Ratio Analysis Flashcards
(17 cards)
Explain ratio analysis
Ratios can only reveal a limited amount of information about a business if they are analysed in insolation.
A much greater depth of understanding is possible if certain comparisons can be made. These enable trends to be uncovered and relative measures of efficiency to be employed.
Trends over time can be detected by making a comparison with the same business’ results in a previous period.
Relative measures of efficiency can be deduced from using a comparison with another business in the same business sector. Nevertheless this can be difficult in practice as businesses are rarely identical in size, capital structure, etc.
Explain liquidity ratios
Liquidity is the amount of cash a business can get quickly in order to settle its immediate debts.
Liquidity funds consist of:
* cash in hand and at the bank
* short-term investments and deposits
* trade debtors.
Liquidity ratios measure the likelihood of a business falling into insolvency, i.e. being unable to pay its debts as when they are due. The acid test ratio is particularly useful as it excludes stock, which is the least liquid of currents assets
and is thus not ideally suited to paying debts.
Explain acid test ratio
A stringent indicator that determines whether a business has enough short-term assets to cover its immediate liabilities without selling stock. Most businesses seek a value of at least 1.
Current Assets - Stock /
Current Liabilities = :1
Stock is excluded because a business may not be able to convert it into cash quickly.
* 1:1 is ideal.
* A figure less than 1 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis).
* A figure of more than 1.2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.
Reasons for change in acid test ratio
- increase or decrease in the time it takes to receive
monies owed (debtors) or pay money owed (creditors) - increase or decrease in cash in the bank
Reasons for changes in current ratio
- increase or decrease in stock
- increase or decrease in the time it takes to receive
monies owed (debtors) or pay money owed (creditors) - increase or decrease in cash in the bank
Explain current ratio
A liquidity ratio that measures a business’ ability to pay short-term obligations.
For most businesses, a ratio between 1.5 and 2 is ideal.
Current Assets/Current Liabilities = :1
* A figure less than 1.5 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis).
* A figure of more than 2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.
Reasons for change in gearing ratios
- increase or decrease in retained profit or shareholders’
funds - increase or decrease in long term liabilities.
Define gearing ratio
A measure of the business’ capital structure. It measures the proportion of total capital that has been obtained from debt or loan sources rather than from equity
sources.
Long Term Liability/Capital Employed x100
Interpreting gearing ratio below 50%
> 50% = Highly Geared
The higher the gearing of a business the greater the level
of risk due to the enhanced exposure to changes in interest
rates. Highly geared businesses may experience problems
in raising new finance as the business is seen as a risky
investment for the ordinary shareholder. However, it may
be adventurous in its expansion plans leading to high
potential profits in the future.
Interpreting gearing ratio above 50%
- <50% = Lowly Geared
A business with a gearing ratio of less than 50% is said to have ‘low gearing’, since its monthly debt repayments do not form a significant proportion of its monthly outgoings. It can be perceived as a weakness – failing to borrow to expand can indicate an overly cautious management. An investment in a business with low gearing would be safe, but dull. However, there is not much to repay and so not much interest to pay.
Limitations of ratio analysis
Ratios reflect changes in performance, but they do not explain these changes:
* A range of ratios is more valid – too much importance should not be attached to any single ratio.
* Major one-off transactions may distort the true performance of a company.
* The financial accounts may have been ‘window dressed’.
SO:All ratios should be compared with those of the previous
year (and preferably three years before that as well) to
determine trends and with those of similar companies.
Explain Return on Capital Employed (ROCE)
ROCE shows the profitability of the investment by calculating its percentage return. This measures the efficiency with which the business generates profits from
the capital invested in it.
Net Profit/Capital Employedx100
A ‘satisfactory figure’ for ROCE is 20% or greater. ROCE shows the amount of profit made for every £1 invested in the business.
A business’ ROCE can also be compared with the percentage return offered by risk free interest-bearing accounts at banks and building societies. Anything over
3% higher would be considered ‘good’. However, the higher the perceived risk the better the return that would be required by investors.
Reasons for changes in Return on Capital Employed (ROCE)
- increase or decrease in GP or NP margins
- increase or decrease in retained profit or shareholders’
funds - increase or decrease in long term liabilities.
3 profitability ratios
> ROCE
Net profit margin
Gross profit margin
Explain Profitability ratios
Profitability measures a business’ total profit against resources used in making that profit. On its own, profit is a relatively meaningless figure – it needs comparing against
figures such as turnover and capital employed.
These profitability ratios are used to assess how well the business is performing. They concentrate on profit, capital employed and turnover.
A constant gross profit ratio combined with a declining net profit ratio means the business is having problems controlling its expenses.
The gross profit margin and net profit margin ratios can be used together to assess the ability of the company to control their overheads.
Reason for changes in net profit margin
- increase or decrease in sales turnover
- increase or decrease in cost of goods sold
- increase or decrease in expenses.
Reason for changes in gross profit margin
- increase or decrease in sales turnover
- increase or decrease in cost of goods sold.
