Financial Ratios — Flashcards & Quiz

Q1: Explain the key profitability ratios and what they measure.

Gross profit margin = (Gross Profit / Revenue) x 100 — measures production efficiency and pricing effectiveness. Net profit margin = (Net Profit / Revenue) x 100 — measures overall profitability after all expenses. Return on equity (ROE) = (Net Profit / Owner's Equity) x 100 — measures how effectively the business uses owner investment to generate profit.

Q2: What are liquidity ratios and why are they important?

Liquidity ratios measure a business's ability to meet short-term financial obligations. Current ratio = Current Assets / Current Liabilities — ideally 1.5:1 to 2:1. Quick ratio (acid test) = (Current Assets - Inventory) / Current Liabilities — a stricter test excluding inventory, ideally above 1:1. Low ratios indicate potential difficulty paying debts; excessively high ratios suggest capital is not being used productively.

Q3: Explain efficiency ratios and their importance in operations management.

Efficiency ratios measure how effectively a business uses its resources. Inventory turnover = COGS / Average Inventory — how many times inventory is sold per year; higher is better. Accounts receivable days = (Receivables / Revenue) x 365 — average days to collect payment; lower is better. Asset turnover = Revenue / Total Assets — revenue generated per dollar of assets; higher indicates better asset utilisation.

Q4: What is the debt-to-equity ratio and what does it indicate?

Debt-to-equity ratio = Total Liabilities / Owner's Equity. It measures the proportion of debt versus equity used to finance the business. A ratio above 1:1 means more debt than equity (higher financial risk). A lower ratio indicates more conservative financing. The ideal ratio varies by industry — capital-intensive industries like mining typically carry higher debt.

Q1: A current ratio of 0.5:1 indicates the business can easily meet its short-term obligations.

Answer: FALSE

A current ratio below 1:1 means current liabilities exceed current assets — the business may struggle to pay short-term debts. The ideal range is 1.5:1 to 2:1.

Q2: The quick ratio excludes inventory from current assets because inventory may not be easily converted to cash.

Answer: TRUE

The quick (acid test) ratio excludes inventory because it may take time to sell and may need to be discounted. It provides a stricter test of short-term liquidity.

Q3: A high inventory turnover ratio always indicates strong business performance.

Answer: FALSE

While high inventory turnover generally indicates efficient stock management, excessively high turnover may indicate stockouts and lost sales due to insufficient inventory.