Lecture 24-26 (Ratio Analysis)

Question 1

How do you decide where to invest?

Answer 1

Obtain audited accounts
Analyse accounts
Use ratio analysis to help
Gain understanding of business so you can make an informed decision

Question 2

What considerations does a finance provider need to make before making a debt investment (e.g. loan)?

Answer 2

Can the organisation make capital and interest repayments?
What terms and conditions will we impose (interest rates etc.)?
Are there assets available for sale if all goes wrong?
Can we get security against these assets?

Question 3

What considerations does a finance provider need to make before making an equity investment?

Answer 3

What are dividend levels and capital appreciation likely to be?
Is current share price over or under valued?

Question 4

Why calculate ratios?

Answer 4

1. To review performance over time.
2. Compare performance of competitors.
3. Compare performance with industry averages.
4. Use past performance to help forecast future performance.
5. Highlight problems, then take corrective action.

Question 5

INVESTOR RATIOS

Answer 5

An aid to judging a company as a stock market investment.

Question 6

MANAGEMENT PERFORMANCE

Answer 6

An aid to judging how well the company is being run by management.

Question 7

LIQUIDITY

Answer 7

Aids judgement of adequacy of company’s cash and near cash resources.

Question 8

GEARING

Answer 8

Measure of the company’s financial risk.

Question 9

EARNINGS PER SHARE (investor ratio)

Answer 9

profit after tax for ordinary shareholders/number of issued ordinary shares

Most often quoted measure of company performance and progress.
Measure percentage increase from year to year- can lead to short-termism.

Question 10

PRICE EARNINGS RATIO (investor ratio)

Answer 10

share price/earnings per share

• Compares the amount invested by the shareholder in the company with the earnings per share. Number of years current profit represented by share price.
• Reflects market’s confidence in future prospects of the company.
• Compare average P/E for the industry, given daily in the Financial Times.
• Commonly used as a basis for investment decisions

Question 11

DIVIDEND PER SHARE (investor ratios)

Answer 11

dividend of the period/number of issued ordinary shares

• Of immediate interest to many investors. Dividend is the most immediate reward for share ownership.
• Most companies attempt to maintain a consistently increasing trend.
• Reduction in dividend per share is often only proposed by management as a last resort.

Question 12

DIVIDEND COVER (payout ratio) (investor ratio)

Answer 12

earnings per share/ dividend per share

OR

profit after tax/ total dividend for ordinary shareholders.

• Number of times dividend can be paid out of current earnings.
• The higher the dividend cover, the “safer” the dividend.

Question 13

DIVIDEND YIELD (investor ratio)

Answer 13

dividend per share/ share price x 100

• Compares dividend per share with the current market price of the share.
• Might seem low yield compared to other types of investment.
• Dividend are not the only benefit from share ownership. there is an expectation of an increase in share price. Retained profits generate growth in future profits.

Question 14

RETURN ON SHAREHOLDERS EQUITY (management performance)

Answer 14

profit after tax/ share capital + reserves x 100%

• Performance of company from the shareholders’ perspective.
• Profits used to cover dividend and to generate retained earnings for future growth.
• Essential to use profit after tax and after interest charges.
• Share capital figure should include share premium as well, as really looking for cash generated from share issue.

Question 15

RETURN ON CAPITAL EMPLOYED (management performance)

Answer 15

operating profit (before interest and tax)/ (total assets - current liabilities) x 100

• Performance of company as a whole.
• Measure of management efficiency.
• Relates to all sources of long term finance NOT equity.
• Denominator can also be shown as:
  ordinary share capital + reserves + long term loans

Question 16

GROSS PROFIT RATIO (management performance)

Answer 16

gross profit/sales(revenue) x 100%

• concentrates on costs of making goods and services ready for sale.
• small changes in this ratio can be highly significant.
• there tends to be a “normal” value for each industry.
• operating profit margin can also be calculated.

Question 17

TOTAL ASSET USAGE (management performance)

Answer 17

sales(revenue)/ total assets

• indicates how well a company has used its productive capacity.
• use in trend`s of what has happened over time.

Question 18

CURRENT RATIO (liquidity)

Answer 18

current assets/current liabilities

Are short term assets adequate to settle short term liabilities?
If less than 1 look closely at cash flow.
Ability to generate daily cash might make this ratio adequate.
Must look at norm for industry.
Usually between 1.5 and 2 for manufacturing industry.

Question 19

ACID TEST (liquidity)

Answer 19

current assets - inventory / current liabilities

Places emphasis on the most liquid assets.
Excludes inventory
Expected value of around 1 but varies from industry to industry. Cash flow must be considered.

Question 20

INVENTORY HOLDING PERIOD (liquidity)

Answer 20

average inventories held/cost of sales x 365

How quickly goods move through the business.
Generally the shorter the better, but too short may risk being “out of stock”.
Assumption that year end figures represent normal level for year.

Question 21

CUSTOMERS COLLECTION PERIOD (liquidity)

Answer 21

trade receivables/credit sales(revenue) x 365

Speed of collecting from credit customers
Compare with the credit period given, or the normal credit period for the industry.
If you cannot split out credit and cash sales use total revenue figure.

Question 22

SUPPLIERS PAYMENT PERIOD (liquidity)

Answer 22

trade payables/credit purchases x 365

(if no credit purchases figure, use cost of sales)

• Paying too fast- risk of cash shortage
• Paying too slowly- risk of losing supplier
• Companies must disclose this information in the directors’ report.

Question 23

GEARING (ratio)

Answer 23

long term loan + preference share capital / equity share capital + reserves x 100

Debt/equity ratio
Most often quoted in the financial press. A high figure indicates reliance on sources of long term finance.
Long term loan includes short term portion of loans, in current liabilities in statement of financial position.
Also bank overdraft, if a permanent feature.
Interest payments must always be met, so company has exposure to interest rate movements.

Question 24

INTEREST COVER

Answer 24

operating profit (before interest and taxes) / interest

Indicates how “safe” the annual interest payments are in relation to profit.

Indicates how many times profits can fall before the company is unable to cover payments out of current profits.

Question 25

LIMITATIONS OF RATIOS

Answer 25

• Only useful guidelines.
• Miss seasonal variations
• Financial Statements contain assumptions and estimates.
• Using historic information.
• Of comparing companies must be fair comparison and have similar accounting policies.
• Prior year figures must be on same basis for comparison.
• Take all relevant factors into account.
• Check for qualified audit report.