1. RATIOS Flashcards
Profitability ratios (8)
Gross profit margin (gross profit/rev)
Operating profit margin (op profit/rev)
Net profit margin (net profit/rev)
Return on capital employed (EBIT/CE)
Asset turnover (rev/CE)
Return on equity (net prof/equity)
Operational gearing ratio ((Revenue-Variable Cost)/Profit before tax)
Equity multiplier (total assets/equity)
generally - higher = better = comp better at converting sales to profit
gross profit margin (profitability)
both from income statement
gross profit = rev - COGS
- compare to last year comment on trend (where have rev/COGS moved?)
- higher = can spend higher proportion of income on other op expenses
GOOD : relationship between turnover and direct cost of providing product/service
BAD: may portray bis in too pos a light - ignores operating expenses which are v real
operating profit margin (profitability)
operating profit margin % = operating profit / rev (x100)
rev = top of income statement
op profit = rev - cogs - operating costs
-compare to last year and say what that means
- varies widely between sectors (supermarkets v low, jewellers v high)
- effected by competition, economic climate, industry etc
-higher = better, yoy increase = sales up more than costs
GOOD: provides relationship between turnover and all costs of providing service including op costs
GOOD: appropriate for making comparisons because differences in way bis is financed wont influence measure
BAD: discrepancies can arise between comps for various reasons e.g. method of depreciation used - so hard to make comparisons
net profit margin (profitability ratio)
net profit margin (%) = net profit / revenues (x100)
net income = bottom of income statement (all expenses removed)
revs = top
- compare to last year
GOOD: all costs accounted for, so measures how successful a comp is at making profit on each sale
GOOD: provides final pic of comps overall health
BAD: can be influenced by one off items e.g. sale of an asset
BAD: doesnt provide insight into whether management is managing production costs
return on equity (ROE)
profitability ratio
ROE (%) = net income / equity (x100)
net profit = bottom of income statement
equity = assets - liabilities = share capital + share premium + retained earnings
measures rate of profit earned for shareholders
higher = better conversion of equity finance to profits
must be compared to comp previous and industry - varies by industry, lifecycle of bis
GOOD: shows how well comp benefits shareholders beyond earnings
GOOD: shows return on investments
BAD: doesnt show risk associated with high level of return - e.g. may use lots of debt to generate high net profit and this isnt reflected
BAD: easily manipulated - inflating income by overvaluing assets or deflating equity (increasing liabilities or with buybacks)
BAD: v low with new comps and capital requirement high in early days
Equity multiplier - profitability ratio
eq multiplier = total assets / shareholders funds
fin. leverage ratio - evaluates companies use of debt to purchase assets - higher debt = lower shareholder funds and higher eq multiplier
- comps wiht horrible sales and margins can take on excessive debt to artificially increase ROE - eq multipier allows you to see what portion of return on eq is result of debt
DuPont analysis
breaks ROE into 3 distinct elements after analysing drivers of ROE
operating efficiency - measured by net profit margin (less pre fdivi)
- as net profits increase (reducing costs or increasing prices) ROE will increase
asset use efficiency - measured by total asset turnover (rev/CE) - industry specific
- as asset turnover increases ROE increases
financial leverage - measured by equity multiplier (assets/ shareholder funds)
- if ROE increases with increases eq multiplier - could indicate overleverage and higher risk
ROE = net profit margin x total asset turnover x equity multiplier
extended DuPont analysis
ROE (%) = (Operating profit margin x Tax retention rate - Interest expense rate) x Equity multiplier x Total asset turnover
removed effect of tax and interest
Asset turnover
asset turnover = revenue / capital employed
= x: 1 ratio
capital employed = assets - current liabilities
OR = non current liabilities + equity
measures efficient use of assets to produce sales - helps measure productivity of company’s assets
high = better but too high could indicate overtrading (insufficient assets to sustain level of sales rev)
comps with low profit margins tend to higher assets turnover
retail tends to be higher (2-3)
utilities with large asset base will be lower
compare to prev years as ever
ROCE = OPM x asset turnover
v diff quality bis can achieve same ROCE (e.g. high asset turnover x low margin = low asset turnover x high margin)
operational gearing ratio
profitability
operational gearing ratio = (revenues - variable costs) / Profit before tax
Ratio of fixed to variable costs - higher level = grater risk
if comp has greater level of fixed = greater variation in profit as a result of revenue changes
effect of op gearing ratio can be calced by taking increase/decrease in normal output and x by geearing ratio
Breakeven point
graphshows relationship between sales and total costs
denominator = contribution per unit because it contributes to meeting fixed costs
contribution margin = margin profit per unit sale
computed using contribution income statements which separate fixed and variable costs
ROCE
profitability
ROCE = operating profit / capital employed
capital employed = assets - current liabilities
OR = non current liabilities + equity
often regarded as one of best measures for judging management of comp in its utilization of available cap resources
compare ROCE to target figs
useful for cap intensive comps as it analyses debt and liabilities as well as probability - gives clear pic of financials
