A2. Financial strategy formulation Flashcards
Ratios analysis
Ratios analysis can be used to evaluate the success of a financial strategy. Ratios are normally split into 4 categories: profitability, debt, liquidity and shareholder investor ratios.
Profitability ratios.
Profitability ratios. These are measures of value added being generated by an organisation. Return of capital employed (ROCE). Return on equity (ROE). Gross profit margin. Operating profit margin.
Return of capital employed (ROCE).
Measures how efficiently a company uses its capital to generate profits. It should ideally be increasing. If it is static or reducing it is important to determine whether it is due to a reduced profit margin (which is likely to be bad news) or lower asset turnover (which may simply be impact of recent investment).
When interpreting we should look for: how risky is the business? how capital intensive? ROCE of similar businesses? and how does it compare with current market borrowing rates?
Problems (for comparability): revaluations, accounting policies, classification of bank overdraft.
If ROCE is calculated post tax then it can be compared against WACC to assess whether the return provided to investors is adequate.
ROCE= (Profit before interest and tax)/(Capital employed)
Capital employed = Equity + Lon-term liabilities = Non-current assets + net current assets = total assets – current liabilities
Return on equity (ROE).
While ROCE looks at the overall return on the long-term sources of finance, ROE focuses on the return for the ordinary shareholders.
ROE= (Profit after tax- preference dividends)/(Ordinary share capital+reserves)%
Gross profit margin.
Measures how well a company is running its core operations. Shows the impact of:
Sales prices, volume and mix
Purchase prices and related costs (discounts, carriage)
Production costs, direct (materials, labour) and indirect (overheads)
Inventory levels and valuation, including errors, cut -off and cost of running out of goods.
Gross profit margin= (Gross profit)/Revenue x100
Operating profit margin.
PBIT is used to remove distortion between differently financed companies (loans vs shares). How well company is controlling its non-production overheads?
Shows the impact of:
Sales expenses in relation to sales levels
Administrative expenses, including salary levels
Distribution expenses in relation to sales levels
Operating profit margin= PBIT/Revenue x100
Efficiency ratios.
These are measures of utilisation of Current & Non-current Assets of an organisation:
Asset turnover.
Shows how much revenue is produced per unit of capital invested. Therefore, how efficiently the entity is using its capital to generate revenue.
Asset turnover= Revenue/(Capital Employed)= Revenue/(Total assets less current liabilities)
Working capital management ratios
Receivables collection period.
Payables payment period.
Inventory holding period.
Working capital cycle.
Receivables collection period.
Shows, on average, how long it takes for the trade receivables to settle their account with the company. The average credit term granted to customers should be taken into account as well as the efficiency of the credit control function within the company, customer liquidity problems.
Receivables collection period=
(Trade Receivables)/(Credit sales )×365
Payables payment period.
This ratio is measuring the time it takes the company to settle its trade payable balances. Trade payables provide the company with a valuable source of short-term finance but delaying payment for too long a period of time can cause operational problems as suppliers may stop providing goods or services until payment is received.
Payables payment days=
(Trade payables)/(Credit purchases (COS))×365
Inventory holding period.
Ratio measures the number of days inventories are held by a company on average before they are sold. Generally, the quicker the turnover the better.
But need to consider:
Lead times and bulk buying discounts
Seasonal fluctuations in orders
Alternative uses of warehouse space
Likelihood of inventory perishing or becoming obsolete
Inventory days=
(Inventory )/(Cost of sales (depreciation excluded))×365
Working capital cycle.
It represents the time between payment of cash for inventories and eventual receipt of cash from sale of the inventories. It shows the number of days for which finance is required.
Inventory holding period+Receivables collection period-payables payment period
Liquidity ratios
Liquidity Ratios measure the extent to which an organisation is capable of converting assets into cash and cash equivalents. Current ratio. Quick ratio (acid test).
Current ratio.
The ratio measures the company’s ability to pay its current liabilities out of its current assets. The industry the company operates in should be taken into consideration. Excessively large levels can indicate excessive receivables and inventories, and poor control of working capital.
Current ratio= (Current assets)/(Current liabilities)
Quick ratio (acid test).
Eliminates illiquid and subjectively valued inventory. What is acceptable will depend on industry (like supermarkets will have a very low one).
Quick ratio= (Current assets-Inventory)/(Current liabilities)
Financial leverage (gearing ratios).
Gearing Ratios measure the dependence of an organisation on external financing as against shareholder funds.
Gearing (financial).
Gearing (operational).
Gearing (financial).
Measures the relationship between shareholders’ capital plus reserves, and either prior charge capital or borrowings or both. Is concerned with long-term financial stability of the company. It looks how much the company is financed by debt.
Gearing (financial)=
(Prior charge capital )/(Equity capital (including reserves))×100%
Prior charge capital is capital which has a right to the receipt of interest or of preferred dividends in precedence to any claim on distributable earnings on the part of the ordinary shareholders.
Gearing (financial)=(
Market value of prior charge capital)/(Market value of equity+Market value of prior charge capital)×100%
Gearing (operational).
Gearing (operational). This shows indirectly the level of fixed costs incurred by a business. If operational gearing is high, then a business’s cash flows are likely to fall significantly if sales fall (because it has a high level of fixed costs)
Operational gearing = Contribution/PBIT
Investor ratios.
Investor ratios. Investors may either be seeking income (in the form of dividends; and/or capital growth (in the form of an increase in the share price). Total shareholder return (TSR). Dividend yield. Basic EPS. Dividend cover. Dividend pay-out rate. Price/earnings (P/E ratio). Interest cover. Interest yield.
Total shareholder return (TSR).
