Ratios Flashcards
Trade Payable Days
How many days averagely the business takes to pay its credit suppliers. If the figure for credit purchase is unavailable, use ‘Purchases’ figure. If that’s not available, use ‘Cost of Sales’
Trade Payable Days 2
If the payable days is shown ad 40 days e.g -> the business averagely takes 40 days to pay for its credit purchases. An increase in this ratio= good for the business cash flow, although discounts may have been lost due to not paying promptly. Also, suppliers may be unwilling to keep supplying on credit if the figure is too high. Having this figure higher than receivable days would be good for cash flows as it means receiving cash from customers before having to pay suppliers
How to reduce capital gearing levels
Additional share capital (not a bonus issue) and, if possible, share premium.
Increased retained earnings.
Increased revaluation reserve.
Sale of unwanted assets to repay NCL
How to increase capital gearing levels
Buy back ordinary shares.
Convert short term debt into long term loans.
Issue preference shares or debentures
Profit in relation to revenue
Profit for the year/ sales revenues x 100
E.g if the profit in relation to revenue = 15%
Profit for the year = revenue x 15%
Revenue = profit for the year / 15%
What is total equity made up of?
Issued share capital + Capital Reserves + Retained earnings
How would gross profit margin & Cost of Sales be used to calculate revenue
E.g COS = £120000 and GP= 20%.
If GP is 20% of revenue, then CoS must be 80% of revenue
Therefore , revenue = £120000/0.8=£150000
GP= £150000-£120000=£30000
Liquid capital ratio
(CA- Inventory)/ CL : 1
Measures a business’ ability to meet its CL w/ it’s most liquid assets : cash & cash equivalents & trade receivables.
The ratio excludes stock as the business can’t be sure that all the stock will be sold
Expenses in relation to revenue
Expenses/ Revenue x100
If the ERR is shown as 42%, -> 42p expenses for every £1 of revenue.
An increase = a business has been less able to control its expenses which is bad for profitability .
an increase in this ratio is a sign of decreasing financial efficiency
How to improve liquid capital ratio
Reduce the amount of inventory being held , if necessary, by reducing the selling price of old inventory.
Additional long term borrowing (bank loans/ debentures).
Sale of unwanted NCAs
Net profit margin (profit in relation to revenue) (P)
Profit for the year before tax/ Revenue x 100
If NPM is shown as 5% -> 5p profit for every £1 of revenue. An increase = higher profit in relation to the size of the business measured by revenue
How to increase the NPM
Higher sales revenue w/o a larger increase in COS or expenses.
Higher gross profit margin w/o a larger increase in expenses
Lower expenses w/o decreasing sales revenue or gross profit margin
Return on Capital Employed
If the ROCE is shown as 12% -> 12p profit for every £1 of capital employed. An increase in ROCE= higher profit in relation to the business size , as measured by capital employed.
How to increase the ROCE
Higher sales revenue w/o a larger increase in the the COS or expenses
Higher GPM w/o a larger increase in expenses
Lower expenses w/o decreasing sales revenue or GPM
Profitability ratios
GPM
Markup
Profit in relation to revenue (Net profit margin)
Return on capital employed
Gross profit margin
GP/ Revenue x100
If the GPM is shown as 20% = 20p GP for every £1 of revenue.
How to increase the GPM
Higher selling prices, w/o COS increasing
Lower purchase price w/o selling price decreasing
More efficient use of inventory, w/ less wastage, damage or theft
Current ratio
If CR= 1.65 : 1 -> £1.65 CA for every £1 of CL. An increase in the CR means greater liquidity-> greater ability to pay CL when they’re due. However an excessively high CR suggests that the business has tied up CA unnecessarily
How to improve the CR
Sale of unwanted NCA
Increase value of profitable sales
Additional long term borrowing/ turn its overdraft into a LT loan (reduces short term liabilities & increases capital)
Mark up
If the M is shows as 50% = 50p gross profit for every £1 of COS
How to increase the markup
Higher selling prices , w/o Cos increasing
Lower purchase price w/o selling price decreasing
More efficient use of inventory, w/ less wastage, damage or theft
Liquid Capital Ratio
L’or shown as 0.85 : 1-> £0.85 liquid assets for every £1 of CL. An increase in LCR= greater liquidity= greater ability to lay CL when they’re due. However an excessively high LCR suggests the business hastied up liquid assets unnecessarily.
