week 23 Flashcards
what is solvency
the ability to cover liabilities when they fall due
potential problem if current assets < current liabilities
what is liquidity
refers to the ease of turning an asset into cash (without loss)
cash is most liquid
what is the working capital/current ratio
current assets / current liabilities
indicates ability to pay current liabilities from current assets
what is a good working capital/current ratio
between 1.5 and 2, very industry dependant
what is the limitation of working capital/current ratio
some assets are more liquid than others
what is the quick ratio (acid test)
(current assets - inventories) / current liabilities
more stringent test of liquidity because inventory is less liquid
what is a good ratio for the quick ratio
at least 1, depends on industry and size
how do you predict insolvency
current and quick ratios are crude measures of liquidity, most users of financial statements are interested in liquidity as an indicator of whether the company can pay all its debts or will go into liquidation in the near future
when does overtrading occur
when a business is operating at a level beyond its financial capacity
why does overtrading occur
young, expanding business
manager miscalculation
unavailability of financing
what are symptoms of overtrading
persistent use of bank overdraft facility
working capital ratios and liquidity ratios
significant increases in payment payables periods and settlement periods for receivables
long inventory holding period
low current and quick ratios
what are the impacts of overtrading
liquidity problems
supply problems
planning problems
business failure
business must ensure sufficient financing. for long term success
how do you calculate dividend yield
annual equity dividend / current market value of equity shares x 100
what is dividend yield
seeks to assess equity shareholders annual cash return on investment
often between 2-5%
dividend yield is very important to some shareholders but not others
may be compared with other investments
how do you calculate dividend cover
profit for the year / annual equity dividend
what is dividend cover
shows the number of times dividend is covered by current profits
indicates how likely it is that company will be able to maintain dividends if profits fall
measure of risk
how do you calculate earnings per share
profit for the year / number of equity shares in issue
what is earnings per share
key measure of profitability and ability to pay dividends
profit - represents profit avaliable for distribution to equity shareholders
weighted average number of shares to take account of the period which shares are in issue
what is basic EPS
takes account of all equity shares in issue
what is diluted EPS
takes account of shares that may result if thee are financial statements which might be converted into shares in the future because this conversion would dilute the EPS
how do you calculate return on equity
profit for the year / (equity - minority interest) x 100
what is return on equity
comprehensive indicator of performance - how well managers use funds invested by shareholders
ROE should exceed cost of equity capital for the firm to be regarded as a success
what is minority interest
refers to ownership aside from the parent
reported on balance sheet - reflects claim on assets belonging to other non controlling shareholders
how do you calculate price-earnings ratio
current market price of each equity share/earnings per share
what is price-earnings ratio
compares amount invested in one share with earnings per share
represents the number of years of current earnings that investors are prepared to buy
often is in the range between 10 and 25, variation across industries
what does low P/e ratio mean
riskier firm
firm is expected to stagnate
what does high P/e ratio mean
firm is expected to grow
why is there variation in P/e ratio
due to level of stock market and industry of firm
how do you calculate market book ratio
market capitalisation of shares (market value) / book value of shares (capital and reserves)
what is market to book ratio
relationship between stock market value of shareholder equity and accounting value of shareholder equity
can indicate whether a company is under or over valued or whether market expectations of the company are high or low
how do you calculate interest cover
operating profit (before tax and interest) / interest expense
what is interest cover
an indicator of how much cushion there is before interest is paid
what is gearing or leverage
the relationship between fixed interest capital and the amount of equity capital
why should shareholders care about gearing
concerned about risk, gearing is an indicator of financial risk
high leverage = high risk
how do you calculate equity
share capital + share premium account + reserves + retained profits
how do you calculate debt
preference shares + loans + bonds + other non-current borrowings
are preference shares debt or equity
typically debt because interest must be paid before any dividends to ordinary shareholders
what is debt-equity ratio
debt capital / equity capital x 100
what is the gearing ratio
debt capital / (debt capital + equity capital) x 100
why is high gearing potentially negative
increases profit available for distribution as dividends and it is deductible for tax purposes
more debt, more financial risk and more volatility attributable to shareholders
what is financial risk
relates to company’s exposure to fixed interest
what is operating risk
relates to particular industry in which the firm is operating
