Chapter 7: Investment Analysis

Question 1

7.1: Company Accounts

Answer 1

LOOK AT SALTUS’S FINANCIAL STATEMENTS AND COMPARE TO LEARN BETTER

Question 2

How to find an companies annual report and accounts

Answer 2

Usually on the companies website under something like ‘investor relations’

Question 3

Most UK companies prepare a strategic report, as well as a directors’ report, which are added within their annual report.

What is the strategic report for?

Answer 3

This strategic report is to provide a holistic and meaningful picture of a company’s business model, strategy, development, performance, position and future prospects.

It gives descriptions of the risks the business faces and offers explanation for some of the items in the accounts that would benefit from more information.

Question 4

What type of company in the UK are subject to the strictest reporting requirements?

Answer 4

PLCs

Question 5

7.2: Financial Statements

Question 6

What is the purpose of the International Financial Reporting Standards? (IFRS)

Answer 6

These standards ensure consistency across borders in the way in which company accounts are presented. 

Any company listed on EU stock exchanges must prepare their accounts in line with IFRS.

Other UK companies must comply with UK Generally Accepted Accounting Practice (UK GAAP) prescribed by the UK Accounting Standards Board.

Question 7

A companies financial statements summarise all transactions entered into by the company during its accounting period.

They are usually produced on an accrual basis. What does this mean?

Answer 7

Where transactions are reported when they occur, which is not necessarily when cash is actually received.

So, as soon as an invoice is issued for work that is being carried out, it would be entered in the accounts, even though it may be weeks or even months before that money is received into the bank account of the business.

Question 8

Companies are assumed to be a ‘going concern’

What does this mean?

Answer 8

The presumption that the company will continue in operation for the foreseeable future.

If this is not going to be the case, then additional disclosures would be required. So a ‘going concern’ is actually not a ‘concern’.

Question 9

All firms must have their accounts audited. True or false

Answer 9

False, all except small firms

Question 10

What is the role of an auditor?

Answer 10

An auditor will carry out an independent assessment of the companies accounts and report on whether the accounts have been properly prepared in accordance with the Companies Act and all relevant accounting standards

Question 11

An auditor has carried out a audit on a large companies financial statement and they issue as ‘unqualified audit report’

What does this mean?

Answer 11

This means that they do not have any disagreement with information and have had sufficient information to make that call.

ie, they passed the audit

Question 12

Another part of an auditors role is to make a judgement on the corporate governance.

What does this mean

Answer 12

This is effectively how the board of directors are managing the business, so whether the company is being run in the best long-term interests of its shareholders.

Question 13

A companies Accounts are typically made up of three main parts:

Statement of financial position (known as the balance sheet)

Income statement (known as the profit and loss account)

Cash Flow statement

Tell me about each

Answer 13

7.2.1: Statement of financial position:

The balance sheet shows the assets and liabilities of a company at a single point in time, i.e., the end of its accounting period.

The elements that are shown on the statement of financial position are:

Assets,
Liabilities, and,
Shareholder funds. 

Question 14

7.2.1a: Assets

The assets shown on the statement of financial position (balance sheet) are separated out between current assets and non-current asset

What is the difference?

Answer 14

Current

Non current

Question 15

Inventory management

We need to think about how companies account for their stock or inventories.

There are three methods that can be used:

Answer 15

First in first out

Last in first out

Weighted average cost

Question 16

Depreciation

When a company buys a large piece of equipment, it doesn’t make sense to account for the whole expense in one year. After all, the equipment will be used to generate products and profits over a number of years, So, the cost is spread over a period of time known as the asset’s useful economic life.

This is known as depreciation (there is a similar method for intangible assets known as amortisation).

There are two methods for calculating depreciation that you need to know for the exam: the straight line method and the reducing balance method. 

Question 17

7.2.1b: Liabilities

The liabilities section of an account, like the assets section, is separated into current liabilities and non-current liabilities.

What is the difference?

Answer 17

Current liabilites = payable within 12 months (short term loans, overdrafts)

Non current liabilities = long term. Corporate bonds issues, loans from banks

Question 18

7.2.1c: Shareholder funds

At the bottom of the financial statement, we can see how the company is financed by the shareholder funds.

