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Flashcards in Chapter 32 Deck (33):
1

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

2

Profitability ratio?

This compares the gross and operation profits of the business with sales revenue.

3

Liquidity ratio?

this gives a measure of how easily a business could meet its short-term debts or liabilities

4

Financial ratios

these give an indication of how efficiently a business is using its resources and collecting its debts

5

Shareholders ratio?

these can be used by existing or potential shareholders to asses the rate of return on shares and the prospects for their investment

6

Gearing ratios

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

7

What are the profitability ratios?

Gross profit ratio
Net profit ratio
Return on capital employed (ROCE)

8

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.

9

what is the formula for ROCE?

assesing the profitability of a business
net or operating profit x 100
capital employed

10

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

11

Gross profit margin formula?

gross profit x100
sales turnover

12

Net profit margin formula?

Net profit x100
sales turnover

13

What are the liquidity ratios?

current ratio
acid test ratio
liquid assets

14

Current ratio formula?

this compares the current assets with the current liabilities of the business
=current assets/current liabilities

15

Acid test ratio formula?

= liquid assets/ current liabilities

16

Liquid assets formula?

=Current assets - stock

17

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

18

Financial efficiency ratios

Inventory (stock) turnover ratio
Debtors days

19

Shareholder or investment ratios

Dividend yield ratio
Dividend cover ratio
Price/earnings ratio (P/E ratio)

20

What are the Gearing ratios?

Gearing ratio

21

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

22

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.

23

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
Sales turnover

24

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.

25

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

26

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.

27

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
annual dividends

28

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.

29

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.

30

Gearing ratio

long term loans x100
capital employed

31

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.

32

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.

33

Disadvantages of ratio analysis


One ratio result is not very helpful – to allow meaningful analysis to be made, a comparison needs to be made between one result and either:
other businesses, called inter-firm comparisons or
other time periods, called trend analysis.

Trend analysis needs to be take into account changing circumstances over time which could have affected the ratio results. These factors may be outside the company’s control, such as economic recession.