Chapter 9

Question 1

What is the primary purpose of financial ratios?

Answer 1

To assess a company’s financial performance by analyzing profitability, liquidity, solvency, and efficiency.

Question 3

How do profitability ratios help in financial analysis?

Answer 3

They measure a company’s ability to generate profit relative to its revenue, assets, or equity.

Question 4

What does the gross profit percentage indicate?

Answer 4

It shows the percentage of revenue remaining after deducting the cost of goods sold, indicating pricing efficiency.

Question 5

How is the net profit percentage different from the gross profit percentage?

Answer 5

It accounts for all operating expenses, taxes, and interest, reflecting the company’s overall profitability.

Question 6

Why is return on capital employed (ROCE) an important metric?

Answer 6

It measures how efficiently a company uses its capital to generate profit.

Question 7

What does a high stock turnover ratio indicate?

Answer 7

Efficient inventory management with frequent stock movement, reducing storage costs.

Question 8

How do gearing ratios measure financial risk?

Answer 8

They compare long-term borrowings to shareholders’ equity, indicating leverage and financial stability.

Question 9

What is the current ratio, and what does it measure?

Answer 9

It measures liquidity by comparing current assets to current liabilities, assessing short-term solvency.

Question 10

How does the quick ratio differ from the current ratio?

Answer 10

It excludes inventory from current assets, providing a stricter measure of liquidity.

Question 11

What is the combined ratio in insurance?

Answer 11

It is the sum of claims, commission, and expense ratios, assessing underwriting profitability.

Question 12

Why is the solvency ratio critical for insurance companies?

Answer 12

It ensures the company has enough capital to cover outstanding claims and liabilities.

Question 13

How does the return on equity (ROE) measure an insurer’s efficiency?

Answer 13

It evaluates profitability in relation to shareholder investments.

Question 14

What does a high ratio of outstanding claims to net assets suggest?

Answer 14

A higher claims burden, which could indicate financial stress.

Question 15

Why might financial ratios be misleading if used in isolation?

Answer 15

They depend on financial reporting accuracy and may not reflect future performance.

Question 16

How do financial ratios assist in benchmarking?

Answer 16

They allow comparison of performance between companies and industry standards.

Question 17

What limitations exist in using financial ratios for decision-making?

Answer 17

Ratios can be affected by accounting policies, economic changes, and one-time events.

Question 18

Why is the creditors’ payment period ratio important for a company?

Answer 18

It shows how long a company takes to pay suppliers, affecting cash flow management

Question 19

How does a high debtor turnover ratio benefit a business?

Answer 19

It indicates faster collection of receivables, improving liquidity.

Question 20

What could cause a decrease in the gross profit percentage?

Answer 20

Higher production costs, lower selling prices, or increased competition.

Question 21

Which financial ratio measures a company’s ability to meet short-term liabilities?
a) Gearing ratio
b) Current ratio
c) Return on assets
d) Profit margin

Answer 21

b) Current ratio

Question 22

What does a high stock turnover ratio indicate?
a) Low profitability
b) Efficient inventory management
c) High credit risk
d) Poor liquidity

Answer 22

b) Efficient inventory management

Question 23

How is return on capital employed (ROCE) calculated?
a) Net profit / Revenue
b) Operating profit / Capital employed
c) Net profit / Shareholder’s equity
d) Current assets / Current liabilities

Answer 23

b) Operating profit / Capital employed

Question 24

What does the quick ratio exclude from current assets?
a) Accounts receivable
b) Inventory
c) Cash
d) Investments

Answer 24

b) Inventory

Question 25

If an insurance company’s combined ratio is above 100%, what does it indicate?
a) Underwriting loss
b) Profitability
c) Strong liquidity
d) High solvency

Answer 25

a) Underwriting loss

Question 26

Which ratio measures a company’s reliance on debt for financing? a) Return on equity b) Gearing ratio c) Current ratio d) Profit margin

Answer 26

b) Gearing ratio

Question 27

What does a high total liabilities to cash plus investments ratio indicate?

Answer 27

Potential liquidity risk, as liabilities may exceed liquid assets.

