Ratios (general)

Question 1

What are the main profitability ratios?

Answer 1

Gross profit (GP / Sales x 100)

Net profit (NP /Sales x 100)

ROCE (Return on capital employed):

Profit before tax and interest (operating or net profit) / Share capital + Reserves + Long term borrowings (Non current liabilities) x 100

ROCE = OP Prof / Share cap +Res +NCL x 100

Question 2

What can be learnt from Gross Profit Ratio

Answer 2

Changes in GP % mean:

Increase = Company in strong position to exploit market

Decrease = Tough times, more competition, lower sell price, lower profit.

Change = Change of product mix, increasing volume of product with high gross margin will increase profit ratio

Question 3

What Can be learnt from relationship b/w Net and Gross profit?

Answer 3

Relationship b/w net and gross profit shows how well a company has been doing in managing it’s expenses.

E.g: if net profit has decreased over time and gross profit has remained the same this can indicate poor management.

Question 4

What can be learnt from Net profit?

Answer 4

Net profit:

• gives profit margin on sales; normally 5 - 10%.
• Shows how effective managment is

High profit margin indicates more effective management

If margin is low company may deliberately be increasing overheads to cope with future expansion plans

Question 5

Return on Capital Employed ratio

Answer 5

ROCE=

Profit before interest charges+ tax /

Share capital + Reserves + Long term liabilities (non-current liabilities) x 100

Roce enables investor to see if insurers are making money form them and to compare between companies. The higher the ROCE % the better b/c it means you are making money on the capital employed.

Question 6

Why is the ROCE ratio important?

Answer 6

ROCE Ratio is important because:

• A low return could be easily wiped out in a recession
• When acquiring other businesses or moving into new markets, there should be a high ROCE to make it worthwhile for the capital providers (investors)
• A persistent low ROCE may indicate that it is time to dispose of it.

Question 7

What is ROCE designed to look at?

Answer 7

The ROCE is designed to look at:

• the relationship of profit to the total capital employed.
• How effectively and efficiently management have deployed the resources available to it (irrespective of how it was financed)
• The higher the risk in a company the higher the reurn required (eg. start up companies would be expected to produce a higher return).

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Question 8

What is the difference between profitability ratio and productivity ratios?

Answer 8

Profitability compares money values of outputs and inputs productivity

Productivity compares direct inputs and outputs but does not use money as a measuring rod.

Question 9

Name the two productivity ratios

Answer 9

Efficiency ratios:

Trade receivables /debtors /

Sales x 365

Indicates how successful debt collection has been

Payable/creditors /

Purchase x 365

credit can provide an additional source of finance but excessive delays in payment can result in loss of terms a supplier is prepared to offer.

Inventory or stock /

Purchase x 365

changes in inventory turnover can indicate how well a company is doing. Lengthening in stock turnover can reveal a slow down of trading.

Question 10

Are most bankruptcies caused by a lack of profitability or liquidity?

Answer 10

Liquidity; the inability to pay creditors on time.

Question 11

What are liquid assets?

Answer 11

Liquid assets are all those assets that either are money or can be turned into money at short notice. eg. Short term deposits with banks or other financial institutions.

A jeweler with gold has liquid assets b/c it can be sold easily.

Stock of car dealer/manufacturer much less liquid b/c you cannot sell whenever you want.

Question 12

What are the two liquidity ratios?

Answer 12

Two most useful LIDUIQ ratios are:

CURRENT RATIO:

Current assets

Current liabilities

CR of more than 2 is seen as prudent to maintain creditworthiness but 1.5 has become acceptable.

QUICK RATIO:

Current assets excl stock

Current liabilities

QR is more cash driven and will often be below 1.

Question 13

What is a gearing ratio used to measure?

Answer 13

A gearing ratio is of the best measures of a company’s future.

Question 14

Gearing ratio?

Answer 14

GEARING RATIO:

Long term borrowings

Shareholders’ equity x 100

• a good figure is b/w 80% - 110%.
• Prob with debt is interest must be paid on it and debt must be paid on time.
• borrowing option may be more profitable for shareholders than selling more shars.
• the danger is if the company borrows too much and overstretches it self w/o having the reserves to pay the interst in the lean times.