Chapter 1 - Financial statement analysis and ratios (fin.) Flashcards
stakeholders who benefit from financial statements
INTERNAL STAKEHOLDERS
owners, directors and managers - req fin statements to make bis decisions which affect continued ops
part of managers annual pres to shareholders
employees - need reports to make collective bargaining agreements with managements/unions/etc
can also use to make decisions e.g. promotions
EXTERNAL STAKEHOLDERS
- prospective investors - use statement to help make investment decisions
- analysts - to provide systematic analusis of performance and ratios, enhancing basis for investment decisions
- fin. institutions - use them to decide whether/terms of working cap/loans to finance expansion
-gov entities - to assess correct level of taxation to be paid by comp
-media - analysis, profiles on key staff etc
accounting standards
format of statements governed by law and underprinned by various acc standards
GAAP - generally accepted acc principles
- rules bases - rules and criteria
- guidelines to ensure uniformity and comparability of statements within a country
- US based
IFRS - international financial reporting standards
- set of international standards adopted by >140 jurisdictions
- principles based - good reporting and guidance
core accounting principles (11)
DAMGAMPEMC
- Dual Aspect concept
- Accounting entity concept
- Money Measurement concept
- Going concern concept
- Accruals concept
- Matching principle
- Prudence concept
- Economic entity concept
- Materiality concept
- True and fair concept
- Consistency and comparability concept
- dual aspect concept
fundamental convention - necessitates recognition of all aspects of a transaction
underlying basis for double entry acc system
replaced single entry (where only sales rev recognized not other side relating to receipt of cash)
aspects of transaction recognised under 2 main types
debit - portion that accounts for increase in assets/expenses and decrease in liabilities/equity/income
credit - portion that accounts for decrease in assets/expenses and increase in income/liabilities/equity
increase in assets must be offset bu increase in claims (liabilities or capital)
- money measurement concept
every recorded transaction is measures in monetary terms
- if not poss then not considered a material event and not recorded in comps accounting recs
- included instread in notes
- accounting entity concept
financial records prepared for distinct entity regarded as separate from individuals that own bis
- personal expenses of owners dont appear in income statement
-personal and bis assets/liabilities must be kept separate under this concept
bis entity distinct from owners
- going concern concept
assumption that bis will be in existence for forseeable future (UK = >12 months from date of statement authorisation)
legal req
assets recorded at lower of cost or book val
where comp is not a going concern - break up basis used and assets calc at net realisable val
auditors will need to issue opinion if they doubt validity of going concern statement
- Accruals concept
Incomes and expenses must be recognised when accrued regardless of when cash is paid
- so can be accounted for in one trading period even if cash is paid in another
income must be reported in period it is earned - not recieved
prepaid income must not be shown in period it is received, but in subsequent periods when service/obligation is performed
expenses record in period they are incurred not period they are paid
prepaid expenses not recorded in eriod paid but when services performed
Exception = CF statement whose main purpose is to present CF effects of transactions during period so accounts for movement of cash
ensures revenues and expenses are matched in acc period - similar to matching principle
- Matching principle/accruals based accounting
closely related to accruals concept (income/expenses recognized when accrued not when cash paid)
revs and related expenses must be matched and reported @ same time
expenses must be charged to income statement in acc period in which rev to which expenses relate in earned
- accrued expenses on income statement when incurred
- pre paid expenses deferred
- depreciation matches against economic benefit from asset over several acc periods
before this = expenses charged to income statement when paid meaning accrued expenses weren’t recognized and prepaid expenses were
matching - presents more balanced view of financial performance of comp - specifically due to depreciation
- Prudence
accounting should exhibit prudence and conservatism
