Accounting Ratios Flashcards

1
Q

Statement of financial position (balance sheet) - summary:

A
  • 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
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2
Q

Non-current assets - key points:

A
  • 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’.

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3
Q

Income statement (P&L account) - key points:

A
  • 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
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4
Q

Non-current assets and depreciation - key points:

A
  • 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
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5
Q

Current assets - key points:

A
  • 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
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6
Q

Cash flow statement - key points:

A
  • 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.
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7
Q

Free cash flow formula

A

Oprating cash flow / net cash AFTER deducting capital expenditure

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8
Q

Accounting ratio limitations - key points:

A
  • 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
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9
Q

Accounting Ratios - statement of financial position -

Profitability

Operating profit

Net profit

Profit margin

A
  • 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.

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10
Q

Return on equity - formula and use:

A

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.

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11
Q

Return on Capital Employed - formula and use:

A

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.

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12
Q

Asset turnover and profit margin - key points:

A

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.

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13
Q

Profit volatility - key points:

A
  • 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
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14
Q

Financial leverage (AKA debt to equity ratio, AKA gearing ratio) - key points and formula:

A

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)

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15
Q

Operating leverage - key points and formula:

A

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.

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16
Q

Interest cover - key points and formula:

A
  • 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

17
Q

Liquidity - working capital/ current ratio - key points and formula:

A

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.

18
Q

Z-Score - summary:

A
  • Can help to predict collapse of company over 1 year period.
  • Less accurate over loneger periods (5+ years)
19
Q

Operational efficiency - industry specific calculations:

A
  • 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
20
Q

Share capital, share premium and reserves - key points:

A

*

21
Q

P/E ratio - key points:

A
  • 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.
22
Q

EPS - key points:

A
  • Earnings per share
  • Calculated by dividing net income (earnings) by the number of shares in issue
  • Measures profit available to ordinary shareholders
23
Q

Dividend yield - key points:

A
  • 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.
24
Q

Price-to-book ratio - key points:

A
  • 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
25
Q

NAV - key points:

A
  • Net asset value per share
  • Calculated as the total net assets of the company (less any preference shares) divided by the number of ordinary shares in issue
  • Ordinary shares in most companies trade at a premium
  • Useful to indicate the minimum price shares should trade, and provides the underlying value of a property company/ investment trust
26
Q

Dividend cover - key points:

A
  • Calculated as the EPS/ dividend per share
  • Indicates how many times the dividend could be paid out of current earnings
  • The higher the dividend cover, the less likely that dividends will reduce if profits fall
27
Q

Where a company announces a share rights issue iffers a low price on new shares - what may be the reasoning for offering new shares at a low price?

A
  • The company needs to raise capital quickly to refinance the company/pay off debts, perhaps because it has come under pressure from interest rates or creditors.
  • The (deep) discounted rights issue will not require underwriting because the nil paid are virtually guaranteed to have a positive intrinsic value.
  • It will reduce the trading price to a more ‘desirable’ level and bring it down to more accessible level - by introducing more shares.
28
Q

Rights issue - key points:

A
  • A rights issue is an invitation to shareholders to buy nw shares in proportion to their existing holding of shares (pre-emption rights) - ensures existing shareholders are always given first refusal on new shares.
  • Rights issues are often not good news, are typically done in order to repay a debt or refinance the company.
  • Rights issues are described as a ratio between new and existing shares and are offered at a discount to the existing market price of the shares.
  • E.g. 1:4 rights issue, shareholders can buy one additional share for every four held.
29
Q

Theoretical nil paid price - definition:

A
  • The ‘theoretical nil paid price’ is the price an investor would (theoretically) pay for the right to buy a discounted share (in the rights issue).
  • Nil paid price is the difference in ‘theoretical ex-rights price’ and share price of existing shares and the subscription price.
30
Q

Swallowing the Tail - definition:

A

Some investors may want to sell some of their rights and take up the offer with the money they make. This is called Swallowing the Tail, and it uses the following formula:

number of rights x subscription price / theoretical ex-rights price = number of rights you need to sell to take up the remainder

31
Q

Bonus issue - definition:

A
  • A bonus issue is a method of issuing new shares to the existing shareholders where new shares are issued without cost (there is no new equity investment needed).
  • Effect of a bonus issue is to dilute the existing market price of a share and has the effect of reducing the price and making it more attractive to investors.
32
Q

Share splits and consolidations - key points:

A
  • Share split is where shares in issue are split into a greater number, each with a smaller nominal value: one £2 ordinary share is split into two £1 ordinary shares
  • The effect is the same as a bonus issue: the total value of the company is spread over a larger number of shares (with a lower market price).
  • The opposite of a share split is a share consolidation, where existing shares are consolidated into a smaller number, each with a higher nominal value (as RBS did in 2012 after the credit crisis when the share price dropped so low).
33
Q

Buy-back process - key points:

A
  • The purchase by a company of its own shares is called share buy-back.
  • Regulatory as well as shareholders approval is required before a company is allowed to buy back its shares, but this can be done.
  • in fact, business protection policies on directors/ shareholders for company share buy-back can be put in place - and this is where it is used most frequently.
  • Buy-backs increase share price for a couple of reasons, broadly by reducing the number of shares in the market.
34
Q

Explain TWO differences between company warrants and covered warrants:

A
  • A company warrant is issued by a company and relates to itself; whereas a covered warrant is issued by a financial institution and relates to other copanies than that from the issuer.
  • A company warrant is based on one company; whereas a covered warrant may be issued on one underlying security, but also against indices, sectors or groups of securities.
  • Company warrants are calls (option to buy only; whereas covered warrants can be calls and puts (option to sell).
  • The risk of covered warrants is reduced because the issuer must hold the underlying securities (‘covered’), but there is still some risk if the issuer fails.
35
Q

Principal features of The Alternative Investment Market (AIM):

A
  • Launched in June 1995
  • Currently lists circa 1,000 companies with total market cap of c £93bn
  • Many AIM companies lack true liquidity (sometimes any liquidity)
  • Lower listing standards and lighter touch regulation than for the main LSE market - is a criticism of the AIM market
  • Lower listing fees and ongoing costs than for the main LSE market