An important part of the construction of a statement of financial position is that the net assets, which is assets – liabilities, should equal the total equity in the company or shareholder funds. I.e. they should balance (hence the name balance sheet). In our example, for the 2023 year both figures are £167.4 million.

Question 19

7.2.2: Income statement

Answer 19

The income statement or profit and loss account, shows the performance of the company over the accounting period, and summarises the company’s revenue transactions.

Question 20

What is issued share capital
Capital reserves
Retained earnings

These all are within the equity portion of the balance sheet.

Question 21

On the income statement we have the profits retained for the financial year. This is different from the retained earnings on the balance sheet, as that included the total resources maintained, as opposed to a single year figure.

Question 22

7.2.3: Cash flow statement

The cash flow statement seeks to identify how a company’s cash has been generated over the accounting period. Having a healthy cash flow will ensure a business isn’t reliant on selling its fixed assets or borrowing to finance its day-to-day operations.

It looks at the cash actually paid and received, as opposed to the accrual’s basis on the income statement.

It also adds back items such as depreciation charges on the sale of fixed assets, which affects profits but not the cash position.

Question 23

7.3: Accounting for Subsidiaries

What are known as consolidated accounts and a consolidated income statement?

Answer 23

Where companies control other companies then they need to show amalgamated accounts for the whole group of companies together, known as consolidated accounts. I.e. they will add all the assets from the parent company with all the assets and liabilities of any subsidiaries.

Similarly, the income from the subsidiary will be reported on the consolidated income statement.

consolidated income statement = income from all companies within the group

Consolidated accounts = assets and liabilities of all subsidiaries/companies within the group.

Question 24

What is a subsidiary company?

What is an associate company?

What are investments (in relation to above)

Answer 24

A subsidiary company =
is defined as one where the parent company has a greater than 50% stake in it.

An associate company =
is one where the parent owns between 20% and 50% of the voting rights. In this the equity method of accounting is used instead.

Investments =
Where a company holds less than 20% of the shares of a company. These are recorded on the balance sheet and any dividends received recorded on the income statement.

Question 25

What is minority interest, in relation to consolidated accounts?

Answer 25

SUBSIDARY COMPANIES = Let’s say that company X has a 75% holding in a subsidiary Y. This means that they will include all the assets and liabilities of subsidiary Y in the consolidated accounts BUT…. 25% isn’t theirs! That portion belongs to what we call the minority interest. This minority interest is recorded in the equity part of the balance sheet.

A subsidiary company is defined as one where the parent company has a greater than 50% stake in it.

ASSOCIATED COMPANIE =

An associate company is one where the parent owns between 20% and 50% of the voting rights. In this the equity method of accounting is used instead.

Let’s say company X also has a 40% stake in an associate company Z. 40% of the net assets of company Z will appear on company X’s balance sheet and 40% of operating profit, interest payable, interest receivable and tax will occur on company X’s income statement. Any dividends will therefore not be recorded as income on the income statement.

SUBISDARY COMPANIES = all the assets and liabilities of subsidiary Y in the consolidated accounts

ASSOCIATED COMPANIES = ONLY PORTION THAT IS OWNED

Question 26

7.4: Analysing Companies

Question 27

7.4.1: Analysis Profitability of a company

formulas to remember for this:

Operating margin
Net margin
Return on equity (ROE)
Return on capital employed (ROCE) 

Answer 27

When looking at profitability you look at how much profit is being made and how it relates to factors such as investments, level of sales etc

Operating margin
Net margin
Return on equity (ROE)
Return on capital employed (ROCE) 

Question 28

7.4.1: Analysis Profitability of a company (5 calcs to learn)

Tell me differences between each:

-Operating margin
-Net margin

IMPORTANT: Profit measures as seen above are not particularly useful on their own… they need to be measured relative to the levels of equity and assets used to achieve the profits, which is where the below calculations help.

-Return on equity (ROE)
-Return on capital employed (ROCE) 
-ROCE using the sales linked ratios of Asset turnover and Profit Margin.

