Financial Ratios

The current ratio measures a business’s ability to pay back their current liabilities with their current assets. The higher the current ratio, the more capable the business is of meeting their short-term obligations. It is generally accepted that a ratio of 2:1 indicates a sound financial position for a firm.

Many firms operate successfully with current ratios of less than 2:1. Some companies, especially larger retailers such as Wal-Mart, have been able to negotiate much longer-than-average payment terms with their suppliers. If a retailer doesn't offer credit to its customers, this can show on its balance sheet as a high payables balance relative to its receivables balance. Large retailers can also minimize their inventory volume through an efficient supply chain, which makes their current assets shrink against current liabilities, resulting in a lower current ratio. Wal-Mart's current ratio in January 2019 was 0.80. Businesses in service industries, such as doctors and dentists who rely on cash payments for their services, also do not need as high a ratio and operate on ratios of less than 2:1

Use management strategies for other section. 

Solvency is the extent to which the business can meet its financial commitments in the longer term (more than 12 months). Gearing is the proportion of debt (external finance) and the proportion of equity (internal finance) that is used to finance the activities of a business. Gearing ratios determine the firm’s solvency. Gearing is an important consideration for businesses as the more highly geared the business (that is, those that have a higher proportion of debt to equity), the greater the risk for the business but the greater potential for profit. Debt affects stakeholders and potential investors because the high risk involved may discourage investment.

The business’s level of gearing is an important decision. Factors such as risk, return and degree of control over the enterprise influence the level of leverage that is appropriate for a business. In balancing the gearing of a business, consideration must be given to the level of control by owners. 

For example, profits earned must be sufficient to cover interest payments. If funds are not available to meet interest charges and accounts are not paid, lenders and creditors have the right to claim payment from the business.

The debt to equity ratio shows the extent to which the firm is relying on debt or outside sources to finance the business. This ratio is an important control aspect for management because the relationship between debt and equity must be carefully balanced. 

A ratio of greater than 1 means that the business has more debt than equity. 

A ratio of between 0 and 1 means that the business has more equity than debt.

The higher the ratio, the less solvent the firm. A highly geared firm carries more risk with regard  to longer term financial stability. Investors would be less attracted to a firm with a higher debt to equity ratio because this indicates a greater financial risk.

To improve a business’s gearing, they will need to look at ways of either reducing their debt or increasing equity. In an attempt to decrease debt businesses could sell non-essential assets to pay off their debts, or they could even renegotiate their loans to spread their payments over a longer period. Alternatively, the business could lease assets as opposed to purchasing them. 

Strategies to increase equity include retaining more profits, or injecting more equity funding by either selling more shares (if a public company) or inviting new owners.

The financial sector as a whole has one of the highest debt to equity ratios. This is because banks borrow large amounts of funds to then loan large amounts of money. A debt to equity ratio of higher than 2:1 is quite common in this industry. 

Other industries that have a higher debt to equity ratio are capital-intensive industries, such as large manufacturing companies and the airline industry, who commonly use high levels of debt.

Why are profitability ratios important?

• Owners and shareholders want to know whether the firm is earning an acceptable return on their investment.

• Creditors want to know whether they will be paid and should offer credit in the future.

• Lenders want to know whether the principal on the loan and interest will be repaid and whether to lend to the firm in the future.

• Management uses profitability to decide on the need for adjustments to policies.

The amount of profit is determined by a number of factors, such as the volume of sales, the mark-up on purchases and the level of expenses. Financial information must be examined to see where changes have occurred and where changes need to be made in the future.

If the ratio is low, alternative suppliers may need to be sourced and competitors investigated. Since all the other expenses incurred by businesses such as wages, electricity and advertising are deducted from the gross profit to determine net profit, the net profit ratio therefore gives a more accurate indication of the profitability of a business

The costs or expenses after gross profit must be low enough to generate a net profit. The amount of sales must be sufficiently high to cover the costs or expenses of the firm and still result in a profit. Since businesses vary greatly, there is no set figure for profit ratios. 

A business would be aiming at a higher gross and net profit ratio. Comparisons need to be made with a business’s past performance, their competitors and the industry average

The return for the owners has to be better than any return that could be gained from alternative investments, such as bank investments. If return on equity rises due to increased leverage (debt) the improved result should be seen as carrying increased risk. The higher the ratio or percentage, the better the return for the owner. 

If returns compare favourably, owners might consider expansion or diversification of the business. If the return is unfavourable, the owners would consider alternative options, including selling off the business.

The expense ratio indicates the day-to-day efficiency of the business. A business aims to keep expenses at a reasonable level. Management use this ratio to determine where the highest expenses are from and why the ratio has either increased or decreased. 

For example, if the selling expense ratio has increased, it may be that advertising costs have not generated the expected increase in sales. Alternatively, a decline in the financial expense ratio may be a result of lower interest rates or less debt being used by the firm. Obviously the lower the percentage, the better. If the expense ratio is too high, then the business would need to look at ways of monitoring and controlling their expenses and avoiding unnecessary expenses.

Accounts receivable turnover ratio measures the effectiveness of a firm’s credit policy and how efficiently it collects its debts. It measures how many times the accounts receivable balance is converted into cash or how quickly debtors pay their accounts. 

If a firm’s accounts receivable turnover is 84 days but its credit policy allows 30 days before payment, the firm would need to examine its cash flow, its credit policies, its credit collection procedures and costs, and its policies relating to doubtful debts. If a business is not efficient in collecting their accounts receivable they need to implement strategies to improve this, such as charging interest on overdue payments, offering discounts for early payments or being more selective when granting credit.

