Topic 12 - Comparison of Financial Ratios Flashcards
What are some limitations of using ratios?
- Different accounting policies to calculate profits and value assets can make comparisons difficult or inaccurate across industries or companies. Even same same company if management decides to change policies over time.
- Ratios use historic data which may not be best guide to future.
- High inflation over years can impact figures as could indicate upward trend when in real terms company static or in decline.
What is EPS used for?
What should a financial planner be looking for in the EPS and what does it tell them?
Profitability and quality of earnings stream - Profit after tax, minority interests and preference dividends.
Want to see EPS rising year on year. Shows company can finance future expansion and pay dividends to the client.
What is the Dividend Per Share?
Why can it be misleading and what can be done to minimise the potential for a misleading reading?
Dividend Per Share = Net Dividend per Ordinary Share
Can be misleading if in growth phase and retaining profits for growth. Long term growth may be better than short term income.
Can use EPS and DPS together to get bigger picture. Also shows how affordable dividend and future consistency of it.
What is the Dividend Yield and how is it used?
What considerations should be considered if the dividend yield is higher than competitors?
Dividend Yield - Compare dividends paid on different companies with other investments e.g bonds/cash
If competitor has higher dividend yield then consider:
- Is competitor mature with limited growth potential
- Is competitor restricted by governement i.e utilities with capped fees
What is the Dividend Cover and what does it tell you?
How is it calculated?
Dividend Cover - Tells sustainability of future dividends. Calculated as times the dividend payment covered by the earnings.
If less than 1 then company is using earnings from past years to pay current dividend.
The higher dividend cover the less likely the company will need to stop paying or reduce dividends
What is the P/E Ratio and what does it tell us?
What sceptical considerations should be made if the high P/E is high? And how can misleading information be better avoided?
What are the different ways to calculate the P/E Ratio?
Relationship between market price of firm and earnings per share. Shows how highly investors value firm’s earnings and reflects market feeling about potential for future growth in earnings.
Only compare firm P/E relative to sector’s average as across sectors, P/Es can vary significantly.
High P/E could already be reflected in share price or share even overpriced as it normally means they are in more demand.
Justifying the P/E Ratio with PEG - Regression Analysis/Line of Best Fit - Dividing historical P/E Ratio by company’s average EPS growth over next 5 years. Ratio of less than one indicates that shares are potentially attractive.
Can be calculated on historical actual earnings data based over last 12 months or forward looking based on forecasts.
Must be careful to use same earnings denominator in both P/E ratios being compared.
What is EBITA used for?
Why is I, T, D and A left out?
What is an argument for and against using EBITA?
- Used as measure of company’s value and underlying operational cash flow and also comparison of performance against other companies.
- Interest & tax not directly linked to profitability of operation. Depereciation & amortisation not related to future cash flows..
- Spreads cost of assets over ‘useful life’. but could be misleading to ignore long term costs of assets as some industries capital intensive.
- Disagreement as some say taking ITDA out removes real expenses in picture. Argument though that these are sunk costs and can vary widely among companies for reasons other than profitability.
What is amortisation?
Decrease value of intangible assets (patents, copyrights) or making regular payments to pay off debt.
What is Return on Capital Employed?
How is it expressed/calculation?
How well assets used to make money to add shareholder value. Investor sees what company will make in return for investments. Sort of like a savings account.
Shows beyond profit, how it came to that profit. E.g company can grow but could just be investing more so the return is the same.
Epxressed as income generated by activities as % of total capital. Used to compare returns to the cost of borrowing as well as other companies.
jWhat is the Quick Ratio?
What’s the ideal ratio?
Key is profitability and liquidity (ability to generate sufficient cash to pay for operations).
Acid Test looks at cash liquidity. Ability to cover current liabilities and costs immediately. If less than 1 it can’t pay back current liabilities. Higher the ratio the more liquid the company is. Too high though the company may not be utilising it’s assets in best way i.e too liquid.
