3.7.2 Financial ratio analysis

• What do profitability ratios measure?


  They measure a company’s ability to generate profits relative to its sales or assets.
• What is the formula for Gross Profit Margin?

  Gross Profit Margin = (gross profit / revenue) X 100
• What are the types of profitability ratios?

  • Gross Profit Margin
  • Operating Profit Margin
  • Net Profit Margin
• What does a higher gross profit margin indicate?

  A higher gross profit margin suggests efficient management of production costs relative to sales.
• What is the formula for Operating Profit Margin?

  Operating Profit Margin = (operating profit / revenue) X 100
• What does a higher operating profit margin indicate?

  A higher operating profit margin indicates better control over operational costs.
• What is the formula for Net Profit Margin?

  Net Profit Margin = (net profit / revenue) X 100
• What does the net profit margin indicate?

  It shows the percentage of revenue remaining as net profit after all expenses have been deducted.
• What do liquidity ratios measure?

  They measure a company’s ability to meet short-term financial obligations.
• What are the types of liquidity ratios?

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

  Current Ratio = current assets / current liabilities
• What does a current ratio above 1 indicate?

  It suggests that the company has enough assets to cover its liabilities.
• What is the formula for Acid Test Ratio?

  Acid Test Ratio = (current assets - inventory) / current liabilities
• Why is the Acid Test Ratio useful?

  It provides a more stringent test of liquidity by excluding inventory.
• What are the types of efficiency ratios?

  • Inventory Turnover Ratio
  • Receivables Days
  • Payables Days
• What do efficiency ratios assess?

  They assess how effectively a business uses its assets and manages its receivables and payables.
• What is the formula for Inventory Turnover Ratio?

  Inventory Turnover = costs of goods sold / average inventory
• What does a higher inventory turnover ratio indicate?

  It suggests efficient inventory management.
• What is the formula for Receivables Days?

  Receivables Days = (receivables / sales revenue) X 365
• What do lower receivables days indicate?

  They suggest efficient credit control.
• What is the formula for Payables Days?

  Payables Days = (payables / cost of sales) X 365
• What does a higher payables days indicate?

  It indicates that a business is taking longer to pay its suppliers.
• What are the types of financial stability ratios?

  • Gearing Ratio
  • Interest Cover Ratio
• What does a higher gearing ratio indicate?

  A higher gearing ratio indicates greater reliance on debt.
• What is the formula for Gearing Ratio?

  Gearing Ratio = ( no current liabilities / total equity + non current liabilities) X 100
• What is the formula for Interest Cover Ratio?

  Interest Cover Ratio = operating profit / interest payable
• What does a higher interest cover ratio indicate?

  A higher interest cover ratio indicates a lower risk of financial distress.
• How can ratios be used in analysis?

  • Trend Analysis: Identify trends in performance over time.
  • Benchmarking: Compare to industry averages or competitors.
  • Limitations: Recognize that ratios are based on historical data and influenced by external factors.