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Questions and Answers
Planning future decisions is not influenced by the current financial position of the business.
Planning future decisions is not influenced by the current financial position of the business.
False
All public limited companies (PLCs) must comply with legal filing requirements regarding annual accounts.
All public limited companies (PLCs) must comply with legal filing requirements regarding annual accounts.
True
The analysis of accounting data is unnecessary for assessing a firm's performance.
The analysis of accounting data is unnecessary for assessing a firm's performance.
False
Comparing a firm's performance with previous years is crucial for planning future action.
Comparing a firm's performance with previous years is crucial for planning future action.
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Ratios and percentages serve as effective gauges for management efficiency.
Ratios and percentages serve as effective gauges for management efficiency.
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Past figures provide a clear and accurate prediction of future business performance.
Past figures provide a clear and accurate prediction of future business performance.
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Different accounting policies can result in inaccurate comparisons of financial data across companies.
Different accounting policies can result in inaccurate comparisons of financial data across companies.
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Income statements are valid for any date, unlike statements of financial positions.
Income statements are valid for any date, unlike statements of financial positions.
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Financial institutions use ratio analyses to determine if a firm can repay loans.
Financial institutions use ratio analyses to determine if a firm can repay loans.
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Only shareholders are concerned with a company's performance as reflected in financial accounts.
Only shareholders are concerned with a company's performance as reflected in financial accounts.
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Ratios are solely used to predict future performance of companies.
Ratios are solely used to predict future performance of companies.
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Employees have no interest in the financial health of a company.
Employees have no interest in the financial health of a company.
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Suppliers assess a business's capacity to repay debts before extending credit.
Suppliers assess a business's capacity to repay debts before extending credit.
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Competitors analyze ratio data to make strategic decisions and assess their own performance.
Competitors analyze ratio data to make strategic decisions and assess their own performance.
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Ratio analyses are not useful in identifying loss-making products or services.
Ratio analyses are not useful in identifying loss-making products or services.
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Tax authorities require financial information solely to evaluate a company's profitability.
Tax authorities require financial information solely to evaluate a company's profitability.
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The income statement shows all the profits a business has made during the year.
The income statement shows all the profits a business has made during the year.
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Reserves are calculated by adding the net profit to last year’s reserves and subtracting dividends paid.
Reserves are calculated by adding the net profit to last year’s reserves and subtracting dividends paid.
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Liquidity refers to a company's ability to pay its long-term debts as they fall due.
Liquidity refers to a company's ability to pay its long-term debts as they fall due.
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Gearing compares how much of a business's funding comes from debt capital versus equity capital.
Gearing compares how much of a business's funding comes from debt capital versus equity capital.
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The net profit is derived solely from gross profit without considering any expenses.
The net profit is derived solely from gross profit without considering any expenses.
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Working capital is determined by subtracting current assets from current liabilities.
Working capital is determined by subtracting current assets from current liabilities.
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Current assets include fixed assets like premises and motor vehicles.
Current assets include fixed assets like premises and motor vehicles.
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Depreciation represents a reduction in the value of fixed assets over time.
Depreciation represents a reduction in the value of fixed assets over time.
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Debt capital includes long-term loans and preference shares.
Debt capital includes long-term loans and preference shares.
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The statement of financial position provides a snapshot of a business's performance over a period of time.
The statement of financial position provides a snapshot of a business's performance over a period of time.
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The current ratio is a type of profitability ratio that indicates how well a company generates profit from its sales.
The current ratio is a type of profitability ratio that indicates how well a company generates profit from its sales.
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Preference share capital is a form of debt capital that requires fixed annual interest payments.
Preference share capital is a form of debt capital that requires fixed annual interest payments.
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The figure for cash on hand is part of current liabilities in the statement of financial position.
The figure for cash on hand is part of current liabilities in the statement of financial position.
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Total net assets equal the amount financed by both issued shares and debt capital.
Total net assets equal the amount financed by both issued shares and debt capital.
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High gearing means higher risk due to more interest repayments and long-term debt.
High gearing means higher risk due to more interest repayments and long-term debt.
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Equity capital does not require repayment, whereas debt capital may lead to bankruptcy if not managed properly.
Equity capital does not require repayment, whereas debt capital may lead to bankruptcy if not managed properly.
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If a company is lowly geared, its risk of becoming bankrupt due to high volume of creditors is increased.
If a company is lowly geared, its risk of becoming bankrupt due to high volume of creditors is increased.
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Debtholders receive dividends before equity shareholders.
Debtholders receive dividends before equity shareholders.
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Selling more shares can improve a company's gearing.
Selling more shares can improve a company's gearing.
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Interest payments on debt must be made regardless of the company's profitability.
Interest payments on debt must be made regardless of the company's profitability.