TSR measures the actual return generated by a company, this can be compared to the expected return (ie the cost of equity) to evaluate whether TSR is acceptable to shareholders.
TSR= (Dividend per share+capital gain (or loss))/(Share price at the start of the year) x100
Dividend yield.
This ratio gives the cash return on the investment (valued at current market value) (useful for income-seeking).
Low yield: the company retains a large proportion of profits to reinvest
High yield: This is a risky company or slow-growing (a low share price can explain high dividend yield)
Dividend yield= DPS/(Market price per share) x100%
Basic EPS.
Investors look for growth; earnings levels need to be sustained to pay dividends and invest in the business
EPS= (Profit after interest,after tax and after preference dividends)/(Number of ordinary shares in issue)
Dividend cover.
Shows how easily it was to pay this years dividend, and so how likely it is to be maintained at the current level in future years should earnings dip. Variations are often due to maintaining dividends when profits are declining.
Dividend cover= EPS/DPS
Dividend pay-out rate.
Dividend pay-out rate. A converse of dividend cover. It shows portion of profit paid out to investors in the form of dividend.
Dividend payout rate=
(Cash dividend per share)/EPS x100%
Price/earnings (P/E ratio).
The higher the better: it reflects the confidence of the market in high earnings growth and/or low risk. P/E ratio will be affected by interest rate changes, a rise in rates will mean a fall in the P/E ratio as share become less attractive. P/E ratio also depends on market expectations and confidence.
P/E ratio= (Current market price per share)/EPS
Interest cover.
Considers the number of times a company could pay its interest payments using its profit from operations (generally 3 is safe but depends on business).
Interest cover=PBIT/(Interest expense)
Interest yield.
Interest yield= (Coupon rate)/(Market price ) x100%
Ratio limitations.
Factors affecting comparability:
• Different accounting policies. E.g. One company may revalue its property; this will increase its capital employed and (probably) lower its ROCE. Others may carry their property at historical cost.
• Different accounting dates. E.g. One company has a year ended 30 June, whereas another has 30 September. If the sector is exposed to seasonal trading, this could have a significant impact on many ratios.
• Different ratio definitions. E.g. This may be a particular problem with ratios like ROCE as there is no universally accepted definition
• Comparing to averages. Sector averages are just that – averages. Many of the companies included in the sector may not be a good match to the type of business being compared. Some companies go for high mark-ups, but usually lower inventory turnover, whereas others go for selling more with lower margins.
• Possible deliberate manipulation (creative accounting). Different managerial policies e.g. different companies offer customers different payment terms
• Use of historical/ out of date information. Might be of limited use if business has recently undergone or is about to undergo substantial changes
• Ratio analysis on its own is not sufficient for interpreting company accounts.
Compare ratios with:
Compare ratios with
• Industry averages
• Other businesses in the same business
• With prior year information
High Gearing problems.
The higher a company’s gearing, the more the company is considered risky. An acceptable level is determined by comparison to companies in the same industry. A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength.
The best-known examples of gearing ratios include
• debt-to-equity ratio (total debt / total equity),
• interest cover (EBIT / total interest),
• equity ratio (equity / assets), and
• debt ratio (total debt / total assets).
Dangers associated with high gearing:
- Need to cover high fixed costs, may tempt companies to increase sales prices and so lose sales to competition
- Risk of non-payment of a fixed cost and litigation
- Risk of unsettling shareholders by having no spare funds for dividends
- Risk of lower credit rating
- Risk of unsettling key creditors
Debt v Equity things to consider when raising finance
These are the things you need to think about when asked about raising finance - so just put all these in your answer and link them to the scenario.
• Gearing and financial risk. Equity finance will decrease gearing and financial risk, while debt finance will increase them
• Target capital structure. The aim is to minimise weighted average cost of capital (WACC). In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from the costs of financial distress)
• Availability of security. Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specified class of assets).
• Economic expectations. If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are more attractive than when difficult trading conditions lie ahead.
• Control issues. A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors.
The factors considered when reducing the amount of debt by issuing equity :
As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the associated costs. Companies with high levels of financial distress would find it more costly to contract with their stakeholders. For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods or larger discounts, and may have to accept supplies on more onerous terms.
• Less financial distress may therefore reduce the costs of contracting with stakeholders.
• Having greater equity would also increase the company’s debt capacity. This may enable the company to raise additional finance
• On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits, known as the tax shield. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants.
The dividend decision
The dividend decision is related to how much a firm has decided to spend on investments and also to how much of the finance needed for investments is being raised externally (financing decision); this illustrates the interrelationship between these key decisions.
Dividend capacity
Dividend capacity is the cash generated in any given year that is available to pay to ordinary shareholders (free cash flow to equity).
Dividend capacity=
profits after interest,tax and preference dividends-
debt repayment,share repurchase,investment in assets+
depreciation,any capital raised from new share issues or debt
General factors affecting dividend policy.
When deciding on the dividends to pay out to shareholders, one of the main considerations of the directors will be the amount of cash they wish to retain to meet financing needs. The decision will also be influenced by:
• The need to remain profitable. Dividends are paid out of profits, and unprofitable company cannot go on indefinitely paying dividends out of retained profit made in the past.
• The law on distributable profits. Companies legislation may make companies pay dividend out of accumulated net realised profits. The government may impose direct restrictions on the amount of dividends that can be paid.
• Any dividend restraints imposed by loan agreements and covenants.
• The effect of inflation. There is need to retain some profit to maintain businesses operating capability.
• The company’s gearing level. The sources of funds used should strike balance between equity and debt finance.
• The company’s liquidity position. Dividends are cash payment, so company must have enough to pay.
• The need to repay debt in the near future.
• The ease with which extra finance from other sources can be raised.
