AC105 - Week 8: ratios

What is the objective of financial analysis for lenders

Lenders are interested in short term liquidity and long term solvency

What is the objective of financial analysis for shareholders

Shareholders are concerned with profitability and future share prices

What does financial analysis show both lenders and shareholders

The company's future

What are common size financial statements

A restatement of financial statement information in a standardised form

What do common size statements allow

A comparison across time or businesses

What are the 2 ways in which common size statements can be prepared

Vertically or Horizontally

What is vertical common size analysis

Expresses all figures in a particular statement in terms of one of the figures in the statement where the base value can for example be sales or total assets

What is horizontal common size analysis

Uses the figures in a specified year as the base and subsequent years amounts are stated as a percentage of the base value

The base year statement is usually the earliest or latest statement of a set of statemets

What is trend analysis

Trend analysis shows the changes in key ratios over time and whether ratios indicate trends

Why do we use financial ratios

- To compare financial health of different businesses

- To identify trends

- To determine the degree of efficiency in the management of assets and liabilities

What is ratio analysis

Comparing two related figures as an aid to interpreting the financial statements

What are the 5 types of financial ratio classifications

Profitability ratios (performance ratios)

Efficiency ratios

Liquidity and Solvency ratios: Short term liquidity

Liquidity and solvency ratios: Long term solvency

Investment ratios

What are 4 examples of profitability ratios

Return on capital employed

Return on equity

Operating profit margin and net profit margin

Gross profit margin

What are 4 examples of efficiency ratios

Inventory days

Receivables days

Payables days

Net asset turnover

What are 2 examples of Liquidity and solvency ratios: short term liquidity

- Current ratio

-Quick (acid test) ratio

What are 2 examples of liquidity and solvency ratios: long term solvency

-Gearing ratio and Debt to equity ratio

-Interest cover

What are 4 examples of investment ratios

-Dividend payout ratio and dividend cover

-Dividend yield ratio

-Earnings per share

-Price/earnings ratio

What does return on capital employed (ROCE) assess

The effectivity of capital emplyed where capital employed represents the debt and equity with which the company generates profits

What is an increase in ROCE seen as

An improvement in profitability

ROCE formula

What does return on equity focus on

The levels of profit achieved on the basis of the capital provided by the equity holders

Amounts provided by and dividends and interest paid to preference shares and loan notes are excluded

What is the formula for return on equity

What does gross profit margin measure

Trading performance

Formula for Gross profit margin

What are the 2 ways in which an entitys gross margin percentage can be improved

Increase the price charged for goods or services

Cost control and efficiency

What does operating profit margin measure

Operational performance

What is the formula for operating profit margin

What is the only context in which whether the operating profit margin being satisfactory can be measured

In comparison with industry norms

What does inventory days measure

How long it takes on average for inventory to be sold

What is the formula for inventory days

What are receivables days

Shows how long on average credit customers take to pay the amounts they owe to the business

What is the formula for receivables days

What are payables days

Shows how long the entity takes to pay creditors

What is the formula for payables days

What is net asset turnover ratio

Shows hows effectively the entity uses its resources (capital employed) to generate sales

Formula for net asset turnover ratio

What does it mean to be overtrading

If the ratio is very high, we say that the firm has an "overtrading" problem that is it has insufficient assets to sustain the level of sales revenue achieved (i.e. trying to do too much business with too little capital).

When does overtrading arise

Where a company expands its sales fairly rapidly without securing additional long term capital adequate for its needs

What are 4 symptoms of overtrading

-Inventory increasing possibly more than proportionately to sales

-Receivables increasing possibly more than proportionately to sales

-Cash and liquid assets declining at a fairly alarming rate

-Payables increasing rapidly

What are 3 remedies to overtrading

-Cut back on trading

-Raise further capital

-Improve working capital management

What is the link between efficiency and profitability

What might a company with a low asset turnover ratio seek to do to improve it

Look for unproductive or idle assets that could be sold, or for assets that could be managed more efficiently and effectively

What is working capital

The difference between total current assets and total current liabilities

What is the formula for working capital

Working capital = current assets - current liabilities

Why does a business need working capital

A business needs working capital to operate

e.g. a retail organisation needs to buy and hold inventory for resale and a manufacturing organisation holds inventories of raw materials and inventories of part finished goods and finished goods

What must working capital be

Working capital must be financed and it therefore has a cost

What should the aim of a company be in regards to working capital

Avoid excessive working capital which creates unnecessary cost

Avoid having insufficient amounts of working capital, because inadequate working capital can lead to difficulties with cash flow and liquidity

What does the working capital cycle look like

What is liquidity

A firms ability to generate cash for working capital needs and immediate debt repayments

What is solvency

The long term ability to generate cash internally or externally to satisfy capacity needs, fuel growth and repay debts

What does the current ratio measure

Compares liquid assets of the company with its current liabilities

What is the formula for current ratio

Current Ratio = Current Assets / Current Liabilities

What is a rule of thumb ratio for a satisfactory current ratio

2:1 Current Assets to Current Liabilities

What does the acid test ratio measure

It is a more rigorous measure of liquidity in that it excludes inventory

What is the formula for acid test ratio?

When does financial gearing occur

Financial gearing occurs when a business is financed at least in part by borrowing instead of only equity in order to finance growth and exploit tax advantages (interest is tax deductible)

4 dangers of high financial gearing

- Less control over financing decisions

- Risk of bankruptcy

- High volatility in profits available to shareholders

- Limited flexibility due to restrictions imposed on loan agreements

What does gearing ratio measureThe contribution of long term debt to the capital structure of the company

What is the debt to equity ratio

The debt-to-equity ratio is an alternative formula for measuring the level of gearing

What is the formula for debt to equity

What does it mean if the debt to equity ratio is greater than 1

If the debt-to-equity ratio is greater than 1, then the company is financing more assets with debt than with equity. If the ratio is less than 1, then the company is financing more assets with equity than with debt.

The higher the debt-to-equity ratio, the greater the company's financial risk.

What does interest cover ratio show

Interest cover ratio shows the amount of profit available to cover interest

What is the formula for interest cover ratio

What does the dividend payout ratio show

The proportion of profits paid out as dividends to shareholders

What is the formula for dividend payout ratio

What is dividend cover ratio

The dividend cover ratio measures a company's ability to maintain dividend payments

It shows how many times the dividends could be paid out of profits.

What is the formula for dividend cover ratio

What does dividend yield measure

Dividend yield shows the cash return to a share relative to its current market value.

The ratio measures dividend policy rather than performance

What is the formula for dividend yield

What is the dividend yield of a growing company most likely to be

Low

What do earnings per share measure

The earnings available to shareholders per shares issued

EPS is always expressed in pence and is calculated to one decimal lace

Formula for earnings per share

What does price/earnings ratio measure

Price/earnings ratio measures market confidence in the future earnings power of a business.

It measures how much investors are willing to pay for a company relative to its current earnings, which reflects investors' expectations of future earnings growth.

What is the formula for Price/Earnings ratio

What are 5 limitations of ratio analysis

1. Limitations of financial statement

2. Qualitative factors are ignored

3. Lack of standard formulae

4. Problems of price level changes

5. Ratios alone are not adequate