- prevents eq being overvalued through overstatement of assets and income
- prevents liabilities from being understated
should not recognise an asset at value higher than could be recovered from its sale or use
inherent risk that assets are likely to be overstated and liabilities likely to be understated as company benefits through higher share price and cheaper sources of financing
- consistency and comparability concept
comp must use same acc method or principle throughout accounting period - allowing comparability
- should continue to use same assumptions such as depreciation yoy in same way
-if assumptions are altered - must explain
statements within industry must also be consistent
- Materiality concept
companies may ignore acc standards if net impact of doing so would have small impact on financial statements
- such that someone reading statement wouldnt be mislead
varies based on comp size
100k charged now or in 9 months (matching principle) immaterial to apple but material to Tala
- Economic entity concept
transactions of the comp must be kept separate from owners and other entities
- True and fair concept
Directors must only approve accounts that are true and fair view of assets, liabilities, financial position and profit and loss
- no statutory definition of true and fair
New regulator from 2019 - ARGA replaced FRC - accountable to parliament - can make direct changes to accounts rather than via courts
- directly regulates biggest audit firms
Construction of comp accounts
balance sheet - statement of fin. position
P&L - income statement
CF statement
statement of fin position/balance sheet composition
snapshot of financial position @ particular moment
split into 2 halves which must balance (assets-liabilities) = equity
Assets
CURRENT ASSETS
- cash
- trade receivables
-inventories/stocks
-prepayments
NON CURRENT ASSETS
-tangible
-intangible
-investment in financial assets
current vs non current assets
current = those that can be liquidated within a year
non current = longer term
CURRENT ASSETS
those purchased with intention of resale/cash conversion within 12 months
cash - cash balances at bank
trade receivables - amount owed by customers following sale on credit (recorded on income statement already - accruals concept) - aka debtors
inventories/stocks - finished goods or work in progress
prepayments - company prepaying an expense
NON CURRENT ASSETS
LT investments with useful life of >year
tangible non current - physical substance e.g land, buildings, plant and machinery
usually recognized initially @ acquisition cost and depreciation over time
intangible non current - non monetary without physical substance, e.g. brands, goodwill, trademarks, copyrights
Purchased goodwill = Price paid for company - Fair value of identifiable net assets
strict reqs for definition of intangible asset so some commercial brands not included as they dont meet accounting definition
NON CURRENT ASSETS
LT investments with useful life of >year
tangible non current - physical substance e.g land, buildings, plant and machinery
usually recognized initially @ acquisition cost and depreciation over time
intangible non current - non monetary without physical substance, e.g. brands, goodwill, trademarks, copyrights
Purchased goodwill = Price paid for company - Fair value of identifiable net assets
strict reqs for definition of intangible asset so some commercial brands not included as they dont meet accounting definition]
investment in financial assets - LT investments in fin. instruments e.g shares, bonds etx
recorded @ fair value
LIABILITIES
- provision
-contingent liability
effectively money owed to someone else. current = to be paid within a year, non current = to pe paid after a year
CURRENT
-overdrafts
-trade payables
- tax payable
-provisions
-accruals
NON- CURRENT
-loans
-bonds
-finance leases
provision - liability of uncertain timing/amount
contingent liability - possible liability depending on occurrence of another uncertain future event, or present obligation whose payment is unlikely/whole amount hard to measure
CURRENT LIABILITES
- overdrafts - ST debt with bank
- trade payables - ST debt when comp has bought something on credit
-tax payable
-provisions - liability of uncertain timing or amount.
-accruals - expenses incurred but not yet paid
NON CURRENT LIABILITIES
borrowing not repayable in next 12 months
-LT bank loans
-bonds
-finance leases
EQUITY
= shareholder’s funds, owners’ equity or capital
SHARE CAPITAL
- NV of ord and pref shares (may differ from authorized share capital as not all may be called up)
CAPITAL RESERVES
- cash on hand for future expenses or to offset losses
