Ratios

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Table of Contents

Interpretation of Accounts (‘Ratios’) 4

Part B 4

Examples 5

Interpretation of Accounts (‘Ratios’)

The ratios question is split into three main parts:

a) Where you are asked to calculate 5/6 specific ratios;

b) Where you can use your own choice of ratios to answer a particular question;

c) Where you are asked a theory question which relates to the interpretation of accounts.

Part B

The big area for losing or gaining marks is part (B). In part (B) we are asked to answer a question (see the normal ones below) and to use whatever ratios we want in order to back up our view. There are three pretty standard questions that are asked:

  1. Would we buy shares in this company (or would we be happy if we currently owned shares in it)?
  2. Would the debenture holders (people who lend money to the company) be happy?
  3. If you were a bank manager, would you lend money to the company?

The good news is that the answers to each of these questions are remarkably similar so we definitely don’t need to learn three totally different things. In fact, the answers we will give for the ‘Debenture’ and the ‘Bank’ questions are basically the same (because they are both people who have lent money to the firm and are keen to have their interest and original loan amount repaid).

To be ready for whichever option comes up therefore, we need to be very comfortable working out and explaining 5 or 6 of the most important ratios (and we’ll use these same ones to answer whichever question appears in part (B).

The most important areas to cover (and the ratios we will use) in our answer are:

  • Profitability (Return on Capital Employed)
  • Liquidity (Current Ratio & Acid Test Ratio)
  • Gearing (Gearing Ratio & Interest Cover)
  • Dividend Policy (Earnings Per Share v Dividend Per Share)
  • Industry/Sector
  • Share Price or Security (Depending on what the question we’ve been asked is)

The crucial thing in Part (B) is to be happy that you can calcu...

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