Question 27

What does the solvency ratio assess? a) Liquidity risk b) Profitability c) Financial stability of an insurer d) Claim frequency

Answer 27

c) Financial stability of an insurer

Question 28

Why is a high debtor turnover ratio beneficial? a) Increases profitability b) Ensures quick cash inflows c) Reduces creditor payments d) Lowers gross profit percentage

Answer 28

b) Ensures quick cash inflows

Question 29

Which ratio is most useful in assessing an insurance company’s risk exposure? a) Profit margin b) Return on assets c) Ratio of outstanding claims to net assets d) Stock turnover ratio

Answer 29

c) Ratio of outstanding claims to net assets

Question 30

If a company has a current ratio below 1, what does this suggest? a) Strong liquidity b) Potential short-term financial difficulty c) High profitability d) Low gearing

Answer 30

b) Potential short-term financial difficulty

Question 31

Which ratio best measures an insurer’s underwriting profitability? a) Current ratio b) Loss ratio c) Return on assets d) Gearing ratio

Answer 31

b) Loss ratio

Question 32

A company’s quick ratio is 0.8. What does this suggest? a) Strong liquidity b) Potential cash flow issues c) High profitability d) Overstated reserves

Answer 32

b) Potential cash flow issues

Question 33

Which financial ratio compares long-term debt to shareholders' equity? a) Gearing ratio b) Combined ratio c) Liquidity ratio d) Solvency ratio

Answer 33

a) Gearing ratio

Question 34

What does an increase in a company’s debtor collection period indicate? a) Improved cash flow b) Higher liquidity c) Slower cash inflows d) Higher profitability

Answer 34

c) Slower cash inflows

Question 35

If an insurer has a solvency ratio below regulatory requirements, what is the likely consequence? a) Higher investment returns b) Regulatory intervention c) Increased underwriting profits d) Better liquidity

Answer 35

b) Regulatory intervention

Question 36

What is the impact of a rising loss ratio on an insurer? a) Higher underwriting profitability b) Increased claims costs c) Lower reserve requirements d) Better capital efficiency

Answer 36

b) Increased claims costs

Question 37

A very high creditors' payment period may indicate that a company is: a) Paying suppliers late b) Highly profitable c) Managing inventory efficiently d) Increasing reserves

Answer 37

a) Paying suppliers late

Question 38

Which ratio measures the efficiency of an insurer in utilizing its capital to generate profit? a) Quick ratio b) Return on equity c) Combined ratio d) Gearing ratio

Answer 38

b) Return on equity

Question 39

What does a combined ratio of exactly 100% indicate? a) Underwriting loss b) Break-even underwriting performance c) High solvency d) Low liquidity risk

Answer 39

b) Break-even underwriting performance

Question 40

If a company’s stock turnover ratio declines, what could be a possible cause? a) Faster inventory movement b) Higher revenue growth c) Excess inventory buildup d) Lower creditor payments

Answer 40

C) Excess inventory buildup

Question 41

What does the gross profit percentage ratio measure? A) Net profit in relation to capital employed B) Sales volume C) Gross profit as a percentage of sales D) Claims paid to premiums

Answer 41

Answer: C) Gross profit as a percentage of sales Explanation: This ratio evaluates how much of each pound of revenue is retained after direct costs.

Question 42

Which ratio helps determine how efficiently a company uses its capital? A) ROCE B) Quick ratio C) Claims ratio D) Commission ratio

Answer 42

Answer: A) ROCE Explanation: Return on Capital Employed shows how effectively a company generates profit from its capital.

Question 43

What does the current ratio assess? A) Long-term solvency B) Investment return C) Ability to meet short-term liabilities D) Profitability

Answer 43

Answer: C) Ability to meet short-term liabilities Explanation: It's a liquidity measure that compares current assets to current liabilities.

Question 44

A combined ratio below 100% indicates: A) Profit from investments B) Underwriting profit C) High gearing D) Poor liquidity

Answer 44

Answer: B) Underwriting profit Explanation: It means that premium income exceeds claims and expenses.

Question 45

Which ratio is most relevant to an insurance company’s ability to settle claims quickly? A) Solvency ratio B) Quick ratio C) Liquidity ratio (liabilities / cash + investments) D) Claims ratio

Answer 45

Answer: C) Liquidity ratio Explanation: This evaluates cash and investments relative to total liabilities

Question 46

What does a high gearing ratio suggest? A) Strong equity backing B) Heavy reliance on borrowed funds C) Improved ROE D) Lower claims reserve

Answer 46

Answer: B) Heavy reliance on borrowed funds Explanation: High gearing means a larger proportion of debt compared to equity.

Question 47

The claims ratio is calculated using: A) Claims / Net assets B) Claims / Earned premium net of reinsurance C) Expenses / Sales D) Premiums / Claims

Answer 47

Answer: B) Claims / Earned premium net of reinsurance Explanation: It assesses how much of the premium is used to pay claims​

Question 48

Which of the following is used in calculating the combined ratio? A) Return on capital B) Return on equity C) Claims, expenses, and commission ratios D) Debtor days

Answer 48

Answer: C) Claims, expenses, and commission ratios Explanation: These three make up the total combined underwriting cost ratio.

