ratio analysis

Question 1

what are the main categories of financial ratios?

Answer 1

-Operating (profitability) ratios
- Short-term liquidity ratios
- Working capital efficiency
- Medium-/long-term solvency (gearing) ratios

Question 2

How is Return on Capital Employed (ROCE) calculated?

Answer 2

(Operating profit / Capital employed) × 100%

Question 3

What does ROCE indicate?

Answer 3

Measures profit as a percentage of capital employed, showing the return on investment.

Question 4

How can ROCE be improved?

Answer 4

By increasing profit margin or asset turnover.

Question 5

How is Net Profit Margin calculated?

Answer 5

(Operating profit / Revenue) × 100%

Question 6

What does a high Net Profit Margin indicate?

Answer 6

Costs are well controlled
Sales prices are high

Question 7

How is Asset Turnover Ratio calculated?

Answer 7

Revenue / Capital employed

Question 8

What does Asset Turnover Ratio measure?

Answer 8

How efficiently a business uses assets to generate revenue.

Question 9

How can Asset Turnover Ratio be improved?

Answer 9

By increasing sales without additional investment.

Question 10

How is Gross Profit Percentage calculated?

Answer 10

(Gross profit / Revenue) × 100%

Question 11

What can cause variations in Gross Profit Percentage?

Answer 11

Selling prices
Sales mix
Trade discounts and carriage costs
Production costs
Inventory valuation errors

Question 12

How is the Current Ratio calculated?

Answer 12

Current assets / Current liabilities

Question 13

What does “current” mean in liquidity ratios?

Answer 13

Amounts due to be paid, received, or used within 12 months.

Question 14

What is considered a safe Current Ratio?

Answer 14

2:1 (varies by industry).

Question 15

What does a low Current Ratio indicate?

Answer 15

Possible insolvency.

Question 16

What does a high Current Ratio indicate?

Answer 16

Inefficient use of working capital.

Question 17

Why should year-end figures be reviewed in the Current Ratio?

Answer 17

To check if they are typical or misleading

Question 18

How is the Liquidity Ratio (Quick Ratio/Acid Test) calculated?

Answer 18

(Current assets - Inventories) / Current liabilities

Question 19

What is the norm for the Liquidity Ratio?

Answer 19

1:1 (varies by industry)

Question 20

What does the Liquidity Ratio measure?

Answer 20

The business’s immediate ability to pay short-term liabilities

Question 21

Why is tracking liquidity ratios over time important?

Answer 21

A decreasing trend may indicate cash flow problems.

Question 22

How is the Inventory Holding Period calculated?

Answer 22

(Average inventory / Cost of sales) × 365

Question 23

What does the Inventory Holding Period measure?

Answer 23

The number of days inventory is held before being sold.

Question 24

How can the Inventory Holding Period be calculated for different inventory types?

Answer 24

By adjusting cost of sales to reflect raw materials, work-in-progress, or finished goods

Question 25

How is Inventory Turnover Ratio calculated?

Answer 25

Cost of sales / Average inventory

Question 26

What does a short Inventory Holding Period indicate?

Answer 26

Efficiency but possible stockout risk.

Question 27

What does a long Inventory Holding Period indicate?

Answer 27

Funds may be unnecessarily tied up

Question 28

What factors can cause changes in Inventory Holding Period?

Answer 28

Efficiency changes Management policy (e.g., bulk purchasing)

Question 29

What are limitations of Inventory Holding Period analysis?

Answer 29

Obsolete inventory included Different valuation policies Average inventory may not reflect actual levels

Question 30

How is the Trade Receivables Collection Period calculated?

Answer 30

(Year-end trade receivables / Credit sales) × 365

Question 31

What does the Trade Receivables Collection Period measure?

Answer 31

The average time customers take to pay.

Question 32

What factors affect the Trade Receivables Collection Period?

Answer 32

Credit control effectiveness Payment speed of new customers Changes in credit terms Early settlement discounts

Question 33

What is a normal Trade Receivables Collection Period?

Answer 33

Typically aligns with stated credit terms (e.g., 30 days)

Question 34

What is a limitation of the Trade Receivables Collection Period?

Answer 34

Year-end trade receivables may not be representative

Question 35

How is the Trade Payables Payment Period calculated?

Answer 35

(Year-end trade payables / Credit purchases) × 365

Question 36

What does a high or increasing Trade Payables Payment Period indicate?

Answer 36

Good cash flow management (free credit) Risk of suppliers cutting credit if excessive

Question 37

What is a limitation of the Trade Payables Payment Period?

Answer 37

Year-end trade payables may not reflect typical levels

Question 38

What is the Operating Cycle?

Answer 38

The time taken from purchasing raw materials to receiving payment for finished goods

Question 39

How is the Operating Cycle calculated?

Answer 39

Inventory holding period + Receivables collection period – Payables payment period

Question 40

What is financial gearing?

Answer 40

A comparison of how much long-term capital comes from equity vs. fixed-return investors.

Question 41

How is Gearing calculated?

Answer 41

(Fixed return capital / (Equity capital & reserves + Fixed return capital)) × 100%

Question 42

How can the denominator in Gearing be calculated differently?

Answer 42

Using total assets less current liabilities Using market values or book values

Question 43

What defines a highly geared company?

Answer 43

A company with a high proportion of preference shares, debentures, or loan stock.

Question 44

What are risks of high gearing?

Answer 44

Volatile share price Requires stable profits and suitable asset security May struggle to raise additional finance (ratio > 50%) Could face liquidity issues or corporate failure

Question 45

What are limitations of Gearing analysis?

Answer 45

Different accounting policies (e.g., goodwill treatment, asset revaluation) Non-recorded assets (e.g., operating leases)