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A company can only issue as many shares as authorized when raising equity capital.
A company can only issue as many shares as authorized when raising equity capital.
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A highly geared firm is less likely to experience bankruptcy than a lowly geared firm.
A highly geared firm is less likely to experience bankruptcy than a lowly geared firm.
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Dividends paid to shareholders are tax deductible for the firm.
Dividends paid to shareholders are tax deductible for the firm.
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A firm with many assets used as debt collateral may face difficulties in raising additional debt.
A firm with many assets used as debt collateral may face difficulties in raising additional debt.
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The gross profit margin ratio measures what percentage of total sales a business retains after deducting cost of sales.
The gross profit margin ratio measures what percentage of total sales a business retains after deducting cost of sales.
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A net profit margin of 22.92% indicates that a business retains less than a quarter of its sales after all expenses are accounted for.
A net profit margin of 22.92% indicates that a business retains less than a quarter of its sales after all expenses are accounted for.
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A decrease in the gross profit margin year over year suggests that a company is performing better in terms of profitability.
A decrease in the gross profit margin year over year suggests that a company is performing better in terms of profitability.
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Return on investment (ROI) is calculated by dividing total capital employed by net profit.
Return on investment (ROI) is calculated by dividing total capital employed by net profit.
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Higher profitability ratios are generally better, as they indicate greater efficiency and profit retention.
Higher profitability ratios are generally better, as they indicate greater efficiency and profit retention.
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Investors are typically not interested in the net profit margin of a business.
Investors are typically not interested in the net profit margin of a business.
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Sourcing cheaper raw materials can be a recommendation to improve the gross profit margin.
Sourcing cheaper raw materials can be a recommendation to improve the gross profit margin.
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The acid test ratio is primarily concerned with measuring a company's long-term profitability.
The acid test ratio is primarily concerned with measuring a company's long-term profitability.
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A high net profit margin indicates that a business is efficient at controlling its indirect expenses.
A high net profit margin indicates that a business is efficient at controlling its indirect expenses.
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It is advisable for businesses to frequently compare their profit margins with competitors to gauge market competitiveness.
It is advisable for businesses to frequently compare their profit margins with competitors to gauge market competitiveness.
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If a business has a lower ROI than its competitors, it may struggle to attract investment.
If a business has a lower ROI than its competitors, it may struggle to attract investment.
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A high gross profit margin is always considered ideal across all industries, regardless of sales volume.
A high gross profit margin is always considered ideal across all industries, regardless of sales volume.
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Monitoring the trend of gross profit margins is critical for assessing ongoing business performance.
Monitoring the trend of gross profit margins is critical for assessing ongoing business performance.
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Direct labour costs are included in the calculation of gross profit.
Direct labour costs are included in the calculation of gross profit.
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A business should ideally have a liquidity ratio of 2:1 to meet its short-term debts effectively.
A business should ideally have a liquidity ratio of 2:1 to meet its short-term debts effectively.
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The acid test ratio includes closing stock in its calculation to assess liquidity.
The acid test ratio includes closing stock in its calculation to assess liquidity.
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A gearing ratio of 0.46:1 indicates that the business is highly geared and carries a lot of financial risk.
A gearing ratio of 0.46:1 indicates that the business is highly geared and carries a lot of financial risk.
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If a firm's liquidity ratio falls below 1:1, it indicates that the business may not be able to pay its short-term debts.
If a firm's liquidity ratio falls below 1:1, it indicates that the business may not be able to pay its short-term debts.
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Outsourcing the production of goods is a recommended strategy to reduce the cost of sales.
Outsourcing the production of goods is a recommended strategy to reduce the cost of sales.
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A current ratio of 1.23:1 is considered ideal and indicates that the business has good liquidity.
A current ratio of 1.23:1 is considered ideal and indicates that the business has good liquidity.
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The acid test ratio is also known as the quick ratio.
The acid test ratio is also known as the quick ratio.
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Increasing the commission scheme for sales personnel is a suggested method to improve sales performance.
Increasing the commission scheme for sales personnel is a suggested method to improve sales performance.
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A business that has a liquidity ratio greater than 1:1 is considered to be overtrading.
A business that has a liquidity ratio greater than 1:1 is considered to be overtrading.
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Employees with share options may be affected by a decline in return on investment (ROI).
Employees with share options may be affected by a decline in return on investment (ROI).
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The debt to equity ratio measures the proportion of capital made up of retained earnings and long-term loans.
The debt to equity ratio measures the proportion of capital made up of retained earnings and long-term loans.
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A business can improve its liquidity by better budgeting and enhancing its cash flow forecast.
A business can improve its liquidity by better budgeting and enhancing its cash flow forecast.
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The ideal acid test ratio is 2:1.
