Using Financial Ratios 3.7.2

Question 1

What are financial ratios and what they they provide for managers

Answer 1

They compare two pieces of information e.g profit as a percentage of revenue.

They give managers a more in depth understanding of the financial performance of a business

Question 2

What are the four types of finanacial ratios

Answer 2

Profitability ratios
Liquidity ratios
Efficiency ratios
Gearing ratios

Question 3

What do profitability ratios provide for a business

Answer 3

A key measure of success for a business comparing profit to revenue and investment

Question 4

What do efficiency ratios provide for a business

Answer 4

An indication of how well an aspect of business has been managed

Question 5

What do liquidity ratios assess

Answer 5

The ability a business has to pay its debts

Question 6

What do gearing ratios assess

Answer 6

The extent to which a business is based on borrowed finance

Question 7

What do profit margin ratios compare

Answer 7

They compare a type of profit to the revenue that it was generated from over a trading period.

Question 8

How can gross profit margin, operating profit margin and net profit margin be calculate

Answer 8

Gross profit / revenue x 100
Operating profit / revenue x 100
Net profit / revenue x 100

Question 9

How may managers use profit margin ratios to asses their business

Answer 9

They may compare these ratios as doing so will give them an indication of the quality of profit and how well the business is managing various aspects of the business such as its direct and indirect costs

Question 10

What does ROCE ratio do

Answer 10

Compares operating profit earned with the amount of capital employed by a business

Question 11

What is capital employed

Answer 11

Capital employed is its total equity plus any non current liabilities

Question 12

ROCE calculation

Answer 12

Operating profit / capital employed (total equity + non current liabilities)

Question 13

What does ROCE show for a business

Answer 13

How effective a business is at generating profit from the investment placed within the business

Question 14

What can ROCE be compared to

Answer 14

Can be compared to previous years and the general rate of interest

Question 15

How can a business improve ROCE

Answer 15

Increasing operating profit or reducing capital employed

Question 16

Current ratios is a key ……….. ………..

Answer 16

Current ratios are a key liquidity ratio

Question 17

What do current ratios compare and what does it enable a business to understand

Answer 17

Compare the current assets with current liabilities. It assesses whether a business has sufficient working capital to pay off its short term debts

Question 18

How is current ratio calculated

Answer 18

Current assets / current liabilities

Question 19

What does a current ratio of 2:1 suggest

Answer 19

Suggest that a business has £2 of current assets for every £1 of current liabilities

Question 20

What is meant when a current ratio is less than 1 e.g 0.5 : 1

Answer 20

The business may struggle to pay off its short term debts

Question 21

What does gearing ratios analyse

Answer 21

Analyses how a business has raised its long term finance

Question 22

What does the gearing ratio represent and how is it calculated

Answer 22

Represents the proportion of a firms equity that is borrowed.

Calculated by :
Non current liabilities / (total equity + non current liabilities) x 100

Question 23

What is meant by a highly geared business and how may it affect a business

Answer 23

A highly geared business has more than 50% of its capital in the form of loans. They may be vulnerable to increases in interest rates (they have to pay more back)

Question 24

What benefits may a low geared business have

Answer 24

Have the opportunity to borrow funds in order to expand. These may be business with secure cash flow or considerable assets

Question 25

Why may being highly geared not always be bad for a business

Answer 25

Some shareholders may want a business to be financed through loan capital as long term borrowing can sometimes be cheaper than annual return shareholders require. E.g interests om a ten year loan may only require 6% whereas shareholders might expect an annual return of 20%

Question 26

What is meant by liquidity

Answer 26

The ability for a business to pay off its short term liabilities

Question 27

What do inventory turnover ratios measure and what does it compare

Answer 27

Measures the success of a company at converting inventories into revenue. It compares the value of inventories (at cost - cost of goods sold) with the sales achieved. The faster a business can sell its inventories the faster it achieves a profit

Question 28

How are inventory turnover ratios calculated

Answer 28

Costs of goods sold / average inventories held

Question 29

What is meant when inventory turnover rate is low

Answer 29

The lower the number the more efficient a business is.

Question 30

What are turnover rates determined by (give examples)

Answer 30

They are dependant on the nature of a product. Perishable goods such as foods will have a much faster turnover than manufactured foods e.g blu-ray players/

Question 31

How to determine average number of days inventory is held

Answer 31

(Costs of goods sold / average inventories held) / 365

Question 32

What do receivable days ratio calculate

Answer 32

The amount of time it takes for a business to collect debts that it is owed. The shorter the period, the faster cash is flowing into the business

Question 33

How is receivable day ratios calculated

Answer 33

Receivables / revenues x 365

Question 34

Shorter receivable period means

Answer 34

The firm will find it easier to meet its short term cash needs

Question 35

When may a firm experience long payment periods

Answer 35

When firms offer trade credit to customers - this can cause cash flow problems

Question 36

What do payable days ratio calculate

Answer 36

Calculates the time it takes for a business to pay its creditors - the longer the period the long the business is retaining cash within the business

Question 37

How is payable ratio calculated

Answer 37

Payables / costs of sales x 365

Question 38

Why may long payable periods benefit a business and how can it also damage a business

Answer 38

The longer the period the easier it may be for a business to pay off short term debts

However,
Business that delay payments to suppliers/creditors may damage relationships and cause future problems when making deals

Question 39

When might a business want to calculate its inventory turnover

Answer 39

When it holds large inventories - business will be interested in how quickly these inventories will be turned over as this will help free up working capital

Question 40

Difference between receivables and payables

Answer 40

Receivables are the monies owed to a business from its debtors
Payables are expenses that a business must make to its creditors

Question 41

What is the link between receivables and liquidity of a firm

Answer 41

The faster a business is able to retrieve debts from its debtors (receivables) the quicker cash will flow into a business, improving its liquidity position

Question 42

Who may use financial accounts and how may they be used

Answer 42

Managers - assess performance of the business and whether resources are being used efficiently

Potential investors and lenders - assess security and liquidity of a business

Shareholders - assess return they may receive on their investment

Government - calculate the tax liability of the business

Question 43

3 benefits of ratio analysis

Answer 43

• allows business to calculate and compare trends over a period of time
• shows greater insights than financial accounts on their own
• information can be used against benchmark data e.g industry average

Question 44

3 limitations of financial ratio analysis

Answer 44

• doesn’t take into account qualitative issues such as brand image or customer service performance
• does not take into account the impact of long term decisions such as investment today may lower profitability but boost it in the long term
• ratios do not take into account economic conditions or the performance of other business

Question 45

What does window dressing involve and give an example

Answer 45

Manipulating its financial accounts to make them look more favourable to stakeholders. E.g delaying payments to a later period to boost short term profit this may boost morale and attract potential shareholders.