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Intro to Accounting and Finance > Week 3- Evaluating Business Performance > Flashcards

Week 3- Evaluating Business Performance Flashcards

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1
Q

Name 3 advantages of the P/E ratio

A
  • 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
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2
Q

Name 2 issues with the P/E ratio

A
  • Future earning are used for calculation
  • Historic figures are used for calculation
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3
Q

Name 3 limitations of the P/E ratio

A
  • The future is uncertain
  • Forecasts are too optimistic
  • Often based on 1 year but this might have been an exceptionally good or bad year
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4
Q

How can we evaluate business preformance?

A

Type of accounting information used :
- Financial statements

Method of analysis:
- Ratio analysis

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5
Q

What is a ratio?

A

A ratio expresses the relationship between two different figures

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6
Q

What is ratio analysis?

A

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

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7
Q

How may ratios be compared?

A
  • Past periods
  • Similar businesses during the same period
  • Planned performance
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8
Q

How do you analyse and interpret financial statements using ratio analysis?

A
  • 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
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9
Q

What are the 5 categories of ratios?

A
  • Profitability
  • Efficiency
  • Liquidity
  • Financial gearing (long term financial stability)
  • Investment (performance)
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10
Q

Describe profitability

A
  • 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
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11
Q

What are the 3 types of profitability

A
  • Return on capital employed (ROCE)
  • Earnings before interest, tax, depreciation & amortisation (EBITDA)
  • Gross profit margin/Gross profit percentage
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12
Q

Describe ROCE

A
  • 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 )

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12
Q

Describe ROCE

A
  • 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

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13
Q

Describe EBITDA

A
  • A measure of a company’s overall performance

= Net income + Taxes + Interest expense + Depreciation & Amortisation

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14
Q

Describe profit margin/Gross profit percentage

A
  • 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%

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14
Q

Describe profit margin/Gross profit percentage

A
  • 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%

15
Q

What are the 3 types of efficiency?

A
  • Inventories turnover period
  • Trade receivables settlement period
  • Trade payables settlement period
16
Q

Describe inventories turnover period

A
  • 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

17
Q

Describe trade receivables settlement period

A
  • 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

18
Q

Describe trade payables settlement period

A
  • 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

19
Q

What are the 2 types of liquidity?

A
  • Current ratio
  • Acid test/Quick ratio
20
Q

Describe current ratio

A
  • 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

21
Q

Describe acid test/quick ratio

A
  • Looks at short term liquidity
  • Eliminates inventories, as this is considered least liquid asset
  • Varies between industries

= Current assets - inventories / Current liabilities

22
Q

What is financial gearing?

A
  • Occurs when a company is financed by loans as well as equity
23
Q

Why is loan capital a cheap source of finance for a company?

A

Because of relatively low risk for lender

24
Q

What are the 3 types of financial gearing?

A
  • Gearing ratio
  • Interest cover
  • Asset cover
25
Q

Describe gearing ratio

A
  • 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%

26
Q

Describe interest cover

A
  • 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

27
Q

Describe asset cover

A
  • 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

28
Q

What are the 4 types of investment?

A
  • Dividend cover
  • Dividend yield
  • Earnings per share
  • Price/Earnings (P/E) Ratio
29
Q

Describe dividend cover

A
  • Companies cannot maintain dividends if not covered by profits

= Profit after tax and preference dividends for the year / Total ordinary share dividends

30
Q

Describe dividend yield

A
  • 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%

31
Q

Describe earnings per share

A
  • 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

32
Q

Describe P/E Ratio

A
  • 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

Intro to Accounting and Finance (8 decks)

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