14. Sources Of Information - Uses and Limitations Flashcards

Question 1

Q

A. Company accounts (page 2)

Answer

A

The purpose of company accounts is to provide investors and other interested parties with information on the performance of the company.

Question 2

Q

A1. Statutory accounting requirements (pages 2 & 3)

Answer

A

Under the Companies Acts, the directors of a company are legally required to prepare financial statements and make certain disclosures:

accounts have to show the results of the company’s activities over an accounting period (usually 12 months)
amount and format of the material depends on whether the company is small, medium or large
accounts of PLCs must have stock market listings
listed companies must also publish half yearly or interim accounts

Question 3

Q

A1. Statutory accounting requirements (pages 2 & 3)

Continued

Answer

A

STRATEGIC REPORT

all companies must now provide a strategic report (as well as a director’s report) within their annual report
provides a company’s shareholders with a holistic and meaningful picture of a company’s business model, strategy, development and performance
should provide a fair review of the company’s business and a description of the risks it faces
the review should be balanced and comprehensive

Question 4

Q

A2. Financial statements (page 3)

Answer

A

The standards by which financial statements are prepared and presented are laid out in the Companies Acts.

Mandatory accounting standards are set out by the UK Accounting Standards Board which is part of the Financial Reporting Council (FRC).

Question 5

Q

A2. Financial statements (page 3)

Continued

Answer

A

International standards are needed to make effective comparisons between companies in different countries:

International Financial Reporting Standards (IFRS) aim to harmonise the way accounts are presented
international standards prescribe what needs to be disclosed in financial statements but not any particular layout

Question 6

Q

A2A. Auditor’s report (pages 3 & 4)

Answer

A

Companies are required to appoint independent auditors unless they are classed as a small company.

Auditor’s role is to carry out an independent assessment of the company’s accounts prepared by the directors and report to shareholders on whether the accounts have been properly prepared in accordance with the Companies Acts and all accounting standards.

Question 7

Q

A2A. Auditor’s report (pages 3 & 4)

Continued

Answer

A

Auditor’s requirements:

audit the accounts and report to the members of the company
review whether the corporate governance statement reflects the company’s compliance with the provisions of the UK Corporate Governance Code and report if it does not
review the director’s report and other information in the annual report
ensure the information given in the strategic report for the financial accounting year is consistent with those accounts

Question 8

Q

A2A. Auditor’s report (pages 3 & 4)

Continued

Answer

A

Audit reports are either unqualified or qualified.

Qualified (modified) reports fall into three categories:

Disclaimer of opinion - where the auditor is unable to form an opinion
Adverse opinion - where the auditor disagrees with accounting treatment which the directors refuse to amend
Qualification - where the auditor has a material disagreement with the treatment adapted by the directors

Question 9

Q

A2B. Corporate governance (page 4)

Answer

A

Corporate governance is concerned with the transparent disclosure of a company’s activities to it’s shareholders, director accountability and the two-way communication between the board and the company’s shareholders.

All listed companies are expected to abide by the UK Corporate Governance Code.

Question 10

Q

A3. Framework for financial statements (pages 4 & 5)

Answer

A

Financial Statements are based on a set of underlying assumptions:

Accrual Basis: the effects of transactions and other events are recognised when they occur, rather than when cash or its equivalent is received or paid
Going Concern: the financial statements presume that an entity will continue in operation for the foreseeable future

Question 11

Q

A3. Framework for financial statements (pages 4 & 5)

Continued

Answer

A

The International Accounting Standard (IAS): Presentation of Financial Statements sets out the overall framework for presenting financial statements.