Question 49

What does the debtor turnover ratio measure? A) Number of stock items B) How quickly customers pay C) Number of claims settled D) Net premiums earned

Answer 49

Answer: B) How quickly customers pay Explanation: It’s calculated as sales / debtors.

Question 50

A return on equity (ROE) of 20% suggests: A) The insurer is poorly capitalised B) A strong return to shareholders C) Too much debt D) Over-reserving of claims

Answer 50

Answer: B) A strong return to shareholders Explanation: ROE indicates how efficiently shareholder funds generate profits.

Question 51

Which ratio can indicate under-reserving of claims? A) High combined ratio B) Low ROE C) Low outstanding claims/net assets D) High expense ratio

Answer 51

Answer: C) Low outstanding claims/net assets Explanation: Under-reserving can misleadingly improve this ratio​

Question 52

The gearing ratio is calculated as: A) Net profit / Borrowings B) Net assets / Premiums C) Long-term borrowings / Shareholders' equity D) Capital employed / Sales

Answer 52

Answer: C) Long-term borrowings / Shareholders' equity Explanation: This shows financial leverage.

Question 53

What is the main limitation of financial ratios? A) They are too complex B) They require too many resources C) They rely on historical, potentially outdated data D) They replace forecasting

Answer 53

Answer: C) They rely on historical, potentially outdated data Explanation: Financial data used is backward-looking and may not reflect current performance.

Question 54

What is the formula for the liquidity ratio for insurers? A) Total liabilities / Cash + investments B) Net assets / Premiums C) Liabilities / Claims paid D) Share capital / Net premium

Answer 54

Answer: A) Total liabilities / Cash + investments Explanation: Used to measure ability to meet obligations using liquid resources.

Question 55

Which ratio best reflects underwriting discipline? A) Combined ratio B) ROCE C) Solvency ratio D) Liquidity ratio

Answer 55

Answer: A) Combined ratio Explanation: It measures how well premiums cover costs, without investment income influence.

Question 56

An insurer has paid claims of £1,200,000 and earned premiums of £1,500,000. What is the claims ratio?

Answer 56

Answer: Claims ratio = (1,200,000 / 1,500,000) × 100 = 80% Explanation: This indicates that 80% of premium income is used to settle claims.

Question 57

Acquisition costs = £250,000; Earned premiums (net of reinsurance) = £2,000,000 What is the commission ratio?

Answer 57

Answer: Commission ratio = (250,000 / 2,000,000) × 100 = 12.5%

Question 58

Expenses = £300,000; Earned premium = £2,000,000 What is the expense ratio?

Answer 58

Answer: (300,000 / 2,000,000) × 100 = 15%

Question 59

Use the above values: Claims = £1,200,000 Expenses = £300,000 Commission = £250,000 Earned premiums = £2,000,000 What is the combined ratio?

Answer 59

Answer: Total = 1,200,000 + 300,000 + 250,000 = 1,750,000 Combined ratio = (1,750,000 / 2,000,000) × 100 = 87.5%

Question 60

Net assets = £4,000,000; Earned premium = £2,500,000 Solvency ratio?

Answer 60

Answer: (4,000,000 / 2,500,000) = 1.6 or 160% solvency

Question 61

Total liabilities = £5,000,000; Cash + investments = £10,000,000 Liquidity ratio?

Answer 61

Answer: (5,000,000 / 10,000,000) = 0.5 Interpretation: Strong liquidity (lower is better)

Question 62

Profit after tax = £400,000; Shareholder equity = £2,000,000 What is the ROE?

Answer 62

Answer: (400,000 / 2,000,000) × 100 = 20%

Question 63

Long-term borrowings = £1,000,000; Shareholders’ equity = £4,000,000 Gearing ratio?

Answer 63

(1,000,000 / 4,000,000) × 100 = 25%

Question 64

Gross profit = £300,000; Sales = £1,200,000 Gross profit percentage?

Answer 64

Answer: (300,000 / 1,200,000) × 100 = 25%

Question 65

Net profit = £180,000; Sales = £1,200,000 Net profit percentage?

Answer 65

Answer: (180,000 / 1,200,000) × 100 = 15%

Question 66

Profit before interest and tax = £500,000 Capital employed = £2,500,000 ROCE?

Answer 66

Answer: (500,000 / 2,500,000) × 100 = 20%

Question 67

Outstanding claims = £1,000,000; Net assets = £5,000,000 Ratio?

Answer 67

Answer: (1,000,000 / 5,000,000) = 0.2 or 20%

Question 68

Sales = £600,000; Debtors = £50,000 Debtor turnover?

Answer 68

Answer: 600,000 / 50,000 = 12 times/year

Question 69

Purchases = £240,000; Creditors = £20,000 Creditor turnover?