-share prem account - £ in here when shares issued above NV. not distributable as divi. can be converted into bonus issue
REVALUATION RESERVES
- arises from upward revaluation of non current assets
REV RESERVES/RETAINED EARNINGS
- accumulation of profits of lifetime of comp
- can be used for divi
NON CONTROLLING INTEREST
- arise when parent comp controls subsidiary but doesnt own all share capital
-eq attributable to remaining shareholders is here
EQUITY
= shareholder’s funds, owners’ equity or capital
SHARE CAPITAL
- NV of ord and pref shares (may differ from authorized share capital as not all may be called up)
CAPITAL RESERVES
- cash on hand for future expenses or to offset losses
-share prem account - £ in here when shares issued above NV. not distributable as divi. can be converted into bonus issue
REVALUATION RESERVES
- arises from upward revaluation of non current assets
REV RESERVES/RETAINED EARNINGS
- accumulation of profits of lifetime of comp
- can be used for divi
NON CONTROLLING INTEREST
- arise when parent comp controls subsidiary but doesnt own all share capital
-eq attributable to remaining shareholders is here
depreciation
method to allocate cost of tangible non current asset over its useful life
annual depreciation charge main in income statement to spread cost of asset over useful life - helping to match cost with rev it produces
doesnt apply to freehold land or non current assets - since they dont have limited economic life
- they are periodically revalued
annual depreciation charge calc by 1st subtracting estimated disposal val from cost = depreciable amount, then writing off over assets useful life. 2 methods
straight line depreciation
spreads depreciable amount over useful economic life equally/linearly
annual depreciation charge is a nonc ash entry on income statement to reflect estimated cost of resource sin period
on balance sheet = asset recorded at NBV
net book val = cost - accumulated depreciation
reducing balancing depreciation method
an accelerated depreciation method - s
depreciation calc @ fixed % of net book val - so higher depreciation costs in earlier years
may be more realistic as assets more effective when they are new
annual depreciation = depreciation rate x book val @ beginning of eyar
depreciate rate = %depreciation /year * 2
amortization
process of gradually writing off initial cost of an asset/loan - income statement/bal sheet not cash position
loan = spreading out loan payments over time
asset = spreading cost of intangible asset over its useful life (depreciation = for tangible)
writing down allowance
-cap allowance can be claimed when you buy assets to use in a bis - some/all of val can be deducted from pre tax profits
-e.g. patents, IP,copyright
purpose - tax relief for reduction in val of qualifying assets, allowing cost to be written off against taxable income of bis
availablee to; sole traders, self employed, or partnerships, comp and orgs liable to corp tax
what is income statement/ PL statement
sumarises income earned and expenditure incurred over acc period
function: to report profit/loss
order of income statement
IS: revenue
Revenu @ top of income statement
everything comp has sold, whether payment received or no
aka turnover, sales
IS: cost of sales
2nd line
rev - COGS = gross profit
includes raw mats, wages of staff making prods etc
costs to comp of generating the revenue
IS: gross profit
rev - COGS = gross profit
total sales - cost of the sales
reflects income prior to overhead expenses
Operating profit
= gross profit - op expenses - depreciation and amortisation
aka operating income aka PBIT/EBIT
op expenses - distro costs, admin expenses, marketing, rent etc
EBITDA
EBITDA = earnings before interest, tax, depreciation and amortisation
= rev - expenses (Excluding those above)
eliminates effect of financing and acc decisions
= net profit + tax + interest + dep and amort
Interest payable/interest receivable
operating profit/EBIT/PBIT
-interest payable
+interest receivable
Profit before tax
Interest payable/interest receivable
operating profit/EBIT/PBIT
-interest payable
+interest receivable
Profit before tax
payable - interest incurred from borrowings, loans, bonds, overdrafts
receivable - interest income earned from surplus funds deposited
Net profit
bottom of income statement
all profit less all expenditures
= profit attributed to shareholders technically as all could be distributed as divi
numerator of EPS calc (EPS = net profit/no. of ord shares)
capital vs revenue expenditure
capital expenditure - money spent buying non current assets e.g. plant, property etc.