From 1 January 2016 annual reports must contain:

Income statement
Consolidated statement of financial position
Consolidated statement of cash flows
Consolidated statement of changes in equity
Notes forming part of the consolidated financial statements
Index to notes forming part of the consolidated financial statements

Question 12

Q

A4. Statement of financial position (page 5)

Answer

A

Shows the assets and liabilities of a company
Can be seen as a list of the resources of a company and how they have been financed
Is a reflection of a company’s position at one point in time

Question 13

Q

A4A. Assets (pages 5 & 6)

Answer

A

The assets in a statement of financial position are separated into:

current assets
non-current assets

CURRENT ASSETS

assets purchased with the intention of resale or conversion into cash
assets are listed in descending order of liquidity
typically appear at the lower of cost or net realisable value

NON-CURRENT ASSETS
Fixed assets, or long-term assets of the company. Split into:
- Tangible assets (physical assets)
- Intangible assets (contracts, patents, brand names)

Question 14

Q

A4A. Assets (pages 5 & 6)

Continued

Answer

A

Three ways in which companies can account for their stock are:

FIRST IN FIRST OUT (FIFO):

LAST IN FIRST OUT (LIFO): Used in the USA (not UK)

WEIGHTED AVERAGE COST

Question 15

Q

A4A. Assets (pages 5 & 6)

Continued

DEPRECIATION CHARGE CALCULATION

Answer

A

NON-CURRENT ASSETS AND DEPRECIATION

tangible assets depreciate over time
a depreciation charge needs to be accounted for
the cost of tangible assets is charged to the income statement over a number of accounting periods

DEPRECIATION CHARGE CALCULATION
(STRAIGHT-LINE METHOD):

                            original cost - expected residual value Depreciation p.a. = ------------------------------------------------------
                                        expected useful life

Example:

Original cost of tractor = £10,000
Useful life = 5 years
Expected resale/residual value = £1,000

Step 1: £10,000 - £1,000 = £9,000
Step 2: £9,000 / 5 = £1,800 (Annual Depreciation charge)

Question 16

Q

A4B. Shareholder funds and liabilities (pages 7 & 8)

Answer

A

The bottom half of the statement shows shareholder funds and liabilities.

Its construction is underpinned by the accounting equation:

Assets = Liabilities + Equity

Question 17

Q

A4B. Shareholder funds and liabilities (pages 7 & 8)

Continued

Answer

A

LIABILITIES
- categorised into current non-current liabilities

CURRENT LIABILITIES

fall due within a year of the statement date
includes the amount a company owes to suppliers or creditors as a result of buying goods/services on credit
includes payments received on account
includes accruals and deferred income

NON-CURRENT LIABILITIES (LONG-TERM)

fall due within more than a year of the statement date
could be debentures, loan stock or longer-term borrowing
fall into two categories:
1. issues of debentures and unsecured loan capital
2. loans from banks and other financial institutions

Question 18

Q

A4B. Shareholder funds and liabilities (pages 7 & 8)

Continued

Answer

A

SHAREHOLDER FUNDS

SHARE CAPITAL and RESERVES represent the funds due to the owners of the company and are the permanent capital of the company
when a company is created the memorandum of association states the amount of share capital with which the company is to be registered and which will be split into shares of a fixed amount
Issued SHARE CAPITAL are what are issued at any point in time
Capital RESERVES include the following:
1. REVALUATION RESERVE (arrises from the upward revaluation of tixed tangible and intangible assets)
2. SHARE PREMIUM RESERVE (arises from issuing shares above their normal value)
3. CAPITAL REDEMPTION RESERVE (is created when a company redeems or buys back its shares)
Capital Reserves are not distributable to the company’s shareholders (but can be converted into a bonus issue of ordinary shares)
Retained earnings (not distributed)
Non-controlling interest (owned by minority interests)

Question 19

Q

A5. Income statement (pages 9 & 10)

Answer

A

INCOME STATEMENT

shows the performance of the company over the accounting period
details how the company’s reported profit was arrived at
how much profit was earned
and how it was distributed

Key Terms from the Income Statement:

REVENUE (represents sales generated over the accounting period regardless of whether cash has been received)
PROFIT FROM OPERATIONS (OPERATING PROFIT)
- stated after deducting costs of sales
- as well as distribution costs
- and administration expenses (include depreciation charges)

Gross Profit Calculated:

Gross Profit = Revenue - Cost of Sales

PROFIT BEFORE TAX (operating profit less exception items such as dividends or corporation tax estimates)
PROFIT (the company’s total earnings or profit)

Question 20

Q

A5A. Statement of comprehensive income (page 10)

Answer

A

STATEMENT OF COMPREHENSIVE INCOME

includes such things as:
revaluation gains and losses of property
actuarial gains and losses on pension scheme plans
foreign exchange translation differences

Question 21

Q

A5B. State of changes in equity (pages 10 & 11)

Answer

A

STATEMENT OF CHANGES IN EQUITY
- summarises the movement in the shareholder funds during the year (i.e. share capital, share premium, retained earnings etc).

