Accounting: Analysing Companies Flashcards
What ratios are used to measure earnings compared to sales and what are the formulas?
Operating Margin:
Operating profit is the profit made after paying the operating cost of goods sold as well as general and administrative expenses. It excludes the effects of investments, financing (interest expense) and tax.
Operating profit / sales
Net Margin:
Net profit margin (also called profit margin) measures the percentage of net income of an entity to its net sales. It represents the proportion of sales that is left over after all relevant expenses have been adjusted.
Net profit after taxation / Sales
What ratios are used to compare profits relative to the levels of equity and assets used to achieve the profits?
ROE:
A measure of profitability of the shareholders’ investment. So, ROE measures the percentage return the company is achieving on the amount of funds provided by shareholders.
Net profit after tax / Total equity
ROCE:
determines how much the company has earned from the total of the different types of capital it has employed, such as equity, or long- or short-term borrowings
Profit before interest and tax / capital employed
Why is ROCE a better comparison of companies than ROE?
because ROE is heavily affected by differences in company capital structure (the degree to which a company is funded by debt and/or equity).
For ROE, what three elements makes up make up the definition of ‘equity’ for the return on equity formula.
- Shareholders’ capital.
- Reserves.
- Retained profits.
Describe briefly what is measured by the ROE metric.
- Ability to generate;
- profit.
- How efficiently it uses;
- shareholders’ funds/capital.
- Relative performance within sector/against peers.
How would increased borrowing effect ROE and ROCE?
High levels of borrowing would increase ROE but decrease ROCE as ROCE contains long term borrowing in the denominator.
How may an analyst understand why ROCE has decreased?
ROCE is comprised of asset turnover x profit margin, so they could assess these to see if there has been a change.
What does asset turnover measure?
Sales / Capital Employed
Measures how efficiently a company uses its assets to produce sales. The higher the number is, the better.
If a company can generate more sales with fewer assets, it has a higher turnover ratio and this indicates that it is using its assets efficiently. On the other hand, a low turnover may indicate that the business should either use its assets more efficiently or sell them.
It also indicates pricing strategy: companies with low-profit margins tend to have high-asset turnover, while those with high-profit margins have low asset turnover.
two ratios used to measure profit volatility?
Financial leverage and operational leverage
Formula and interpretation of financial leverage?
(Long-term loans + preference shares) / (Total equity−preference shares)
Ratio of debt to equity, commonly referred to as ‘gearing’. This measure indicates, among other things, the sensitivity of a company’s profits to changes in interest rates.
Generally, gearing above 100% is considered too high.
What are the effects of gearing on profits?
High gearing exaggerates changes to ROE. When profits are high, high gearing boosts ROE, which is the main reason why companies gear. But if profits fall, ROE falls faster and further for a highly geared company than for a lower geared company. This is because the proportion of equity used in funding the company is lower.
If revenues decline, a highly geared company is less likely to be able to raise new loans to fund any corrective actions needed to maintain sales and profits. Where loans can be raised, above-average interest rates may have to be paid to reflect the additional risk.
A rise in interest charges also increases costs more for highly geared, more indebted companies. The exceptions are those companies that have structured their loans at competitive fixed rates, but this effect may only be short-term.
Financial leverage is achieved by borrowing money to invest in an asset or business. The goal is to increase the return on investment (ROI) by using borrowed funds to generate a higher return than the cost of the debt.
What are the significance for investors when companies are highly geared?
- If interest rates go up, costs go up, reducing ROE.
- If losses ensue, gearing levels deteriorate further, because equity will be reduced.
- A company may then find itself unable to raise funds either by borrowing or selling shares, or, if it can, only at an extremely high cost, which affects the results for years to come.
Formula and interpretation of operational leverage?
Fixed costs / Variable costs
Operating leverage is 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, particularly around the break-even point.
There is 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. An indirect measure is the company’s break-even point (where costs equal revenue). The higher this point is, the higher the company’s leverage will be
Two formulas to measure liquidity?
Current ratio and liquidity ratio
Analysis of Current ratio?
Current assets / current liabilities
Shows that sufficient cash will be generated from current assets in the course of normal business to pay off all the creditors.
current ratio should be between 1.5 and 2, although this depends on the type of business and the prevailing economic conditions. A low ratio for a particular business may indicate a potential future insolvency.
At the other extreme, a business may have too much working capital, which usually means that assets are not being used as profitably as they could be.
