Ratio Analysis

Question 1

What are profitability ratios?

Answer 1

Profitability ratios look at profit in relative terms i.e profit earned as a proportion of sales achieved (profit margins) or as a proportion of the investment made (return on capital employed)

Question 2

What is return on capital employed (ROCE)?

Answer 2

This expressed the profit as a percentage of the capital employed in the business I.e it measures the efficiency with which firms generate profit

Question 3

What are the two ROCE equations?

Answer 3

ROCE= operating profit /total equity + non current liabilities *100
Or
ROCE= operating profit/ capital employed *100

Question 4

How do you analyse profitability ratios?

Answer 4

-a higher figure is better (gaining profit more efficiently)
-compare to previous years and competitors
-compare to the interest rate- the return a business makes should be higher than the return from investing the money in a bank
-Watch out for low quality profit which boosts ROCE

Question 5

How to improve ROCE?

Answer 5

-gain more profit from existing capital I.e be more efficient e.g lean production
-reduce the amount of capital employed ( repay long term loans) but gain same profit

Question 6

What is the gross profit margin?

Answer 6

-gross profit shows the gross profit made on each sale I.e what proportion of the revenue from sale is gross profit

Question 7

What is the equations for gross profit margin?

Answer 7

GPM= gross profit/ revenue*100

Question 8

How to analyse GPM?

Answer 8

-a higher figure is better as more of the revenue from a sale is gross profit
-compare to previous years and competitors
-price affects GPM: increase price and GPM increases
-cost of sales per unit affects GPM: decrease cost of sales per unit and GPM increases
-if sales are infrequent, firms need a high GPM to compensate

Question 9

How to improve Gross Profit Margins?

Answer 9

-increase price
-reduce cost of sales e.g cheaper supplies

-remember whilst GPM can be seen as the gross profit made per sale it can also be seen as total gross profit as a proportion of firms revenue

Question 10

What is the operating profit margin?

Answer 10

Operating profit margin shows the operating profit made on each sale I.e what proportion of the revenue from a sale is operating profit

Question 11

What is the equation for operating profit margins?

Answer 11

-operating profit margin= operating profit/ revenue*100

Question 12

How to analyse operating profit margins?

Answer 12

-if operating profit margin falls it could be because operating profit has fallen due to increase expenses and/ or because gross profit margins have fallen
-compare to GPM: if GPM is rising and OPM falling then the cause must be rising expenses
-compare to other years and competitors

Question 13

How to improve operating profit margins?

Answer 13

-reduce expenses e.g budgeting
-increase price per unit

Question 14

What does the Operating profit margin tell us?

Answer 14

-how effectively sales are turned into operating profit
-how efficiently a business is run
-if the price has added value

Question 15

What is inventory turnover?

Answer 15

-Inventory turnover measures the number of times in a trading year that the firm sells the value of its inventory

Question 16

What is the equation for inventory turnover?

Answer 16

Inventory turnover= cost of sales/ inventory held

Question 17

How to analyse inventory turnover?

Answer 17

-a higher figure is better because profit is earned more quickly
-must look at industry to see if figure is good e.g green grocer would expect 250-300 times a year

Question 18

What could a falling inventory turnover indicate?

Answer 18

-less demand for stock
-more stock being held e.g new product lines or poor buying

Question 19

How to improve inventory turnover?

Answer 19

-increase demand- marketing (promotion, price)
-order less stock -JIT

Question 20

What are receivable days?

Answer 20

-receivable days calculate the number of days,on average, it takes to collect debts( receivables). It helps show how well a firm is managing its current assets

Question 21

What is the equation for receivable days?

Answer 21

Receivable days= receivables/ revenue *365

Question 22

How to analyse receivable days?

Answer 22

-low figure is better as it aids cash flow
-figure must be compared to the official credit period to see if the figure is acceptable. This may have been altered from the previous year as a marketing strategy to attract customers

Question 23

How can you improve receivable days?