Question 22

Q

A6. Cash flow statement (pages 11 & 12)

Answer

A

CASH FLOW STATEMENTS (A STATEMENT OF CASH FLOWS)

identify how a company’s cash has been generate over the accounting period
and how it has been expended

CONSTRUCTION OF A STATEMENT OF CASH FLOWS:

removing accruals from the income statement
adjusting for balance sheet items
adding back non-cash items
bringing in changes in balance sheet items that impact the company’s cash position

It is important that a company generates positive cash flow at the operating level otherwise it will become dependant on non-current asset sales and borrowing facilities to finance its day-to-day operations.

Question 23

Q

A7. Consolidated accounts (pages 12 & 13)

Answer

A

CONSOLIDATED ACCOUNTS

shows the financial position for a group of companies
such as when a company ownes another company (parent company with a subsidiary)
a consolidate account shows assets and liabilites of the parent company with that of its subsidiaries
owning more than 50% of the shares is enough to create a subsidiary
where more than 50% but less than 100% of shares are owned, the other party owners are known as minority interests
the percentage of net income owned by the minority interests is shown at the foot of the group statement

Question 24

Q

A7A. Associates (page 13)

Answer

A

An ASSOCIATE company has a 20% to 50% shareholding.

The equity method of accounting is used in this instance.

Question 25

Q

A7B. Investments (page 13)

Answer

A

Where the holding is less than 20%, then this investment is shown as an asset in the statement of financial position.

Any dividends received would be taken to the income statement in arriving at profit on ordinary shares before taxation.

Question 26

Q

B. Analysing companies (pages 13 & 14)

Answer

A

Four potential measures can be analysed in order to estimate a company’s potential:

PROFITABILITY (what rate of profit is being earned?)
VOLATILITY (how sensitive are profits to changes in the markets or economy?)
LIQUIDITY (is the company able to way its way?)
OPERATIONAL EFFICIENCY (is the management making efficient use of the company’s resources?)

SEGMENTS

many companies are a mixture of business
individuals elements known as segments
segmental analysis will highlight which parts of the business produce the best and worst returns

Question 27

Q

B1. Profitability (page 14)

Answer

A

PROFITABILITY

a company’s ability to generate earnings
can be measured in two ways

Profit margin generated from sales
Profit return generated from the capital or equity used by a company

Question 28

Q

B1A. Earnings compared to sales (pages 14 & 15)

OPERATING MARGIN

CALCULATION & DESCRIPTION

Answer

A

OPERATING MARGIN
- provides information about the profitability of a firm’s core business

operating profit is the profit made after paying the operating costs of goods sold as well as general and administration expenses

CALCULATION:

                                  Operating Profit Operating Margin =  ---------------------------- x 100
                                          Sales

Question 29

Q

B1A. Earnings compared to sales (pages 14 & 15)

CONTINUED

NET MARGIN

CALCULATION & DESCRIPTION

Answer

A

NET MARGIN

measures the percentage of net income of an entity to its net sales
used to compare the profit of competitors in the same industry
net margin represents the proportion of sales that is left over after all relevant expenses have been adjusted

CALCULATION:

                    Net profit after taxation Net Margin =  ----------------------------------- x 100
                                     Sales

Question 30

Q

B1B. Return on equity and return on capital employed (pages 15, 16, 17 & 18)

ROE (Return On Equity)

