Analysis and Interpretation Flashcards
(38 cards)
Profitability Definition:
Refers to the earning capacity of the business during the accounting period.
What are the profitability ratios?
- Profit
- Gross Profit
- Expense Ratio
- Rate of return on assets
Profit ratio:
Shows the percentage of profit that is contained in each dollar of sales.
Profit/Net sales
What do the profit ratio results indicate?
- The higher the better.
- The ideal is any positive amount, as a negative amount indicates that a loss has been made.
Increasing Trend for profit ratio:
- Selling a greater proportion of high-profit items
- Cost of sales may have decreases
- Expenses may have decreased
Decreasing Trend for profit ratio:
- Selling a higher proportion of low-profit items.
- Cost of sales may have increased
- Expenses may have increased.
Gross profit ratio:
It is a measure of the level of profit available, after subtracting the cost of sales expense, to cover the remaining expenses of a business.
Gross Profit/Net sales
What do the Gross profit results tell us?
- The higher the better
- The ideal is any positive amount, as a negative amount indicates that a gross loss has been made
Increasing trend for gross profit ratio:
- An increase in the inventory’s selling price is higher than any increase in the purchase price.
- Business has purchased inventory at a lower price
Decreasing Trend for gross profit ratio:
- An increase in the purchase price of inventory Is higher than any increase in selling price
- A decrease in the selling price of inventory is possibly caused by a new competitor entering the market, a price war with competitors, or a desire to increase market share by selling inventory at a lower price.
Expense ratio:
Compares the sales to the total operating expenses. From this ratio, the owner of a business can see the extent to which the operating expenses have affected the profit.
Expenses ( Other than COGS)/Net Sales
What do the results of the expense ratio tell us?
- The lower the better.
Increasing Trend in Expense Ratio:
- Expenses have increased
- Net sales have decreased
Decreasing Trend in Expense Ratio:
- Expenses have decreased
- Net sales have increased
Rate of return on Assets:
Ratio shows the overall earning power of total assets before any payments to equity or debt providers.
Profit/Average Assets
What do the results of the rate of return on assets tell us?
- The higher the better
- Ideal is a positive amount, as a negative result indicates that a loss has been made.
Increasing Trend of Rate of return on asset:
- Money invested is being used more efficiently.
- Greater return earned from the same quantity of assets
Decreasing Trend of rate of return on asset:
- Businesses are using assets less efficiently
- Businesses might need to consider reducing the amount invested in assets
How to improve profitability?
- Locating cheaper supplies
- Increasing prices
- Cutting operating costs
Liquidity Definition:
Ratios assist in assessing the business’s ability to meet its financial commitments in the short term.
What are the liquidity ratios?
- Working capital/Current Ratio
- Quick Asset/Acid test ratio
Working capital/Current Ratio
Shows short-term debt-paying ability. It answers the question of whether the business can meet its debts as they fall due in the normal course of business.
Current Assets/Current Liabilities
What do the results for the working capital/current ratio indicate?
- The higher the ratio the better = Strong liquidity
- Ideal level = 2:1, indicates that for every $1 of current liabilities, the business has $2 in current assets to meet that obligation
- If ratio > 2:1 the business may be missing investment opportunities.
Increasing trend for working capital/current ratio:
- Inventory might be sold more slowly
- Debtors may be taking longer to pay
- Idle cash
