Flashcards in Chapter 32 Deck (33):
what are the different ratios to asses a company's performance?
1. Profitability ratio
2. liquidity ratio
3. financial efficiency ratio
4. Shareholders ratio
5. Gearing ratio
This compares the gross and operation profits of the business with sales revenue.
this gives a measure of how easily a business could meet its short-term debts or liabilities
these give an indication of how efficiently a business is using its resources and collecting its debts
these can be used by existing or potential shareholders to asses the rate of return on shares and the prospects for their investment
these examine the degree to which a business is relying on long-term loans to finance its operations. it is a reflection of a business's financial strategy
What are the profitability ratios?
Gross profit ratio
Net profit ratio
Return on capital employed (ROCE)
what is capital employed?
the total value of all long term finance invested in the business.
=(non-current assets + current assets) -current liabilities + shareholders equity.
what is the formula for ROCE?
assesing the profitability of a business
net or operating profit x 100
Points to note on ROCE?
-the higher the value of the ratio the greater the return on the capital invested in the business
-The return can be compared both with other similar companies and the ROCE of the previous year’s performance. Making comparisons over time allows the trend of profitability in the company to be identified
Gross profit margin formula?
gross profit x100
Net profit margin formula?
Net profit x100
What are the liquidity ratios?
acid test ratio
Current ratio formula?
this compares the current assets with the current liabilities of the business
=current assets/current liabilities
Acid test ratio formula?
= liquid assets/ current liabilities
Liquid assets formula?
=Current assets - stock
limitations of the Liquidity ratios
- give an incomplete analysis
-one ratios result on its own is very limited value - needs the others
-Poor ratio results only highlight a potential business problem
Financial efficiency ratios
Inventory (stock) turnover ratio
Shareholder or investment ratios
Dividend yield ratio
Dividend cover ratio
Price/earnings ratio (P/E ratio)
What are the Gearing ratios?
Inventory (stock) turnover ratio formula
The lower the amount of capital used in holding stocks, the better. Modern stock-control theory focuses on minimising investment in inventories. This ratio records the number of time the stock of a business is bought in and resold in a period of time.
Inventory (stock) turnover ratio = cost of goods sold
value of inventories
Points to note on Inventory turnover ratio
The higher the number, the more efficient the managers are in selling stock rapidly. Very efficient stock management – such as the use of the JIT system – will give a high inventory turnover ratio.
Debtor days ratio
This ratio measures how long, on average, it takes the business to recover payment from customers who have bought goods on credit – the debtors. The shorter this time period is, the better the management is at controlling its working capital.
Debtor days ratio = Accounts receivable (debtors) x 365
Points to note on Debtor days ratio
There is no ‘right’ or ‘wrong’ result – it will vary from business to business and industry to industry.
However, if the results are higher than average this could mean that the business has a poor control of debtors and repayment periods.
Dividend yield ratio
This measures the rate of return a shareholder gets at the current share price.
Dividend yield ratio (%) = dividend per share x 100
current share price
Dividend per share = total annual dividends
total number of issued shares
Points to note on Dividend yield ratio
If the share price rises and the dividend remains unchanged, the dividend yield will fall.
If the dividends rise and the share price remains unchanged, the dividend yield will rise.
Dividend current ratio
This is the number of times the ordinary share dividend could be paid out of current profits. The higher this ratio, the more able the company is to pay the proposed dividends, leaving a considerable margin for reinvesting profits back into the business.
Dividend cover ratio = profit after tax and interest
Point note on Dividend current ratio
If directors decided to increase dividends to shareholders, with no increase no profits, then this ratio would fall. Potential investors might start to query whether this level of dividend can be sustained in future.
A low result means the directors are retaining low profits for future investment and this could raise doubts about the company’s future expansion.
Price/earnings ratio (P/E ratio)
This is a vital ratio for shareholders and potential shareholders. It reflects the confidence that investors have in the future prospects of the business. In general, a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared with companies with a low P/E ratio.
price/earnings = current share price
earnings per share
earnings per share = profit after tax
total number of shares
This is the amount of profit earned per share.
long term loans x100
Points to note on Gearing ratio
The ratio shows the extent to which the company’s assets are financed from external long-term borrowing. A result of over 50 % would indicate a highly geared business.
The higher this ratio, the greater the risk taken by shareholders when investing in the business. This risk arises for two main reasons:
The higher the borrowings of the business, the more interest must be paid and this will affect the ability of the company to pay dividends and earn retained profits.
Interest will still have to be paid – but from declining profits.
Advantages of ratio analysis
Ratios are widely used by company analysts and prospective investors before making assessments and taking important decisions on:
whether to invest in the business
whether to lend it more money
whether profitability is rising or falling
whether the management are using resources efficiently.