Ratio Analysis Flashcards
what are some examples of benchmarks ratios can be compared to
prior year results
peers results
industry averages
how much can the ratios alone tell you about a company
about financial health
but indicates where needs further investigatioj
who are the users of ratios
users of financial statement same set
but certain ratios more useful for certain users
e.g. managers look at profitability ratios
lenders/borrowers look at liquidity ratios
investment analysts focus on investment ratios
what are the 3 categories of ratios
profitability ratios
liquidity and gearing ratios
investors ratios
what companies do investment ratios apply to
publicly listed companies
what do profitability ratios measure
how a company uses its assets to generate profitability
what is formula for gross profit margin
gross profit / revenue * 100 %
what does gross profit margin measure
how well our core operations are running
what could cause fluctuations in gross profit margin
change in what you charge
change in what you sell
possible incorrect inventory
change in costs
change in efficiency
what is the formula for operating profit margin
operating profit / revenue * 100%
what does operating profit margin measure
how we have controlled our overheads
what could cause fluctuations in operating profit margin
same as for gross profit margins, these effects will flow down
diminished control over operating costs
once off expenses e.g advertising campaigns, launching into new geographical area
what is the formula for return on capital employed
PBIT / (long term debt + equity) * 100%
what does return on capital employed measure
compares profit against the capital that was invested to make that profit
i.e. how efficiently they have been with their capital
why might there be fluctuations in ROCE
new assets not running at full capacity yet
older machines now have a reduced activity
what is the formula for return on equity
profit after tax and preference dividend / total equity * 100%
what does return on equity measure
potential return for ordinary shareholders
more relevant for shareholders as after tax and preference dividends = what they are entitled to
what could cause fluctuations in ROE
same as ROCE
gearing levels
tax impacts
what is the formula for asset turnover
revenue / capital employed
what does asset turnover measure
how well assets have worked to generate salesw
what is capital employed
equity and interest bearing debt
is it better to have a higher or lower asset turnover
higher
what could cause fluctuations in asset turnover
new assets bought late in year and no time for assets to generate any enhancement to profits
what is the difference between liquidity and gearing ratios
liquidity = ability to meet short term debts
gearing = ability to meet long term debts
what is the formula for current ratio
current assets / current liabilities
what does the current ratio measure
ability to pay current liabilities out of our current assets
what is the formula for quick ratio
(current assets - inventory) / current liabilities
why does quick ratio exclude inventories
inventories are the least liquid current asset
what could cause fluctuations in current or quick ratio
change in receivables or payables
seasonality
what is the target for current ratio
1.5 to 2 : 1
what is the problem with too low of a current ratio
cannot pay obligations
what is the problem with too high of a current ratio
storage and insurance cost for inventory, risk of it running obsolete
money could be invested and put to better use elsewhere
if a company has no inventories what will the quick and current ratio be
the same
what is the target for the quick ratio
1:1
what is the formula for inventory turnover period
inventories / cost of sales * 365 days
what does inventory turnover period measure
number of days inventory held on average before being sold
is a higher or lower inventory days better
lower
to minimise storage and security costs and risk of inventory running obsolete
as long as it meets customer demand
depends on the industry also
what could fluctuations in inventory days indicate
poor inventory control
buying too much inventory and not selling enough
low demand
bought in bulk to avail of discount
buffer stock due to unpredictable demand
what is the formula for receivables collection period
trade receivables / revenue * 365 days
what does receivables days measure
how long it takes to be paid by our trade receivables
should bear in mind the credit term granted to customers
what could fluctuations in receivables days indicate
lower is better meaning money comes in quicker
increased/decreased credit terms offered to customers
don’t want credit period to be too low as it will irritate customers to be constantly demanding them for money
could indicate worse/better credit control
what is the formula for payables payment period
trade payables / purchases * 365 days
what does payables days measure
how long it takes to pay suppliers
