare the performances of a number of businesses
119
Q

What are the limitation of ratios?

A
  • comparative information is essential for any meaningful analysis
  • accounting ratios are based on income statements and balance sheets, which are subject to judgements and the limitations of historical cost accounting. Inflation differing bases for valuing assets, or specific price changes which can distort the inter company comparisons and comparisons made over time.
  • depends on quality of financial information
  • past performance not necessarily best indicator of future performance
120
Q

For a typical trading or service company, the ratios normally used are:

A
  • profitability ratios
  • productivity ratios
  • liquidity ratios
  • activity or turnover ratios
  • gearing ratios
121
Q

For an insurance company the normal types of ratios to use are:

A
  • solvency
  • liquidity
  • profitability
  • Claims
122
Q

When analysing and comparing different companies, most interested parties will want to:

A
  • analyse the performance of a company in the past

- draw conclusions from this last performance about what action should be taken now or in the future

123
Q

What are the profitability ratios, list them all and explain the formulaes

A
  • gross percentage

Gross profit percentage - Gross profit / sales (revenue) x 100

Net profit percentage - net profit / sales (revenue) x 100

ROCE - profit before interest charges and tax / share capital + reserves + borrowings x 100

124
Q

What are all the productivity ratios, list them and the formulaes

A

Debt collection - trade receivables or debtors / sales x 365

Paying creditors - payables or creditors / purchases x 365

How long stock is held - investory or stock / cost of sales x 365

125
Q

What are the liquidity ratios, list them and the formulaes

A

Current ratio - current assets/current liabilities

Quick ratio - current assets excluding stock / current liabilities

126
Q

What are the activity ratios, list them and the formulaes

A

Stock turnover - cost of sales / average stock

Debtors turnover - sales / debtors

Creditors turnover - purchases / creditors

127
Q

The gearing ratio is the same for both insurance and non insurance companies, and the formulae is…

A

Long term borrowings / shareholders equity x 100

128
Q

The insurance industry solvency ratio is…

A

Net assets / earned premium net of reinsurance

129
Q

The insurance industry liquidity ratio is what? And what Normal industry ratios is this different to?

A

Insurance industry liquidity ratio is - total liabilities / cash + investments

This is different to the regular liquidity ratios which are the current ratio - current assets / current liabilities

And the quick ratio which is current assets excluding stock / current liabilities

130
Q

What is the ROE ratio and what is the ROCE ratio and how are they different?

A

ROE - profit after tax / shareholders equity x 100

ROCE - profit before interest charges and tax / share capital + reserves + borrowings x 100

Both ratios enable investors to see if making money for them.

ROE is used in the insurance industry and looks at the profit made for the shareholders equity.

ROCE is a standard ratio and compares profit before tax against all the capital invested into the business e.g more than just shares

131
Q

The productivity ratios and activity ratios all look at stock, debtors and creditors. List all 6 ratios formulae for both type of ratios.

A

The productivity ratio which is for debt collection is - trade receivables or debtors / sales x 365

The activity ratio which is for debtors turnover (e.g how long the debtors to pay like 2 months ) is - sales / debtors

The productivity ratio for paying creditors is - payables or creditors / purchases x 365

The activity ratio for creditors turnover (how long e.g 2 months company has to pay back suppliers) is - purchases / creditors

The productivity ratio for how long stock is held is - investory or stock / cost of sales x 365

The Activity ratio for how quickly stock turned over is - cost of sales / average stock

M92 Business and Finance (10 decks)

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