Ch 35 Analysis of published accounts (A Level)

Question 1

Define profitability ratio

Answer 1

used to asses how successful tha management of a business has been at arning profits for the business from sales and from capital employed

Question 2

Define capital employed

Answer 2

the total value of all long term finance invested in the business. Equal to fixed assets + current assets - current liabilities OR long term liabilities + shareholder’s equity

Question 3

Return on capital employed (ROCE)

Answer 3

(Net/operating profit/capital employed) x 100

Question 4

Points about ROCE

Answer 4

The higher the value of the ratio, the greater the return on the capital invested in the business
The return can be compared both with other companies or past data to identigy trends of profitability
Can also be compared with the return from interest accounts - could the capital be invested in a bank at a higher rate of interest with no risk?
Should be compared with the interest cost of borrowing finance - if it is less than this interest rate, then any increase in borrowings will reduce returns to shareholders
Calculation is not universally agreed => causes problems for comparisons
Not related to the risks involved in the business. A high return may be the result of a successful undertaking with high risk rather than managerial efficiency

Question 5

Possible strategies to increase ROCE

Answer 5

increase operating profit
raise prices
reduce variable costs
reduce overheadsd, such as delayering or reducing promotion costs
reduce capital employed: sell assets that contribute nothing/little to profit
Potential limitations:

demand could be price elastic
cheaper materials -> quality
may not be effective in the long ron
assets may be needed in the future

Question 6

Define financial efficiency ratio

Answer 6

Used to assess how cost-effective the assets/resources are being used by management

Question 7

Inventory turnover ratio

Answer 7

cost of goods sold/value of inventories

Question 8

Points about inventory ratio

Answer 8

Result is not a percentage but the number of times stock turns ober in the time period
The higher the number, the more efficient the managers are in selling stock rapidly. Efficient stock mgmt - such as the use of JIT
The normal result for a business depends on the industry it operates in
For service-sector firms, this ratio has little relevance

Question 9

Days’ sales in receivables ratio

Answer 9

accounts receivable x 365/sales turnover
measures how long, on average, it takes the business to recover payments from customers who have bought goods on credit (debtors)
the shorter the time period, the better the mgmt is at controlling its working capital

Question 10

Points to note about receivables ratios

Answer 10

There is no right or wrong result, it will vary from business to business and industry to industry
A high days’ sales in receivables ratio may be a deliberate mgmt strategy - customers will be attracted to businesses that give extended credit
Value of this ratio could be reduced by giving shorter credit terms or improving credit control => conflict between departments since finance wants all customers to pay asap but marketing wants to increase credit terms for customers to sell more

Question 11

Define shareholder ratios

Answer 11

Financial tools used by prospective investors who are particularly interested in the business activities

give indication of the prospects for financial gain => help with decision making to see if it is bang for the buck

Question 12

Dividend per share

Answer 12

total annual dividends/total number of issued shares

Question 13

Dividend yield ratio

Answer 13

dividend per share x 100 / current share price

Question 14

Points to note about dividend yield ratio

Answer 14

If share price rises, perhaps due to improved prospects for the business, then with an unchanged dividend, the dividend yield will fall
If the directors propose an increased dividend but the share price does not change, then the dividend yield will increase
Rate of return can be compared with other investments such as bank interest rates and dividend yields from other companies
The result needs to compared with previous years and companies operating in the same industry
Directors may decide to reduce annual dividends for retained profts for long term objectives
A high dividend yield may not indicate a wise investment - the yield could be high because the share price has recently fallen

Question 15

Pay out ratio

Answer 15

dividends/ net income

high pay out ratios (low retention of earnngs) imply that the firm lacks growth opportunities, money is paid out to shareholders who can chooe where else to invest

low pay out ratios (high rentention of earnings) imply that the firm has growrh opportunities and want to invest

