WK 7: Interpretation of Financial & Capital Structure, Investment Ratios

Question 1

Ratio Analysis - what is it used for

Answer 1

Used to highlight underlying trends not always immediately obvious from figures

Question 2

Liquidity

Answer 2

measure of the ability of a business to pay its debts as they fall due

Question 3

Working Capital eqn

Answer 3

Current assets - current liabilities

Question 4

Who is interested in Profitability?

Answer 4

Current/Future investors - long-term lenders. Shows how successfully the business is trading

Question 5

who is interested in Liquidity

Answer 5

Banks and other lenders, particularly short-term lenders - trade payables. How easy it is for business to pay its financial commitments

Question 6

who is interested in efficiency

Answer 6

Management - trade payables. How effectively are the short term assets and liabilities of the business being managed

Question 7

What are the 4 profitability ratios?

Answer 7

1. Return on capital employed: Operating profit (shareholder funds + LT loans) x 100
2. Gross profit margin = Gross profit/sales x 100
3. Operating profit margin = operating profit/sales x 100
4. Expenses ratio = expenses/sales x 100

Question 8

Liquidity ratios : what is the current ratio?

Answer 8

current assets/current liabilities : 1

indication of short term solvency of business - shows ability for business to meet its debts as they fall due

Question 9

Liquidity ratios : what is the acid test ratio?

Answer 9

(current assets - inventories)/current liabilities : 1

Ratio measures very short-term liquidity of business

Question 10

what is gearing?

Answer 10

key measure of capital structure:

measures extent to which a business if financed by debt rather than equity capital

(long term loans / (ordinary share capital + reserves + long term loans)) x 100

Question 11

Gearing advantages

Answer 11

when trading is increasing profits, ordinary shareholders stand to reap disproportionate rewards from highly geared company. Company raise debt at x% but generate return greater than x% = benefit for ordinary shareholders

Question 12

Gearing disadvantages

Answer 12

Gearing carries risk as more highly geared a company greater risk to ordinary shareholders

Shareholder risk:

Not receiving a dividend where there are insufficient profits available after interest has been paid

lenders forcing company into liquidation/bankruptcy if company unable to meet its interest obligations and capital repayments as they fall due

Question 13

Interest cover - what is it?

Answer 13

another measure to explore capital structure

tells you how many times the operating Profit covers interest expense = operating profit/interest expense x times

Considers the number of times that operating profit covers interest expense

Ratio shows how easy it is for company to cover its interest expense ( the cost incurred by an entity for borrowed funds) out of operating profit

Company w low interest will be at greater risk of not meeting interest payments

Question 14

HOW MIGHT A BANK/SHAREHOLDER BE INTERESTED IN A COMPANY’S LEVEL OF GEARING

Answer 14

Low gearing indicates low interest obligations and hence low financial risk. Dividends are more secure and s/h investment is more secure.

High gearing indicates high interest obligations but potentially better returns on s/h. Dividends are less secure and s/h investment is more risky.

Question 15

Investment ratios - name the key ones (4)

Answer 15

earnings per share

price to earnings ratio

dividend yield

dividend cover

Question 16

EPS - explain it

Answer 16

considers how much profit is being made for each share

= profit available to ordinary shareholders/no. of ordinary shares

fundamental measure of how well a share is performing

Question 17

PE Ratio - explain

Answer 17

Compares market price of share with EPS

= market price per share/earnings per share

Ratio involves the share price and is a measure of the market’s view of the expected future earnings of a business

Question 18

Limitations of ratio analysis?(4)

Answer 18

1. they highlight underlying trend’s: don’t provide explanations for changes found
2. differences in accounting policies may detract from the value of inter-firm comparisons
3. financial statements and accounting ratios can be distorted as the result of one off large transactions
4. where a company undertakes a mix of activities, it is important to calculate separate ratios for each set of activities wherever possible