Ratios Analysis

Question 1

Net Asset Turnover
Fixed Asset Turnover

Answer 1

• Efficient use of assets to generate sales revenue.
• Low → unproductive use of assets → sell idle asset or boost production/sales
• Too high → risk of overtrading. → Solution: Invest in more assets or secure more long-term funding.

Question 2

Gross Profit Margin
Operating Profit Margin

Answer 2

• Ability to make profit from cost control and sales revenue generation
• Falling margin reflects rising costs or poor pricing. → Solution: Negotiate supplier discounts, raise prices, improve productivity.
• If OPM falls less than GPM → effective overhead cost control

Question 3

ROCE

Answer 3

• Efficiency in generating profit from capital.
• ROCE = operating profit margin x net asset turnover
• Falling ROCE → weak profitability, poor capital utilization. → Solution: Improve profit margins or sell underperforming assets.

Question 4

Inventory Days

Answer 4

• Speed of inventory turnover.
• Increase → slower sales, overstocking, risk of obsolescence (together with fall in OPM → signals some inventories are becoming obsolete and hard to sell, should be written down)
• but may be due to expectation of increased future demand or discounted bulk-purchasing
• Too low → overtrading risk, insufficient asset to sustain operation → Solution: cutback may be necessary to ensure survival in LR despite loss to sale revenue/profit in SR; increase the level of funding to match the level of operations

Question 5

Receivable Days

Answer 5

• Speed of collecting customer payments.
• Increase → reflects poor credit control or deliberately extending payment times to grow sales (has opportunity cost, ineffective if sales didn’t increase much) → Solution: tighter credit policy or early payment discounts
• Suppliers should be ware is increased receivable days seems to be financed by increased payable days

Question 6

Payable Days

Answer 6

• Speed to pay suppliers.
• Very high → reflects pressure on cash flow
• Very low → missed cost-free financing opportunity may be done deliberately to improve supplier relations
• Should balance cash preservation and supplier relations.

Question 7

Cash Conversion Cycle (CCC)

Answer 7

• Time cash is tied up in operations.
• Increase→ cash is tied up longer in operations → opportunity cost of tied-up funds which could be in more profitable uses → Solution: speed up receivables, optimize inventory, extend payables where possible.

Question 8

Liquidity Ratios

Answer 8

• A business with low liquidity ratio <1.5 may be struggling to pay off current liabilities as they fall due, and signals overtrading→ Solution: should build up cash reserves and acquire more long-term funding
• A very high ratio, however, indicates that excessive amounts are tied up in cash/other current assets (opportunity cost)
• If liquidity falls with NCA increased significantly, then not a big problem - indicates the business is investing heavily on growth and relies on internal funds to do so, liquidity possition will improve in near future when this investment ends

* link to CCC (inventory, payable, receivable days)

Question 9

P/E Ratio

Answer 9

• Low → investors have poor confidence about its future growth and profitability
• However should do more investigation - if undervalued then a potential investment opportunity

Question 10

Interest Cover

Answer 10

• Ability to pay interest from operating profits.
• Low cover → risk of insolvency → Solution: reduce leverage and refinance expensive debt.

Question 11

Gearing Ratio

Answer 11

• Shows how much the bussines is fianced by borrowing instead of equity
• High gearing ratio may be used due to insufficient funds or to increase returns (but ineffective if returns generated < interest expense)
• Higher gearing ratio = higher risk → small change in EBIT will lead to greater change in ROE

Question 12

Suppliers are concerned with:

Answer 12

• profitability → long-term survival→ continuing relationship
• liquidity and payable days → timely payment to supplier

Question 13

Investors are concerned with

Answer 13

• profitability + investment ratios → returns on investment
• gearing ratio → risk associated with investment

Question 14

Lenders are concerned with

Answer 14

• liquidity ratio → (short term) ability to meet maturing obligation
• profitability + gearing ratio → (long-term) risk of loans+interest not being repaid