Exam-style Questions: Ratio Analysis
1. The data summarised in the table below show the performance of two firms A and B, over five years.
a) Using the information in the table explain the comparative attractiveness of the two firms to a potential investor.
b) Why is it important that potential investors should be aware of the ratio of ordinary share capital to other forms of long term finance, (known as the gearing ratio)?
c) Why might a company use various sources of finance?
d) Using examples, explain why it is important that potential investors should consider non-financial factors before making their investment decision.
(Marks available: 20)
Answer outline and marking scheme for question: 1
Give yourself marks for mentioning any of the points below:
a) It would appear that As performance is deteriorating compared with B. This seems to be confirmed by the net profit as a percentage of capital employed. On this basis B would seem to be the better bet.
But with regards to liquidity it would seem that B is sailing close to the wind and may find itself with cashflow problems.
A seems to be more secure but has it got too much cash?
More information is needed to make a true assessment.
b) The gearing ratio shows the relationship between equity capital and interest bearing capital.
For example if the gearing ratio is less than 100 per cent a company is said to be low geared.
This means that the majority of long term funds comes from the owners of the company, usually implies that a company is not a risk taker and the potential for growth is higher.
c) Sources of funds can be internal or external. Internal sources sources the company has control over compared with external funding. There is the time period for borrowing and charges made that have to be taken into consideration.
Expenditure can be for revenue or capital expenditure.
Capital expenditure is on goods which can be used over a long time period such as machines and can be financed over a long time period.
Revenue expenditure is spent on items such as raw materials or labour. This will be consumed quickly. Trade credit is a source of funds used to purchase raw materials.
d) Examples other than financial help to give a fuller picture of the likely future performance of the company. For example it is important to look at the previous performance of the company to identify trends and compare them with what is happening in the market place.
For example if company sales are increasing in a shrinking market, this should send alarm bells to a potential investor. Why is the market shrinking?
The state of the economy might indicate the timing of investment, for example: is the economy entering a downturn or is the economy enjoying a boom?
(Marks available: 20)