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FIN1003 Financial Reporting and Analysis > Week 5b - Financial Ratios: Uses and Limitations > Flashcards

Week 5b - Financial Ratios: Uses and Limitations Flashcards

1
Q

State the Earnings Per Share (EPS) ratio

A

Earnings per share = Earnings available to ordinary shareholders/Number of ordinary shares in issue

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2
Q

What is the most frequently quoted measure of company performance?

A

Earnings Per Share (EPS)

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3
Q

What is one of the limitations of EPS?

A
  • The percentage change from year to year should be monitored (trend analysis)
  • However, this strong focus on annual earnings may cause short-termism
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4
Q

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

A

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

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5
Q

List the stock market ratios

A 
Earnings per share (EPS)
Price/earnings ratio (P/E)
Dividend per share
Dividend yield
Dividend cover
Dividend payout ratio
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6
Q

State the formula for the Price/earnings ratio (P/E)

A

Price/earnings ratio (P/E) = Market value per share (share price)/Earnings per share

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7
Q

What can the Price/earnings ratio (P/E) be interpreted as?

A

The number of years for which the currently reported profit is represented by the current share price

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8
Q

What does the PE ratio reflect?

A

The market’s confidence in future prospects of the company

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9
Q

What does a high PE ratio indicate?

A

The market believes that the current level of earnings may be sustained for a longer period

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10
Q

Why is the industry average PE ratio useful?

A

Can be used as a benchmark

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11
Q

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

A

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
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12
Q

State the formula for the dividend yield ratio

A

Dividend yield = (Dividend per share/Share price)*100

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13
Q

What does the dividend yield ratio indicate?

A

The relationship between what the investors can expect to receive from the shares and the amount which is invested in the shares

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14
Q

State the benefits from share ownership

A
  • Dividends

- Growth in share price

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15
Q

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

A

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
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16
Q

State the formula for the dividend cover ratio

A

Dividend cover = Earnings available/ Dividend paid

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17
Q

What does the dividend cover ratio show?

A

The number of times the dividend is covered by the year’s profits

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18
Q

What does a high dividend cover indicate?

A
  • 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

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19
Q

Why is dividend strategy important for a company?

A
  • 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)
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20
Q

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

A

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

21
Q

What exactly is the dividend payout ratio?

A

The Dividend Payout ratio is the inverse of Dividend

Cover

22
Q

Give the formula for the dividend payout ratio

A

Dividend Payout Ratio = Dividend paid/Earnings available

23
Q

What does the dividend payout ratio indicate?

A

The proportion of funds that is being distributed each year and therefore highlights the proportion that is being retained for growth

24
Q

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

A

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
25
Q

What is the pyramid of ratios?

A

A useful tool of detective work to trace the cause of a change in return on assets (ROA)

26
Q

Draw a diagram illustrating the pyramid of ratios

A

Week 5b page 20

27
Q

Give the formula for net profit/total assets in relation to the pyramid of ratios

A

Net profit/total assets = (Net profit/sales)*(Sales/Total assets)

28
Q

What are the two different types of business regarding the pursuit of profit?

A
  1. One business trades on high margins and sells goods or services less frequently
  2. 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
29
Q

What is financial failure?

A

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’

30
Q

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

A
  • Cash flow/Total assets
  • Net income/Total assets
  • Total debt/Total assets
  • Working capital/Total assets
  • Current ratio
  • No credit interval
31
Q

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

A

Week 5b page 26

32
Q

What combinations of ratios can be used to predict financial failure in the US and UK?

A
  • Altman’s (2000) revised Z-score for US companies

* Taffler’s Z-score for UK companies

33
Q

List some of the limitations of financial ratios when measuring and comparing company performance

A
  • 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?
34
Q

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?

A
  • E.g. losses incurred in closing down a production facility; profits from selling non-current assets
35
Q

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?

A
  • 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.
36
Q

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?

A
  • 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.
37
Q

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?

A
  • 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.
38
Q

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
  • A 3% increase in sales/profits is not an indication of success if the inflation rate was 4%
39
Q

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?

A

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
40
Q

Financial ratios may be limited when comparing two businesses due to different accounting policies. Explain why.

A

Capitalisation of development expenditure; depreciation methods; prudence

41
Q

Financial ratios may be limited when comparing two businesses due to different financing policies. Explain why.

A

Capital structure; leases; etc.

42
Q

Financial ratios may be limited when comparing two businesses due to different policies used to achieve growth. Explain why.

A

Internal growth (investments in non-current assets); external growth (acquire other companies)

43
Q

Financial ratios may be limited when comparing two businesses due to different operating policies. Explain why.

A

Subcontracting manufacturing to overseas companies; standardisation

44
Q

Financial ratios may be limited when comparing two businesses due to different accounting dates. Explain why.

A

Seasonal business (e.g. a retailer with a fiscal year end before or after Christmas)

45
Q

What do KPIs stand for?

A

Key Performance Indicators

46
Q

Why do many businesses use KPIs?

A

To help measure the degree of success achieved in carrying out their operations

47
Q

What do KPIs include?

A
  • 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
48
Q

What are the different ways in which the financial ratios of a business can be compared and analysed to measure performance?

A

•Bases of comparison

  • Other years and past periods
  • Similar businesses
  • Sector averages
  • Budgeted or planned results
  • Other divisions
  • Stock market
  • Policies
49
Q

What information should be provided when performing ratio analysis?

A
  • 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!!!)

FIN1003 Financial Reporting and Analysis (22 decks)

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