If the LCR is worsening but the CR is improving, = business is holding too much inventory
Inventory turnover in days
If the inventory turnover in days is shown as 26 days -> a business holds stock for an average of 26 days. An increase in this ratio= bad for the business -> indicates lower sales and damages cash flow-> sign of decreasing financial efficiency
How to improve inventory turnover (times/days)
Reduce the amount of stock being held , w/o decreasing sales.
Increase the sales levels (e.g better advertising or lower selling prices) w/o increasing the level of inventory
Profitability ratios
GPM and Markup —>examine the relationship between selling price and the cost of buying or producing the goods that are sold . They don’t analyse the final profit made by a business .
Profit in relation to revenue & ROCE examine the final profit made by a business
Limitations of using ratio analysis to assess business performance
Window dressing
Average ratios may not be reliable
Ratios only focus on numbers
Ratios don’t show the cause of the performances
Current Ratio ( L)
Compares all of the business’ current assets with its current liabilities
(Liquidity ratios are always expressed as X:1 ams to two decimal places)
Rate of inventory turnover (times)
If the inventory turnover in times is shows as 3 -> business has gotten through (sold) its average inventory 3x during the year.
An increase in this ratio = GOOD fore the business as it probably indicates higher sales and it certainly helps cash flow.
An increase in this ratio is a sign of financial efficiency.
Trade Receivable Days
How many days on average , credit customers take to pay for goods and services -> if credit sales figure isn’t available, use the Revenue figure
Trade receivable days 2
If the receivable days = 35 days = on average credit customers take 35 days to pay for their goods.
An increase in this ratio = bad for cash flow of the business & sign of decreasing financial efficiency.
Also an increase in the likelihood of irrecoverable debts. A decrease in this fire may lead to a loss of customers due to tighter credit control, having this figure higher than payables days would be BAD for cash flow as it means laying suppliers before reviving cash from customers
Dividend Per Share
The total dividend a company pays out over a 12 month period divided by the total number of issued shares- used by companies to calculate share profits with its shareholders.
It can tell an investor about the company’s past financial health and its current financial stability. For example suppose company ABC had a dividend share of 60p last year but this year it doesn’t pay a dividend to its shareholders discount signal to investors. The company may be in poor financial health and cannot withstand the current market conditions decrease in dividend per share could cause investors to sell their stake in the company this the market value of ABC down.
However a decrease does not always signal accompany is not financially stable for example suppose ABCD didn’t pay out a dividend with shareholders because it’s using its profit to reinvest into the company to create a new product. This reinvestment into the business can potentially produce higher dividends in the long-term.
Suppose company has been paying a steady dividend of 90 people share the next year company a realise raises its dividend to £1.10 per share. This signals the company is financially stable and performing well and its market condition and increase in dividending per share also signals the management team is confident in the companies future profits.
Dividend Yield
The amount of money a company pay shareholders over the course of a year for owning a share of its shareholding divided by its current stock price displayed as a percentage.
It’s important for an investor concerned with wanting to generate an income from dividends however a higher dividend yield could indicate that a company is paying more of their profit out in dividends and not keeping as much profit as retained profit. If a company pays out large amount of dividends this may not be attractive to potential investors who may want to invest in a company to benefit from future growth. by paying out large amount of dividends i.e. a higher dividend yield would potentially reduce the market price of the share as there is less profit for future growth.
