Accounting Ratios Flashcards
Statement of financial position (balance sheet) - summary:
- The statement of financial position is a snap-shot of a company taken on the last day of the accounting period. It lists the assets and liabilities of a company, and provides a picture of the company’s financial health at the year end.
- Provides shareholders with information on company performance
- Assets are spread between non-current assets and current assets
Non-current assets - key points:
- Long term assets used by the company to generate revenues
- Split between:
- Tangible assets - for use in the production and supply of goods and services (property, plant and equipment)
- Intangible assets - non-physical assets such as patents, trademarks, loyal customer base and company reputation
Intangible assets may be referred to as ‘goodwill’.
Income statement (P&L account) - key points:
- Shows all income and expenditure relating to a company’s period of account, usually lasting one year.
- Summarises income and expenditure for the whole 12 month period (and whether there is a profit or loss).
- Key terms are:
- Gross profit = revenue - cost of sales
- Operating profit = after deducting cost of sales as well as distribution costs and admin expenses from gross profit
- Revenue = represents sales over the period = calculated on an accrual basis
- Net income = total earnings or profit, also referred to as profit after tax
Non-current assets and depreciation - key points:
- Tangible assets held for the long-term
- Cost is charged to the income statement over a number of periods by dividing it by the number of years of capable use
- This is known as depreciation
- Two methods
- Straight line - most used in UK
- Annual dpreciation = original cost - expected residual value / expected useful life
- Reducing method - uses a more complex formula
- Depreciation % rate is applied to book value of the asset
- Straight line - most used in UK
Current assets - key points:
- Bought with the intention of resale or conversion into cash
- Usually within 12 months
- Listed in the statement of financial position at cost or net realisable value (NRV)
- Three common ways companies can account for their stock:
- FIFO - first in first our
- LIFO - last in first out
- Weighted average cost
Cash flow statement - key points:
- Shows the cash received and paid by a company during the accounting period.
- Similar to bank statement; cash is king and shows how healthy the cash in the business is at that time.
- Statement of financial position and income statement are prepared on an accruals basis, meaning they match income and expenditure in the period in which they relate, irrespective of cash movements.
- Profit is a key performance measure, but is not necessarily supported by cash generation, not all income statements have an immediate cash effect.
- Since cash is vital to ongoing viability of a company, we need a statement showing how much cash is generated, what sources have been used and what applications of cash company has made - this is the purpose of the cash flow statement.
Free cash flow formula
Oprating cash flow / net cash AFTER deducting capital expenditure
Accounting ratio limitations - key points:
- Based on historic data
- Using ratios in isolation can be misleading - need to be compared to the ratios of companies in the same sector.
- Ratios take no account of “soft” qualitive factors such as management style
- Accounting data can be manipulated and , by definition, ratios based upon such data wll be false/ misleading
Accounting Ratios - statement of financial position -
Profitability
Operating profit
Net profit
Profit margin
- Two definitions of profit
- Net profit
- Operating profit
- Operating profit = profit after deduction of operating and admin costs. Excludes effects of investments, interest expenses and tax. Also referred to as EBIT in accounts.
- Net profit = what is left to distribute to shareholders after interest and tax is paid.
Profit margin = Profit as a % of total sales. Can work out operating margin or net margin by dividing the above forms of profit by total sales.
Margin is a useful fundamental as it provides indicator of profitability from one year to the next.
Return on equity - formula and use:
ROE measures the return on shareholder investment as a %. The ability to earn consistent above average ROE is the most fundamental characteristic of a good company.
ROE = Net profit / Shareholders’ funds
The return on equity evaluates the profitability from the shareholders point of view, relating to the profit available for distribution as a dividend.
Indicates how efficiently a company’s management has utilised the shareholders’ funds.
ROE is most effectively used when comparing equities with other asset classes such as property or bonds/ fixed interest.
Return on Capital Employed - formula and use:
ROCE is a measure of profitability that is used to indicate how efficiently and effectively a company has utilised its assets during a given accounting period.
Capital employed includes ALL capital, including long-term liabilities.
