Financial Ratio Analysis Lecture Review

Flashcards covering key concepts, formulas, and strategies related to ratio analysis, including profitability, liquidity, and efficiency ratios, derived from the lecture notes.

What is ratio analysis?

A financial analysis tool used in the interpretation and assessment of a firm's financial statement.

What does ratio analysis help in evaluating for a firm's financial performance?

Certain trends, strengths and weaknesses, and aids in decision making by making meaningful historical and inter-firm comparisons.

What do profitability ratios assess?

The performance of a firm based on its profit-generating ability.

What is the formula for Gross Profit Margin?

(gross profit / sales revenue) × 100

What are some strategies to improve Gross Profit Margin?

Increase prices in markets with little competition, source cheaper suppliers without compromising quality, adopt more aggressive promotional strategies, or reduce direct labor costs by increasing staff productivity.

What is the formula for Profit Margin?

(profit before interest and tax / sales revenue) × 100

What does a high profit margin indicate?

That the business is managing its expenses very well.

What does a low profit margin indicate?

That the business is having difficulties in controlling overall costs.

What are some strategies to improve Profit Margin?

Check indirect costs to avoid unnecessary expenses (e.g., costly holidays) or negotiate with key stakeholders (e.g., landlords) to cut costs.

What does Return on Capital Employed (ROCE) assess?

The returns a firm is making from its capital employed, measuring the profitability of a firm's invested capital and how well it generates profit from key sources of finance.

What is the formula for Return on Capital Employed (ROCE)?

(profit before interest and tax / capital employed) × 100

How is Capital Employed calculated?

non-current liabilities + equity

What do liquidity ratios measure?

The ability of the firm to pay off its short-term debt obligations.

What are common liquid assets?

Cash, debtors, and stock (inventory).

What is the formula for the Current Ratio?

current assets / current liabilities

What is the recommended range for the Current Ratio?

Between 1.5-2.

What does a Current Ratio below 1:1 indicate?

Current assets are less than current liabilities, which could put the firm in financial difficulties when paying its creditors.

Why should a high Current Ratio be avoided?

It could mean too much cash is held and not invested, too much stock is held leading to high storage costs, or too many debtors increasing the possibility of bad debts.

What are some strategies to improve the Current Ratio?

Reduce bank overdrafts by getting long term loans, or sell long-term assets to increase cash and working capital.

What is the formula for the Acid Test Ratio (or Quick Ratio)?

(current assets - stock) / current liabilities

What do efficiency ratios assess?

How well a firm internally utilizes its assets and liabilities.

What does the Stock Turnover Ratio measure?

How quickly a firm's stock is sold and replaced over a given period of time.

What are the two formulas for the Stock Turnover Ratio?

(cost of sales / average stock) for number of times, and (average stock / cost of goods sold) × 365 for number of days.

What does a higher stock turnover (number of times) generally indicate for a business?

The firm is selling its stock quickly, earning more profit from sales, and has good control over purchasing decisions preventing obsolescence or expiry.

What is working capital management?

The assessment of the way current assets and current liabilities are being administered.

What are some strategies to improve Stock Turnover Ratios?

Dispose of slow-moving or obsolete goods, sell a narrower range of better-selling products, keep low levels of stock, or adopt a just-in-time (JIT) production method.

What does Debtor Days measure?

The average number of days a firm takes to collect its debts from customers it has sold goods to on credit.

What is the formula for Debtor Days?

(debtors / total sales revenue) × 365

Why is a shorter debtor days period considered better for a business?

It provides the business with working capital for day-to-day operations and allows money to be invested into other projects.

What are some possible strategies to improve Debtor Days?

Provide discounts or incentives for early payment, impose stiff penalties for late payments, stop transactions with late debtors until payment is finalized, or resort to legal means (though this can be costly and harm reputation).

What does Creditor Days measure?

The average number of days a firm takes to pay its creditors.

What is the formula for Creditor Days?

(creditors / cost of sales) × 365

Assets

Money coming in

Cash

Stock

Debtors

Liabilities

Money going out

Overdraft

Trade creditors

Short term borrowing