CALCULATION & DESCRIPTION

Answer

A

ROE - Return on Equity

is a measure of the profitability of the shareholder’s investment
measures the percentage return the company is achieving on the amount of funds provided by shareholders
with the funds provided by shareholders coming from two sources:
1. share capital and share premium (funds being paid by investors)
2. retained earnings (profits not paid out as dividends)
The higher the ROE the better
ROE is heavily affected by differences in company capital structure

CALCULATION:

          Net profit after tax ROE = ------------------------------ x 100
                Total Equity

Question 31

Q

B1B. Return on equity and return on capital employed (pages 15, 16, 17 & 18)

CONTINUED

ROCE (Earnings Compared to Capital Employed)

CALCULATION & DESCRIPTION

Answer

A

ROCE (Earnings Compared to Capital Employed)

determines how much the company has earned from the total of the different types of capital it has employed
measures the percentage return achieved on the capital employed in the business
ROCE is a better comparison between companies than ROE
ROCE includes long-term finance and is therefore a more comprehensive test of profitability than ROE
ROCE is limited though in that it does not account for depreciation

CALCULATION:

          Profit before interest and tax ROCE = ------------------------------------------- x 100
                   Capital Employed

Question 32

Q

B1B. Return on equity and return on capital employed (pages 15, 16, 17 & 18)

CONTINUED

ROCE (Earnings Compared to Capital Employed)

CAN BE BROKEN DOWN INTO TWO PARTS

Means that you can identify which element/part is responsible for a fall or rise in ROCE

CALCULATION & DESCRIPTION

Answer

A

PART 1: ASSET TURNOVER
- this shows how much of the return arises from good asset utilisation
Sales
CALCULATION: —————————
Capital Employed

PART 2: PROFIT MARGIN
- how much arises from profit and cost management
Profit
CALCULATION: —————————
Sales

THE FORMULA LINKING ALL THREE:

             Profit before interest & tax  ROCE =  ------------------------------------------
                    Capital Employed

             Sales                           Profit  =   ---------------------------     x    -----------------
    Capital Employed                Sales

Question 33

Q

B1C. Other profitability measures (pages 18 & 19)

Answer

A

Profits are often quoted against a particular industry-specific measurement, for example:

Retail companies (profits per square foot)
Distribution companies (profits per ton mile)
Airlines (profits per passenger mile)
Creative companies (profits per employee)

Profit analysis can help identify:

overall level of return on equity invested
level of return being achieved on sales and assets

Question 34

Q

B2. Profit volatility (page 19)

Answer

A

PROFIT VOLATILITY

essential to an investment decision
can be assessed using two different measures:

FINANCIAL LEVERAGE
- ratio of debt to equity, commonly referred to as ‘gearing’
- indicates the sensitivity of a company’s profits to changes in interest rates
OPERATING LEVERAGE
- ratio of fixed costs to variable costs
- known as ‘break-even’ analysis
- indicates the sensitivity of operating profit to changes in sales volumes

Question 35

Q

B2A. Financial leverage (pages 19, 20, 21 & 22)

FINANCIAL LEVERAGE / GEARING (CALC 1)

CALCULATION & DESCRIPTION

Answer

A

FINANCIAL LEVERAGE

the extent to which a company uses borrowed money
carries a risk of bankruptcy
but can lead to increased returns

CALCULATION:

              (Long-term loans + preference shares) Gearing = ----------------------------------------------------------
                   (Total equity - preference shares)

Debt to equity ratios of more than 100% are considered too high in the UK
High gearing is usually more acceptable in the utilities sector

Question 36

Q

B2A. Financial leverage (pages 19, 20, 21 & 22)

FINANCIAL LEVERAGE / GEARING (CALC 2)

CALCULATION & DESCRIPTION

CONTINUED

Answer

A

ALTERNATIVE METHODS TO CALCULATE GEARING

CALCULATION:

              (Long-term loans + PS + short-term loans) Gearing = ----------------------------------------------------------
                   (Total assets - current liabilities)

PS = Preference shares

Question 37

Q

B2A. Financial leverage (pages 19, 20, 21 & 22)

INTEREST COVER

CALCULATION & DESCRIPTION

CONTINUED

Answer

A

INTEREST COVER
- How many times could the interest bill be paid out of current profits?