Answer 28

All are used to assess a companies profitability

Operating margin =
Provides information about the profitability of the firm’s core business. It is profit made after paying the operating costs of goods sold, as well as general and administrative expenses. DOES NOT look at other income received such as from investments. So, operating margin concentrates on the core business of the company.

Net margin (profit margin) =
Measures the percentage of net income of an entity to its net sales. It represents the proportion of sales that is left over after all relevant expenses have been adjusted. Whilst companies in some industries are able to generate high net profit margin, other industries offer very narrow margins.

7.4.1c: Return on Equity (ROE) =
Ratio of net income of a business during a year to its shareholder’s equity. It is a measure of the profitability of the shareholders’ investment.

7.4.1d: Return on Capital Employed (ROCE) =
ROCE determines how much the company has earned from the total of the different types of capital it has employed, so this would include the equity but also long- or short-term borrowings. It would include funds raised by the issuing of corporate bonds. (As it includes this long-term finance in the calculation, it is a more comprehensive test of profitability than ROE.

Question 29

The Return on Capital Employed (ROCE) calculation we looked at above is a high-level ratio. So, it can be broken down into two component parts:.

Asset Turnover
Profit Margin

Answer 29

Asset Turnover = ratio of sales and capital employed

Asset turnover measures how efficiently a company uses its assets to produce sales. Higher the better. (If a company can generate more sales with fewer assets, it has a higher turnover ratio)

Profit Margin = ratio of profit and sales

Profit margin works in the opposite direction.
Ie if a company has a high asset turnover it is likely to have a low-profit margin and those with high profit margins, tend to have lower asset turnover.

o Think of budget supermarket next to a designer bakery.

Question 30

7.4.2: Analysis of the Volatility of a company
(A company’s profits could disappear overnight, so analysing volatility is critical too)

Tell me differences between (CALCs to learn):

-financial leverage (gearing)
- Interest Cover
-operating leverage

Answer 30

financial leverage = level of debt within the business, often known as gearing

operating leverage = examines the fixed and variable costs of the business. Operating leverage is a measure of the impact of a company’s cost mix on the rate of change in profitability. It measures a company’s fixed costs as a percentage of its total costs, and introduces a concept known as the breakeven point. Looking at gearing as well as operational leverage can help investors anticipate falls in profits, as they link the expected return to many of the risks involved such as over-borrowing.

The higher the operational leverage, the higher the risk.

A company would be deemed to have a high operating leverage if fixed costs were above 80% of the total costs.

Question 31

Why is it important to measures a companies level of financial leverage (gearing)

NOTE:

The level of gearing will vary depending on the industry, so gearing ratios can only really be used to compare a company’s position against its immediate competitors

Answer 31

This analysis the volatility of a company

Financial leverage looks at the ratio of debt to equity and measures the sensitivity to changes in interest rates, and the company’s ability to cover the interest payments on their borrowing.

Whilst borrowing is not a bad thing, if a company has very high levels of debt, then the risk of bankruptcy increases as, if they don’t repay debts, this can lead to difficulties in obtaining finance in the future.

They are also far more susceptible to rises in interest rates affecting the level of profits.

Just as with investment trusts and REITs, gearing can increase profits, AND it can magnify losses.

Within a company, there can be tax advantages of borrowing, such as reducing profits and reducing the corporation tax bill.

The level of gearing will vary depending on the industry, so gearing ratios can only really be used to compare a company’s position against its immediate competitors

Question 32

Interest cover

Answer 32

7.4.2b: Interest Cover

Show how many times a payment of X can be paid out of a fund Y.

Interest cover = how many times the interest bill could be paid out of current profits. This ratio is very sensitive to changes in interest rates

Question 33

What is the breakeven point?

Answer 33

Where a company earns enough money in to cover all of its costs, fixed and variable.

So:

• The breakeven point is when the marginal contribution per item x number of items matches (covers) fixed costs.

The ‘break even quantity’ is the number of items we need to sell to reach breakeven point.

Question 34

Let’s consider the costs that a company has.

Fixed costs
o The types of things that stay the same, regardless of the level of production or ‘output’.

o Examples are salaries, rent etc.

o These aren’t fixed in tablets of stone, but they are at least long-term and likely!

Variable costs
o Change depending on level of production.

o These include costs such as the price of raw materials.

