Ratio Analysis Questions and Answers

Question 1:
Calculate the relevant investment ratios with the following information:
Dividend per share = $0.20
Market price per share = $5.00
Annual earning = $100,000
Number of equity shares = 200,000

Answer:
(1) Dividend yield = ( Dividend per share/ Market price per share ) * 100 % = (0.2 / 5) * 100% = 4%
(2) Earnings per share (EPS) = Profit available to shareholders / Number of shares = $100,000 / 200,000 = $0.50
(3) Price earnings ratio (P/E) = Market price per share / EPS = $5 / $0.50 = 10
(4) Payout Ratio = Dividend per share / EPS = 0.2 / 0.5 = 0.4 = 40%

Question 2:
Calculate the relevant profitability ratios with the following information:
Stock at start of year: $30,000
Stock at end of year : $20,000
Annual Sales: $50,000
Annual Purchases: $10,000
Total expenses: $5,000
Capital at start: $62,000
Capital at end: $18,000

Answer:
(1) Gross profit percentage = (Gross profit / Net sales) * 100 % = (30,000 / 50,000) *100% = 60%
(2) Net profit percentage = (Net profit / Net sales) * 100 % = (25,000 / 50,000) * 100% = 50%
(3) Return on capital employed = (Profit before interest / Capital employed) * 100 % = (25,000 / 40,000) * 100% = 62.5%
Workings:
Gross profit = Sales - Cost of goods sold = 50,000 - 20,000 = $30,000
Cost of goods sold = Stock at start + Purchases - Stock at end = 30,000 + 10,000 - 20,000 = $20,000
Net profit = Gross profit - Total expenses = 30,000 - 5,000 = $25,000
Average capital employed = (Capital at start + Capital at end) / 2 = (62,000 + 18,000) / 2 = $40,000

Question 3:
Calculate the relevant liquidity ratios with the following information:
Trade Debtors: $21,000
Trade Creditors: $15,000
Proposed dividends: $2,500
Bank: $5,000
Closing stock: $9,000
Opening stock: $8,000

Answer:
(1) Current ratio = Current Assets / Current Liabilities = 35,000 / 17,500 = 2
(2) Quick ratio = (Current Assets - stock) / Current Liabilities = (35,000 - 9,000) / 17,500 = 1.49
Workings:
Current assets = closing stock + debtors + bank = 9,000 + 21,000 + 5,000 = $35,000
Current liabilities = creditors + proposed dividends = 15,000 + 2,500 = $17,500

Explanation:

Investment ratios, profitability ratios, and liquidity ratios are essential financial metrics used by investors, managers, and financial analysts to assess a company’s financial health, performance, and operational efficiency. Each category of ratios focuses on different aspects of a company’s financial situation, offering unique insights into its operations and potential risks.

Investment Ratios are used to evaluate the attractiveness of a company’s stock as an investment and determine its value to investors. These ratios help investors assess whether a company is a good investment based on its market performance, earnings, and growth prospects. Common investment ratios include earnings per share (EPS), price-to-earnings (P/E) ratio, dividend yield, and price/earnings-to-growth (PEG) ratio. For instance, EPS measures the amount of profit attributed to each share, while the P/E ratio compares the stock’s market price to its earnings per share. Dividend yield provides insight into the percentage of earnings paid out as dividends to shareholders, while the PEG ratio incorporates a company's earnings growth rate to assess stock valuation relative to its projected growth. These ratios are vital for investors trying to decide whether to buy, sell, or hold a particular stock.

Profitability Ratios are used to measure a company’s ability to generate profit relative to revenue, assets, equity, or other financial measures. These ratios indicate how efficient a company is at utilizing its resources to produce earnings. Profitability ratios are important for investors and management to gauge financial success, operational performance, and growth potential. Common profitability ratios include net profit margin, gross profit margin, return on assets (ROA), and return on equity (ROE). Net profit margin measures the percentage of revenue that translates into profit after all expenses are deducted, while gross profit margin reflects the proportion of revenue left after accounting for the cost of goods sold. ROA assesses how well a company uses its assets to generate profit, and ROE measures the return generated on shareholders' equity. A high profitability ratio indicates efficient cost management and revenue generation, making it attractive to investors.

Liquidity Ratios assess a company’s ability to meet its short-term financial obligations using its available assets. These ratios are essential for understanding whether a business has enough liquid resources to pay its current liabilities without facing financial difficulties. Common liquidity ratios include the current ratio, quick ratio (acid-test ratio), and cash ratio. The current ratio compares current assets to current liabilities, showing the company's ability to pay debts within one year. The quick ratio excludes inventory from assets to give a more conservative view of liquidity by focusing on the most liquid assets. The cash ratio provides an even stricter assessment by only considering cash and cash equivalents in relation to short-term liabilities. Liquidity ratios are critical for lenders, investors, and management as they highlight a company's ability to handle unexpected expenses or financial challenges.

Together, investment ratios, profitability ratios, and liquidity ratios provide a comprehensive view of a company’s financial position. Investment ratios allow stakeholders to evaluate the company’s market value and attractiveness as a stock option. Profitability ratios measure operational success and the company’s ability to generate earnings, while liquidity ratios ensure that the company maintains sufficient liquid resources to meet short-term obligations. These financial ratios, when used in combination, help investors, financial analysts, and managers make informed decisions and formulate strategies to support financial stability and growth.