Theory question 103
Interpretation of Accounts(a) State two ratios which fall under the following classification of accounting ratios: (i) profitability; (ii) Activity; (iii) Liquidity; (iv) Investment; (v) leverage.
(b) Outline: (i) three uses of accounting ratios; (ii) two limitations in the use of accounting ratios.
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(a)(i) Profitability: gross profit margin; net profit margin; return on capital employed.
(ii) Activity: rate of stock turnover; debtors' collection period; creditors' payment period; asset turnover.
(iii) Liquidity: current ratio; acid test (quick) ratio.
(iv) Investment: earnings per share; dividend per share; dividend yield; price/earnings ratio; dividend cover.
(v) Leverage: gearing ratio; debt-to-equity ratio; interest cover.
(b)(i) Any three: measure profitability and performance; judge liquidity and ability to pay debts; compare with past years or other firms; judge credit-worthiness; help forecasting and planning; assess management efficiency; guide investors.
(ii) Any two: firms use different accounting policies so comparisons mislead; ratios ignore non-money (qualitative) factors; inflation distorts comparisons over time; figures may be window-dressed; based on past data; terms are defined differently by different firms.
Give the ratio names, not formulas, unless asked.