financial ratios

Question 1

Gross profit margin

Answer 1

(Gross profit ÷ revenue) x 100

Question 2

Gross profit mark up

Answer 2

(Gross profit ÷ cost of sales) x 100

Question 3

Expenses in relation to revenue

Answer 3

(Expenses ÷ revenue) x 100

Question 4

Profit in relation to revenue

Answer 4

(Profit for yr before tax ÷ revenue) x 100

Question 5

Return on capital employed

Answer 5

Profit from operations ÷ capital employed

Capital employed: capital/funds + non current liabilities

Question 6

Current ratio/ net current asset ratio

Answer 6

(Current assets ÷ current liabilities)

Expressed as x:1
Acceptable figure: 2:1

Question 7

Liquid capital ratio/ acid test ratio

Answer 7

(Current assets - closing inventory) ÷ current liabilities

Expressed as x:1
Acceptable figure: 1:1

Question 8

Rate of inventory turnover (2 formulas)

Answer 8

(Average inventory ÷ cost of sales) x 365

Cost of sales ÷ average inventory (in times)

Average inventory: (opening stock + closing stock) ÷ 2

Question 9

Trade receivables days

Answer 9

(Trade receivables ÷ credit sales) x 365

Question 10

Trade payable days

Answer 10

(Trade payables ÷ credit purchases) x 365

Question 11

Gearing

Answer 11

(Non-current liabilities ÷ capital employed) x 100

Question 12

What are the 2 liquidity ratios

Answer 12

• current ratio/ net current asset ratio
• acid test ratio/ liquid capital ratio

Question 13

What are the 3 efficiency ratios

Answer 13

• rate of inventory turnover
• trade receivables days
• trade payable days

Question 14

What is the capital structure ratio

Answer 14

The gearing ratio

Question 15

Dividend yield

Answer 15

(Dividend per share ÷ market price per share) x 100

Question 16

Earnings per share

Answer 16

Earnings (profit after tax) ÷ no. of issued ordinary shares

*always in pence (0.10p)

Question 17

Dividend cover

Answer 17

Profit after interest and tax ÷ ordinary share dividends paid

*ideally above 1
*less than 1 = have to use retained earnings

Question 18

Price earnings

Answer 18

Current market price ÷ earnings per share

Question 19

Interest cover

Answer 19

Profit before interest and tax ÷ interest payable

*ideally needs to be 2+
* below 1 = cannot pay off interest
* 1 = barely scraping

Question 20

What are the 5 profitability ratios

Answer 20

Gross profit margin
Operating profit margin
Profit for the year margin
Gross profit mark-up
ROCE

Question 21

What are the 5 investor ratios

Answer 21

Dividend yield
Earnings per share
Dividend cover
Price earnings
Interest cover

Question 22

Give 3 users of ratio analysis and what they would use it for

Answer 22

Managers and owners - to help make financial decisions

Banks - assess whether or not to offer a loan

Suppliers - to assess the likelihood of receiving payment

Customers - to be assured of continuity of supplies

Shareholders - to be assured their investment is sound

Prospective investors - to compare with others investments

Employees and trade unions - to check financial prospects with implications for job security and remuneration

Question 23

What does the gross profit margin indicate

Answer 23

• low figure = buying price too high, increase in purchases, selling price too low, sales volume too low
• high figure = purchasing EOS, high selling price etc
• small decrease shouldn’t be a concern unless it continuously falls
• lower figure = lower profits = lower dividend payments

Question 24

What is gross profit mark-up and what does it indicate

Answer 24

how much above the cost a company sells its products—essentially the percentage added to cost to reach the selling price

• high figure = potential for good profitability, especially if operating costs are well managed
• high figure = could indicate overpricing = might hurt competitiveness in price-sensitive markets
• low figure = profitability depends heavily on volume and cost control

Question 25

What is expenses in relation to revenue and what does it indicate

Answer 25

**shows how much of a company’s revenue is being used to cover its expenses** - decrease indicates a fall in expenses and more efficient cost management - high figure = may indicate inefficiency or rising costs = lower profits - low figure = more revenue = more profits available for dividends - low figure could suggest underinvestment in business - may hurt long-term growth = lower profitability in long term

Question 26

What is profit in relation to revenue and what does it indicate

Answer 26

**It reflects how efficiently a company turns sales into actual earnings** - increase would show cost in IS being kept under control - decrease = struggle to control costs = lower profits = lower dividends - high figure = Strong cost control and efficient operations - high figure = Potentially strong returns for shareholders - Low figure = inefficiencies or high overhead - Low figure = Vulnerable to economic downturns

Question 27

What does ROCE indicate

Answer 27

- low % shows a profit that could quickly be turned into a loss - improving figure = possibly paid off long-term loan = lower interest = higher profits = can pay higher dividends - improving figure = managing operating expenses better - Improving figure = generating better profit from investments