So, if the fixed costs stay the same whether the company produces things or not, then we need to see whether each item sold covers the variable costs of producing that item.

This is known as the marginal contribution. It is the sales price of an item minus the variable costs in producing that item.

In other words, the contribution that each sale makes towards the company’s coffers after allowing for variable costs.

Question 35

marginal contribution =

Answer 35

t is the sales price of an item minus the variable costs in producing that item.

In other words, the contribution that each sale makes towards the company’s coffers after allowing for variable costs.

Question 36

7.4.3: Measuring Liquidity of a company

Liquidity is crucial to a business. Without the cash to pay bills even a company with plenty of assets, could be forced into liquidation. 

The liquidity formula generally uses assets and liabilities that are current or short-term.
CALCs to remember:

7.4.3a: Working capital (current) ratio

7.4.3b: Liquidity ratio (also called the quick or acid test) (this takes away assets that would take too long to liquidate in crises to the ‘current ratio’)

Answer 36

Working capital (current) ratio =
The working capital ratio or current ratio ensures there is enough cash in current assets to pay off all current creditors.

A healthy ratio would be between 1.5 and 2 (Too little would indicate cash flow problems, but too much would indicate that assets are not being used as profitably as they could be)

Liquidity Ratio =
Should be at least 1, although it will depend on the type of business.

Question 37

Tell me some issues with using the liquidity ratios mentioned above

Answer 37

static measures

Not good long term predictors

Don’t take certain key info into account

Liquidity ratios are good at indicating how tight the cash flow is within the business, but research has shown that they are not particularly good at forecasting the collapse of a company.

Those companies who know they have a liquidity problem put measures in place to improve the situation.

It is when changes within the business occur that take a business by surprise that there can be major issues.

A more in-depth analysis that combines several ratios, called a Z-score, can more accurately predict collapse in the short term i.e., over one year, but it is less reliable over longer periods, such as 5 years plus. You won’t need to understand Z-scores for your exam, but basically they bring together lots of corporate income and balance sheet values to measure the financial health of a company.

Another problem with liquidity ratios is that they are static measures, so can’t reflect in detail what is happening to cash flows throughout the year.

Question 38

7.4.4: Measuring Operational Efficiency of a company

also known as (and incorporating) working capital management

Looks at changes to the working capital, to ensure that the stock levels, debtors and creditors are being controlled sufficiently. CALC TO REMEMBER

7.4.4a: Working capital
7.4.4b: Debtor turnover
7.4.4c: Debtor collection period in days
7.4.4d: Stock turnover
7.4.4e: Creditor turnover
7.4.4e: Creditor turnover in days

Answer 38

Working capital = Working capital is the term applied to net current assets and represents the money that circulates through the business automatically, so money being spent on goods and services to enable production to take place, and money being received as customers pay for their purchases.

7.4.4b: Debtor turnover =
Debtor turnover is the ratio of a business’ net credit sales to its accounts receivable during a given period.

It is an activity ratio that estimates the number of times a business collects its average accounts receivable balance during a period. It measures the efficiency of a business in collecting its credit sales.

A high turnover is good, and a low figure may indicate inefficiency in collecting outstanding sales. 

A debtor turnover ratio of 5.7 times means that the business collects its average accounts receivable approximately 5.7 times during the given period, typically a year. In other words, the company converts its credit sales into cash 5.7 times annually (or every 64 days if using the Debtor collection period in days calc) This allows them to maintain working capital levels

7.4.4d: Stock turnover =
The stock turnover ratio is used to assess how efficiently a business is managing its inventories.

In general, a high turnover indicates efficient operations. A low turnover compared to the industry average and competitors suggests poor management. 

7.4.4e: Creditor turnover

Creditor turnover evaluates how fast a company pays off its creditors or suppliers.

It is a measure of short-term liquidity.

Question 39

What is working capital?

Answer 39

Working capital is the term applied to net current assets and represents the money that circulates through the business automatically, so money being spent on goods and services to enable production to take place, and money being received as customers pay for their purchases.

Question 40

7.4.4b: Debtor turnover

Debtor turnover is the ratio of a business’ net credit sales to its accounts receivable during a given period.