cant be considered in isolation - must compare to last year and across sector
unlike ROE - doesnt capture risk associated with generation of return
older comps generally have higher ROCEs than newer - due to depreciation which can be misleading
Liquidity ratios
current ratio (CA/CL)
acid test ratio (CA-Inv/CL)
Altman Z score- quantifies likelihood of insolvency
Current ratio (x)
Liquidity
aka working cap ratio
current ratio = current assets / current liabilities
- ideally 1.5-2
- purpose is to determine if the cover that current assets provide to cover liabilities that fall due within a year
ISSUES
-overdrafts may actually be long term but are a current liability
-doesnt take timing of CF into account
-inventory may not be easily liquidated (recession, distressed prices)
5 TYPES OF ACCOUNTING RATIO
profitability - asses trading/operating performance: profits needed to provide investors with returns
liquidity -evaluates trading risk of the company
operational efficiency
gearing -assesses ability of bis to meet lLT debts and risks to those financing comp
investor - asses returns to those financing the comp
current ratio modified form
to address critisim that current ratio is static
current ratio = CA/CL
= net sales to working capital
working cap turnover ratio = net annual sales/ avg amount of working cap
working cap = current assets - current liabilities
Quick/acid test
liquidity
quick ratio = (current assets - inventory) / current liabilities
<1 may be cause for concern depending on industry
akak (Cash + marketable secs + trade receivables) / current liabilities
still doesnt take CF timing into account
if quick ratio is much lower than working cap - current assets are highly dependent on inventory - retail stores big e.g. of this = sensitivity to recession
Altman Z score
liquidity
determine prob of comp going into liquidation - analyses sales and gearing and distills to single score
only as good as sata that goes into it
cannot asses comp with little or no earnings (new)
highly sensitive to write offs in accounts which may falsely indictae bankruptcy
A - tests corporate distress
B - reflects extent of gearing
C - assesses ability to squeeze profits from assets
D - how much must MV fall by for liabilities to exceed assets
E- how efficiently assets used to generate sales
working capital/cash cycle
/working cap = current assets - liabilities
= funding avail for conducting day to day bis
aka operational efficiency ratios
efficiency can be increased by
- minimising inventory elvels
- ensuring debtors pay quickly, delaying payments to creditors
comps should maintain at least an equal balance between coleection period and payment period for receivables and payables
considers velocity of CF within working cap cycle
payables payment period (Payables/COGS)
receivables payment period (Receivables/Revenue)
inventory holding days (INV/COGS)
receivables collection period
op efficiency
receivables collection period = 365 x trade receivables / revenue
asses how quickly comp can realise cals of receivables
indicates proportion of year’s sales which are unpaid (@ bal sheet date)
may be distorted by large comps either v quick or slow to pay
static - can be distorted espec by seasonal sales
payables payment period
op efficiency
average time cycle for outward payment
payables payment period = 365 * trade payables/ COGS
want this to be even balance with receivables collection period
could upset creditors if too high
inventory holding days
365 * inventory / COGS
indicates how quickly a comp is selling its inventory
high turnover bis will have low inventory day
generally prefer shorter as there are costs to hold inventory
compare to industry - low suggests strong sales or ineffective buying
static so bad for seasonal bis
inventory management
- likely demand
-possibility of supply shortages
- likelihoo dof price rises
- amount of storage
- perishability
- prospect of obsolescence
financial gearing ratios (4)
debt to equity (Interest bearing debt + pref shares) / (Equity S/H Funds – pref)
net debt to equity (Interest bearing debt + pref shares - cash) / (Equity S/H Funds – pref)
interest cover (operating profit + int received + other receivables)/ int paid)
asset cover (Total Assets – Current Liabs)/ Loans payable
high levels of gearing can indicate greater levels of financial risk
debt to equity
gearing
debt includes liabilities with an interest bearing component (bot ST and LT)
trade payables, deferred income and divi payables generally excluded
sometimes pref shares included in equity
overdrafts included? case by case - ST anomaly or LT financing
generally >100% indicates comp would struggle to pay LT debt if loans called in
bis like utilities with steady earnings can tolerate a higher level than vol sectors e..g banking/tech - utility bis tend to be monopolies
net debt to equity
gearing
financial leverage ratio that measures how much a company is financing its
operations with debt as compared to its shareholders’ funds
alt to debt to eq taking into account assets tha can be used to offset debt
(cash and ST investments from bal sheet )
interest cover
gearing
measures ability to pay ineterst out of op profits and other incomer receivables
higher = less risky
appropriate level varies sector to sector
key for lenders
asset/loan cover
gearing
asset cover = (total assets - current liabilities) / loans payable
assesses security/likelihood of loan repayment
should be calc for each priority of loan
bal sheet assets recorded @ book value which is often higher than liquidation/selling value - which could inflate ratio
investor ratios
EPS (earnigns attributable to ord SH / weighted avg no. of shares)
diluted EPS
earnings yield (EPS / share price)
divi cover (EPS / divi per share)
divi yield (divi per share/ share price)
investor ratios
