Ratio Analysis

Question 1

What is the purpose of ratio analysis?

Answer 1

• Compare the performance of the business with previous years.
• Compare the performance of a business to that of its competitors.
• Compare against industry averages.
• Highlight areas of the business that need attention.
• Highlight trends to aid future decision-making.

Question 2

What are the limitations of a ratio analysis?

Answer 2

• Ratio information is historical so is not relevant to the current or future position.
• Ratio do not take into account external factors, for example, recessions.
• Ratio do not take into account internal factors, for example, low staff morale.
• Ratios do not take into account product developments.
• It is difficult to find competitors of the exact type and size to make valid comparisons.

Question 3

What are the profitability ratio?

Answer 3

• Gross profit percentage
• Profit for the year percentage
• Return on equity employed

Question 4

What is the formula and description of gross profit percentage?

Answer 4

Formula:
(gross profit/sales revenue) x 100

Description:
This measures the percentage of profit made from buying and selling. The higher the percentage, the better.

Question 5

How can the gross profit percentage improve?

Answer 5

• Increases sales revenue, e.g. by increasing prices.
• Switch to a cheaper supplier of purchases.

Question 6

What is the formula and description of profit for the year percentage?

Answer 6

Formula:
(profit for the year/sales revenue) x 100

Description:
This measures the percentage of profit made once expenses are deducted from gross profit. The higher the percentage, the better.

Question 7

How can the profit for the year percentage improve?

Answer 7

• Reduce expenses, e.g. lower wage costs by making staff redundant.
• Increase sales revenue
• Improve gross profit to have a knock-on effect.

Question 8

What is the formula and description of return on equity employed?

Answer 8

Formula:
(profit for the year/equity) x 100

Description:
This measures the percentage of investment that is returned to investors such as shareholders. The higher the percentage, the better.

Question 9

How can the return on equity employed be improved?

Answer 9

• Attempt to increase profit for the year, e.g. y reducing expenses or improving revenue.

Question 10

What are the liquidity ratios?

Answer 10

• Current ratio
• Acid test ratio

Question 11

What is the formula and description of current ratio?

Answer 11

Formula:
current assets/current liabilities

Description:

Question 12

How can the current ratio be improved?

Answer 12

• If lower than 2:1, try secure more current assets, e.g. selling non-current assets for cash.
• If too high, they should invest some current assets.

Question 13

What is the formula and description of acid test ratio?

Answer 13

Formula:
(current assets - closing inventory)/current liabilities

Description:

Question 14

How can the acid test ratio be improved?

Answer 14

• less than 1:1, secure more current assets, e.g. encouraging cash sales.
• acid test too low indicates too much money tied up in inventory, so it could implement JIT inventory control to avoid this.

Question 15

What is the efficiency ratio?

Answer 15

• Rate of inventory turnover

Question 16

What is the formula and description of rate of inventory turnover?

Answer 16

Formula:
cost of sales/average inventory

average inventory = (opening inventory + closing inventory)/2

Question 17

How can the rate of inventory turnover be improved?

Answer 17

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