It is an activity ratio that estimates the number of times a business collects its average accounts receivable balance during a period. It measures the efficiency of a business in collecting its credit sales.

Question 41

7.4.5: Limitations of ratios: Tell me the main limitations to using ratios

Ratios are useful to help understand a company’s financial position, and to be able to compare a company’s performance to the others within the industry, major competitors or against its own previous results.

However… ratios are not without their limitations, and often create more questions than answers:

Answer 41

Companies have different accounting procedures, so results could be unreliable

Historical data is used often

ETC ETC

Question 42

DO ACTIVITY 4.1. INCLUDES ALL RATIOS

Question 43

Analysis Profitability of a company

Operating margin
Net margin
Return on equity (ROE)
Return on capital employed (ROCE) 

7.4.2: Analysis of the Volatility of a company:

Financial leverage (gearing)
Interest Cover
operating leverage

7.4.3: Measuring Liquidity of a company

7.4.3a: Working capital (current) ratio
7.4.3b: Liquidity ratio (also called the quick or acid test)

Measuring Operational Efficiency of a company
7.4.4a: Working capital
7.4.4b: Debtor turnover
7.4.4c: Debtor collection period in days
7.4.4d: Stock turnover
7.4.4e: Creditor turnover
7.4.4e: Creditor turnover in days

Answer 43

It is highly unlikely that you will be given a copy of the whole balance sheet or income statement and asked to calculate the ratios in the exam, but you may be given excerpts.

Question 44

7.4.6: Investment ratios

It’s usual to get a few questions around these in your exam, so it’s important that you know the basics about each ratio.

In the exam you may have to compare ratios from two different companies, or be given some information and asked to calculate a number of ratios and pick the correct answer. You may also be given a ratio and asked to state what it implies.

Answer 44

-Earnings Per Share
-Dividend Yield (same as interest yields on bonds)
-Dividend Cover
-Price to Earning ratio (P/E ratio)
-Price to Earning ratio to growth rate
-Net asset value
-Price to book ratio (PB ratio)
-Gordans growth model (to calc share price)

Question 45

Financial statements

Statement of Financial Position (balance sheet), including:
assets.
liabilities.
shareholder funds.

Income Statement (profit and loss account):
shows the performance of the company over the accounting period.
summarises the company’s revenue transactions.

Cash flow statement:
seeks to identify how a company’s cash has been generated over the accounting period.

Question 46

The main areas of analysing companies

Profitability, including calculations for:
operating margin.
net margin.
return on equity (ROE).
return on capital employed (ROCE).
Volatility, looking at:
financial leverage (gearing).
operating leverage (costs).
Liquidity including calculations for:
working capital (current) ratio.
liquidity ratio.
Working capital management
Looks at changes to the working capital, to ensure that the stock levels, debtors and creditors are being controlled sufficiently.
Uses working capital formula to identify amount of current assets over current liabilities.
Debtor turnover
Estimates the number of times a business collects its average accounts receivable balance during a period.
Debtor collection period in days.
The number of days that it takes the company to collect its invoices.
Stock turnover
Assesses how efficiently a business is managing its inventories.
Creditor turnover
Evaluates how fast a company pays off its creditors or suppliers.

Answer 46

Limitations of ratios
Different accounting procedures can make the figures unreliable.
Share splits or share consolidations can alter these ratios.
Often use historical data, sometimes over a year out of date.
Only as good as the source of information used.
Impact of inflation, interest rates, and taxation may be different year on year.
Often need to be compared to a similar business.

Question 49

A company has trade payables of £35,000 that are due in the next 3 months. In which section of the balance sheet would you find this?

Current assets.

Non-current assets.

Current liabilities.

Non-current liabilities.

Answer 49

Current liabilities.

Current liabilities are any liabilities that are due within the next 12 months.

Question 50

A company uses the First In First Out method of inventory management. This means:

Stock is valued at the weighted average cost of stock purchased over the accounting period.

Remaining stock prices will resemble those of current prices.

It will produce the lowest profit figure.

It assumes that the most recent stock will be sold first.

Answer 50

Remaining stock prices will resemble those of current prices.