reflected on balance sheet
revenue expenditure - $ spent that impacts income statement e.g. wages, rent, audit fees
CF statement
summary of payments and receipts that have occurred throughout year - representing total inflow/outflow of cash
IAS7 = reqs CF statement to be broken down into 3 headings
OPERATING ACTIVITIES
- cash generated and consumed by main rev producing activities (trading activities) of comp - usually excluding interest expenses
INVESTING ACTIVITIES
- cash inflows/outflows from the disposal/purchase of LT assets
FINANCING ACTIVITIES
-cash spent paying divi/interst
-cash raised from issuing shares or bowwing on LT minus cash spent repaying debt/buying back shares
short term, high qual + highly liquid investments are classified as cash equivalents e.g. T bills
CF statement composition
OP ACTIVITIES
NET INCOME - start with this and reconcile to reflect net cash
+ depreciation/amortisation
+depreciation/amortisation (not cash)
+ loss from sales fixed assets (not cash)/ - gains
+ decrease in trade receivables/ - increase
+ decrease in inventory/ + increase
+ accounts payable / - accounts receivable
+ increase in accrued expenses/ - decrease
INVESTING ACTIVITIES
+ decrease in fixed assets, securities investments, non tangible current assets (sales)
- increase in fixed assets, securities investments, tangible non current assets (purchases)
FINANCING ACTIVITIES
+ increase in borrowing, increase in capital stock, increased interest received
- divi or interest payments, redeeming loans
Total FCF = total enterprise CF post reconciliation - divi - tax
Profitability ratios (8)
Gross profit margin (gross profit/rev)
Operating profit margin (op profit/rev)
Net profit margin
Return on capital employed (EBIT/CE)
Asset turnover (rev/assets)
Return on equity (net prof/equity)
Operational gearing ratio ((Revenue-Variable Cost)/Profit before tax)
Equity multiplier
generally - higher = better = comp better at converting sales to profit
gross profit margin (profitability)
both from income statement
gross profit = rev - COGS
- compare to last year comment on trend (where have rev/COGS moved?)
- higher = can spend higher proportion of income on other op expenses
GOOD : relationship between turnover and direct cost of providing product/service
BAD: may portray bis in too pos a light - ignores operating expenses which are v real
operating profit margin (profitability)
operating profit margin % = operating profit / rev (x100)
rev = top of income statement
op profit = rev - cogs - operating costs
-compare to last year and say what that means
- varies widely between sectors (supermarkets v low, jewellers v high)
- effected by competition, economic climate, industry etc
-higher = better, yoy increase = sales up more than costs
GOOD: provides relationship between turnover and all costs of providing service including op costs
GOOD: appropriate for making comparisons because differences in way bis is financed wont influence measure
BAD: discrepancies can arise between comps for various reasons e.g. method of depreciation used - so hard to make comparisons
net profit margin (profitability ratio)
net profit margin (%) = net profit / revenues (x100)
net income = bottom of income statement (all expenses removed)
revs = top
- compare to last year
GOOD: all costs accounted for, so measures how successful a comp is at making profit on each sale
GOOD: provides final pic of comps overall health
BAD: can be influenced by one off items e.g. sale of an asset
BAD: doesnt provide insight into whether management is managing production costs
return on equity (ROE)
profitability ratio
ROE (%) = net income / equity (x100)
net profit = bottom of income statement
equity = assets - liabilities = share capital + share premium + retained earnings
measures rate of profit earned for shareholders
higher = better conversion of equity finance to profits
must be compared to comp previous and industry - varies by industry, lifecycle of bis
GOOD: shows how well comp benefits shareholders beyond earnings
GOOD: shows return on investments
BAD: doesnt show risk associated with high level of return - e.g. may use lots of debt to generate high net profit and this isnt reflected
BAD: easily manipulated - inflating income by overvaluing assets or deflating equity (increasing liabilities or with buybacks)
BAD: v low with new comps and capital requirement high in early days
Equity multiplier - profitability ratio
eq multiplier = total assets / shareholders funds
fin. leverage ratio - evaluates companies use of debt to purchase assets - higher debt = lower shareholder funds and higher eq multiplier
- comps wiht horrible sales and margins can take on excessive debt to artificially increase ROE - eq multipier allows you to see what portion of return on eq is result of debt
DuPont analysis
breaks ROE into 3 distinct elements after analysing drivers of ROE
operating efficiency - measured by net profit margin (less pre fdivi)
- as net profits increase (reducing costs or increasing prices) ROE will increase
asset use efficiency - measured by total asset turnover (rev/total assets) - industry specific
- as asset turnover increases ROE increases