Question 16

Dividend cover ratio

Answer 16

the number of times the ordinary share dividend could be paid out of current profits. The higher tthe ratio, the more able the company is to pay the proposed dividends

profit after tax and interest / annual dividends

1/ pay out ratio

Question 17

Points to note abot dividend cover ratio

Answer 17

If directors decided to increase dividends to shareholders, with no increase in profits, then this ratio would fall
A low result means the directors are retaining low profits for future investmentand this could raise doubts about the company’s future expansion

Question 18

Price/earnings ratio

Answer 18

Expresses how many years of EPS are needed to buy the share

How much investors are willing to pay per dollar of earnings

Reflects the confidence that investors have in the future prospects of the business

A high P/E ratio suggests that investors are expecting higher earnings growth in the future compared with companies with a low P/E ratio

earnings per share = profit after tax / total no. of shares

current share price / earnings per share

Question 19

Points to note about P/E ratio

Answer 19

Ratio should only be compared with other companies in the same industry since investors may have different levels of optimism about the prospects for different industries
It would not be useful for investors using P/E ratio as a basis for their investment decisions to compare the P/E of a tech company and a utility company
Result shows how much investors are currently willing to pay for each $1 of earnings
Stocks with low P/E are cheap and good investment opportunities if the investors have reason to believe that the pessimism of other investors is wrong

Question 20

Gearing ratio

Answer 20

Measures the degree to which the capital of the business is financed from long term loans. The greater the reliance of a business on loan capital, the more highly geared it will be

long term loans x 100 / shareholders’ equity + long term loans

Question 21

Points to note about gearing ratio

Answer 21

A result over 50% would indicate a highly geared business
The higher this ratio, the greater the risk taken by shareholders when investing in the busines
the higher the borrowing, the more interest must be paid
interest has to be paid from declining profits
Debts have to repaid eventually and the interests compared to capital would leave business with low liquidity
A low gearing ratio indicates a safe business strategy OR management not borrowing for expansion => a problem for shareholders who want rapid and increasing returns on investment (growth strategy financed by high debt will find returns increasing much faster than in slower growth companies who dont take risk)
Ratio can be reduced by using non-loan sources of finance to increase capital employed, such as issuing more shares or retaining profits

Question 22

Interest cover ratio

Answer 22

Assesses how many times a firm could pay its annual interest charges out of current net/operating profit
the higher the figure, the less risky the borrowing levels are for the business
Three factors determine the value of this ratio: the operating profit of the firm, the total amount borrowed and the effective rate of interest
Low values (lower than 1.5) are worrying because they indicate that the firm may encounter difficulties in paying interest.
<1 => economic loss
operating profit (before tax and interest)/annual interest paid

Question 23

Debt to equity ratio

Answer 23

measure a company’s financial leverage

indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
if higher than 1, then Debt > Equity.

between 1-2 is safe

Above 2, the Debt-to-equity ratio may indicate excessive risk, although high values are common in capital intensive industries that need much capital and have to use debt.

Total Liabilities / Shareholders’ Equity

Question 24

Cost of debt

Answer 24

Total interest/Total debt

efers to the effective rate a company pays on its current debt

give investors an idea of the riskiness of the company compared to others, because riskier companies generally have a higher cost of debt

Question 25

Debt ratio

Answer 25

the proportion of a company’s assets that are financed by debt.

debt/debt+equity OR debt/total assets

The higher this ratio, the more leveraged the company is, implying greater financial risk

for the exam, total debt = long term liabilities

Question 26

Financial leverage (or gearing)

Answer 26

the ratio between the total funds available to a firm and its equity.
the degree to which a company acquires assets or to which it funds its ongoing operations with long- or short-term debt.
A high degree of financial leverage means high interest payments, which negatively affect the company’s bottom-line earnings per share.
measures the percentage change in earnings per share over the percentage change in EBIT. DFL (degree of financial leverage) is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
total assets/equity = 1 + total debt/equity
It is larger when D/E is larger.
An increase in financial leverage has two effects:
It increases ROE
It increases corporate risk
It pays off to to increase ROE through financial leverage in good times. But it is counterproductive and risky in bad times.

