Financial ratios

Question 1

What is ratio analysis?

Answer 1

• A tool used to interpret accounts
• To assess financial performance and financial position
• To identify areas for improvement

Question 2

What is a ratio?

Answer 2

• A relationship between two or more numbers from financial statements
• Can be percentages, currency or numerical values, or days (only relevant when compared)

Question 3

What do ratios help to do and not help to do?

Answer 3

• Provides questions to ask rather than provides answers

Question 4

What are the two broad forms of management ratios?

Answer 4

Performance and position

Question 5

What is the main performance ratio and what is that broken down into?

Answer 5

• ROCE Tree

• Profitability
• Efficiency -Day Ratios

Question 6

What are the position ratios?

Answer 6

• Liquidity-Day ratios

* Stability

Question 7

What is profitability?

Answer 7

Concerned with a business’ ability to generate profits from its sales revenues

Question 8

What is efficiency?

Answer 8

Concerned with a business’ ability to generate sales revenue from its resources

Question 9

What is liquidity?

Answer 9

Concerned with the business’ ability to meet its short-term obligations

Question 10

What is stability?

Answer 10

Concerned with the business’ ability to meet its longer term obligations (specifically interest bearing debt)

Question 11

What is ROCE? and equation

Answer 11

Return on Capital Employed -the percentage return the company is earning on its long-term investors’ capital

(𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡)/(𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑)×100%

Question 12

How is capital employed calculated?

Answer 12

Non-current Liabilities+Equity

Question 13

What does a high percentage and low percentage show from ROCE analysis?

Answer 13

High:
• Good profit performance
• Efficient use of capital

Low:
• Poor profit performance
• Inefficient use of capital

Question 14

What do businesses want to know about ROCE change?

Answer 14

Whether it is due to a change in profitability or efficiency?

Question 15

What does decomposing ROCE into its constitient parts show?

Answer 15

The equation above demonstrates that a company’s ROCE is driven by its ability to maximise profitability (operating/profit margin) and/or optimise capital efficiency (asset turnover)

Question 16

What is the decomposed ROCE equation?

Answer 16

𝑅𝑂𝐶𝐸=(𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡)/𝑅𝑒𝑣𝑒𝑛𝑢𝑒 × 𝑅𝑒𝑣𝑒𝑛𝑢𝑒/(𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑)

Question 17

What is the equation for the Operating Profit Margin (OPM)?

Answer 17

(𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡)/𝑅𝑒𝑣𝑒𝑛𝑢𝑒 × 100

Question 18

What is the equation for Asset/Capital turnover turnover and definition?

Answer 18

𝑅𝑒𝑣𝑒𝑛𝑢𝑒/(𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑) units in £

Measures the efficiency of a company’s use of its assets in generating sales revenue or sales income to the company

Question 19

What profitbaility ratios come under the operating profit margin umbrella?

Answer 19

• Gross Profit Margin (GPM)

* Opex to revenues

Question 20

What efficiency ratios come under the asset turnover umbrella?

Answer 20

• Revenue to non-current assets

* Revenue to working capital

Question 21

Whatis used for working capital analysis? and the different types?

Answer 21

• Day ratios

• Recievable days
• Inventory days
• Payables days

Question 22

What are receivable days and equation?

Answer 22

• Average number of days that a customer invoice is outstanding before it is collected.
• (𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠)/𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠×365

Question 23

What are inventory days and equation?

Answer 23

• The average number of days the company holds its inventory before selling it.
• 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦/(𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠)×365

Question 24

What are payables days and equation?

Answer 24

• Average number of days it takes to clear all outstanding payables
• (𝑇𝑟𝑎𝑑𝑒 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠)/(𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠)×365

Question 25

What should the various day ratios be for good cash flow?

Answer 25

* Receivable days=short * Payable days=Long * Inventory days=short

Question 26

What is the equation and definition of revenue to non-current assets?

Answer 26

•(Revenue)/(non-current assets) | Measures how efficient the business is at turning long-term assets into revenue

Question 27

What is the equation and definition of revenue to working capital?

Answer 27

(Revenue)/(Working capital) | •Measures how efficient the business is at turning working capital into revenue

Question 28

What needs to be taken into account when analysing revenue to working capital?

Answer 28

The ratio may get worse because working capital has gone up significantly or vice versa

Question 29

What is the calculation of working capital?

Answer 29

Current assets - current liabilities

Question 30

What does positive working capital look like? and effect on cash

Answer 30

* Inventory days and receivable days large or together bigger than payable days * Cash tied up

Question 31

What does negative working capital look like? and effect on cash

Answer 31

* Payables days large and inventory days and receivable days small * Realised cash

Question 32

What is the equation for current ratios? and definition

Answer 32

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜=(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠)/(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠) | The extent to which the business can use current assets to settle current liabilities if they all fall due.

Question 33

What is the equation for quick ratios? and definition?

Answer 33

𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜= (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)/(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠) Sterner test showing ability of a business to use quick assets to settle current liabilities if they all fall due.

Question 34

What do different values mean for liquidity ratios?

Answer 34

* Absolute value > 1 : liquid * Absolute value < 1 : illiquid * BUT consider the business model i.e spending available cash * Key aim is stability in ratio over time even if below 1

Question 35

What happens with liquidity ratios when a business has bank elements to it?

Answer 35

• Should be noted when analysing but can be taken out to get a picture of the retail side for example

Question 36

What is the equation of capital gearing? and definition

Answer 36

* 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑒𝑎𝑟𝑖𝑛𝑔=(𝑑𝑒𝑏𝑡 )/(𝑑𝑒𝑏𝑡+𝑒𝑞𝑢𝑖𝑡𝑦) X 100 * The proportion of total formal financing represented by interest-bearing debt * Greater than 50% generally considered to be risky

Question 37

What is the equation for interest cover and definition?

Answer 37

* 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟=(𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡)/(𝑁𝑒𝑡 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠) * The number of times over the interest bill be paid out of operating profits if necessary * Less than 3x generally considered to be risky

Question 38

How has capital gearing of businesses changed in recent years?

Answer 38

Increased for a lot of businesses due to low-interest rates meaning risk of high capital gearing is slightly less

Question 39

What debt is included for capital gearing?

Answer 39

All short and long term interest-bearing debt

Question 40

What is net financing costs?

Answer 40

Net costs of finance costs and finance income