Answer 69

Answer: 240,000 / 20,000 = 12 times/year

Question 70

Cost of sales = £360,000; Average stock = £60,000 Stock turnover ratio?

Answer 70

Answer: 360,000 / 60,000 = 6 times/year

Question 71

An insurer earned £5,000,000 in gross premiums. After £1,500,000 in reinsurance, it retained £3,500,000. Claims incurred were £2,800,000. What is the claims ratio based on earned premiums net of reinsurance?

Answer 71

Answer: Claims ratio = (2,800,000 / 3,500,000) × 100 = 80% Explanation: Use net earned premiums as the denominator.

Question 72

A company reports a gross profit margin of 40% on sales of £6,000,000. Net profit is £720,000. What is the net profit percentage?

Answer 72

Answer: Net profit % = (720,000 / 6,000,000) × 100 = 12%

Question 73

An insurance firm has the following data: Total liabilities = £8,000,000 Cash = £2,000,000 Investments = £3,000,000 What is the liquidity ratio (liabilities / (cash + investments))?

Answer 73

Answer: Liquidity ratio = 8,000,000 / (2,000,000 + 3,000,000) = 1.6

Question 74

A firm’s capital employed is £10m. Operating profit before tax and interest is £1.5m. It also holds £3m in long-term debt. Calculate the ROCE.

Answer 74

Answer: ROCE = (1.5m / 10m) × 100 = 15%

Question 75

Gross written premium: £12,000,000 Net earned premium: £9,000,000 Claims: £6,300,000 Expenses: £1,200,000 Commissions: £900,000 What is the combined ratio?

Answer 75

Answer: Combined ratio = ((6.3m + 1.2m + 0.9m) / 9m) × 100 = (8.4m / 9m) × 100 = 93.3%

Question 76

A firm has: Outstanding claims: £1.2m Net assets: £4m Annual claims paid: £3.6m What is the ratio of outstanding claims to net assets?

Answer 76

Answer: = (1.2m / 4m) × 100 = 30%

Question 77

Annual credit sales = £2,400,000 Average trade debtors = £200,000 What is the debtor turnover and average collection period (days)?

Answer 77

Answer: Turnover = 2,400,000 / 200,000 = 12 times/year Collection period = 365 / 12 = ~30.4 days

Question 78

Revenue = £10m Cost of sales = £7.2m Operating expenses = £1.5m Calculate both gross profit % and operating profit %.

Answer 78

Answer: Gross profit = 10m – 7.2m = 2.8m → GP% = (2.8m / 10m) × 100 = 28% Operating profit = 2.8m – 1.5m = 1.3m → OP% = (1.3m / 10m) × 100 = 13%

Question 79

Reinsurance recoveries = £500,000 Total claims incurred = £2,500,000 Net claims = £2,000,000 Net earned premium = £5,000,000 Calculate the claims ratio and comment.

Answer 79

Answer: Claims ratio = (2,000,000 / 5,000,000) × 100 = 40% Comment: Low ratio indicates efficient claims management or under-reserving risk.

Question 80

Net profit = £400,000 Shareholder funds = £1,600,000 Long-term loans = £1,400,000 Calculate: (a) ROE and (b) Gearing

Answer 80

Answer: (a) ROE = (400k / 1.6m) × 100 = 25% (b) Gearing = (1.4m / 1.6m) × 100 = 87.5% — high debt exposure

Question 81

A reinsurer requires liquidity ratio below 1.2. Your insurer has: Liabilities: £9m Cash + investments: £6m Do they meet the requirement?

Answer 81

Answer: Liquidity = 9m / 6m = 1.5 → No, fails test

Question 82

Premium growth = 8% Claims growth = 15% Interpret this relationship.

Answer 82

Answer: Claims growing faster than premiums → potential strain on profitability and combined ratio deterioration.

Question 83

Given: Commission = £1.1m Net earned premium = £10m Claims = £7.5m Expenses = £1.6m Calculate combined ratio and interpret.

Answer 83

Combined = (7.5 + 1.6 + 1.1) / 10 × 100 = 10.2 / 10 = 102% → underwriting loss

Question 84

Solvency capital requirement = £3.5m Available capital = £5.25m What is solvency coverage ratio?

Answer 84

Answer: = (5.25m / 3.5m) × 100 = 150% Interpretation: Good solvency coverage

Question 85

Operating profit = £900,000 Sales = £6,000,000 Capital employed = £5,000,000 Calculate: (a) Operating margin; (b) ROCE

Answer 85

Answer: (a) Operating margin = (900k / 6m) × 100 = 15% (b) ROCE = (900k / 5m) × 100 = 18%