11) Financial ratios

Question 1

what are the four categories of ratios

Answer 1

Profitability and return
Debt and gearing
 Liquidity
 Investor ratios

Question 2

What do and are the profitability and return ratios tell you?

and name the categories they fall under

Answer 2

Profitability and return ratios are probably the most widely used. They are key to any financial manager wanting to assess performance against objectives as well as being crucial to the investment decision.

An external investor will also monitor these ratios closely when deciding whether to provide the company with finance and to assess the value of the overall business.

ROCE
Profit margins
Asset turnover

Question 3

What is return on capital employed? ROCE

and main disadvantage

Answer 3

Return to all providers of capital

ROCE gives a measure of how efficiently a business is using the funds available. It measures how much is earned per $1 invested.

Operating profit
÷
Capital employed (Equity & Non Current liabilities)

Operating profit= Profit BEFORE interest and tax
CE= Total Assets - Current liabilities (leaves N/C Liabilities and Equity)
CE= Share capital + Reserves + Long term loans

Disadvantage: uses profit, which is not directly linked to the objective of maximizing shareholder wealth.

Question 4

ROCE can be broken down into? %

Answer 4

Asset turnover

Net profit margin

Question 5

What is asset turnover (Times) and the general formula

Answer 5

The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue. The higher the asset turnover ratio, the more efficient a company is at generating revenue from its assets.

Sales Rev
÷
Capital employed (Equity and Non Current liabilities)

Question 6

What are the two types of asset turnover

Answer 6

working capital

Non current asset turnover

Question 7

what is working capital asset turnover formula

Answer 7

Working capital turnover is a ratio that measures how efficiently a company is using its working capital to support a given level of sales. shows the relationship between the funds used to finance a company’s operations and the revenues a company generates as a result

Sales rev
÷
Net working capital

Question 8

what is non current asset turnover formula

Answer 8

Used to measure operating performance. This efficiency ratio compares net sales and measures a company’s ability to generate net sales from its fixed-asset investments (E.g. PP&E)

Sales rev
÷
N/C Assets

Question 9

What is Net profit margin and formula %

what is the definition of net profit

Answer 9

The net profit margin illustrates how much of each dollar in revenue collected by a company translates into profit. i.e. how much % of the total revenue is actually profit

A comparison of the changes in the two ratios can often reveal more information about cost control and the changes in operating gearing. Operating profit can also be expressed as profit before interest and taxation (PBIT).

Net profit
÷
Sales rev

Net profit = Revenue - CoS - Operating expenses - Interest- Taxes

Question 10

What are the two profit margin formula

Answer 10

A comparison of the changes in the two ratios can often reveal more information about cost control and the changes in operating gearing. Operating profit can also be expressed as profit before interest and taxation (PBIT).

Gross profit margin
Operating ratio

Question 11

what is Gross profit margin

Answer 11

gross profit margin shows the amount of profit after cost of sales/goods sold

Gross profit
÷
Sales rev

Question 12

what is Operating ratio

Answer 12

measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax.

Expenses
÷
Sales rev

Question 13

What is return on equity? ROE

Answer 13

ROE measures how much profit a company generates for its ordinary shareholders with the money they have invested in the company.

Question 14

What is return on equity? ROE Formula

Answer 14

Profit after tax and preference dividend
÷
Equity

Equity= ordinary share capital + Reserves

Question 15

what are the disadvantages of ROE

Answer 15

Disadvantages of ROE:

it uses profits, which are an unreliable measure and not directly linked to shareholder wealth
it is sensitive to gearing levels – ROE will increase as gearing ratio increases.

Question 16

What are the debt and gearing ratios looking at?

Answer 16

Ratios that look at debt and gearing are a crucial way of assessing the risk profile of the business. They will therefore be used extensively by financial managers when taking financing decisions as well as by current and potential investors when assessing the amount of financing to offer and the level of return to demand.

Question 17

what are the list of debt and gearing ratios?