ROCE = Operating profit / Capital employed
Where:
- Operating profit = EBIT
- Capital employed = total assets - current liabilities (money owed and due for payment within one year of the statement of financial position)
Can be further broken down into two separate components: asset turnover, and profit margin.
Asset turnover and profit margin - key points:
Profit Margin x Asset Turnover = ROCE
Asset turnover is calculated as sales as a % of capital employed.
Key indicator of how efficiently company is using assets to generate profit. Measures how much of the ROCE is from good asset utilisation.
Profit volatility - key points:
- Measures consistency of profits from year-to-year
- Specifically, how sensitive is the company to interest rate changes
- How easily it could pay interest on debts out of current income
- Ratio of fixed costs to variable costs
Profit volatility involves three key measures:
- Financial leverage
- Operating leverage
- Interest cover
Financial leverage (AKA debt to equity ratio, AKA gearing ratio) - key points and formula:
Gearing is a measure of profit volatility as it’s a key indicator of a company’s sensitivity to interest rate changes. Ratios of more than 100% considered high in the UK, but what is acceptable will vary between industries.
- High gearing exaggerates changes to return on equity.
- Where a company has debt it must pay interest before dividend payouts to investors.
- Gearing is a measure of the amount of debt a company has - can be measured as a % of total long-term capital available (debt and equity capital), or as a % of the funds provided by ordinary shareholders.
Financial Leverage = (long term loans + preference shares / (total equity - preference shares)
Operating leverage - key points and formula:
OL considers fixed costs to variable costs. Measures the sensitivity of operating profits to changes in sales volume.
High OL (high fixed costs to variable costs) indicates more volatility around the break-even point.
Low OL (low fixed costs) indicated reduced volatility around B/E point.
Operating leverage = fixed costs / variable costs
Fixed costs above 80% are considered high.
Interest cover - key points and formula:
- This is a measure of profit volatility rather than an investment ratio.
- It gives lenders an indication of the strength of the cover of interest payments - high interest cover gives lenders confidendce
Interest cover = profit before interest and tax / gross interest payable
Liquidity - working capital/ current ratio - key points and formula:
Liquidity demonstrates the ability for a company to repay its debts.
Before understanding liquidity, we need to understand working capital.
- WC measures extent to which claims of short-term creditors are covered by current assets.
- Current ratio = current assets / current liabilities
If WC/ current ratio is less than 1, this indicates current liabilities are greater than current assets - in other words, company is using creditors to finance ongoing working capital needs.
Healthy ratio is considered to be 1.5 to 2 industry dependent.
Too high a ratio might indicate inefficient use of current assets.
Z-Score - summary:
- Can help to predict collapse of company over 1 year period.
- Less accurate over loneger periods (5+ years)
Operational efficiency - industry specific calculations:
- Sales per employee
- Wages as a % of sales
- Admin costs as a % of sales
- Distribution costs as a % of sales
- Assets per employee
- R&D as a % of sales
Share capital, share premium and reserves - key points:
*
P/E ratio - key points:
- Price/Earnings ratio
- Calculated by dividing share price by earnings per share
- Indication of the market’s expectations of the company’s growth potential.
- It is the time, in years, it would take the current EPS to repay the share price
- High P/E omdocates a greater percieved ability to grow EPS compared to competitors, producing higher quality/more reliable earnings, being a potential target, or experiencing a temporary fall in profits.
EPS - key points:
- Earnings per share
- Calculated by dividing net income (earnings) by the number of shares in issue
- Measures profit available to ordinary shareholders
Dividend yield - key points:
- Calculated as the dividend per share as a percentage of the share price
- Used to compare yields to other investments and shares
- Indicates ability to grow dividends in the future. A low yield indicates ability for high growth and vice-versa.
- A high yield indicates a share may be undervalued, and so is often looked out for by value investors.
Price-to-book ratio - key points:
- Calculated as the share price divided by net asset value per share
- Indicates how much shareholders are paying for the net assets of the company
- If trading at a discount, this could indicate share is undervalued, or the market sees it will remain a stagnant investment
- If trading at a premium, this indicates the market views it has above average growth potential