financial leverage - measured by equity multiplier (assets/ shareholder funds)
- if ROE increases with increases eq multiplier - could indicate overleverage and higher risk
ROE = net profit margin x total asset turnover x equity multiplier
extended DuPont analysis
ROE (%) = (Operating profit margin x Tax retention rate - Interest expense rate) x Equity multiplier x Total asset turnover
removed effect of tax and interest
Asset turnover
asset turnover = revenue / capital employed
= x: 1 ratio
capital employed = assets - current liabilities
OR = non current liabilities + equity
measures efficient use of assets to produce sales - helps measure productivity of company’s assets
high = better but too high could indicate overtrading (insufficient assets to sustain level of sales rev)
comps with low profit margins tend to higher assets turnover
retail tends to be higher (2-3)
utilities with large asset base will be lower
compare to prev years as ever
ROCE = OPM x asset turnover
v diff quality bis can achieve same ROCE (e.g. high asset turnover x low margin = low asset turnover x high margin)
operational gearing ratio
profitability
operational gearing ratio = (revenues - variable costs) / Profit before tax
if comp has greater level of fixed = greater variation in profit as a result of revenue changes
effect of op gearing ratio can be calced by taking increase/decrease in normal output and x by geearing ratio
Breakeven point
denominator = contribution per unit because it contributes to meeting fixed costs
contribution margin = margin profit per unit sale
computed using contribution income statements which separate fixed and variable costs
ROCE
profitability
ROCE = operating profit / capital employed
capital employed = assets - current liabilities
OR = non current liabilities + equity
often regarded as one of best measures for judging management of comp in its utilization of available cap resources
compare ROCE to target figs
useful for cap intensive comps as it analyses debt and liabilities as well as probability - gives clear pic of financials
cant be considered in isolation - must compare to last year and across sector
unlike ROE - doesnt capture risk associated with generation of return
older comps generally have higher ROCEs than newer - due to depreciation which can be misleading
Liquidity ratios
current ratio (CA/CL)
acid test ratio (CA-Inv/CL)
Altman Z score
Current ratio (x)
Liquidity
aka working cap ratio
current ratio = current assets / current liabilities
- ideally 1.5-2
- purpose is to determine if the cover that current assets provide to cover liabilities that fall due within a year
ISSUES
-overdrafts may actually be long term but are a current liability
-doesnt take timing of CF into account
-inventory may not be easily liquidated (recession, distressed prices)
5 TYPES OF ACCOUNTING RATIO
profitability - asses trading/operating performance: profits needed to provide investors with returns
liquidity -evaluates trading risk of the company
operational efficiency
gearing -assesses ability of bis to meet lLT debts and risks to those financing comp
investor - asses returns to those financing the comp
current ratio modified form
to address critisim that current ratio is static
= net sales to working capital
working cap turnover ratio = net annual sales/ avg amount of working cap
working cap = current assets - current liabilities
Quick/acid test
liquidity
quick ratio = (current assets - inventory) / current liabilities
<1 may be cause for concern depending on industry
akak (Cash + marketable secs + trade receivables) / current liabilities
still doesnt take CF timing into account
if quick ratio is much lower than working cap - current assets are highly dependent on inventory - retail stores big e.g. of this = sensitivity to recession
Altman Z score
liquidity
determine prob of comp going into liquidation - analyses sales and gearing and distills to single score
only as good as sata that goes into it
cannot asses comp with little or no earnings (new)
highly sensitive to write offs in accounts which may falsely indictae bankruptcy
A - tests corporate distress
B - reflects extent of gearing
C - assesses ability to squeeze profits from assets
D - how much must MV fall by for liabilities to exceed assets
E- how efficiently assets used to generate sales
working capital/cash cycle
working cap = current assets - liabilities
= funding avail for conducting day to day bis
aka operational efficiency ratios
efficiency can be increased by
- minimising inventory elvels
- ensuring debtors pay quickly, delaying payments to creditors
comps should maintain at least an equal balance between coleection period and payment period for receivables and payables
considers velocity of CF within working cap cycle
payables payment period (Payables/COGS)
receivables payment period (Receivables/Revenue)
inventory holding days (COGS/INV)
receivables collection period
op efficiency
receivables collection period = 365 x trade receivables / revenue
asses how quickly comp can realise cals of receivables
indicates proportion of year’s sales which are unpaid (@ bal sheet date)
may be distorted by large comps either v quick or slow to pay