Answer 23

-offer incentives not to take credit e.g cash discounts
-reduce credit period offered
-chase up worst offenders I.e most aged debtors

Question 24

What are payable days?

Answer 24

-payable days shows the number of days a firm typically takes to pay its suppliers and other creditors

Question 25

What is the equation for payable days?

Answer 25

Payable days= payables/ cost of sales* 365

Question 26

How to analyse payable days?

Answer 26

-high figure is better as it helps liquidity as payments are being delayed (but relationships with suppliers may suffer) -delayed payments may incur interest. Discounts for paying cash are lost if credit is taken -a firms liquidity position can be assessed by comparing receivable days and payable days. The firm wants payable days to be higher than receivable days as it is receiving payment more quickly than it is paying payables (creditors)

Question 27

What are liquidity ratios?

Answer 27

-liquidity is the speed or ease with which assets can be turned into cash -current assets are most liquid -needs to be balance as the firm does not want too much cash as there is a low return on it -if firm holds too much cash the firm should consider using it to buy non current assets -the liquidity ratio looks at the firms ability to turn assets into cash

Question 28

What is the current ratio?

Answer 28

-current ratio measures the ability of the business to meet its current liabilities using current assets over the next year

Question 29

What is the equation for current ratio?

Answer 29

-current assets/ current liabilities Or -current assets: current liabilities

Question 30

What is analysis for current ratio?

Answer 30

-a figure of about 1.5:1 to 2:1 is recommended - figures differ between industries. Those dealing in cash tend to have lower current ratio figures as more of their current assets are cash, so there is more certainty that they can pay their current liabilities- they don’t need as much of a safety net -high ratios may mean too much cash in bank eg 3:1 -if the firm has large quantities of inventory it may choose to have a high current ratio in case the inventory doesn’t sell

Question 31

How to improve current ratio?

Answer 31

-this mean making it higher -sell non current assets to gain cash -take out a long term loan to gain cash (short term borrowing raises current liabilities so has no effect on the ratio )

Question 32

What is a gearing ratio?

Answer 32

There are two main sources of finance for firms: share capital (not repayable) and loan capital (repayable with interest)

Question 33

What is the equation for gearing?

Answer 33

Gearing= non-current liabilities/ total equity+ non current liabilities *100

Question 34

What is the analysis for gearing ratio?

Answer 34

-over 50%=highly geared i.e taking a higher risk as loans must be repaid with interest -it is better to have a low gearing( below 25%) if sales are low (lack of revenue for repayments ) and/or interest rates are high -high gearing can be good as they can use loan to improve the business but the firm needs high sales and /or low interest rates and a healthy cash flow to meet repayments -must compare to ROCE and interest rates - if ROCE is higher than interest rates then its beneficial to take the loan and buy non current assets

Question 35

How to improve gearing ratio?

Answer 35

-sell more shares -pay back loans- reduce non current liabilities

Question 36

Why should gearing be re calculated?

Answer 36

-gearing can be re calculated to show the effect of taking out a loan. As non- current liabilities are in both the top and bottom parts of the formula, add the loan amount to both the top and bottom then re calculated

Question 37

What is a case study of gearing problems?

Answer 37

-Intu owns Trafford centre- £4.5 bn debt - high gearing -coronavirus caused closure of retailers and there was already pressure due to online stores so wanted rent reduction which lead Intu to have less revenue -brink of administration

Question 38

What are the limitations of ratio analysis?

Answer 38

-ratios on their own have very limited meaning, they are valuable when compared with those of previous years, internal targets or competitors -interfirm comparisons must be treated with caution. Each company has different assets, products and markets. There is no single correct or standard pattern -they do not product the future which is always liable to be different -abnormal or worrying ratios may be a quantitative signal indicating a qualitative problem -all activity is subject to external forces -ratio analysis only considers financial aspects of performance