Interpretation of Financial Statements Flashcards
What is efficiency defined as?
What does an efficiency ratio test?
Some examples, companies may use: (3)
Efficiency is defined as: work output/work input
- An efficiency ratio tests a key output against the input that produces it.
- Are resources are being used efficiently?
- Some examples companies may use:
o Profit per employee
o Profit per unit floor area (retail business)
o Turnover generated from assets
What is asset turnover?
Asset Turnover
The efficiency with which the company uses capital employed to generate sales
Revenue/Net Assets = £ or times
Where Net Assets = total assets – current liabilities
Or can be expressed as: Revenue/Capital Employed = £ or times
Where Capital Employed = equity + non-current liabilities
Non-current asset turnover
Measures the efficiency with which the company uses non-current assets to generate sales
Revenue/Non-current assets
Ratio relationships
ROCE = PBIT/Capital Employed
= Profit margin x Asset turnover
ROCE is influenced by
Pyramid approach – can drill down further
Average inventories turnover period
The number of days inventory is held on average
Average inventory = (opening inventory + closing inventory)
The quicker inventory is sold the better?
Depends on industry
Inventory turnover
A measure of the number of times the inventory is used up the period - e.g. in a year.
Expressed as ‘number of times’.
Average stock = (opening stock + closing inventory)
Higher the better.
Receivable days/ collection period
Measures the average number of days the company takes to collect payments from debtors.
Assumes all sales are on credit.
To express in terms of: months X 12 or weeks X 52
Payable days/ payment period
Measures the average number of days the company takes to pay creditors.
Taking longer = short-term borrowing from suppliers
Working Capital
Or net current assets
Working Capital = Current Assets – Current Liabilities
Working capital cycle:
= Inventory turnover + days receivables – days payables
The Working Capital Cycle (picture)
Liquidity ratios
- 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
Assesses exposure to the need to suddenly meet liabilities.
Current ratio = current assets/current liabilities
Expressed as a ratio, e.g. 3:1
May be dangerous if less than 1?
Depends on industry
Quick (acid test) ratio
Same as current ratio but minus inventory (because it takes longer to turn stocks into cash or near cash)
Normally greater than 1? may be negative
Analysis of Financing
How is the company financed – capital structure
Companies are financed through a mixture of:
- Share capital
- Retained profits
- Loans
Gearing
- Refers to the relationship between debt and equity
- Indicates how the company’s capital is constituted between debt and equity (shareholders’ funds).
High gearing is OK when interest rates are low but not so good when they are high
Debt to Equity ratio
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
use ppt
Return on ordinary shareholders funds
Gearing interpretation
- Big cog : little cog effect
- Is high gearing beneficial?
Business usually makes greater returns than interest rates on borrowings
- Interest is tax deductible
Highly geared:
- relatively high levels of debt funding
- the more interest to pay before ordinary dividends paid
- could indicate more risk
Investment ratios
- Investors BUY shares in a company in order to earn a return
- There are a number of ratios that are useful for investors:
o Current shareholders
o Or potential investors
Investment ratios - definitions
- Dividend – proportion of profit after interest (earnings) and tax paid to shareholders.
o The remainder of the earnings is re-invested - Share volume – the number of ordinary shares in circulation
- Share price – as of today
- Dividend cover
- Dividend yield
- Earnings per share
- Price/Earnings ratio
Dividend cover
- Shows the number of times that the ordinary dividend can be paid out of current earnings
- How many times is the dividend covered by earnings?
Dividend Yield
- Expressed as %
- Measures the rate of return an ordinary shareholder gets by comparing the cost of their shares with the dividend payable
- Does not take into account capital growth
- Based on current price which may not be the price paid
Earnings per share IAS 33
- Used to estimate future growth which affects future share price.
- Measure of growth over time – may be manipulated
- Not all the profit has to be paid out in the form of dividends
- 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