CALCULATION:
Profit before interest and tax
Interest Cover = ——————————————-
Gross interest payable

Question 38

Q

B2A. Financial leverage (pages 19, 20, 21 & 22)

CONTINUED

Answer

A

EFFECT OF GEARING ON PROFITS:

High gearing exaggerated ROE
If revenues decline, a highly geared company is less likely to be able to raise new loans to fund corrective action needed to maintain sales and profits
A rise in interest charges also increases costs more for highly geared, more indebted companies

Question 39

Q

B2A. Financial leverage (pages 19, 20, 21 & 22)

CONTINUED

Answer

A

SIGNIFICANCE FOR INVESTORS

If interest rates go up, costs go up, reducing ROE
If losses ensure, gearing levels deteriorate further, because equity will be reduced
A company may find itself unable to raise funds either by borrowing or selling shares

Question 40

Q

B2B. Operating leverage (pages 22 & 23)

Answer

A

OPERATING LEVERAGE

a measure of the impact of a company’s cost mix (the proportion of fixed costs to variable costs) on the rate of change in profitability
no standard benchmark, but generally if fixed costs are above 80% of total costs, a company is likely to be considered as having a high operating leverage

Question 41

Q

B2B. Operating leverage (pages 22 & 23)

CONTINUED

Answer

A

INFORMATION IN THE ACCOUNTS

some accounts will show a ‘COST OF SALES’ figure, which for general purposes can be DEEMED TO BE VARIABLE COSTS
where this is not disclosed, the ‘notes to the accounts’ needs to be analysed and judgements made as to which costs are fixed and variable
ALL OTHER COSTS INVOLVED BEFORE TRADING PROFIT IS CALCULATED DEEMDED TO BE FIXED COSTS
the break-even point might be specified in the ‘notes to the accounts’ section

Question 42

Q

B2B. Operating leverage (pages 22 & 23)

CONTINUED

Answer

A

INDUSTRY INFORMATION

many trade associations provide quarterly reports on capacity utilisation for the industry as a whole
therefore the relative position of a particular company is generally known
combined with an analysis of the company’s operating leverage and a view of the future sales prospects, this tells investors a lot about how rapidly profits (or losses) may change after they have invested in the business

SIGNIFICANCE FOR INVESTORS

investors should not choose a company for profits in isolation:
1. they may be high-risk profits poised to fall abruptly after only modest market changes
2. even well-managed, highly respected ‘big name’ firms can suffer lower profits

Question 43

Q

B3. Liquidity management (page 23)

Answer

A

Liquidity is critical to a business:

without the cash to pay bills even a company with plenty of assets could soon be in liquidation
therefore liquidity ratios, cash flows and working capital management are watched with care by investors and analysts

Question 44

Q

B3A. Working capital (‘current’) ratio (page 24)

CALCULATION & DESCRIPTION

Answer

A

CURRENT RATIO

most investors like to see a cushion to protect a company against a downturn in sales
generally, investors prefer to see that sufficient cash will be generated from current assets in the course of a normal business day to pay off creditors
as a generalisation, the ratio should be between 1.5 and 2

CALCULATION:

                          Current assets Current Ratio =  --------------------------
                         Current liabilities

Question 45

Q

B3B. Liquidity ratio (page 24)

CALCULATION & DESCRIPTION

Answer

A

LIQUIDITY RATIO

this ratio is more cautious
only measures those assets that can be quickly and definitely turned into cash
the liquidity ratio should be at least 1

CALCULATION:

                          Current assets - stock Liquidity Ratio =  -----------------------------------
                              Current liabilities

Question 46

Q

B3B. Liquidity ratio (page 24)

CONTINUED

Answer

A

THE Z SCORE

liquidity ratios are useful for indicating the ‘tightness’ of current cash flows
but not very good at forecasting actual financial collapse

Z-Score Check

this occurs when a promising investment is turned down because of poor liquidity ratios
it combines a number of special ratios and is reasonably accurate at predicting collapse over one year (but less so over a longer period of time such as five years or more)