EPS (earnigns attributable to ord SH / weighted avg no. of shares)
diluted EPS
earnings yield (EPS / share price)
divi cover (EPS / divi per share)
divi yield (divi per share/ share price)
EPS
investor
EPS = net profit (loss) attributable to SH / avg weighted no. of shares for period
- indicates companies scope for increasing divi
- assess how expensive of cheap a comp is
restated vs diluted EPS
EPS will change is no. of outstanding shares changes
Diluted EPS
must publish diluted EPS on income statement to warn of potential future changes in EPS for hypothetical events (the exercise of rights which have already been granted and would require issue of further shares)
- convertible loan stocks in issue
- warrants in issue
- employee share options issued but not exercised
diluted EPS convertibles
(pref shares and loan stock)
diluted EPS = (net profit - pref divi) / (weighted avg no. of ord shares + dilutive shares)
- calc interest saved on conversion
- deduct corp tax from that saving
- add interest saving to profit
- calc additional no. of shares
- enter into formula
over time - according to prospectus - no. of shares resulting from convertible decreases over time as share price rises
assume all shares would be converted to give max possible dilution warning to shareholders
in some cases the decrease in interest cost may offset the dilution effect of conversion on EPS
diluted EPS warrants and options
diluted eps figure on income statement - assumes exercise of all outstanding warrants and options
warns of potential future changes
options are generally not dilutive as trade in existing shares on market - only include dilutive options if present in calc
new total no. of shares = avg no. of basic shares outstanding + no. of new shares issued on ex - no. of shares issued @ fair val (due to proceeds on exercise)
then do EPS calc with this fig (net profit - pref divi)/ fig
fair val = avg market price over period
earnings yield and PE ratio
investor ratios
PE = share price/EPS = 1/earnings yield
earnings yield = EPS/ share price x100
EPS = (net inc - pref divi)/weighted avg no. of shares
earnings yield expresses EPS as % of market price
indication of value (can compare ftse100 with 10yr gilt) if lower for ftse then shares likely to be overval
difference between 2 = equity risk prem
high earnings yield may reflect anticipation of poor earnings/other weaknesses
low may reflect high growth prospects
P/E should be compared in similar sector or to prev year - not in isolation!
high = overvalued potentially
divi yield
investor
divi yield = divi per share / market price per share x100
no relation between divi yield and perception of comp in market place
not guaranteed - Shell cut quarterly divi by 66% in 2020
Janus Henderson research - 220$ bili global divi cut in 2020
European banks instructed to pause divi to maintain cap by regulators
High - could be high divi or low share price (latter would give high PE, comp risky so more yield)
could be comp with strong CF
defensive sector comps often by high divis reliably
divi cover
investor
divi cover = EPS/ net divi per share
OR
divi cover = net earnings attributable to SH/ total ord divi
net earnings attrib.. = net income - pref divi
> 2 = safe
<1 cause for concern as having to fund out of reserves not current earnings
<1.5 not sustainable
limitations of ratio analysis
limitations
- uses historic data so not predictive
-different industries have different characteristics and within a secotr comps may be at different stages
-profitability ratios dont account for future econ events, management changes etc
liquidity - no account taken of maco environments
-accounting policies may differ (e.g depreciation of non current assets)
- distortions - e.g. use of year end balance to analyse full year transactions
window dressing - putting figures in best light @ time of statments
- postponing payments to suppliers to improve cash balance
- finding ways to book revenue earlier
-repaying debt temporarily near end of period
- applies to sate govs too e.g Brazil before 2015 election
-
window dressing methods
circular transactions - sale and repurchase to give inflated turnover with no commercial authenticity
- improves profitability ratios
- should be disclosed under IAS 24
bed and breakfast transactions
- circular transaction that occurs over end of acc period
- illegal if disclosures not made in accordance with acc standards
postpoing of payments to improve cash balance
booking rev earlier
repaying debt near end of period financed by sale of inventory
false or misleading statements
trend analysis - horizontal analysis
assesses bal sheet/income statement over time - observing trends and any changes in them
- can see if numbers are unusually high or low
apply base % of 100 to first year to make this easier
- e.g. allows you to compare rate of divi growth with rate of rev growth
can be missused by analysts to report skewed findings - can change no of periods (should disclose)
- or should good MoM figures when YoY is bad
common size/vertical analysis
each line on bal sheet is shown as % of one tiem (usually total assets
BIG ACC Q
operating profit margin (op proft/rev)
- provides relationship between turnover and all costs of providing service including op costs
- GOOD: appropriate for making comparisons because differences in way bis is financed wont influence measure
- BAD: discrepancies can arise between comps for various reasons e.g. method of depreciation used - so hard to make comparisons
quick ratio (current assets - inventory) / current liabilities
<1 may be cause for concern depending on industry
still doesnt take CF timing into account
if quick ratio is much lower than working cap - current assets are highly dependent on inventory - retail stores big e.g. of this = sensitivity to recession