Question 28

What does the current ratio indicate

Answer 28

**a firms ability to pay its short term debts** - above 2:1 = holding too many assets = inefficient use of assets - 2:1 = strong short term financial health = ability to pay short term debts comfortably - below 1:1 = liquidity problems - high inventory turnover = might have low current ratio

Question 29

What is the liquid capital (acid) ratio and what does it indicate

Answer 29

**measures a company’s ability to pay its short-term liabilities using its most liquid assets—excluding inventory** - high figure = any can easily cover short-term debts without relying on inventory sales (Stable) - Really high figure = Holding too much cash or receivables may mean missed investment opportunities - Low figure = Could signal tight cash flow or over-reliance on inventory turnover or credit

Question 30

What is rate of inventory turnover and what does it indicate

Answer 30

**the amount of time stock is being held** - what this figure should be depends on type of business - lower figure than competitors = selling less = lower profits - high figure = healthy demand = high sales = high profits = potential for high dividends

Question 31

What does trade receivable days indicate

Answer 31

**how long it takes TR to pay for goods sold to them on credit** - higher figure than TP days is bad (cash flow problems) - high figure = firm takes long to collect payments = good customer goodwill but may put pressure on cash flow - high figure = weak credit control

Question 32

What is trade payable days and what does it indicate

Answer 32

**how long the business takes to pay its trade payable** - TP days shorter than TR days = cash flow problems - improving figure/ higher than industry average = keeping cash for longer = positive

Question 33

What does the gearing ratio indicate

Answer 33

- high gearing = high borrowing, debt and risk - low gearing = low borrowing, debt and risk - improving figure = paid off a debt = less risky = more attractive to investors

Question 34

What is dividend yield and what does it indicate

Answer 34

**how much money can shareholders get from dividends relative to share price (see if investment is worthwhile)** - fluctuations = uncertainty = dividend figure not a true indicator of potential income - Stable or increasing dividend yields can mean a company is confident in its financial stability and future cash flow - low figure = company pays out a relatively small dividend compared to its share price - low figure = may indicate firm reinvesting profits back into the firm rather than paying them out to shareholders - business might have cut its dividend, possibly due to financial difficulties or a strategic shift - high figure = good for income focused investors

Question 35

What is earnings per share and what does it indicate

Answer 35

**how much profit/loss you’ll make on each share you buy** - decrease = overall profitability of firm decreasing = possible struggle to maintain dividend payments - if lower than dividends per share = using retained earnings to pay dividends = not sustainable in long term (possibly trying to keep shareholders happily)

Question 36

What is dividend cover and what does it indicate

Answer 36

**how many times a company’s earnings can pay its dividend payments i.e how comfortably can they pay it off** - decrease = possible indicator of deteriorating financial health = lower confidence - high figure = profits being retained for future investment rather than being paid out to shareholders

Question 37

What is price earnings and what does it indicate

Answer 37

**ratio of a company's share price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued** - decrease = indicator of less confidence from investors or a better share value (cheaper shares) - increase/high figure = (more) investor confidence in future of firm = shares more expensive now = not good for potential investor

Question 38

What is interest cover and what does it indicate

Answer 38

**how easily a business can pay its interest on loans** - increase = paid off debts = lower risk = can take out more loans if needed - high figure = able to pay debts efficiently - decrease = less efficient in covering debts

Question 39

Give 3 financial and 3 non-financial limitations of ratio analysis

Answer 39

- Uses historic information = might not be up to date by time of use and it doesn’t indicate future performance - only as good as the data they’re based on (not reliable = and decision making) - should not use quantitative data on its own, should use qualitative data in decision making - ratios can not be used on their own, need to be compared - business performance also dependent on external factors e.g. inflation = ratios doesn’t show full extent of business performance - is any information provided for why ratio figures are poor/good - it’s better to have access to whole financial statements to make decisions - if only one year of data is provided - can’t analyse trends = can’t see if company improving/deteriorating - if fluctuations in ratio over years - there’s uncertainty

Question 40

What factors should be take into account when determining whether to invest into a business

Answer 40

- ethical stance of business - has qualitative data been provided e.g. CSR stance, culture, reputation etc - risk preference - do we know the type of business to make a fair judgement - stability of industries (emerging industry vs stable market *emerging industry = more likely to reinvest profits than pay dividends *stable market = more attractive to potential investors - are they same type of business and in same industry - if not, it’s difficult to accurately compare - does the business priorities dividends or growth

Question 41

What does dividend per share indicate

Answer 41

- increase = improvement in profitability - higher than earnings per share = paying out more dividends than hey we’re earning = making a loss = using retained earnings to pay dividend = not sustainable in longterm