Because the oldest stock is being sold first then the stock remaining will more closely resemble current prices. In a rising market this will produce the highest profit figure being recorded on the companies accounts

Question 51

The share premium account represents:

How much was raised in the IPO.

How much above the issue price shares are currently trading.

How much shares were issued above their nominal value.

How much the current share price is above the nominal value.

Answer 51

How much shares were issued above their nominal value.

The share premium account represents how much over and above the nominal value the shares were first issued.

Question 52

A company has a share price of 240p, earnings per share of 12p and a dividend of 4p per share. These figures show that:

The P/E ratio is 60.

The dividend yield is 33%.

The dividend cover is 3.

The gearing ratio is 20.

Answer 52

The dividend cover is 3.

The easiest way to tackle these questions is to go through each answer in turn.

P/E = share price ÷ EPS = 240 ÷12 = 20, so A is not correct.

Dividend yield = dividend ÷ share price x 100 = 4 ÷ 240 x 100 = 1.67%

Dividend cover = EPS ÷ dividend per share = 12 ÷ 4 = 3. (You’ve found a correct one, so could stop there!)

You cannot calculate gearing from the information given.

Question 53

The current ratio of company X is 0.5. This suggests..

the dividend is uncovered.

it has low gearing.

it is unlikely to be able to cover its current liabilities from its current assets.

it is unable to pay interest due out of its profits.

Answer 53

it is unlikely to be able to cover its current liabilities from its current assets.

Current ratio = current assets ÷ current liabilities. If this is less than one, it may suggest the company will not be able to cover its current liabilities using its current assets.

Question 54

ABC Plc has net earnings of £25,000,000. Its ordinary share capital is £55,000,000, its preference share capital is £10,000,000, its share premium account is £40,000,000, and retained earnings are £15,000,000. What is the return on equity?

21%.

38%.

45%.

61%.

Answer 54

21%.

Return on equity = net profit ÷ shareholder funds

Shareholder funds = ordinary share capital + preference share capital + reserves

=55,000,000 + 10,000,000 + 40,000,000 + 15,000,000 = £120,000,000

ROE = 25,000,000 ÷ 120,000,000 = 21% OR you can just use 25 ÷ 120 to save typing in all those zeros.

Question 55

Calculate the operating profit margin given the following information for ABC plc.

Sales: £85,000,000
Cost of Sales: £65,000,000
Operating costs: £10,000,000
Tax: £2,000,000

23.5%.

11.8%.

10%.

9.4%.

Answer 55

11.8%.

Operating profit margin = operating profit ÷ sales x 100.

Operating profit = sales – cost of sales – operating costs = 85,000,000-65,000,000-10,000,000 = £10,000,000

Operating profit margin = 10,000,000 ÷ 85,000,000 x 100 = 11.8%.

Question 56

PQR plc have just paid a dividend of 10p per share. It is expected to grow at a rate of 5%. If an investor’s required rate of return is 8% what price should they pay for the shares?

80p.

200p.

333p.

350p.

Answer 56

350p.

Gordon’s growth model is: next dividend ÷ (r-g) = (10 x 1.05) ÷ (0.08-0.05) = 10.5 ÷ 0.03 = 350p

Question 57

A company has a dividend cover of 2.5, an EPS of 12.5p and a P/E ratio of 10. This means that:

Dividend yield = 4%.

Share price = 100p.

The dividend is 4p per share.

Interest cover is 5 times.

Answer 57

Dividend yield = 4%.

Dividend yield = dividend ÷ share price x 100

We can calculate the dividend from the dividend cover ratio = eps ÷ dividend per share

Rearrange: dividend per share = eps ÷ dividend cover = 12.5 ÷ 2.5 = 5p

We can calculate the share price using the P/E ratio = share price ÷ eps

Rearrange: share price = P/E x eps = 10 x 12.5 = 125p

So B and C are wrong!

And the dividend yield = 5 ÷ 125 x 100 = 4%

Question 58

Which type of company might use profits per employee as a profitability measure?

Retail company.

Distribution company.

Airline.

Creative company.

Answer 58

Creative company.

Retail companies use profits per square foot, distribution companies use profits per ton mile, airlines use profit per passenger mile.