static - can be distorted espec by seasonal sales
payables payment period
op efficiency
payables payment period = 365 * trade payables/ COGS
want this to be even balance with receivables collection period
could upset creditors if too high
inventory holding days
365 * inventory / COGS
indicates how quickly a comp is selling its inventory
high turnover bis will have low inventory day
generally prefer shorter as there are costs to hold inventory
compare to industry - low suggests strong sales or ineffective buying
static so bad for seasonal bis
inventory management
- likely demand
-possibility of supply shortages
- likelihoo dof price rises
- amount of storage
- perishability
- prospect of obsolescence
financial gearing ratios (4)
debt to equity (Interest bearing debt + pref shares) / (Equity S/H Funds – pref)
net debt to equity (Interest bearing debt + pref shares - cash) / (Equity S/H Funds – pref)
interest cover (operating profit + int received + other receivables)/ int paid)
asset cover (Total Assets – Current Liabs)/ Loans payable
high levels of gearing can indicate greater levels of financial risk
debt to equity
gearing
debt includes liabilities with an interest bearing component (bot ST and LT)
trade payables, deferred income and divi payables generally excluded
sometimes pref shares included in equity
overdrafts included? case by case - ST anomaly or LT financing
generally >100% indicates comp would struggle to pay LT debt if loans called in
bis like utilities with steady earnings can tolerate a higher level than vol sectors e..g banking/tech - utility bis tend to be monopolies
net debt to equity
gearing
alt to debt to eq taking into account assets tha can be used to offset debt
(cash and ST investments from bal sheet )
interest cover
gearing
measures ability to pay ineterst out of op profits and other incomer receivables
higher = less risky
appropriate level varies sector to sector
key for lenders
asset/loan cover
gearing
asset cover = (total assets - current liabilities) / loans payable
assesses security/likelihood of loan repayment
should be calc for each priority of loan
bal sheet assets recorded @ book value which is often higher than liquidation/selling value - which could inflate ratio
investor ratios
EPS (earnigns attributable to ord SH / weighted avg no. of shares)
diluted EPS
earnings yield (EPS / share price)
divi cover (EPS / divi per share)
divi yield (divi per share/ share price)
investor ratios
EPS (earnigns attributable to ord SH / weighted avg no. of shares)
diluted EPS
earnings yield (EPS / share price)
divi cover (EPS / divi per share)
divi yield (divi per share/ share price)
EPS
investor
EPS = net profit (loss) attributable to SH / avg weighted no. of shares for period
- indicates companies scope for increasing divi
- assess how expensive of cheap a comp is
restated vs diluted EPS
EPS will change is no. of outstanding shares changes
Diluted EPS
must publish diluted EPS on income statement to warn of potential future changes in EPS for hypothetical events (the exercise of rights which have already been granted and would require issue of further shares)
- convertible loan stocks in issue
- warrants in issue
- employee share options issued but not exercised
Bonus/scrip/capitalization issue
effectively a free issue of shares paid for with retained earnings/share prem account
converts retained earnings to share capital
retained earnings down
share cap up
no change to total shareholder funds or net assets
NV of share remains the same
share price adjusts to reflect new shares in issue, as does EPS and divi per share
bonus factor = no.of shares after issue/no. of shares before issue
restated EPS = EPS/bonus factor
UK, most Europe, China, India- 5:2 = 5 new shares for every 2 you own
US: 5:2 = every 2 shares held will be converted to 5
if fractional share - rounded down and offset w/ cash payment
share split/reverse split
UK comp act - NV of share must be 100p
comp can increase no. of shares by decreasing NV - stock split - increases marketability, decreases trading price
reverse split: increase NV, increases trading price
per share ratios effected
no financial impact on comp other than admin as no CF involved
fractional shares typically sold off
rights issue
shares offered to existing holders @ disocunted price to raise finance
- fund takeover
- acquire assets
-repay debt
causes signif change to comp CF
requires publication of prospectus
essentially an issue of shares @ full price combined w/ bonus issue
bonus element backdated to original issue date and prev years EPS adjusted
bonus fraction = cum rights price / TERP
restated EPS = EPS/ bonus factor
5:2 always means 5 new shares issued for 2 existing
increase is share capital and share premium acc
tail swallowing rights issue
aka cashless take up - selling some rights and buying remainder such that no cash expenditre is required
no. of rights to sell = rights price/TERP x rights entitlement
entitlement = total no. of shares investor is allotted
nil paid right
= TERP - rights price
share buybacks
occurs when comp purchases own shares and either cancels or holds in treasure for reissue at later date
- open market