Earnings Per share
Calculated as a companies profit divided by the number of ordinary shares its serves. It serves as an indicator of a company’s profitability. The higher a company’s EPS, the more profitable it is considered.
The EPS shows how much profit a company makes for each of its shares.
A higher EPS =more valuable = investors will pay more for a company with higher profits + attracts investors wanting to generate a short term medium income from their investment.
However, comparing EPS in isolation = terms of one company against another may not have much meaning to investors because ordinary shareholders do not have direct access to the earnings. Instead investors will compare EPS with the SHARE PRICE of the shares to determine the value (potential) of earnings and how investors feel about future growth.
Dividend Cover
Mention of an ability to pay dividends from its profits DC. DC shows an investor how many times the companies profits cover the dividends.
A high DC = interests investor + shows that the company is more profitable.
DC is used by investors to assess the risk of not receiving dividends, (a lower dividend cover is more of a risk ).
A DC less than pay = that company doesn’t have sufficient profits to cover the dividends proposed to investors.
However the company may still pay out dividends even if it’s dividend cover is less than 1 because it may be borrowing money to cover the dividend costs. This is a dangerous strategy as interest has to be paid on any borrowing.
Price Earnings Ratio
Shows how expensive a share is to buy for an investor- how much an investor is prepared to pay for each £1 of the company’s profit.
A higher PER = investors expects a high level of earnings in the future and that growth will be strong. The share price has risen faster than earnings on expectations of an improvement. A low= arises as share price falls -> the share price is cheaper (not good for an investor with shares looking for a long term investment).
For some investors , high = attractive = high expectations for future growth. For others , low= expectations aren’t too high and the company is more likely to outperform earnings forecasts.
Interest cover
How easily a company can pay its interest payments form its profits.
The higher the number of times a company can cover its interest payments form its profits. The lower the IC , the more the company is burdened by debt expense.
Companies need to have more than enough earnings to cover interest paintings in order to survive and financial hardships that may arise.
Stability in IC ratios is one of the more important things to look forward when analysing interest cover coverage ratio in this way .
Declining ICR = our company may be unable to pay in the future.
Interest cover is a very good assessment of companies short term financial health.
Capital Gearing
CG =65% —> 65p NCL for every £1 of capital employed.
Anything above 50% —> a high level of CH= greater risk of the business not being able to afford the interest repayments.
A high level of CG = banks are less willing to agree to further loans.
Anything below 50% —> low level of CG= less risk of the business being unable to afford the interest and repayments. However a slightly higher one (yet still under 50%) = research and development
However an excessively low level of CG =directors could be criticised for not using using NCL to improve the company’s performance.
Indicators for Capital Growth
Each of the investor ratios would need to be compared with previous years. An increase in each ratio suggest a potential capital growth overtime.
Increasing profits – share price changes are due to demand. Companies making increasing profits each year are likely to be in huge demand and therefore will see capital growth as the price of the shares increases in line with demand.
Increased EPS compared to previous years. This would again suggest capital growth as increased payouts through dividends will see a rise in demand for the shares and therefore increased capital growth.
A high price earnings ratio (can be overvalued by false confidence/mislead belief that the share price will grow) suggest a company will see an increase in earnings in future years. Whilst this is an excellent indication for future growth it must also be remembered that some shares have a ceiling in that there may be a limit to the amount of growth they can achieve.
Compare the current market price with the share price high.
Interest cover and gearing these ratios should be used to track/analyse the companies current position in relation to interest payments. Remember long-term liabilities incur interest and this will have a detrimental effect on profit.
Define Dividend yield
The percentage amount paid per share return as a dividend
Return on investment
Short term
Define price earnings
Tell us the true value of a share : share price valuation and open market if earnings per share were £1.
For every £1 the share makes how much people are going to make
Define interest cover
How many times you can pay interest out of profit
The ability to pay out debts, take out loans
gearing + interest cover
Define earnings per share
Profit made/earned by each share
Define dividend cover
How many dividends we can pay out with profit for the year?
