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IFAI > Campbells notes - RATIOS > Flashcards

Campbells notes - RATIOS Flashcards

1
Q

General
The purpose of accounting ratios is to measure the performance in terms of what?

A
  1. Profitability
  2. Liquidity and the overall financial strength of the company
  3. use of Assets
  4. Investment opportunities (trends & potential growth)
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2
Q

General
What can ratios be used to do and who could use them?

A
  1. To establish the CREDIT WORTHINESS of debtors
  2. By INVESTORS who wish to consider relative merits of a portfolio of investments
  3. By BANKS AND OTHER LENDORS who may wish to consider granting a loan
  4. By AUDITORS when conducting an analytical review
  5. By MERGER AND ACQUISITION teams
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3
Q

General
An accounting ratio on it’s own is of little use. What would you need to make it useful?

A

A comparative. Either:
1. past performance
2. The performance of a similar (like for like) business. e.g. comparison between Morrison and Asda would be useful, B&Q and Asda not so much.

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4
Q

General

What is a horizontal analysis?

A

This is a comparison over time - usually two or more years. The key focus is on change and the accountant can use this to assess the performance of a business.

How to do it - Take year 1 figs away from year 2, divide the difference by year 2 to get the % increase or decrease. Could be a plus or minus percentage.

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5
Q

General

What is a vertical analysis?

A

This is a comparison over time - using either the p&l or statement of financial position. It is also known as a common size analysis.

How to do it -
If using the Statement of Profit and Loss, calculate the expenditure as a percentage of the revenue.

If using the Statement of Financial Position, calculate the assets as a percentage of the total asset. Calculate the liabilities as a percentage of the equity and total liabilities.
USE THE BALANCED / MATCHING FIGURE

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6
Q

General

What are two advantages of using vertical analysis?

A
  1. In the Profit and Loss, the managers can see how the business is consuming sales revenue
  2. An analysis of the Statement of Financial Position helps managers understand the importance of each asset and liability within the business.
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7
Q

General
What are the 6 ratios which can be used for EFFICIENCY comparisons?

A

PARIQ
1. P - Payable days/turnover
2. A - Asset turnover ratios (TAT / NCAT / NAT)
3. R - Receivable days/turnover
4. I - Inventory days/turnover
5. Q - Quick and current ratio

NB - By calculating the payable, receivable and inventory days, you can work out the cash operating cycle.

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8
Q

General
What are the 6 ratios which can be used for PROFITABILITY comparisons?

A

GONRRR

  1. Gross profit margin
  2. Operating profit margin
  3. Net profit margin
  4. Return on Capital employed
  5. Return on total assets
  6. Return on Shareholder Equity

Remember
3 x margin ratios
and
3 x returns (ROCE / ROSE / ROA)

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9
Q

General
What are the 4 ratios which can be used for CAPITAL STRUCTURE comparisons?

A

CEII
1. CAPITAL GEARING (also known as total or financial)
2. EQUITY GEARING
3. INTEREST COVER RATIO
4. INTEREST GEARING %

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10
Q

General
What are the 6 ratios which can be used for INVESTMENT AND COMPANY VALUATION comparisons?

A

DPD DED
1. Dividend Cover
2. Dividend PayOut Ratio
3. Price Earnings Ratio

  1. Dividend Yield
  2. Earnings per Share
  3. Diluted Earnings per Share
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11
Q

Profitability

What could be the cause if the gross profit percentage decreases?

A

Cause of a fall in gross profit percentage could be:

  1. Discounts - reduced selling prices
  2. Increased purchase price
  3. Stock losses caused via theft, damage, reduction in value
  4. Cash losses
  5. Accounting Error

If it is found that there have been no discounts, stock written down, stock write offs or increases in purchase costs, the fall should be investigated.

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12
Q

Profitability

What is the formula for gross profit %

A

Gross Profit / revenue x 100

(Gross profit being revenue - cost of sales)

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13
Q

Profitability

What is the formula for net profit %

A

Net Profit / revenue x 100

(Net profit being profit for period)

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14
Q

Profitability

What is the formula for operating profit margin?

A

Operating Profit / Revenue x 100

(Operating profit being revenue - cost of goods sold - operating expenses)

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15
Q

Profitability

If there has been a fall in the net profit percentage, expenses ratios may help identify whether a particular expenses is the cause for concern. What would be the formula for the expenses ratio?