-proportional offer (set % from each investor purchased)
-universal tender (fixed no. acquired @ particular price)
using proceeds of fresh issue or from distributable profits
way of keeping comp nimble to prevent having to cut divi @ times of stress (Shell 2020)
- if comp increases divi after good year this is expected to be maintained - buybacks allow return of wealth with les stress
- discount management
-preventing controlling stakes
-common is US as mroe tax efficient than divi payments
- scrutinised as priortitises interests of external shareholders vs workforce, environment etc
- if funded via debt this increases probability of default on other debt and respresnts direct transfer of val from creditors to shareholders
increases price, relative ownership stake and per share metrics
diluted EPS convertibles
(pref shares and loan stock)
diluted EPS = (net profit - pref divi) / (weighted avg no. of ord shares + dilutive shares)
- calc interest saved on conversion
- deduct corp tax from that saving
- add interest saving to profit
- calc additional no. of shares
- enter into formula
over time - according to prospectus - no. of shares resulting from convertible decreases over time as share price rises
assume all shares would be converted to give max possible dilution warning to shareholders
in some cases the decrease in interest cost may offset the dilution effect of conversion on EPS
diluted EPS warrants and options
diluted eps figure on income statement - assumes exercise of all outstanding warrants and options
warns of potential future changes
options are generally not dilutive as trade in existing shares on market - only include dilutive options if present in calc
new total no. of shares = avg no. of basic shares outstanding + no. of new shares issued on ex - no. of shares issued @ fair val (due to proceeds on exercise)
then do EPS calc with this fig (net profit - pref divi)/ fig
fair val = avg market price over period
earnings yield and PE ratio
investor ratios
PE = share price/EPS = 1/earnings yield
earnings yield = EPS/ share price x100
EPS = (net inc - pref divi)/weighted avg no. of shares
earnings yield expresses EPS as % of market price
indication of value (can compare ftse100 with 10yr gilt) if lower for ftse then shares likely to be overval
difference between 2 = equity risk prem
high earnings yield may reflect anticipation of poor earnings/other weaknesses
low may reflect high growth prospects
P/E should be compared in similar sector or to prev year - not in isolation!
high = overvalued potentially
divi yield
investor
divi yield = divi per share / market price per share x100
no relation between divi yield and perception of comp in market place
not guaranteed - Shell cut quarterly divi by 66% in 2020
Janus Henderson research - 220$ bili global divi cut in 2020
European banks instructed to pause divi to maintain cap by regulators
High - could be high divi or low share price (latter would give high PE, comp risky so more yield)
could be comp with strong CF
defensive sector comps often by high divis reliably
divi cover
investor
divi cover = EPS/ net divi per share
OR
divi cover = net earnings attributable to SH/ total ord divi
net earnings attrib.. = net income - pref divi
> 2 = safe
<1 cause for concern as having to fund out of reserves not current earnings
<1.5 not sustainable
limitations of ratio analysis
limitations
- uses historic data so not predictive
-different industries have different characteristics and within a secotr comps may be at different stages
-profitability ratios dont account for future econ events, management changes etc
liquidity - no account taken of maco environments
-accounting policies may differ (e.g depreciation of non current assets)
- distortions - e.g. use of year end balance to analyse full year transactions
window dressing - putting figures in best light @ time of statments
- postponing payments to suppliers to improve cash balance
- finding ways to book revenue earlier
-repaying debt temporarily near end of period
- applies to sate govs too e.g Brazil before 2015 election
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window dressing methods
circular transactions - sale and repurchase to give inflated turnover with no commercial authenticity
- improves profitability ratios
- should be disclosed under IAS 24
bed and breakfast transactions
- circular transaction that occurs over end of acc period
- illegal if disclosures not made in accordance with acc standards
postpoing of payments to improve cash balance
booking rev earlier
repaying debt near end of period financed by sale of inventory
false or misleading statements
trend analysis - horizontal analysis
assesses bal sheet/income statement over time - observing trends and any changes in them
- can see if numbers are unusually high or low
apply base % of 100 to first year to make this easier
- e.g. allows you to compare rate of divi growth with rate of rev growth
can be missused by analysts to report skewed findings - can change no of periods (should disclose)
- or should good MoM figures when YoY is bad
common size/vertical analysis
each line on bal sheet is shown as % of one tiem (usually total assets
