Week 3- Evaluating Business Performance Flashcards
Name 3 advantages of the P/E ratio
- A popular and easy to calculate ratio
- Investors look at the P/E ratio of a share to decide whether to invest in a company
- A tool to compare different companies
Name 2 issues with the P/E ratio
- Future earning are used for calculation
- Historic figures are used for calculation
Name 3 limitations of the P/E ratio
- The future is uncertain
- Forecasts are too optimistic
- Often based on 1 year but this might have been an exceptionally good or bad year
How can we evaluate business preformance?
Type of accounting information used :
- Financial statements
Method of analysis:
- Ratio analysis
What is a ratio?
A ratio expresses the relationship between two different figures
What is ratio analysis?
A comparison of the same ratio (i.e. calculated in the same way) over several different time periods to identify whether the ratio is staying the same, raising or falling
How may ratios be compared?
- Past periods
- Similar businesses during the same period
- Planned performance
How do you analyse and interpret financial statements using ratio analysis?
- Identify the major categories of ratios that can be used for analysis purposes
- Calculate important ratios for assessing the financial performance and positions of a business
- Explain the significance of the ratios calculated
- Discuss the limitations of ratios as a tool of financial analysis
What are the 5 categories of ratios?
- Profitability
- Efficiency
- Liquidity
- Financial gearing (long term financial stability)
- Investment (performance)
Describe profitability
- Provides insights into how well a company has created wealth for its owners
- Relates profits made to the size of business and how much capital is invested in it
What are the 3 types of profitability
- Return on capital employed (ROCE)
- Earnings before interest, tax, depreciation & amortisation (EBITDA)
- Gross profit margin/Gross profit percentage
Describe ROCE
- The most important measure of profitability
- Measures relationship between operating profit and long-term capital invested
- Enables assessment of how effectively funds have been deployed
= ( Profit before interest and tax / Capital employed )
Describe ROCE
- The most important measure of profitability
- Measures relationship between operating profit and long-term capital invested
- Enables assessment of how effectively funds have been deployed
= ( Profit before interest and tax / Capital employed ) x 100
Describe EBITDA
- A measure of a company’s overall performance
= Net income + Taxes + Interest expense + Depreciation & Amortisation
Describe profit margin/Gross profit percentage
- Relates gross profit of the business to the sales revenue
- Measures the profitability in buying (or manufacturing) and selling goods or services before any other expenses taken into account
- Tends to be consistent over years, and between similar companies
= ( Gross profit / Sales revenues ) x 100%
Describe profit margin/Gross profit percentage
- Relates gross profit of the business to the sales revenue
- Measures the profitability in buying (or manufacturing) and selling goods or services before any other expenses taken into account
- Tends to be consistent over years, and between similar companies
= ( Gross profit / Sales revenues ) x 100%
What are the 3 types of efficiency?
- Inventories turnover period
- Trade receivables settlement period
- Trade payables settlement period
Describe inventories turnover period
- Measures how much inventory a company has in relation to its scale of operations
- Expressed in number of days inventory is held
- Can use average inventories
= ( Inventories / Cost of sales ) x 365
Describe trade receivables settlement period
- Measures average length of time for customers to settle their balance
- Can use average trade receivables
- Can use total revenue if details of credit sales revenue not available
= ( Trade receivables / Credit sales revenue ) x 365
Describe trade payables settlement period
- Measures time obtained from suppliers before paying
- Can use cost of sales if information on credit purchases is not available
= ( Trade payables / Credit purchases ) x 365
What are the 2 types of liquidity?
- Current ratio
- Acid test/Quick ratio
Describe current ratio
- As well as profits, companies must have sufficient liquid resources
- Assesses whether company could pay its bills over the next few months
- Varies greatly between industries e.g. supermarket
= Current assets / Current liabilities
Describe acid test/quick ratio
- Looks at short term liquidity
- Eliminates inventories, as this is considered least liquid asset
- Varies between industries
= Current assets - inventories / Current liabilities
What is financial gearing?
- Occurs when a company is financed by loans as well as equity
Why is loan capital a cheap source of finance for a company?
Because of relatively low risk for lender
What are the 3 types of financial gearing?
- Gearing ratio
- Interest cover
- Asset cover
Describe gearing ratio
- Measures relation between debt and equity finance
- ‘Long term borrowings’ usually includes all forms of long term loan capital, including debentures
= ( Long and short term borrowings / Equity ) x 100%
Describe interest cover
- Measures number of times a company could pay its interest out of profit
- Different loan issues may have different priority over others for interest payments, depending on loan agreements
= Operating profit / Interest payable
Describe asset cover
- Measures amount available to repay loans in event of a winding up
- Assumes intangible assets worthless
= ( (Total assets - Intangible assets) - (Current liabilities - Short term debt) ) / Total debts
What are the 4 types of investment?
- Dividend cover
- Dividend yield
- Earnings per share
- Price/Earnings (P/E) Ratio
Describe dividend cover
- Companies cannot maintain dividends if not covered by profits
= Profit after tax and preference dividends for the year / Total ordinary share dividends
Describe dividend yield
- Shows the amount of income (dividends) an investor receives per unit of investment (share price)
= ( Ordinary dividends per share / Current market price of an ordinary share ) x100%
Describe earnings per share
- Amount of profit earned for each ordinary share
- Profit = after taxation and preference dividends
- Trend over time can help asses the investment potential of a company’s shares
= ( Profit for the year / Number of issued ordinary shares ) x 100pence
Describe P/E Ratio
- Measure of market confidence in the future of the business
- Market price encapsulates everything known to the market about the company
-Relating this to earnings give an insight into the market’s opinion of the company’s performance - High PER - company considered attractive as a source of revenue (e.g. low risk investment, high future growth in earnings)
= Market value of a share / Earnings per share
