Ratios

Give the formula for gross profit percentage

(Gross profit/ Sales)x100

Give the net profit margin

(Net profit/ Sales)x100

Distinguish between gross profit and net profit

Gross profit is revenue- the cost of buying the goods.

Net profit is revenue- all expenses.

What is the return on capital employed?

(Net profit/ Capital employed)x100

What headings would you classify as being capital employed?

Ordinary shares, preference shares, reserves, long-term loan

What is the definition for return on capital employed?

Return on capital employed is the net profit generated from the amount of money invested in the business.

What is considered a bad ROI?

A bad ROI is under 4% as it is a lower return than risk-free investments (eg high interest savings account)

What type of ratio is the current ratio?

The current ratio is a liquidity ratio

What is liquidity?

Liquidity refers to the amount of liquid assets a firm has. In other words, the things they own that can be used to pay their debts.

The more liquid a company is….

the more likely it is to pay its debts

What do liquidity ratios measure?

Liquidity ratios measure the ability of the firm to pay their short-term debts.

What does solvency refer to?

Solvency refers to a business’s ability to survive.

If a business has more assets than debts it is solvent.

If a business has more debts than assets it is insolvent.

What would a very high liquidity ratio indicate?

While this is a good, it also means the business is making inefficient use of its resources.

What is the current ratio formula?

Current assets: Current liabilites

Where will the “1” always be in these liquidity formulae?

The variable is always on the left, the 1 is always on the right.

What is the recommended ratio for current ratio?

1.5-2: 1

What is the formula for acid test ratio?

(Current assets- closing stock): Current liabilities

What is the ideal acid test ratio?

1: 1

What does the acid test ratio include and what does it not include?

The acid test ratio only includes liquid assets.

The acid test ratio does NOT include closing stock.

What does a gearing ratio tell us?

The gearing ratio tells us the proportion of the business’s funding that comes from the business’ borrowings or from the issue of shares.

What is the only gearing ratio on our course?

The debt/ equity ratio

What is the formula for the debt/ equity ratio?

Debt capital: equity capital

What is debt capital?

Preference shares and long-term loan

What is equity capital?

Ordinary shares and retained earnings

What should the debt/ equity ratio be?

Less than 1: 1

What is a business described as if its debt/ equity ratio is above 1:1?

The business is described as highly geared.

How is a business described if its debt: equity ratio is below 1:1?

Lowly geared

Define debt/ equity ratio

• The debt/ equity ratio is an analysis of the capital structure of a business.

• It indicates what proportion of the capital that is made up of long-term loans and preference shares as opposed to the proportion of the capital made up of reserves and issued ordinary share capital.

Explain 4 benefits of establishing a cashflow forecast

1. To avoid cash deficit- it lets the business know in advance when it will run short of money.

2. To raise finance- it stokes investor confidence- confidences investor this is a “sound” investment

3. To increase profits- it lets the business know in advance when it will have surplus cash. The business can then plan to invest this cash.

4. To improve financial control- the business can compare its actual receipts and payments with those originally planned in the cash flow forecast. It lets business know if on target. Manager can take corrective action. Improves financial control.

What are limitations of using ratios in business?

1. Human relations- staff relations with management are not taken into account.

2. Value of assets- fixed assets are usually not externally assessed every year.

3. Historical figures- ratios used figures based on the past performance of a business. It is not based on future projections.

4. External factors- ratios do not take into account other threats and opportunities in the business environment ( eg a multinational competitor entering the market)

What is the profit and loss account?

• The P&L account calculates the amount of profit or loss a business makes in a year.

• The Trading Account measures the gross profit by subtracting the sales/revenue from cost of sales.

• The P&L account works out the net profit by subtracting expenses from the gross profit.

What is the balance sheet?

• The balance sheet shows the business’ financial position.

• It displays everything the business owns and owes.

• Total net assets should equal capital employed.

What is the importance of a balance sheet?

• The value of the business’ fixed assets tells the bank manager how much collateral the business has.

• The working capital figure tells the bank manager whether the business has enough funds to pay its bills as they fall due.

• The financed by section of the balance sheet tells investors how the business is funded.

What is the importance of a P&L account?

Gross profit indicates if manager should raise prices and ask for reduction in cost from supplier.

The manager could make cutbacks to reduce expenses.

Equally, profit determines if the business can afford to pay out dividends to its shareholders.