17.2 Analysis & Interpretation of FS - Investor Ratios

Question 1

What are the shareholders investment ratios

Answer 1

• Earnings per share (EPS)
• Price earnings (P/E) ratio
• Earnings yield
• Dividend per share (DPS)
• Dividend cover
• Dividend yield
• Return on equity (ROE)
  o Most often used for PLCs not LTDs

Question 2

What is earnings per share

Answer 2

EPS = Profit attributable to the ordinary shareholders / Weighted average number of ordinary shares in issue

• Profit attributed to the ordinary shareholders should be:
  o After the deduction of preference dividends
   These are treated almost like debt
  o Exclude the profit from discontinued operations
• Only ratio that has to feature on FS

Question 3

What are the limitations of earnings per share

Answer 3

• Does not consider the impact of inflation on earnings
• Based on historical earnings, which are not necessarily a reliable indicator of future growth
• Affected by changes in capital structure
• Affected by choices in capital structure

Question 4

How can EPS be manipulated

Answer 4

• Changing number of shares
  o Reverse share splits
• Changing earnings
  o Accruals or depreciation

Question 5

What is the price earnings ratio

Answer 5

P/E = Market price per ordinary share / EPS

• Ratio of company’s current share price to EPS
• The higher the better or viewed more favourably
  o Judge the cost of the share to the return it produces
  o Represented in pence
• Represents the markets view of the companies growth potential, it’s dividend policy and degree of investment risk
• A high P/E indicates the market expects rapid growth of EPS
• Shows the number of years earnings at the current rate to recover the price paid for the share

Question 6

What is earnings yield

Answer 6

Earnings yield = (Earnings per share / Market value of share) × 100

• Reciprocal of P/E ratio
  o Earnings as a % of market price
• More useful in trend analysis than P/E

Question 7

What is dividend per share

Answer 7

DPS = Total dividend paid / Total number of ordinary shares

• Expressed in pence
• Of interest to shareholders
  o Shows the amount they receive per share held
  o Can indicate how profitable the company is
• Compared to EPS which is maximum return this is the amount that is actually received. Can compare to see amount that is being retained

Question 8

What is dividend yield

Answer 8

Dividend yield = DPS / Market price per ordinary share

• Expressed as a %
  o Good for comparison
• Shows the current level of dividend return on the investment
• The lower the dividend yield, the more the market is expecting future dividend growth, and vice versa
• Dividend yield is an important component when considering overall performance of a share

Question 9

How can dividend yield be interpreted

Answer 9

• The dividend yield is a market base ratio that needs to be interpreted with great care
• A high DY can arise from
  o High levels of dividend payment
   Can be a good thing, if sustainable
  o Low market price for shares
   Not a desirable situation
• The clientele effect results in companies being reluctant to reduce dividend payments for fear an adverse market reaction in terms of share price
  o This can contribute to high apparent dividend yields that may not be an indicator of good corporate performance

Question 10

What is dividend cover

Answer 10

Dividend cover = PAT / Dividend = x times
Or = (Earnings per share / Dividend per share × 100 = x%

• Measure of the proportion of profits distributed and retained in the business
  o Dividend cover of 2 times, 50% of RE distributed and 50% kept
• When it increases, higher proportion of PAT is retained
• The higher the dividend cover, the more likely the current dividend police is sustainable
• How many times could the dividend be paid out from profit after tax

Question 11

How are dividends paid out

Answer 11

• The legality of a dividend payment usually depends on cumulative profits (RE) rather than profits for the year
  o Also must have the cash in hand not just profit on the books
• However, I’d a company repeatedly pays dividends that are in excess of annual profits then this clearly unsustainable in the long run
• Shareholder sentiment to the ratio varies:
  o Some will react positively to a high dividend cover as it implies that the dividends may be sustainable even in the face of declining profitability
  o Others will view a high cover as an indicator of an excessively low dividend payment

Question 12

What is the dividend pay out ratio

Answer 12

Dividend pay out ratio = (Dividends paid / Net profit) = x%

• An alternative measure to dividend cover
• Expressed as a percentage

Question 13

What is the return on equity

Answer 13

• Covered in the profitability lecture
  o But also regarded as an investor ratio
• The difference between ROE and ROCE will derive from the financial impact of leverage
• Ideally the shareholders benefit from improved returns on equity due to returns on borrowed funds that exceed the cost of those borrowings
• Nonetheless, investors will need to consider limitations of the borrowing capacity of the company, and increase in risk associated with increases in borrowing

Question 14

What are some bankruptcy prediction ratios

Answer 14

• Investors and other users of financial statements are likely to be concerned about the risk the company will go bankrupt
• Z scores, H scores and A scores all try to predict the likelihood of bankruptcy
  o Will not have to calculate these
  o And they are only an indicator
• There are also a number of professional risk assessors that provide credit rating services
  o Standard and Poor, Moody’s

Question 15

How do investor ratios interlink with other ratios

Answer 15

• While trade receivable days is not directly an investor ratio
• If it is high it can indicate liquidity issues
• That can affect dividends and long term going concern