The ideal acid test ratio is 2:1.
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Debt capital is calculated by combining long-term loans and preference shares.
Debt capital is calculated by combining long-term loans and preference shares.
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Study Notes
Ratio Analysis
- Ratio analysis helps monitor a business's health and performance by using financial information, accounts, and calculations.
- The analysis reveals insights into past performance and allows for comparisons with targets and competitors.
- It is a vital tool used by a variety of stakeholders, including:
- Financial Institutions (banks): assess the business's ability to repay loans.
- Board of Directors: evaluate company performance against budgets and benchmarks.
- Shareholders: evaluate management, estimate income potential.
- Suppliers: gauge the business's ability to pay for goods on credit.
- Employees: understand company success and job security.
- Tax Authorities: ensure accurate tax assessment.
- Potential Takeover Bidders: assess the business's net value for potential acquisition.
- Competitors: compare performance to industry benchmarks and inform strategic decisions.
Importance of Ratio Analysis and Financial Accounts
- Enables the identification of loss-making products or services, allowing for improvement or discontinuation.
- Facilitates the valuation of business net assets, crucial for financing decisions like borrowings and management buyouts.
- Supports planning by providing insights into the current financial position and influencing future decisions.
- Ensures legal compliance for public and private companies with regards to filing annual accounts.
- Facilitates the analysis of accounting and business data.
- Enables comparisons between periods and other companies to highlight problems and areas for improvement.
- Acts as a gauge for management efficiency, evaluating how effectively resources are used.
- Highlights trends in performance over time, for instance, detecting a decline in profitability.
Limitations of Ratio Analysis and Financial Accounts
- Isolates financial information from other critical aspects of a business, such as industrial relations, market share, and economic climate.
- Relies on historical figures, limiting its accuracy in forecasting future performance.
- May be affected by varying accounting policies used year-on-year and across companies, potentially hindering accurate comparisons.
- Data differences exist between income statements (covering a year) and statements of financial position (covering a specific date).
- Ratios can be manipulated through asset undervaluation or overvaluation, leading to biased representation of a business's true position.
- Economic variables, such as inflation, exchange rates, and interest rates, are not factored into ratio calculations.
Financial Accounts
- Final accounts summarize a business's financial performance over a year.
- These accounts provide essential figures used in ratio analysis and performance evaluation.
- These comprise two main financial statements:
-
Income Statement (previously called trading and profit and loss account):
- Shows sales (cash and credit) and expenses incurred over the year.
- Evaluates management’s resource utilization.
- Highlights key figures including:
- Gross Profit: Revenue - Cost of Goods Sold
- Net Profit: Gross Profit - Expenses + Non-Sales Income
- Reserves / Retained Earnings: Profits retained for future investment.
-
Statement of Financial Position (previously called the balance sheet):
- Shows the financial status of a business at a specific date.
- Provides insights into liquidity, gearing, and funding positions.
- Contains key figures including:
- Current Assets: Quickly convertible assets (e.g., debtors, stock, cash).
- Current Liabilities (Creditors falling due within 1 year): Short-term debts due within one year (e.g., bank overdraft, accrued expenses).
- Working Capital: Current Assets - Current Liabilities: Available cash for day-to-day operations.
- Debt Capital: Long-term loans and preference shares: finance permanent assets.
- Equity Capital: Issued shares and reserves: the owner's investment in the business.
- Capital Employed: Equity Capital + Debt Capital: The total long-term finance used by the business.
- Preference Share Capital: Long-term debt component with fixed interest payments.
- Authorized Share Capital: Total shares allowed for issue, as stipulated in the company's legal documents.
- Issued Share Capital: Total shares actually sold.
-
Income Statement (previously called trading and profit and loss account):
Ratio Categories
-
Profitability Ratios: measure how effectively a business generates profits from its operations.
- Gross Profit Margin Ratio/Gross Profit Percentage Ratio: Gross Profit / Sales: Indicates the percentage of sales remaining after deducting the cost of goods sold.
- Net Profit Margin Ratio/Net Profit Percentage Ration: Net Profit / Sales: Indicates the percentage of sales remaining after deducting all expenses.
- Return on Investment Ratio: Net Profit / Capital Employed: Shows the profitability of the business in relation to the total long-term finance used.
-
Liquidity Ratios: measure a business's ability to meet short-term financial obligations.
- Current Ratio/Working Capital Ratio: Current Assets / Current Liabilities: Indicates the amount of current assets available for every €1 of current liabilities.
- Acid Test Ratio: (Current Assets - Stock) / Current Liabilities: Provides a stricter measure of liquidity, excluding stock from current assets.
-
Gearing Ratios: measure the proportion of a business's financing that comes from debt.