2011

22 (a)   Calculate the gross profit ratio for 2011. Show all working. 2 marks 

2012

Question 22 

(a) Calculate the current ratio (current assets ÷ current liabilities) of this business. Show all working. 2 marks

(b) Calculate the debt to equity ratio (total liabilities ÷ total equity) of this business. Show all working. 2 marks

(c) Why is it important for a business to control its debt to equity ratio? 4 marks

2013

4   What does the expense ratio measure? 

(A)  Efficiency

(B)  Growth 

(C)  Profitability 

(D)  Solvency 

6 Which of the following would immediately improve the working capital of a business? 

(A) Increasing credit sales 

(B) Using sale and lease back 

(C) Preparing a cash flow statement 

(D) Repaying debt to creditors more quickly

10 Which of the following would improve the financial position of a business? 

(A)   Lower current ratio and lower accounts receivable turnover ratio 

(B)  Higher current ratio and lower accounts receivable turnover ratio 

(C)  Lower current ratio and higher accounts receivable turnover ratio 

(D)  Higher current ratio and higher accounts receivable turnover ratio 

2014

19  Which of the following statements is true about liquidity for Kerry’s Warehouse in 2014?

(A) It is better than industry average and has improved since 2013. 

(B) It is better than industry average and has worsened since 2013. 

(C) It is worse than industry average and has improved since 2013. 

(D) It is worse than industry average and has worsened since 2013.

20 Which of the following statements is true about gearing for Kerry’s Warehouse in 2014? 

(A) It is better than industry average and has improved since 2013. 

(B) It is better than industry average and has worsened since 2013. 

(C) It is worse than industry average and has improved since 2013.

(D) It is worse than industry average and has worsened since 2013.

2015

Use  the information to answer Questions 16−17.

The table shows extracts from the financial statements of a business for 2014 and 2015

16  What is the net profit ratio (net profit ÷ sales) for 2014?

(A) 10% 

(B) 20% 

(C) 25% 

(D) 47%

17  Which of the following describes the change in gross profit ratio Gross profit ratio and expense ratio from 2014 to 2015?

2016

11 If Steve is a sole trader, how much equity does he have in the business? 

(A) $12 800 

(B) $35 500 

(C) $135 500 

(D) $146 000 

12 The current ratio (current assets ÷ current liabilities) for this business is 

(A) too high.

 (B) acceptable. 

(C) dangerously low. 

(D) unable to be calculated

2017

12    The efficiency of a business can best be determined by which of the following? 

A.  Gross profit ratio 

B.  Value of current assets 

C.  Value of current liabilities 

D.  Accounts receivable turnover ratio 

17 The expense ratio (total expenses ÷ sales) is always 

A. the difference between the net profit ratio and the gross profit ratio. 

B. the difference between sales and the gross profit ratio. 

C. greater than the gross profit ratio. 

D. greater than the net profit ratio. 

2018

19 What is the gross profit ratio for the business? 

A. 53% 

B. 67% 

C. 78% 

D. 90% 

20 What is the average number of days the business takes to collect its debts? 

A. 15 days 

B. 25 days 

C. 29 days 

D. 30 days

2019

What is the gearing ratio (total liabilities ÷ total equity) for this business?

A. 0.67 : 1

B. 0.73 : 1

C. 0.75 : 1

D. 0.81 : 1 

22 (b) Explain ONE advantage of debt financing. 3 marks

(c) Explain ONE disadvantage of equity financing. 3 marks

2020

19 The liquidity position of this business in 2020 indicates that it is

A. better than the industry average and has improved since 2019.

B. better than the industry average and has worsened since 2019.

C. worse than the industry average and has improved since 2019.

D. worse than the industry average and has worsened since 2019.

20 The gearing for this business in 2020 indicates that it is

A. better than the industry average and has improved since 2019.

B. better than the industry average and has worsened since 2019.

C. worse than the industry average and has improved since 2019.

D. worse than the industry average and has worsened since 2019.

24 a) Calculate the accounts receivable turnover ratio (sales ÷ accounts receivable) for this business.  1 mark

(b) Interpret this business’s expense ratio (total expenses ÷ sales)  2 marks

(c) Recommend ONE financial strategy this business could implement to improv efficiency in the collection of accounts receivable. 3 marks

(d) Explain TWO ways in which comparative ratio analysis can be used by this business to assess its financial position. 4 marks

2021

Question 22 

A luxury Australian handbag business is going to expand. They intend to borrow 30 million US dollars to buy several new retail properties across Australia.  

2024

10 A business has the following financial information. 

Sales $800 000
Cost of goods sold $200 000
Gross profit $600 000
Net profit $250 000 

Expense ratio = total expenses ÷ sales 

What is the expense ratio for this business? 

A. 25% 

B. 31% 

C. 35% 

D. 44% 

14 The table shows the cash flow information for a business. 

What is the closing cash balance for September? 

A. $7000 

B. $47 000 

C. $54 000 

D. $150 000 

Question 24 (10 marks) 

(a) The following is an extract from a business balance sheet. 

a) 

i) Calculate the current ratio for this business. Show all working. (Current ratio = current assets ÷ current liabilities) 2 marks

ii) Explain the influence of ONE financial institution on the financial management of this business. 4 marks

b) Explain how offering discounts for early payment may improve a business’s cash flow and reduce working capital. 4 marks