Financial Ratios — WACE Business — Unit 4 Flashcards & Quiz

Q1: What is the purpose of financial ratios, and how is the current ratio calculated and interpreted?

Financial ratios turn figures from financial statements into measures of liquidity, profitability and stability, so performance can be compared over time, against targets and with similar businesses. The current ratio is a liquidity ratio: current ratio = current assets ÷ current liabilities. It shows whether the business can pay debts due within 12 months. Below 1:1 means current liabilities exceed current assets, a sign of possible difficulty paying short-term debts; a common rule of thumb is about 1.5:1 to 2:1, while a very high ratio may mean too much idle cash or stock.

Q2: How are the gross profit ratio and the profit ratio calculated and interpreted?

Both are profitability ratios. Gross profit ratio = gross profit ÷ net sales: the share of each sales dollar left after cost of goods sold, reflecting pricing and the cost of buying or making goods. Profit ratio = profit ÷ net sales: the share of each sales dollar left as profit after all expenses, reflecting overall efficiency. Higher is better for both; a falling gross profit ratio points to rising cost of sales or price cutting, while a falling profit ratio with a steady gross profit ratio points to rising operating expenses.

Q3: How is the expense ratio calculated and interpreted?

Expense ratio = operating expenses ÷ net sales. It shows how many cents of each sales dollar are used on operating expenses such as wages, rent, advertising and administration. A lower expense ratio is better, showing tighter control of expenses. Because profit = gross profit − operating expenses, the gross profit ratio minus the expense ratio equals the profit ratio.

Q4: How is the return on equity ratio calculated and what does it show?

Return on equity = profit ÷ equity at end (the owners’ equity at the end of the period). It measures the return earned on the owners’ investment in the business: how many cents of profit each dollar of equity generated. A higher ROE is better; owners compare it with returns they could earn elsewhere, such as a term deposit, to judge whether their investment is worthwhile given the risk.

Q5: What is the debt-to-equity ratio and what does it indicate?

Debt-to-equity ratio = total liabilities ÷ total equity. It is a stability ratio that 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. A common rule of thumb is about 1.5:1 to 2:1.

Q2: The gross profit ratio is calculated as gross profit divided by net sales.

Answer: TRUE

Gross profit ratio = gross profit ÷ net sales, usually expressed as a percentage.

Q3: A rising expense ratio shows that the business is controlling its operating expenses more effectively.

Answer: FALSE

Expense ratio = operating expenses ÷ net sales. A rising ratio means expenses are taking a larger share of each sales dollar — weaker expense control.