Question 47

Q

B3C. Sources and uses of cash flow statements (page 25)

Answer

A

CASH FLOW STATEMENT

identifies where money is coming from
and where it is being spent
Increases in assets = a use of funds (purchasing)
Decreases in assets = a source of funds (selling)
Increase in liabilities = source of funds (new loan)
Decrease in liabilities = use of funds (repayment)

Question 48

Q

B3D. Analysing cash flow statements (page 25)

Answer

A

Cash flow statements need to be assessed in conjunction with the statement of financial position
Key factors that the investor should focus on:
Is the company cash-flow positive at the operating level?
Where is the company spending its money?
How much cash is being provided from non-operating sources?
What changes to its financial position have occurred?

Question 49

Q

B3E. Working capital management (pages 25, 26, 27 & 28)

NET CURRENT ACCOUNT ASSETS

CALCULATION & DESCRIPTION

Answer

A

WORKING CAPITAL (NET CURRENT ACCOUNT ASSETS)

represents the money that circulates through the business automatically
i.e. money being spent on goods and services to enable production to take place and money being received as customers pay for their purchases
when many small transactions are taking place very rapidly, working capital levels can grow unnecessarily large

CALCULATION:

Current assets - current liabilities = Net current assets

Question 50

Q

B3E. Working capital management (pages 25, 26, 27 & 28)

DEBTOR TURNOVER

CALCULATION & DESCRIPTION

Answer

A

DEBTOR TURNOVER

is the ratio of a business’ net credit sales to its accounts receivable during a given period
is an activity ratio that estimates the number of times a business collects its average accounts receivable balance during a period
measures the efficiency of a business in collecting its credit sales
HIGH FIGURE more favourable
usually calculated on an annual basis

CALCULATION:

                              Sales Debtor Turnover = -------------
                             Debtors

Question 51

Q

B3E. Working capital management (pages 25, 26, 27 & 28)

DEBTOR COLLECTION PERIOD IN DAYS

CALCULATION & DESCRIPTION

Answer

A

DEBTOR COLLECTION PERIOD IN DAYS

expressed in days to represent the number of days that it takes the company to collect its invoices
benchmark to beat is 60 days

CALCULATION:
Debtors
Debtor collection period in days = ————— x 365
Sales

Question 52

Q

B3E. Working capital management (pages 25, 26, 27 & 28)

STOCK TURNOVER

CALCULATION & DESCRIPTION

Answer

A

STOCK TURNOVER

is a ratio used to assess how efficiently a business is managing its inventories
a high inventory turnover indicates efficient operations
stock turnover is a measure of the number of times inventory is sold or used in a given time period, such as over one year

CALCULATION:
Cost of sales
Stock Turnover = ———————-
Stock

365 days / the answer gives how many days the stock is held for on average

Question 53

Q

B3E. Working capital management (pages 25, 26, 27 & 28)

CREDITOR TURNOVER
&
CREDITOR PAYMENT PERIOD IN DAYS

CALCULATIONS & DESCRIPTIONS

Answer

A

CREDITOR TURNOVER

evaluates how fast a company pays off its creditors (suppliers)
the ratio shows how many times in a given period the company pays its accounts payable
a higher value indicates that a company was able to pay them off quickly

CALCULATION:

                                Cost of sales Creditor turnover =  -----------------------
                               Trade creditors

CREDITOR PAYMENT PERIOD IN DAYS
CALCULATION:
Trade creditors
Creditor payment period in days = ———————– x 365
Cost of Sales

Question 54

Q

B4. Operational management (page 28)

Answer

A

Operational measures mostly involve comparing key numbers such as sales, employees and assets against other business measures.