Question 27

Market to book ratio

Answer 27

Used to identify the value of a company comparing the book value (accounting value: value of assets over the liabilities) of a firm to its market value (determined by the stock market, number of shares x share price)

> 1: firm has goodwill; implies an expectation of earnings growth, or that intangible and other assets (goodwill/brand equity) are undervalued in the balance sheet

<1: has badwill, implies an expectation of earnings decrease or even loss, or that intangible and other assets are overvalued

Question 28

Earnings yield ratio

Answer 28

EPS/ share price

shows the percentage of each dollar invested in the stock that was earned by the company.
if earning yield is < interest rate => stocks as a whole may be considered overvalued.

If the earnings yield is higher, stocks may considered undervalued relative to bonds.

Question 29

Earnings yield ratio and P/E ratio

Answer 29

earning periodic investment income may be secondary to growing their investments’ values over time. This is a why investors may refer to value-based investment metrics such as P/E ratio more often than earnings yield when making stock investments.

Question 30

,ROTA (Return on total assets)

Answer 30

EBIT/ Total assets

considered to be an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid

how much money is generated from each dollar invested into the organization

Question 31

Notes about ROTA

Answer 31

Over time, the value of an asset may diminish or increase. (e.g. real estate, the value of the asset may rise over time/ mechanical pieces of a business depreciate over time as wear and tear affects their value.

Comparisons should be made with companies in the same industry. When ROTA is higher than industry average, a company is said to have a competitive advantage.

In absolute terms, you should achieve a ROTA of at least 8-12% if you want to get a decent ROE (which measures the final profitability for investors, after considering interest and taxes).

Question 32

Limitations of ROTA

Answer 32

• Firms deal with several products, not just one.
• Hard to disentangle specific contributions from average components
• Depends heavily on asset valuations in the Balance Sheet
• Age of plants, depreciation etc. play an important role

Question 33

Asset turnover

Answer 33

total sales/total assets

an indicator of the efficiency with which a company is deploying its assets in generating revenue.

between 1 and 1.5

Question 34

ROE (Return on investments made by shareholders/equity)

Answer 34

net income/owner’s funds or Shareholder’s Equity

measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.

0-15% is considered an adequate ROE of most companies

A good ROE drives an increase in the share price, helps firms raising new funds from shareholders and in general supports a firm’s growth.

ROE depends on: ROA and The financial structure of the company

Question 35

Why do firms use debt instead of equity?

Answer 35

Banks and other lenders accept interest rates that are lower than expected returns for equity (lenders have precedence over shareholders during bankruptcy, which makes loans less risky than equity)
Interest is deducted from taxable income (dividends or capital gains for shareholders are not), so it reduces corporate taxes

Question 36

Working capital to sales ratio

Answer 36

working capital / sales

working capital = current assets - current liabilities

measures the ability of a firm to finance sales growth

values between 10-20% are considered solid

not necessarily in sync with current and quick ratio (e.g. fast growing firms have high denominator without necessarily adding liquidity)

Question 37

Limitations of ratio analysis in general

Answer 37

One ratio result is not helpful
Inter-firm comparisons need to be used with caution and are most effective when companies in the same industry are being compared. Financial years may end at different times for businesses
Trend analysis needs to take into account changing circumstances over time whch could have affected the result. Factors can be outside of company’s control => not exactly an indication of mgmt performance
Deliberate window dressing
Qualitative approach needs to be taken
Do not provide solution
One ratio alone cannot indicate the cause of the problem

Question 38

Cash conversion cycle

Answer 38

How many days to convert production inputs into cash receipts

Short time (effective management of inventory and credit sales)

– The company needs to finance account receivables and inventory for a short period of time

• Long time

– Longer to sell company’s products

– Receive payments from customers

– Too quick payment of bills

inventory days - receivable days + payable days