Interpretation Flashcards
What is the definition of efficiency in the context of financial ratios?
What does it test?
Name three examples of efficiency ratios companies may use.
Efficiency is defined as: work output / work input.
An efficiency ratio tests a key output against the input that produces it.
- Profit per employee
- Profit per unit floor area (retail business)
- Turnover generated from assets
What does Asset Turnover measure?
How is it calculated? (2)
The efficiency with which the company uses capital employed to generate sales.
Asset Turnover = Revenue / Net Assets = £ or times
where Net Assets = Total Assets – current liabilities.
OR Revenue / Capital Employed = £ or times
Where Capital Employed = equity + non-current liabilities
Non-current asset turnover
What does it measure?
What is the formula for it?
Measures the efficiency with which the company uses non-current assets to generate sales
= Revenue / Non-current assets
Expressed as number of times the assets are turned over in a year
What is the formula for calculating ROCE?
Ratio relationship (picture)
ROCE = PBIT / Capital employed.
Example question Ali and Bhaskar
Return on shareholders’ funds?
Return on capital employed?
Operating profit margin?
Gross profit margin?
What year can average inventories be calculated for?
Average inventories can only be calculated for 2023.
i.e. (£5,169.6m + £5,169.6m) / 2
Would need the 2021 figure to calculate average inventories for 2022
Average inventories can only be calculated for 2023.
i.e. (£5,169.6m + £5,169.6m) / 2
Would need the 2021 figure to calculate average inventories for 2022
What year can average inventories be calculated for?
Can calculate average inventories for ye 2024 and 2023
2024 = (£2,635m + £2,510m) / 2 = £2,572.5m
2023 = (£2,510m + £2,339m) / 2 = £2,424.5m
Inventory turnover (formula)
Is a higher or smaller figure better
Higher the better.
Receivable days/ collection period
What does it assume?
How can it be expressed?
Assumes all sales are on credit.
To express in terms of: months X 12 or weeks X 52
The Working Capital Cycle (picture)
Liquidity ratios
What do they measure?
What can it include?
What is the main question it raises?
- Measure the extent to which a business can cover its short-term obligations
- This can include short-term creditors and loan interest/ repayments
- Can a business use its liquid assets to cover its liabilities?
Current (liquidity) ratio
It can be ____________ if less than 1 but it depends on ____________
It can be dangerous if less than 1 but it depends on industry
How is the company financed – capital structure
Companies are financed through a mixture of: (3)
- Share capital
- Retained profits
- Loans
Gearing
What does it refer to?
Formula?
When is high gearing okay and when is it not?
Refers to the relationship between debt and equity
Indicates how the company’s capital is constituted between debt and equity (shareholders’ funds).
= Debt finance/(Debt finance + Equity finance) x 100
High gearing is OK when interest rates are low but not so good when they are high
Debt to Equity ratio
Formula?
What is it?
What does ________________ ______ include? (3)
Debt finance / Equity finance(Shareholders’ funds) X 100
A measure of the borrowings as a proportion of shareholders’ funds
Shareholders’ funds includes:
- All the share capital,
- share premium accounts,
- any reserves and profit and loss reserves
Financial Gearing: Example
Fill out debt/equity
Taxation is 30% of profit before tax, but after interest
Which company would you consider to be more highly geared?
What is the profit available to shareholders if operating profit = £50,000?
What is the return on ordinary shareholders funds?
What happens if operating profits increase or decrease by 20%
Is gearing beneficial?
Business usually makes…on…?
Interest is …
Business usually makes greater returns than interest rates on borrowings
Interest is tax deductible which means that you can subtract the amount of interest paid from your taxable income. This effectively reduces the amount of income that is subject to tax.
Highly geared:
- relatively high levels of debt funding
- more interest to pay before ordinary dividends paid
- could indicate more risk
Investment ratios - definitions
Dividend?
Share volume?
Share price?
- Dividend – proportion of profit after interest (earnings) and tax paid to shareholders.
The remainder of the earnings is re-invested. - Share volume – the number of ordinary shares in circulation
- Share price – as of today
IAS 33 Earnings per share
- Why is Earnings per Share (EPS) important?
- Can EPS be manipulated?
- Does all the profit have to be paid out as dividends in EPS calculation?
- How does EPS allow for comparison between different years?
- What is a factor that can affect the number of shares in issue during the year?
- It is used to estimate future growth which affects future share price.
- Yes, EPS may be manipulated.
- No, not all the profit has to be paid out in the form of dividends.
- EPS allows comparison between one year’s earnings and the next because profit is related to the tangible number of shares in issue.
- Share issue during the year can affect the number of shares in issue.
Price/Earnings ratio
- What is the formula for calculating the Price/Earnings (P/E) ratio?
- How is Earnings per Share (EPS) described in the context of the P/E ratio?
- How is the Market Price described in the context of the P/E ratio?
- What does the P/E ratio represent in terms of earnings recovery?
- What aspects of a company does the P/E ratio reflect according to the market’s view?
- Why is it useful to compare the P/E ratio to other companies in the sector?
- The price / earnings ratio that can be expected depends on: (4)
- Market price per share / Earnings per share
- Earnings per Share (EPS) is considered a historical value used for comparison.
- The Market Price is seen as a forward-looking value.
- The P/E ratio represents the number of years of earnings necessary to recover the market price of the share.
- The P/E ratio reflects the market’s view of the company’s growth potential, dividend policy, and the degree of risk involved.
- Comparing the P/E ratio to other companies in the sector helps assess relative performance and valuation.
- Overall level of the stock market
The industry
The past record of the company
The view of the market
Prediction and trend analysis
What can it be used for?
What option do you have and what are they called?
What can be tracked over time to detect trends?
- May be used to predict financial distress
- May look at one ratio at a time or several ratios together
- Univariate or multivariate analysis
- Ratios can be tracked over time to detect trends
- Plotted on a graph
The interpretation process (picture)
Consideration of Internal and External Factors
General business environment
Industry specifics
Management – motives, policies
Read the narrative
Exam approach
What format are you required to use? Be professional!
Be mindful of the audience – internal manager, executive director, non-executive director, investor?
Question – address the requirements given
Brief conclusion – no new information
Either calculate the ratios required of you or decide on the most appropriate and calculate them
Work your way down the statements addressing each requirement in turn:
1. State your calculated ratios
2. How do they differ?
3. So what? Can you link information?
Limitations of ratio analysis (4)
Lack of standard definitions – not governed by IFRS (except for EPS)
Are two companies truly comparable?
Accounting policy choices
Timing – SOFP shows one point in time