- Debt: Equity Ratio: Total Debt / Total Equity: Shows the proportion of debt and equity used to finance the business.
Ratio Analysis Procedure
- Ratio Name: identify the specific ratio being calculated.
- Ratio Explanation: provide context and the purpose of the ratio.
- Ratio Formula: state the formula used to calculate the ratio.
- Calculations: demonstrate the calculation using the provided figures.
- Present Answer: display the result in the appropriate format (e.g., percentage, ratio, monetary value).
- Explain Meaning of Result: interpret the outcome of the ratio calculation.
- Compare with Ideal Result: benchmark the result against industry standards or benchmarks.
- Analyse Result: assess the implications of the result for the business and identify any potential improvements.
- Recommendations: suggest actionable steps to improve the ratio outcome.
- Interested Stakeholders: identify the stakeholders who would be interested in the specific ratio and their rationale.
Detailed Ratio Explanations
-
Gross Profit Percentage (GPP) / Gross Profit Margin (GPM):
- Formula: (Gross Profit / Sales) * 100
- Ideal: Higher GPM is generally better, but industry-specific considerations apply.
- Interested Stakeholders: Investors, Employees, Managers.
-
Net Profit Percentage (NPP) / Net Profit Margin (NPM):
- Formula: (Net Profit / Sales) * 100
- Ideal: Higher NPM is generally better, but industry-specific considerations apply.
- Interested Stakeholders: Investors, Employees, Managers.
-
Return on Investment (ROI):
- Formula: (Net Profit / Capital Employed) * 100
- Ideal: Higher ROI is more attractive to investors, but risk considerations apply.
- Interested Stakeholders: Investors, Employees.
-
Current Ratio / Working Capital Ratio:
- Formula: Current Assets / Current Liabilities
- Ideal: Generally considered 2:1, indicating ample short-term assets to cover short-term liabilities.
- Interested Stakeholders: Employees, Suppliers.
-
Acid Test Ratio:
- Formula: (Current Assets - Stock) / Current Liabilities
- Ideal: Similar to current ratio, but excludes less liquid stock to provide a stricter measure of liquidity.
- Interested Stakeholders: Suppliers.
Liquidity Ratios
- Liquidity is about how well a business can pay its short-term debts
- The Liquid Assets Ratio measures how much a business can make from assets after selling off stock and paying its debts
- Formula: (Current assets - Closing Stock) : Creditors falling due within one year
- Ideal Ratio: 1:1
- Below 1:1: The business might struggle to pay off debts and could be overtrading
- Above 1:1: The business might have idle resources
- Trend Analysis: A decrease in the ratio is a bad sign, indicating the business is overtrading
-
Recommendations:
- Sell slow-moving stock to increase cash
- Improve cash flow forecast
- Implement better credit control to reduce bad debts
Gearing Ratios
- Gearing measures how much debt a business uses to finance its operations
- Debt : Equity Ratio compares the proportion of debt used to finance the business with the proportion of equity
- Formula: Debt Capital : Equity Capital
- Debt Capital: Long-term loans + preference shares
- Equity Capital: Issued share capital + reserves
- Ideal Ratio: Less than 1:1, for example, 0.46:1 is considered lowly geared; 1:1 is neutral, and greater than 1:1 is highly geared
- Trend Analysis: An increase in the ratio indicates an increase in debt and might negatively impact cash flow
-
Recommendations:
- Be cautious about expanding if relying on more debt, consider equity instead
- Consider selling more shares or retaining profits if wanting to expand
- Paying off loans or reducing debt can improve gearing
Equity Capital vs. Debt Capital
- Equity Capital: Represents ownership in the company, for example, through ordinary shares and reserves
- Debt Capital: Represents loans the business owes, for example, long-term debts
- Comparison:
| Feature | Equity Capital | Debt Capital |
|---|---|---|
| Repayment | Not required unless the company is being wound up | Repayment is required with interest |
| Dividends | Optional | Fixed interest payments |
| Control | Issuing more shares dilutes company control | No impact on control |
| Priority | Not prioritized | Debtholders are paid before equity holders |
| Taxation | Dividends are not tax deductible for the payer or receiver | Interest is tax deductible for the payer |
| Security | None required | Collateral required |
| Risk | Lower if lowly geared | Higher if highly geared |
- Lowly geared: Lower risk as less interest payments, less debt, and less collateral on the line
- Highly geared: Higher risk as more interest payments, more debt, and more collateral on the line
- Gearing Equation: Equity > Debt = Lowly Geared; Debt > Equity = Highly Geared
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Description
This quiz explores the concept of ratio analysis and its significance in evaluating a business's health and performance. It covers how various stakeholders utilize ratio analysis to make informed decisions based on financial data. Understanding these ratios helps in comparing past performance against targets and competitors.