A

Expense Item / Revenue x 100

(expense item could be things like wages, office expenses and rent and rates)

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16
Q

Profitability

What is the formulas that you can use to calculate Return on Capital Employed?

A

Profit from operations (OP) - preference dividends / Debt + Equity x 100

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17
Q

Profitability

What does Return on Capital Employed Measure?

A

ROCE measures profit from operations as a percentage of the capital (resources) used by a business. Comparisons can then be made with the returns made by similar companies with other investment opportunities.

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18
Q

Profitability

What are 2 of the pitfalls of using ROCE as a comparison?

A
  1. Using ROCE, profit can be manipulated. For example, by reducing discretionary expenses such as depreciation.
  2. Comparison of ROCE may be meaningless if different companies follow different accounting policies. For example, one company may charge all R&D costs as an expense while another may choose to capitalise development costs. In this instance, the 2nd company would be able to report higher profits and it would distort the comparison.
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19
Q

Profitability

What is the formula for Return on Shareholder Equity?

A

Net Profit / Equity x 100

Net Profit is Profit for the Period

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20
Q

Profitability

What does Return on Shareholder Equity Measure?

A

ROSE ratio measures they company’s ability to provide returns to its equity holders / shareholders.

The higher the ratio, the more favourable it is for the company.

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21
Q

Profitability

What is the formula for Return on Assets ratio?

A

Operating Profit / Total Assets x 100

22
Q

Profitability

What does Return on Total Assets ratio measure?

A

The Return on Assets ratio (RAO) evaluates how effectively the assets of the company are used in comparison to the profit earned. Economies of scale help in improving this ratio.

The higher the ratio, the more favourable it is for the company.

23
Q

Efficiency

What is the formula for Stockturn (also known as Inventory Turnover)?

A

Cost of sales / average inventory

(Average inventory being opening and closing inventory / 2. NB If closing inventory is the only available stock figure, use this as the average).

24
Q

Efficiency

What does Stockturn (Inventory Turnover) measure?

A

This measures the number of times in a year that a business can turn over its inventory. A fall in the number of times could be due to increased stock holdings.

25
Q

Efficiency

What is the formula for Inventory Days and what does the formula measure?

A

Inventory / COST OF SALES x 365

The formula measures the number of days the stock is held.

26
Q

Efficiency

What is the formula for Payable Days and what does the formula measure?

A

Trade Payables / CREDIT PURCHASES x 365

The formula measure the number of days the organisation takes to pay its creditors (supplier etc).

In order to maintain good working capital, it is good practice to take slightly longer to pay creditors than it takes for debtors to pay the business.

27
Q

Efficiency

What is the formula for Receivable Days and what does the formula measure?

A

Trade Receivables / CREDIT SALES (or revenue) x 365

The formula measure the number of days it takes for creditors to the company to make payment.

In order to maintain good working capital, it is good practice to take slightly longer to pay creditors than it takes for debtors to pay the business.

28
Q

Efficiency

How do you calculate the cash operating cycle?

A

Work out the number of days the inventory is held, add on the number of days the receivables are paid, take off the number of days the payables are made. This will then give an average total of cash operating cycle for the year.

NB - Much more complicated for manufacturing and WIP including raw materials.

29
Q

Efficiency - Liquidity Ratios

What is the formula for current ratio (also known as the working capital ratio) , why is it important and what does it measure?

A

Current Assets / Current Liabilities

The current assets represent the ability of the business to raise cash, while the current liabilities represent amount due that have to be settled within the next accounting period.

There should always be enough current assets to cover the current liabilities.

The acceptable ratio depends upon the nature of the business, but generally a ratio of 1.5 : 1 is considered to be satisfactory. This would mean that for every £1.50 of assets, the business would have £1 liability. A higher current ratio is always more favourable than a lower current ratio because it shows the company can more easily make debt payments.

30
Q

Efficiency - Liquidity Ratios

What is the formula for the Quick Ratio (also known as the liquid capital ratio or acid test). What differs between this ratio and the current ratio?

