Financial Ratios Flashcards
the problem with absolute figures in financial statements
lacks context; needs to be connected to other figures for meanigful analysis
Limitations of ratio analysis
(core) profitability ratios
concerned with effectiveness at generating profit
- ROE / ROSF
- ROCE
- Operating profit margin
- Gross profit margin
- Mark-up %
(core) efficiency ratios
concerned with efficiency of using assets/resources
- Average inventory days
- Average trade receivables (debtors) days
- Average trade payables days
- Net asset turn / Sales to capital employed
(core) liquidity ratios
concerned with the ability to meet short-term obligations
- Current ratio
- Quick/Acid test ratio
- Cash generated from operations to maturing obligations
(core) debt management ratios
concerned with relationship between equity and debt financing
- Capital gearing (leverage)
- Interest cover
(core) investment ratios
concerned with returns to shareholders
- Dividend cover ratio
- Dividend yield ratio
- Earnings per share
- Price/earnings ratio
Limitations of ratio analysis
- Quality of financial statements
- Inflation
- The restricted view of ratios
- The basis for comparison
- Statement of fianncial position ratios (you can distort ratios)
Using ratios to help predict financial health
- Horizontal and Trend analysis
- Cross-section analysis
-
Comparison with other companies in the same industry for the same year
- Things to watch out for…
- Differences in company characteristics should always be accounted for in interpretation
- Things to watch out for…
-
Comparison with industry averages
- Things to watch out for…
- Multi-product companiesDefinition and size of industry groupings
- Things to watch out for…
-
Comparison with other companies in the same industry for the same year
Common-size financial statements
- The process of standardising financial statements by introducing a common denominator.
- In a common-size SOFP each component of the statement of financial position is expressed as a percentage of total assets
- In a common-size income statement each item is expressed as a percentage of sales
This allows
- comparison of companies of different size (in terms of total assets and sales)
- (internal) structural analysis of the financial statements of a company
- relative magnitude of asset, liability, equity and income statement components
- Combination of horizontal and vertical analysis
key steps of financial ratio analysis
- identify users and what they need to know
- select and calculate appropriate ratios
- interpret and evaluate results
ROE aka. ROSF
Return on Equity aka. Return on Ordinary Shareholders Funds
Profit available to ordinary shareholders
/
Ordinary shareholders equity
=
%
Most companies will use average equity over the year
= (opening Equity + closing Equity)/2
Year end figures can be used if there is not enough information i.e. there needs to be comparability using like for like (year end with year end or average with average).
Return on Capital Employed (ROCE)
Operating profit
/
Total capital employed
=
%
Operating profit % = operating profit / sales
‘Profit available to Ordinary Shareholders’ = profit before dividends
Net asset turnover = sales / total capital employed = sales / (total assets - current liabilities)
two drivers of ROCE
gross profit ratio
gross profit
/
sales revenue
mark up ratio
gross profit
/
cost of sales
non-current asset turnover aka. fixed asset turn
sales revenue
/
non-current assets
really important if the business has a large amount of £ investment in plant, equipment, machinery, buildings
The operating cash cycle
Is the business generating cash from operations or are operations sucking in cash causing liquidity problems?
The cycle refers to the days required for a business to receive inventory, sell the inventory, and collect cash from the sale of the inventory. The cycle plays a major role in determining the efficiency of a business.
Operating Cycle = Inventory Period (days) + Accounts Receivable Period (days it takes to collect cash from the sale of the inventory)
https://corporatefinanceinstitute.com/resources/knowledge/accounting/operating-cycle/
The Working Capital Cycle / Cash Conversion Cycle
The Working Capital Cycle for a business is the length of time it takes to convert net working capital (current assets less current liabilities) all into cash. Businesses typically try to manage this cycle by selling inventory quickly, collecting revenue from customers quickly, and paying bills slowly, to optimize cash flow.
Inventory Days + Receivable Days - Payable Days
Management of the WC Cycle demands:
- MINIMUM INVESTMENT of money in Working Capital, and
- MAXIMUM SPEED of cash through the cycle.
These are monitored via:
- Current Ratio
- Quick/Acid Test Ratio
- Receivables (Debtors) Days
- Payables (Creditors) Days
- Inventory (Stock) Days
It’s usual to use AVERAGES for receivables, inventories, payables.
https://corporatefinanceinstitute.com/resources/knowledge/accounting/working-capital-cycle/
current ratio
current assets / current liabilities
do we have enough current assets that we can turn into cash reasonabily quickly, to cover current liabilities (short-term)
here are ratio of 12/1 will mean that you have 12€ assets for ever 1€ of liabilities, which is good
HOWEVER, a low current ratio is not necessarly bad! For an organisation, it’s actually good to have low levels of inventory, receivables, and cash levels, because that means they are being efficient. Yes, in some industries, a high ratio is better, but for others, especially companies with a high daily cashflow, it makes sense to have a low current ratio.
Textbooks recommend 2:1 or 1:1, but that is completely dependent on the firm. There can also be negative ratios, which is actually also a sign of efficiency. (
quick/acid test ratio
liquid current assets (usually CAs - inventories) / current liabilities
also asnwers: “do we have enough cash to pay immediate bills?
it’s the same as current ratio but takes out inventory because it is the hardest thing to liquify, hence may distort the ratio
again, the hardest thing to turn into cash is first and foremost,
- inventory (and not trade receivables, because you havent even done the sale yet),
- then trade receivables,
- then cash & bank account
capital gearing (leverage) ratio
‘gearing’ = british word for ‘debt’
external funding (debt) / total capital employed
external funding (debt) / equity
equity / total capital employed
Debt is sometimes better than equity, because it is cheaper than equity and you can write of the interest part of it as tax deductible. But only to a certain degree. Because debt increases risk, shareholders will expect more return, as the debt is reinvested in the business. Hence, high levels of debt may increase you risk but since it’s a cheaper way of generating cash, it can be better invested to generate revenue and profit.
This ratio is about the capital structure.
interest cover ratio
Shows how many times you could have paid the interest.
operating profit*
/
interest payable**
=
a multiple (e.g. 4.2 times)
(usually use Interest Expense from Income Statement)
*Operating profit is before interest.
**Interest payable: interest payment for the year.
The higher the ratio the better, because it is less risky.
But very high ratios, it can be argued, don’t use the cheap finance of debt enough.
Earnings per share (EPS)
Shows how many times you could have paid the interest.
ordinary shareholders earnings
/
number of ordinary shares in issue
=
expressed in currency (like 18p per share)
The 18 pence in this case is the profit made from one share.
Price earnings (P/E) ratio
market price per share
/
earnings per share
=
a multiple (like 3.3 times)
For the PE ratio you need a market price, hence you require the EPS ratio first.
It means, if you bough a share for 60 pence today, based on the today’s earnings of the firm, 18 pence, it would take you 3.33 years to break-even.
However, actually, the higher the PE ratio, the better. This is because the share is valued based on its future earnings. The lower the PE ratio, the lower the market expects the business to perform.
dividend cover ratio
Ordinary Shareholders’ Earnings Available for Dividend
/
Paid and proposed ordinary dividends*
=
a multitude (like 4.2 times)
*Paid and proposed ordinary dividends = dividends announced for the year
Dividend cover is like the interest cover, how many times could you have paid the dividends.
(Note: another way of expressing this: dividend payout % ratio which is just the inverse of dividend cover)
Dividend yield ratio
(
Dividend per Share / (1- tax credit for tax year)
/
Market Value per Share
)
x 100
=