Question 55

Q

B4A. Managing staff resources (pages 28 & 29)

Answer

A

SALES PER EMPLOYEE

Divide the sales total by the number of employees
useful to see how fewer or more staff perform

STATISTIC PER EMPLOYEE
- could be employees per square foot, per hotel room etc

WAGE COSTS AS A PERCENTAGE OF SALES

wages/salaries divided into sales
shows the wage costs as a percentage of sales

Question 56

Q

B4B. Managing sales overheads (page 29)

Answer

A

ADMINISTRATIVE COSTS AS A PERCENTAGE OF SALES
- administrative costs divided by sales

DISTRIBUTION COSTS AS A PERCENTAGE OF SALES
- distribution costs divided by sales

Question 57

Q

B4C. Managing assets (pages 29 & 30)

Answer

A

ASSET TURNOVER

measures how frequently assets are used to generate sales
shows how effectively and efficiently a company is using its fixed assets to generate revenue
Sales divided by non-current assets

ASSETS PER EMPLOYEE

calculated using the net assets figure from the statement of financial position
Net assets divided by employees

Question 58

Q

B5. General limitations of ratio analysis (page 30)

Answer

A

Limitations of Ratio Analysis:

changes in accounting policies can make comparisons difficult over time
ratio analysis is based on historical data
only as good as the information on which it is based
individual ratios should not be considered in isolation

Question 59

Q

B6. Comparative performance assessment using ratio analysis (page 30)

Answer

A

A company’s performance can be compared to the:

Economy (AS A WHOLE)
Industry (AS A WHOLE)
Major competitors (CROSS-SECTIONAL ANALYSIS)
Past performance (TIME-SERIES ANALYSIS)

Question 60

Q

C. Investment valuation ratios (page 31)

C1. Investment ratios (page 31)

Answer

A

Various investment ratios.

Question 61

Q

C1A. Earnings per share (EPS) (page 31)

CALCULATION & DESCRIPTION

Answer

A

EARNINGS PER SHARE (EPS)

is a measure of the profitability of a company or the profit available to shareholders
expressed as an amount per share
this is so comparisons can be made between different shares and/or companies

CALCULATION:

                    Net Income EPS =  ------------------------------------------
          Number of Shares in Issue

Net Income = may be written as ‘Profit for the year’
Number of Shares in Issue = may be written as weighted average number of shares

TWO OTHER VERSIONS OF EPS:

EBIT - calculated before the impact of interest payments and taxation
EBITDA - provides a way for company earnings to be compared internationally

Question 62

Q

C1B. Price-earnings ratio (PE) (page 32)

CALCULATION & DESCRIPTION

Answer

A

PRICE-EARNINGS RATIO

measures how highly investors value a company in its ability to grow its income stream
a company with a high PE ratio relative to its sector average reflects investors expectations that the company will achieve above-average growth

Reasons why a company may have a higher PE ratio:

greater perceived ability to grow its EPS than others
producing higher quality earnings than others
being a potential takeover target
experiencing a temporary fall in profits

CALCULATION:

      Share Price PE =  -------------------
           EPS

Question 63

Q

C1C. Dividend yields and cover (pages 32 & 33)

DIVIDEND YIELD

CALCULATION & DESCRIPTION

Answer

A

DIVIDEND YIELDS

give investors an indication of the expected return in a share
can then be compared with other shares
high dividend yield implies low dividend growth

CALCULATION:
Dividend per share
Dividend yield = —————————- x 100 = x%
Share price

Question 64

Q

C1C. Dividend yields and cover (pages 32 & 33)

DIVIDEND COVER

CALCULATION & DESCRIPTION

Answer

A

DIVIDEND COVER

the ability of the company to keep paying dividends at the current level
looks at how many times the company can pay out that level of dividend based on profit for the year
the higher the dividend cover the less likely it is that the company will have to reduce dividends if profits fall

CALCULATION:
EPS
Dividend Cover = ——————————
Dividend per share

Answer 65

A

PRICE TO BOOK RATIO

measures the relationship between the company’s share price and the net book
how much the shareholders are paying for the net assets of the company
if the share price is lower than its book value, it can indicate that it is undervalued
higher than book value means that it has above-average growth potential

CALCULATION:
Share price
Price to book ratio = ————————
NAV per share

Answer 66

A

Equities can be valued on four bases:

Dividend flows
Earnings growth
NAV
Shareholder value added

Answer 67

A

SHARE VALUATION

expected return of a share based on anticipated dividends
Gordon’s growth model is used to calculate

Drawbacks to Gordon’s growth model:

only a few factors are considered in the valuation
it assumes a single constant growth rate for dividends

CALCULATION:
Dividend
Share price = —————————————————–
(Return required - dividend growth)

Dividend: expected dividend one year from now
Return required: required rate of return for an equity investor
Dividend growth: growth rate of the dividends

Answer 68

A

See card 62.

