Chapter 7: Performance Indicators

Question 1

Why are ratios useful? (1)

Answer 1

Ratios calculated from financial statement help to interpret the information they present.

Question 2

How is return on capital employed calculated? (1)

Answer 2

Return on capital employed= Profit from operations/ (total equity + non current liabilities) x 100%.

Question 3

What does the return on capital employed show? (2)

Answer 3

1. How successful a business is in utilising its funding.
2. A low return on capital employed is caused by a low profit margin or a low asset turnover.

Question 4

How do you calculate gross profit margin? (1)

Answer 4

Gross profit margin= gross profit/ revenue x 100%.

Question 5

What could a low (1) or high (2) gross profit margin be because of?

Answer 5

1. A low margin could mean selling prices are too low or cost of sales is too high.
2. A high margin could be because of new products, greater brand awareness, quality improvements or better marketing.
3. Lower production costs lead to a high margin maybe due to new machinery, efficiency improvements, more motivated workers or fewer quality problems.

Question 6

How do you calculate operating profit margin? (1)

Answer 6

Operating profit margin= Profit from operations/ revenue x 100%.

Question 7

What does operating profit margin show? (3)

Answer 7

1. Operating profit margin will be affected by the gross profit margin.
2. Low operating margin could indicate poor gross profit margin or high overheads.
3. Comparative analysis could then reveal the level of prices in relation to competitors.

Question 8

How do you calculate asset turnover? (1)

Answer 8

Asset turnover= Revenue/ (total assets - current liabilities).

Question 9

What does asset turnover show? (3)

Answer 9

1. It is a measure of how fully a company is using its assets.
2. A low asset turnover shows that the company is not generating a sufficient volume of business for the size of its asset base.
3. A low asset turnover can be remedied by increasing sales or by disposing of assets.

Question 10

How do you calculate the current ratio? (1)

Answer 10

Current ratio= current assets/ current liabilities.

Question 11

What does the current ratio show? (5)

Answer 11

1. It is a measure of short term solvency.
2. It indicates the extent to which the claims of short term payables are covered by assets that are expected to be converted to cash.
3. The current ratio should be between 1:1 and 2:1.
4. If the ratio was below 1:1 it would mean there are insufficient assets to meet liabilities.
5. If the ratio was above 2:1 it would mean there are too many assets.

Question 12

How do you calculate trade receivables collection period? (1)

Answer 12

Trade receivables collection period= trade receivables/ revenue x 365 days.

Question 13

What does the trade receivables collection period show? (3)

Answer 13

1. A long collection period could indicate poor credit control.
2. A long period could also indicate overseas customers with longer collection periods.
3. A long period could show a deliberate decision to extend credit terms in order to attract new customers.

Question 14

How do you calculate the acid test (quick test) ratio? (1)

Answer 14

Acid test ratio= (current assets - inventory)/ current liabilities.

Question 15

What does the acid test ratio (quick test) show? (4)

Answer 15

1. This ratio is a better test of solvency as inventory is slow to convert into cash.
2. This ratio could show the company is thriving as increased activity leads to more inventory and less cash.
3. When trade allows inventory might be disposed of without renewal and the ratio will rise.
4. Increased liquidity means more trade but could also mean funds aren’t being used effectively eg high cash surplus.

Question 16

How do you calculate inventory turnover? (1)

Answer 16

Inventory turnover= cost of sales/ inventory.

Question 17

What does inventory turnover show? (2)

Answer 17

1. It measures how efficiently the inventory has been used to generate revenue.
2. The higher the turnover the more efficiently inventory is being used.

Question 18

How do you calculate inventory holding period in days? (1)

Answer 18

Inventory holding period= inventory/ cost of sales x 365 days.

Question 19

What does the inventory holding period show? (1)

Answer 19

1. It shows how many days worth of inventory is being held.
2. A shorter period may be good but it could also cause a loss of customer goodwill or cause production disruptions due to inventory shortage.

Question 20

How do you calculate the trade payables payment period in days? (1)

Answer 20

Trade payables period= trade payables/ cost of sales x 365 days.

Question 21

What does the trade payables payment period show? (1)

Answer 21

1. If the payables period is very short then the business might not be making the best use of resources by paying early.
2. If the payables period is very long then this is a free source of credit but the business may damage relations with suppliers.

Question 22

How do you calculate the working capital cycle? (1)

Answer 22

Working capital cycle= inventory days + receivable days - payable days.

Question 23

What does the working capital cycle show? (2)

Answer 23

1. The length of time between paying for inventory and receiving the cash for goods or services supplied.
2. The more time cash is tied up in working capital the more costs the company incurs either directly (interest) or indirectly (not able to invest in higher interest accounts).

Question 24

How do you calculate gearing?

Answer 24

Gearing= non current liabilities/ (total equity + non current liabilities) x 100%.

Question 25

What does gearing show? (5)

Answer 25

1. Gearing shows how reliant the company is on non equity funding. 2. High gearing means the business has a high % of borrowed funds. 3. Gearing is an indication of long term liquidity and financial risk. 4. High geared companies have to meet large interest commitments before paying dividends. 5. High geared companies may have problems raising further finances in the future.

Question 26

What are is the problem with ratios that use SOFP data? (1)

Answer 26

The SOFP only shows the position of the company at a specific moment, the P&L is the total over a period.

Question 27

What can make SOFP ratios more reliable? (1)

Answer 27

By using average figures eg receivables collection period taking into account sales at the beginning and end of the year.

Question 28

Figures can change during the different seasons. What can be done to make these figures more reliable? (2)

Answer 28

With changing seasonal figures, an average at the beginning and end of the year might not be an option. Instead valuations should be taken at the same time each eg inventory valued at the YE as it’s low and easier to count.

Question 29

Where do ratios fail? (2)

Answer 29

Revenue for a business might double over a year but the ratios wouldn’t show this. It’s important to refer to the underlying drivers of the business’ performance as well as the ratios.

Question 30

How does is a deterioration is ratios linked to internal control’s? (2)

Answer 30

1. From control issue to ratios. 2. From ratio to potential causes.

Question 31

What does ‘from control issue to ratios’ mean? (4)

Answer 31

For example, if inventory after a stock take is undervalued it will affect: 1. Cost of sales will be overstated. 2. Gross profit, return on capital and current ratio will all be understated. 3. Inventory days will also be lower (due to lower inventory and higher cost of sales).

Question 32

Another example of ‘from control issue to ratios’ is: If there was a cutoff error at the YE and a sales invoice was recognised too early in the wrong period:

Answer 32

1. This error means sales, profit and receivables are overstated. 2. Gross profit, return on capital, liquidity ratios, current ratio, quick ratio and receivable days are all overstated.

Question 33

What does ‘from ratio to potential causes’ mean? (2)

Answer 33

If the receivable days ratio has worsened over a year then this might be because of poorer credit control. If gross profit is down prices maybe lower or costs higher, maybe too many discounts, inventory theft, excessive stock or price rises.

Question 34

How are control issues linked back to the financial statements and the ratios? (4)

Answer 34

1. Stolen items= cost of sales will be higher than expected= leads to a fall in gross profit margins. 2. Absent credit controller= receivables balance too high= higher current ratios and receivable days. 3. Theft of cash= less cash then expected= lower current ratio. 4. Items sold to a friend at a low price= lower sales and gross profit= fall in margins and lower receivable days.