Ratio Analysis and interpretation

What is ratio analysis and interpretation?

Looking at the relationship between 2 different quantities

What is the purpose of ratio analysis and interpretation?

To determine the performance and health of a business

What are 3 areas analysed in ratio analysis and interpretation?

Liquidity - Ability to pay debts as it falls due
Stability/Leverage - Ability of business to survive in the long term
Profitability - Ability to make an acceptable level of profit

Why must ratios be compared to another result/standard/ratio?

To interpret the business’s value and determine how well it is preforming

What are the 4 comparisons used to interpret financial ratios?

. Budget for the same accounting period (To see whether the business achieved its expected results for the accounting period)

. Results from same business, previous period (To identify changes and trends in the same business over time)

. Results from similar business for same period

. Average ratios for that type of business (industry averages)

What are the 4 steps for analyzing/ interpreting

. Define ratio (What does it measure)
. Quote figures
. Identify increase/decrease (movement) and trends when comparing and whether it is favorable or unfavorable|
. Reasons for changes… suggestions to improve ratios

What does current ratios measure?

The ability to pay short term debts using current assets

What does quick ratios measure?

The ability to pay short term debts using more liquid current assets

Define liquidity

How easy asset convertible into cash eg. cash completely liquid, accounts receivable quite liquid (usually to be paid within 30-60 days), inventory not very liquid (difficult to sell large quantities at normal price in short time)

Ability of business to pay short-term debts as it falls due.

For a current or working capital ratio what does it mean when the ratio is less than 100%?

The business may find it difficult to pay short term debts, or business is in industry where they are collecting money from sales quickly

For a current or working capital ratio what does it mean when the ratio is between 100-200%?

Should be able to pay short term debts

For a current or working capital ratio what does it mean when the ratio is more than 200%

Able to pay short term debts, extra current assets and should use money to buy non-current assets or invest to generate more income.

What are 2 strategies to improve the current or working capital ratio?

. Improve working capital management (management of current assets/liabilities)
. Debt restructuring - converting short term debts into long term debts

What are the other names for the Quick Ratio?

Acid Test Ratio and Liquidity Ratio

What does a Quick Ratio below 100% indicate?

The business may not be able to pay its short-term debts in an emergency

What does a Quick Ratio above 100% indicate?

The business should be able to pay its immediate debts.

What are three strategies to improve the Quick Ratio?

• Increase inventory turnover.

• Sell underperforming assets (not utilized) and use proceeds to pay short-term debts.

• Debt restructuring - Converting short-term debts into long-term debts.

What does the Debt to Equity Ratio measure?

The level of debt (external) compared to equity financing (internal).

What does the Debt to Total asset Ratio measure?

Assets purchased with contributions from owner or borrowings

What does the leverage ratio measure?

How a business is funded, showing the relationship between internal and external funding.

What happens if a business relies only on capital funding?

The business may expand slowly and be seen as "lazy" because it is not earning maximum returns for shareholders.

What is the risk of excessive borrowing/ debt (highly geared)?

It can lead to a loss of liquidity and profitability.

What is gearing/leverage?

The extent of a business's borrowings.

What does it mean if a business is highly geared?

The business has a high level of borrowings.

What are the consequences of being highly geared?

• Difficulty raising additional funds.

• Large interest and loan repayments.

• Increased risk of business failure.

What does a leverage ratio below 40% indicate?

The business is considered conservative.

What does a leverage ratio between 40% -100% indicate?

The business is lowly geared

What does a leverage ratio above 100% indicate?

The business is considered highly geared.

What are two strategies to improve the leverage/stability ratio?

• Make greater use of equity finance to fund growth.

• Pay off borrowings/debt.

What does the gross profit ratio measure?

The percentage of gross profit contained in each dollar of sales.

What does the profit margin ratio measure?

The percentage of profit contained in each dollar of sales.

What does the expense ratio measure?

The percentage of expenses contained in each dollar of sales.

What does the rate of return on assets ratio measure?

How efficiently assets are used to generate profits (profit as a percentage of total assets).

What could cause the Gross Profit Ratio to increase?

• Selling price increases more than purchase price.

• Purchasing inventory at a lower price.

What could cause the Gross Profit Ratio to decrease?

• Decreasing selling prices due to new competitors or price wars.

• Increasing purchase prices without passing the increase on to customers.

What are two strategies to improve the Gross Profit Ratio?

• Increase sales through advertising campaigns.

• Find a cheaper supplier of inventory.

What could cause the Profit Margin Ratio to increase?

• Reduction in expenses.

• Finding a cheaper supplier of inventory.

• Increase in average selling price.

What could cause the Profit Margin Ratio to decrease?

• Increased expenses not passed on to customers through higher selling prices.

• Poor marketing.

• Increased competition

What are four strategies to improve the Profit Margin Ratio?

• Generate more revenue by focusing on higher revenue-earning activities.

• Stop activities not meeting profit targets.

• Better control or reduction of expenses.

• Find a cheaper supplier of inventory.

Do we want the Expense Ratio to increase or decrease?

Decrease

What could cause the Expense Ratio to increase?

• Increase in expenses.

• Decrease in sales.

What could cause the Expense Ratio to decrease?

• Decrease in expenses.

• Increase in sales.

What are two strategies to improve the Expense Ratio?

• Increase sales e.g. advertising campaigns.

• Better control of / reduction of expenses.

What are 4 strategies to improve the Rate of Return on Assets Ratio?

• Better control of assets by focusing on higher revenue-generating activities.

• Sell unproductive assets or use them more effectively.

• Improve profit through better control of expenses.

• Reduce the asset base by leasing assets instead of owning underperforming assets.