A

Current Assets - Inventory / Current Liabilities

Like the current ratio, this measures a businesses liquidity however it is considered to be the better of the two ratios as it cannot be assumed that all inventory will always be sold for its net book value (if at all).

Generally, a ratio of 1:1 is considered acceptable.

31
Q

Efficiency

What is the formulas for the Asset Turnover ratios and what do they measure?

A

Total Asset Turnover
Revenue / Total Assets

Non-current Asset Turnover
Revenue / Non-Current Assets

Net Asset Turnover
Revenue / (debt + equity)

(Net assets are equal to total assets - current liabilities. If no information is provided, it is acceptable to use the closing figure for assets as an average for the year)

The asset turnover ratios measure the performance of the business in terms of the level of activity to the level of the assets employed.

The answers is expressed as ‘times’.

32
Q

Efficiency

Asset Turnover Ratios - What could a high asset turnover ratio indicate?

A

A high asset turnover ratio is favourable and through time, as a company becomes more efficient, the asset ratio should increase upwards. However, the effect of depreciation needs to be taken into account. If there is no renewal of property, plant and equipment, there will be a fall in net book value. This will have an effect of improving the asset turnover ratios but will create a false impression of good performance. It is known as ‘sweating the assets’ and a company that adopts this policy can become uncompetitive in the long term.

33
Q

Capital Structure

What does the Gearing Ratio measure and why is this important?

A

The gearing ratio measure the amount of debt to equity. It shows how much capital is provided from external sources compared with shareholders contributions.

It is important as it is a measure of risk. A company with very high levels of debt in proportion to equity may be considered at a greater risk of failure.

34
Q

Capital Structure

What could the debt & equity of a company comprise of?

A

DEBT
1. Debentures
2. Long term loans
3. Preference shares
4. Overdraft (only if this is to continue to be for more than one year)

EQUITY
1. Ordinary shares
2. Retained profits
3. Other Reserves

35
Q

Capital Structure

What is the formula for Capital Gearing (also known as Financial or Total Gearing) and what are the markers for being low geared, neutral and highly geared?

A

Debt / Equity + Debt x 100
Low geared = Less than 50%
Neutral = 50%
Highly geared = More than 50%

36
Q

Capital Structure

What are the advantages and disadvantages of being highly geared?

A

Disadvantages

  1. Debenture interest must be paid whether or not the company makes a profit. If the company fails to pay interest, the debenture holder can make a claim on its assets forcing liquidation.
  2. Lenders will be less likely to make a loan to a highly geared company because they are seen to be too risky.

Advantages

  1. Generally, interest is cheaper than dividends.
  2. There is no loss of control.
  3. Debenture interest is an expense and is deductible against tax. There is no tax relief on dividends paid to shareholders.
37
Q

What is the formula for equity gearing?

A

Debt / Equity x 100

38
Q

Capital Structure

What is the formula for Interest Cover Ratio and what does it measure?

A

Profit from operations / finance costs

Expressed in ‘times’ it measures the extent to which profit can fall before a business is unable to meet the interest payable on loans.

39
Q

Capital Structure

What is the formula for Interest Gearing Ratio and what does it measure?

A

Interest expenses / Profit from operations x 100

It shows the interest as a percentage of profit from operations.

40
Q

Capital Structure

Why are preference dividends considered debt?

A

Source of debt with accountants whether preference shares should be regarded as equity or debt. Generally, consensus has come down on the side of debt for the following reasons:

  1. Preference shareholders do not enjoy voting rights.
  2. Preference dividends are fixed.
  3. Preference shares are paid before the ordinary dividend.
  4. Some preference shares are redeemable.
41
Q

What is the formula for Operating Gearing and what does it measure?

A

Fixed costs / variable costs

It measure the proportion of fixed costs a company has relative to its variable costs. As with financial gearing, fixed operating costs increase the risk to shareholders in the same way as fixed interest payments.

42
Q

Investment and Company Valuation

What is the formula for Earnings per Share Ratio and what does it measure?

A

Profit attributable to equity s/holders for the year / weighted average no. of shares during the year

It is used as a measure of profitability and always needs to be stated on the face of the Statement of Profit and Loss in the company accounts for a limited company.

43
Q

Investment and Company Valuation

Why is Earnings per share of considerable importance to investors?

