Week 5b - Financial Ratios: Uses and Limitations Flashcards
State the Earnings Per Share (EPS) ratio
Earnings per share = Earnings available to ordinary shareholders/Number of ordinary shares in issue
What is the most frequently quoted measure of company performance?
Earnings Per Share (EPS)
What is one of the limitations of EPS?
- The percentage change from year to year should be monitored (trend analysis)
- However, this strong focus on annual earnings may cause short-termism
Calculate the Earnings Per Share (EPS) ratio using the following information and comment on the trend
2007
Profit for the period = £7,000
Number of shares = £30,000
2006
Profit for the period = £6,200
Number of shares = £25,000
Earnings per share = Earnings available to ordinary shareholders/Number of ordinary shares in issue
The earnings per share is:
2007
7,000/30,000 = £0.233
2006
6,200/25,000 = £0.25
• EPS has fallen from £0.25 per share to £0.23 per share
List the stock market ratios
Earnings per share (EPS) Price/earnings ratio (P/E) Dividend per share Dividend yield Dividend cover Dividend payout ratio
State the formula for the Price/earnings ratio (P/E)
Price/earnings ratio (P/E) = Market value per share (share price)/Earnings per share
What can the Price/earnings ratio (P/E) be interpreted as?
The number of years for which the currently reported profit is represented by the current share price
What does the PE ratio reflect?
The market’s confidence in future prospects of the company
What does a high PE ratio indicate?
The market believes that the current level of earnings may be sustained for a longer period
Why is the industry average PE ratio useful?
Can be used as a benchmark
Calculate the Price/earnings ratio (P/E) using the following information and comment on the trend
2007
Profit for the period = £7,000
Number of shares = £30,000
2006
Profit for the period = £6,200
Number of shares = £25,000
The share price at the end of 2007 was £2.01, and at the end of 2006 was £1.74
2007
2.01/0.233 = 8.6 times
2006
1.74/0.25 = 7 times
- The P/E ratio has increased from 7 to 8.6.
- Market confidence has increased
State the formula for the dividend yield ratio
Dividend yield = (Dividend per share/Share price)*100
What does the dividend yield ratio indicate?
The relationship between what the investors can expect to receive from the shares and the amount which is invested in the shares
State the benefits from share ownership
- Dividends
- Growth in share price
Calculate the dividend yield using the following information and comment on any trends
Dividend per share was £0.033 during 2007 and
£0.032 during 2006
Market price per share was 2.01 on 31
December 2007 and 1.74 on 31 December 2006
The dividend yield is:
2007
(0.033/2.01) x 100 = 1.64%
2006 (0.032/1.74) x 100 = 1.84%
- The dividend yield has fallen from 1.84% to 1.64%
- Relative to the risk free rate of interest this dividend
yield is low; however, the share price is rising suggesting that the bulk of the return being made by
equity holders, is capital gains
State the formula for the dividend cover ratio
Dividend cover = Earnings available/ Dividend paid
What does the dividend cover ratio show?
The number of times the dividend is covered by the year’s profits
What does a high dividend cover indicate?
- The higher the dividend cover, the ‘safer’ the dividend
* A higher dividend cover may also mean that the company is keeping new wealth to itself
Why is dividend strategy important for a company?
- Dividends carry a signal to the market of the strength and stability of the company
- Many companies like to keep to a ‘target’ dividend cover (with minor fluctuations)
Calculate the Dividend Cover and comment on your result
Dividends paid in 2007 were £1,000,000
Dividends paid in 2006 were £800,000
Profit for the period (2006) = £6,200
Profit for the period (2007) = £7,000
The dividend cover is:
2007
£7,000/£1,000 = 7 times
2006
£6,200/£800 = 7.75 times
Thus, the dividend cover is strong
In 2006 profits covered dividends 7.75 times, falling to 7 times in 2007
Even at the lower 2007 level, profits would have to fall by 85% before the current dividend distribution would be affected
What exactly is the dividend payout ratio?
The Dividend Payout ratio is the inverse of Dividend
Cover
Give the formula for the dividend payout ratio
Dividend Payout Ratio = Dividend paid/Earnings available
What does the dividend payout ratio indicate?
The proportion of funds that is being distributed each year and therefore highlights the proportion that is being retained for growth
Calculate the Dividend Payout Ratio and comment on any trends
Dividends paid in 2007 were £1,000,000
Dividends paid in 2006 were £800,000
Profit for the period (2006) = £6,200
Profit for the period (2007) = £7,000
The dividend payout ratio is:
2007
£1,000/£7,000 x100 = 14.28%
2006
£800/£6,200 x100 = 12.9%
- The dividend payout ratio has increased from 12.9% to 14.28%
- A greater proportion of the profits that are available for distribution, have been distributed in 2007
What is the pyramid of ratios?