Answer 17

Interest cover

Gearing

Question 18

what is interest cover formula

Answer 18

Looks at the POV of P/L- How many times do we cover the interest that is payable in the P/L

Operating profit
÷
Interest payable

OP=Operating profits before debt interest and tax

Question 19

What is the gearing ratio

Answer 19

Non current liabiliites
÷
Equity & Non current liabiliites

Question 20

What is earnings per share

Answer 20

This is the basic measure of a company’s performance from an ordinary shareholder’s point of view. It is the amount of profit, in cents, attributable to each ordinary share.

Earnings available to ordinary shareholders
÷
No of ordinary shares in issue

Earnings available to OS= profit after interest and tax- Preference dividend

Question 21

what are the disadvantages of EPS

Answer 21

EPS does not represent the income of the shareholder. Rather, it represents the investor’s share of profit after tax generated by the company according to an accounting formula.

When calculating the EPS, you cannot compare EPS of one company with EPS of another, as the answer would be meaningless. You should first calculate the growth rate of the EPS and then compare it with the growth of similar companies.

Although the ratio is simple in principle, in practice, there may be a number of complications as both the definitions of earnings and shares in issue require careful analysis. Accounting treatment may cause the ratios to be distorted, if for example the earnings figure includes the effects of extraordinary items.

Question 22

What is PE ratio?

Answer 22

This is the basic measure of a company’s performance from the market’s point of view. Investors estimate a share’s value as the amount they are willing to pay for each unit of earnings. It expresses the current share price as a multiple of the most recent EPS/Current earnings.

If a PE ratio is high, investors expect profits to rise. This does not necessarily mean that all companies on high PE ratios are expected to perform to a high standard, merely that they are expected to do significantly better than in the past. They may have greater growth potential because they are coming from a low base.

Question 23

what is PE formula

Answer 23

Share Price
÷
EPS

Question 24

What is dividend per share (DPS)? %

Answer 24

The DPS helps individual (ordinary) shareholders see how much of the overall dividend pay-out they are entitled to in %

Since the shareholders are the owners of the business, they are entitled to their share of the profits. This is most simply achieved by paying the amount out as a dividend. It is usually expressed as an amount per share. This is because the total amount a shareholder gets has to reflect their share of the company.

Question 25

What is dividend per share (DPS) formula %

Answer 25

Total ordinary dividend
÷
Total number of shares issued

Question 26

what is dividend cover?

Answer 26

It is a measure of how many times the company’s earnings could pay the dividend. The higher the cover, the better the ability to maintain dividends if profits drop

Question 27

what is dividend cover formula

and give the alternative formula

Answer 27

Profit available for ordinary shares
÷
Dividend for the year (interim plus)

OR

EPS
÷
DPS

Question 28

What is dividend yield and formula

Answer 28

The dividend yield, expressed as a percentage, is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.

This provides a direct measure of the wealth received by the (ordinary) shareholder. It is the annual dividend per share expressed as an annual rate of return on the share price.

It means that if you buy a shares, the dividend ÷ by the amount you pay for the share is 5% return. You’re getting a 5% return in the form of a dividend when you buy that share

DPS
÷
Share price

Question 29

what are the disadvantages of dividend yield?

Answer 29

it fails to take account of any anticipated capital growth so does not represent the total return to the investor.

Question 30

What is TSR- Total shareholder return and an advantage?

Answer 30

This measures the returns to the investor by taking account of:

• Dividend income
• Capital growth

The TSR from an investment can easily be compared between companies or benchmarked against industry or market returns without having to worry about differences in size of the businesses.

Question 31

what is TSR frmula?

Answer 31

DPS + Change in share price
÷
Share price at the start of period

Question 32

What is interest yield and formula

Answer 32

The interest yield is the interest or coupon rate expressed as a percentage of the market price. It is a measure of return on investment for the debt holder.

Interest
÷
Market value of debt

Question 33

WHAT is net assets?

Answer 33

Total assets - Total liabilities = Equity (Net Assets)