trade payables offer free short term finance but delaying payment risky
if there is no purchases figure on the accounts, what figure can be used instead to calculate payables days
cost of sales
BUT REMEMBER TO BE CONSISTANT WITH THIS FIGURE WITH THE COMPARATIVE FIGURES
what causes fluctuations in payables days
changed credit terms
if too low = bad reputation and losing out on potential discounts for paying early
what is the formula for debt equity ratio
interest bearing debt / equity * 100%
what does debt/equity ratio measure
long term financial stability and solvency
what are the benefits of a high debt equity ratio
tax shield of debt
could be increasing to invest in positive NPV projects
what are the benefits of a low debt equity ratio
wriggle room to borrow more
static
what are the risks of a high debt equity ratio
solvency risk
could come into difficulty to repay debt
why can not every company use debt in their capital structure
- need a stable history of profits, may be harder for newer companies
- to borrow must have tangible assets for collatoral
what could cause fluctuations in debt equity ratio
share issue/share buyback
repaying or drawing down new debt financing
what is the formula for interest cover
profit before interest and tax / finance costs
what does interest cost cover
how many times does our profit cover our interest payments
what is the target for interest cover
2 +
what could cause fluctuations in interest cover
factors that influence PBIT
change in interest bearing debt
what is the formula for dividend yield
dividend per share / share price * 100%
what does dividend yield measure
what you get back compared to what you put in
i.e. dividend you get compared to price you paid for share
what would cause fluctuations in dividend yield
changes in dividend paid
changes in share price
some stocks are growth stocks so don’t pay dividends
what is the formula for dividend cover
profit after tax / dividends
what does dividend cover measure
compares profit available to be distributed among shareholders vs what was actually paid to shareholders
what could cause fluctuations in dividend cover
changing profit
pressure to keep dividends year on year to keep shareholders happy
what is the formula for earnings per share
net profit per year / number of issued shareholders
what is the formula for price earnings ratio
share price / earnings per share
what does price earnings ratio measure
shareholders confidence in the company’s future
what could cause fluctuations in price earnings ratio
change in profits
change in sentiment from shareholders
what does an analytical income statement aim to do
seeks to work out NOPAT (net operating profit after tax)
focus on operating activities, as these are critical and are hard to replicate compared to investing and financing activities
are analytical income statements published
no
done by analysts
what is operating tax
tax with the tax shield of debt added back
what does an analytical balance sheet seek to find
invested capital
how is investment capital (investment perspective) calculated
operating assets - operating liabilities
how is investment capital (financing perspective) calculated
book value equity + Net interest bearing debt
why is cash excluded from net interest bearing debt
it is seen as surplus
if it were needed for operations, it would have been spent already
what is the formula for return on invested capital
NOPAT / Invested Capital
what does return on invested capital measure
profitability of operations, disregarding how a firm is financed
what can ROIC be compared to
WACC of company (cost of capital)
with competitors (benchmarking)
what type of growth for a business is the most attractive
recurring growth i.e. growing core business
e.g. through efficiency, changing marketing approach, optimising invested capital, more profitable pricing
what type of growth is not that attractive for business
transitory growth
i.e. once off so cannot rely on these going forward
e.g. gains and losses on disposal, restructuring costs, change in tax rates, change in accounting policies
what are some limitations of ratio analysis
- relies on historical info, changes may have occurred and no guarantee these results will continue into the future
- accounts can be manipulated for desired effects
- effects of related parties
- seasonal trading can distort results due to levels of inventories, cash or receivables
- asset acquisitions - some have not had the time to generate revenue
- differences in accounting policies across companies makes comparisons difficult
what are some examples of ‘creative accounting’
making provisions which are reversed post year end
paying back loans just before year end and taking it back out again at beginning of year
what is the effect on the ratio analysis if the accounts were prepared just at the end of the entity’s busy season
likely to have:
- less inventory
- more cash
- more receivables
not representative of the SOFP ratios for the whole year
