Analysis and Interpretation of Ratios Flashcards
Relation between profitability and leverage
- A profit increases the level of equity, and therefore changes the leverage ratio.
- level of profitability and the cost of borrowings.
If returns generated from the borrowed funds exceed the interest cost of borrowing, the higher the leverage the better the profitability.
If returns generated from the borrowed funds are below the cost of borrowing, then the higher the leverage the lower the profitability - The greater the level of liquidity the higher the ** level of leverage that an entity can safely
sustain.**
This is because if creditors seek their funds the organisation can more readily pay them
without selling non-current assets.
what are the two market based ratios?
Price earning ratio (P/E ratio):
Dividend Yield
Market-based Ratio
- Price Earning Ratio (P/E ratio)
Formula
Market Price per ordinary share/earnings per share
Market-based Ratio
- Price Earning Ratio (P/E ratio)
To judge whether a P/E ratio is high (overpriced) or low (underpriced), what two main factors need to be taken into account?
It’s difficult to decide whether a particular P/E is
high or low without taking into account two
main factors:
- Company growth rates
- Industry P/E ratio
Market-based Ratio
- Price Earning Ratio (P/E ratio)
What is it?
Price earnings ratio shows the amount investors are prepared to pay per dollar of earnings.
It also reflects
market expectations for a company’s growth.
Market-based Ratio
Dividends Yield
Formula
Dividends per ordinary share/ market price per ordinary share
Market-based Ratio
Dividends Yield
It can be compared with?
- Competitors
- Current interest rate
- Industry average
whether annual return is attractive to investors who aim to maximise their return
Market-based Ratio
Dividends Yield
What is it?
is amount of dividends shareholders will receive in relation to the share price.
What are limitations of ratio analysis?
- Ratios are as accurate as financial statements
- Ratios offer restricted view of ‘relative’ performance and position (statement of financial position is fixed at a particular point of time)
- Need to compare with benchmarks
- two businesses are identical
and the greater their differences, the greater the limitations of
ratio analysis as a basis for comparison
Common size statements express
balance sheet items as a percentage of total assets
income statement items as a percentage of sales
cash flow statements items as a percentage of cash receipts from customers
if user wishes to compare ratio between business over time, it is essential that the ratios
be calculated on a consistent basis
profitability measures include
Rate on assets (ROA)
Rate on equity (ROE)
net profit margin
gross profit margin
earnings per share
Describe ROA
ROA indicates how effective are funds invested in assets in generating profit. Higher ROA percentages are preferred as assets are used more efficiently to generate profit.
ROA formula
Describe ROE
Return on Equity (ROE) measures how effectively shareholder’s equity is used to generate profit. The higher the ROE, the more efficiently the company is using its investor’s funds to generate profit
ROE formula
Gross profit margin
The gross profit margin is a measure of the business’s profit margin and control over production costs
Gross profit/ sales
describe net profit margin
provide formula
Net profit margin measures net profit as a proportion of sales revenue.
net profit/ sales revenue
describe earnings per share
Earnings per share measures the amount of profit earned per outstanding share of company stock
what is earnings per share used for?
The trend in earnings per share over time is used
to assess the investment potential of a company’s
shares
Only important in comparison to previous EPS not
other companies’ EPS. Why?
A company’s financing decisions may impact on its
EPS considerably.
measures of efficiency
- Asset turnover: efficiency of total assets
- Inventory turnover: efficiency of current assets
- Accounts receivable turnover: efficiency of current assets
- Accounts payable turnover
Efficiency- inventory turnover
formula
Efficiency- inventory turnover
what does this measure
Inventory turnover in days (average inventory
turnover period): shows the average number of
days to convert inventories to sales
Efficiency - accounts receivable turnover
this measures
Accounts receivable turnover in days (Average settlement
period for accounts receivable): shows the average time taken to collect accounts receivable.
Efficiency- accounts receivable turnover
formula
Efficiency- accounts payable turnover
what does this measure?
Efficiency- accounts payable turnover
formula
Efficiency turnover in times
the relation between profitability and efficiency
measures of liquidity
Assess how well the business can meet
short-term obligations or claims against
the assets when they fall due
Three ratios are commonly used to assess
short-term liquidity risk:
current ratio
quick ratio
cash flow from operations to current liabilities
Liquidity current ratio
describe and provide formula
liquidity - quick ratio
describe and provide formula
Liquidity - Cash flow from
operations to current liabilities ratio
describe and provide formula
Relation between profitiability and liquidity
Profit is one of the major sources of funds and
therefore profit can increase liquidity
Nevertheless there can also be an inverse
relationship between liquidity and profitability:
Liquid assets such as cash, accounts
receivable and inventories may produce
_relatively little profit _
Illiquid assets such as plant and machinery
can substantially increase profit
what is financial leverage (gearing)?
: occurs when a
business is partly financed by outside parties
(creditors).
The level of gearing, or the extent to which a
business is financed by outside parties is an
important factor in assessing risk
Why a business would want to take on gearing?
- Gearing may be used to adequately finance the business when owners have insufficient funds
- Increase the returns to owners - provided that the returns generated from the borrowed funds _exceed the interest cost of borrowing _
what ratios may be used to
evaluate the gearing/long term financial
solvency of a business?
- Debt to total assets (gearing/leverage
ratio) - Cash flow from operations to total
liabilities - Interest cover ratio
Leverage
- Debt to total assets ratio
describe
provide formula
Leverage : Cash flow from operations to total
liabilities ratio
describe
formula
Leverage - Interest cover ratio
describe
formula
Relation between leverage and liquidity
The greater the level of liquidity the higher the
level of leverage that an entity can safely
sustain.
This is because if creditors seek their funds the
organisation _can more readily pay them
without_selling non-current assets.
Organisations need to be very careful about
the impact of changes in the liquidity on
leverage levels.