Answer 69

A

NET ASSET VALUE (NAV)
- represents the NAV per share attributable to ordinary shareholders

Useful for assessing the following:

minimum price at which a company’s shares should theoretically trade
the underlying value of a property company
the underlying value of an investment trust

CALCULATION:

        (Total Assets - Liabilities - Preference Shares) NAV = ------------------------------------------------------------------
                    Number of Shares in Issue

Answer 70

A

the approach taken by shareholder value models is to establish whether a company has the ability to add value to its ordinary shareholders by earning returns on its assets in excess of the cost of financing these assets
Economic Value Added (EVA) is the most popular of these shareholder value approaches

POSITIVE RESULT = VALUE ADDED
NEGATIVE RESULT = VALUE DESTROYED

To determine whether a company’s shares are correctly values, the concept of Market Value Added (MVA) needs to be employed

PRESENT VALUE OF THE COMPANY’S FUTURE ANNUAL EVA’S DISCOUNTED AT THE COMPANY’S WAVV IS GREATER THAN THAT IMPLIED BY THE MVA - IMPLIES THAT THE COMPANY’S SHARE ARE UNDERVALUED

Answer 71

A

Listed companies must comply with continuing obligations which are listed in the FCA’s Listing Rules and the Disclosures and Transparency Rules Sourcebook:

it governs the conduct of directors of listed companies
maintains an orderly market
ensures that investors are treated fairly

Disclosure and Transparency Rules contain over-arching requirements, which relate to the timely and accurate dissemination of inside information:

promote prompt and fair disclosure of relevant information to the market
set out the specific sets of circumstances in which an issuer can delay public disclosure of inside information

Answer 72

A

Investors need to be aware of the following:

financial statements can be calculated in a number of legitimate ways giving companies flexibility in how they report figures
foreign companies have different disclosure requirements
Chair’s statements look at the good and not the bad
once a shareholder holds 3% or more of a company’s shares they must inform the company
larger investors have access to senior management

Answer 73

A

Regulatory News Service (RNS) operated by the LSE is the best known regulatory information service.

Ensures that company information is distribute immediately and accurately.

Answer 74

A

Limitations to using data on collectives:

third party data may only include comprehensive data on managers who subscribe to the service
Platforms may only include data on selected funds
Performance data is historic and may not be a good indication of future performance

Answer 75

A

Limitations to investment banks and brokers reports:

analyst’s research will push for the reader to invest in their company (recommend buy notes)
research sent to a large number of market participants so readily know and discounted by the market
such research is not tailored to clients individual needs

Answer 76

A

Limitations include:

this is secondary information so liable to error
journalists are weakly regulated

Answer 77

A

COMPANY ACCOUNTS:

all companies listed on the EU stock exchanges are required to prepare their financial statements in conformity with international accounting standings (IAS)
all listed companies are expected to abide by the UK Corporate Governance Code as a condition of their listing on the LSE
construction of the statement of financial position underpinned by: assets = liabilities + equity
two most common depreciation methods are:
1. straight-line method
2. reducing balance method

ANALYSING COMPANIES:

gross profit revenue less the cost of goods sold
operating profit is gross profit less distribution costs and administration expenses
net income if the company’s total earnings or profit after tax
ratios mean little in isolation
ROCE is a key business measure (% return achieved on the capital employed in the business)

INVESTMENT VALUATION RATIOS:

price-to-book ratio can indicate that it is undervalued
shareholder value models seek to establish whether a company is able to add value for its ordinary shareholders by earning returns on its assets above the cost of financing these assets

OTHER INFORMATION SOURCES:
- Wide range of other information sources available

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14. Sources Of Information - Uses and Limitations Flashcards

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