A useful tool of detective work to trace the cause of a change in return on assets (ROA)
Draw a diagram illustrating the pyramid of ratios
Week 5b page 20
Give the formula for net profit/total assets in relation to the pyramid of ratios
Net profit/total assets = (Net profit/sales)*(Sales/Total assets)
What are the two different types of business regarding the pursuit of profit?
- One business trades on high margins and sells goods or services less frequently
- The other business trades on low margins, charging prices which look highly competitive, and succeeds by having a high level of sales (revenues) - assets are used effectively
What is financial failure?
A business either being forced out of business or being severely affected by its inability to meet its financial obligations. It is often referred to as ‘going bankrupt’
State the ratios found by Beaver (1966) that can be used to predict financial failure in a business for up to five years prior to failure
- Cash flow/Total assets
- Net income/Total assets
- Total debt/Total assets
- Working capital/Total assets
- Current ratio
- No credit interval
Draw a scatter diagram showing the distribution of failed and non-failed businesses plotted against two financial ratios. Include a line of best fit to illustrate the trend and differences between the points plotted. Include the general equation for the boundary/line of best fit
Week 5b page 26
What combinations of ratios can be used to predict financial failure in the US and UK?
- Altman’s (2000) revised Z-score for US companies
* Taffler’s Z-score for UK companies
List some of the limitations of financial ratios when measuring and comparing company performance
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
Limitations posed by the use of financial ratios when measuring and comparing company performance:
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
Why is the effect of exceptional items a limitation on financial ratios?
- E.g. losses incurred in closing down a production facility; profits from selling non-current assets
Limitations posed by the use of financial ratios when measuring and comparing company performance:
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
The statement of financial position shows the position on a given date. Why is this a limitation on financial ratios?
- Not necessarily representative for the whole year. Companies may try to make their position look better at the end of the year because of this.
Limitations posed by the use of financial ratios when measuring and comparing company performance:
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
The statement of financial position is based on historic cost. Why is this a limitation on financial ratios?
- The amounts shown for assets are not necessarily current values; some non-current assets are revalued from time to time
- When looking at the value of ‘equity’, the statements do not indicate the market value of the equity on the stock market.
Limitations posed by the use of financial ratios when measuring and comparing company performance:
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
Information in financial statements is aggregated. Why is this a limitation on financial ratios?
- Most information reported in financial statements is for the business as a whole and so most ratios are an average.
- While companies do produce ‘disaggregated’ or ‘segmental’ information about different parts of the business, it is rather limited.
Limitations posed by the use of financial ratios when measuring and comparing company performance:
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
Inflation is not shown in financial statements. Why is this a limitation on financial ratios?
- A 3% increase in sales/profits is not an indication of success if the inflation rate was 4%
Limitations posed by the use of financial ratios when measuring and comparing company performance:
- The effect of exceptional items
- Statement of financial position shows the position on a given date
- Statement of financial position is based on historic cost
- Information in financial statements is aggregated
- Inflation not shown in financial statements
- Ratio analysis limited by the information companies disclose
- What basis of comparison should be used?
Why is the basis of comparison a limitation on financial ratios?
No two businesses are identical
Comparisons may be limited because companies have different: - Accounting policies - Financing policies - Policies to achieve growth - Operating policies - Accounting dates
Financial ratios may be limited when comparing two businesses due to different accounting policies. Explain why.
Capitalisation of development expenditure; depreciation methods; prudence
Financial ratios may be limited when comparing two businesses due to different financing policies. Explain why.
Capital structure; leases; etc.
Financial ratios may be limited when comparing two businesses due to different policies used to achieve growth. Explain why.
Internal growth (investments in non-current assets); external growth (acquire other companies)
Financial ratios may be limited when comparing two businesses due to different operating policies. Explain why.
Subcontracting manufacturing to overseas companies; standardisation
Financial ratios may be limited when comparing two businesses due to different accounting dates. Explain why.
Seasonal business (e.g. a retailer with a fiscal year end before or after Christmas)
What do KPIs stand for?
Key Performance Indicators
Why do many businesses use KPIs?
To help measure the degree of success achieved in carrying out their operations
What do KPIs include?
- May include financial ratios and other performance measures
- E.g. ratios that compare a figure on the financial
statements with a particular business resource; non
-financial measures of performance
What are the different ways in which the financial ratios of a business can be compared and analysed to measure performance?
•Bases of comparison
- Other years and past periods
- Similar businesses
- Sector averages
- Budgeted or planned results
- Other divisions
- Stock market
- Policies
What information should be provided when performing ratio analysis?
- The name of each ratio
- The formula in words
- The workings to show how the formula has been applied
- The value of the ratio
- A narrative comment (very important!!!)
