Ratio Analysis

The disadvantage to a highly geared company

• High interest payments means less profits are available for investment elsewhere in the business.

• Shareholders are less likely to get a dividend when gearing is high.

• The business would find it more difficult to raise additional loan finance.

• Hugh risk of liquidation due to not being able to make interest payments.

The benefits to a low geared company.

• Low interest payments means more profits are available for investments and expansion.

• Shareholders are more likely to get a good divided

• The business can get additional finance easier

• Less risk of bankruptcy

Ways to reduce gearing

• Sell more ordinary shares and this will increase equity

• Convert debfto ordinary shares, this will reduce the debs and increase equity

• Repay loans which will reduce debt

• Increase the retained profits by paying out less dividends.

Limitations of Ratio Analysis

• Ratios analyse past figures only, these figures are quickly out of date.

• Different companies uses different accounting bases and policies, therefore company comparisons can be inaccurate.

• Financial statements vuve a limited picture of a business. Other important aspects such as staff morale, industrial relations, economic climate, monopoly position are not included.

Distinguish between ordinary shares and preference shares.

• The rate of dividend is fixed for preference shares. There is no fixed rate of dividends for others

• Preference shareholders don’t have voting rights for taking crucial decisions related to the company. Ordinary shareholders does.

• Preference shareholders have priority when it comes to being paid a dividend. Ordinary shareholders are paid a dividend if the company has enough profits to pay a dividend.

Explain the difference between ‘Liquidity’ and ‘Solvency’

• Liquidity is the ability of a company to pay its short-term debts as they fall due, if the acid test is 1:1 or above, the business is liquid.

• Solvency is more concerned with the long term. It measures the ability of a company to meet all of its debts. A company is solvent if its total assets are greater than its outside liabilities. A good ratio here is total assets to total outside liabilities.

A rising liquidity ratio is a significant of professional of management. Briefly discuss.

• It indicates that if it is easier for the firm to pay uts short term debts as they fall due. Allows the firm to avoid interest penalties and to gain a discount.

• If the acid test ratio were to rise significantly over 1:1, it shows that too much of the firm's resource are tied up in liquid assets when they apcould be invested in fixed assets enhancing the productive capacity of the firm. The company might be vulnerable to a takeover by a competitor.

Give possible reasons for the change in gross profit percentage.

• Cost of sales increased without the increase being passed to the customer

• Stock losses, theft of stock or absolete stock

• Incorrect calculation of stock, overvaluing opening stock or undervalued closing stock

• Cash loses, cash sales not recorded or theft of cash

• Increased competition in the market, reducing profit margins

Outline how a company could improve its gross profit percentage

• Increase selling price without suffering an increase in purchase price

• Reducing the cost of purchase by shopping for cheaper suppliers

• Availing discounts from suppliers as a result of bulk buying of materials

• Change the sales mix to sell more high margin items