A

It is important as it is used to:

  1. Compare the performance of the company over a period of time.
  2. Compare the performance of the company’s shares with that of similar companies.
  3. To prepare a P/E (Price Earnings) Ratio - this may be used to place a market value on the shares of an unlisted company.
44
Q

Investment and Company Valuation

What are the 5 ways in which a change in the number of shares can affect the EPS calculation?

A
  1. NEW ISSUE of shares for cash
  2. BONUS ISSUE (an allocation of shares to existing shareholders)
  3. DEBT IS CONVERTED to shares
  4. New shares as part of a SHARE FOR SHARE EXCHANGE (as in a takeover)
  5. RIGHTS ISSUE (i.e. new shares are offered to existing shareholders below the current market price)
45
Q

Investment and Company Valuation

What must you take into consideration for EPS if a new issue is made at full market value? Briefly explain how this would be applied.

A

If a new issue is made during the year, additional profits generated will only apply from the time the new shares have been issued. This means that an adjustment needs to be made for the fraction of the year based on the date of the share issue.

Example of how you would apply this.

Find out the weighted average no. of shares. E.g. No. of shares at the start of year / 12 x how many months before new issue of shares, then no. of shares at the end of the year /12 x how many months of the year = weighted average no. of shares. Add 2 figures together and use this weighted average as total number in issue when you calculate the EPS.

46
Q

Investment and Company Valuation

What do you need to take into consideration when calculating EPS if a rights issue has taken place? Explain how you would do this.

A

A rights issue occurs when a company makes a new share offer to existing shareholders at a rate which is below the current market price. The following procedure should be adopted when calculating EPS (the procedure applies the rules if IAS 33)

  1. Calculate the theoretical ex rights price per share
  2. Adjust the EPS for the previous period
  3. Calculate the EPS for the current period

STEP 1 - Work out the actual correct price of the shares based on market value (e.g. 4 shares at £2 per share = £8), then work out the price of right issue (e.g. 1 share at £1) - add together (£8+£1 /5) and divide by the total number of shares.

STEP 2 - Work out the EPS for previous period then use the following formula

Theoretical ex rights price per share / market price per share x EPS worked out in step 3.

STEP 3 - Calculate the EPS for the current period (taking into account the fraction of the year if necessary)

47
Q

Investment and Company Valuation

What do you need to take into consideration when calculating EPS if a bonus issue has taken place? Explain how you would do this.

A

This is less complicated than a rights issue as it does not involve the company receiving any additional capital. The company gives free shares to existing shareholders and offsets this against reserves (e.g. the share premium). However if EPS is to be used for comparative purposes, it must be adjusted to take account of the bonus issue. To do this, you calculate EPS for the previous year as if the bonus issue has already been made (e.g. add in the Shares into the previous year and do calculation).

48
Q

Investment and Company Valuation

What do you need to take into consideration when calculating a fully diluted EPS when a debenture has been issued? Explain how you would do this.

A

Some companies issue debentures that may be exchanged for shares at a future date (also known as convertible debt). An adjustment must be made if you are looking to compare the EPS to a previous year.
Important to note that Debenture Interest is allowable against Corporation Tax.

STEPS
Add in the interest saved to previous years profit figures.
Minus tax on interest
Do EPS calculation.

49
Q

Investment and Company Valuation

What is the formula for Price Earnings Ratio? Why is it important and what does it indicate?

A

Market price per share / earnings per share

It indicates the value an investor places upon a share and is very important to a company that wishes to issue new shares.

It is expressed as ‘times’ e.g. 2.1 times means a company would take 2.1 years to generate enough profit to cover the market value of the shares.

The P/E ratio is very important for Financial Decision making and can be used to value an unlisted company. If the shares in a company are traded, the market price per share is known however this is not always the case.

50
Q

Investment and Company Valuation

What is the formula for Dividend Cover (also known as the pay - out ratio) and what does it measure?

A

Profit for the year / Dividend paid

It measure the number of times that a dividend paid is covered by the total net profits.

Expressed as ‘times’

51
Q

Investment and Company Valuation

What is the formula for Dividend Yield and what does it measure?

A

Earnings per share / Market Price of an equity share x 100

It measures the rate of return that a shareholder enjoys based upon the market value of each share.

52
Q
A

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