CH 14 - Interpretation of accounts

Question 1

2 ratios associated with Loan Capital

Answer 1

1) Interest cover
2) Asset cover

Question 2

Why is loan capital regarded as a mixed blessing?

Answer 2

-it’s a cheap source of finance for the co because it normally carries a relatively low risk for the lender

Question 3

Why does the security enjoyed by the lender/s have the effect of increasing the risk attributable to the shareholders?

Answer 3

-interest has to be paid regardless of whether the company is making profits
-the greater the proportion of the company’s assets that are financed by debt, the greater the risk that there’ll be nothing left for SH’s if the co fails.

Question 4

What does interest cover measure?

Answer 4

it measures the number of times that the company could pay its interest out of profit before tax. The higher this multiple, the less likely that the company will run into difficulty
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it’s generally considered risky if the co cannot cover interest at least 3/4 times.

Question 5

What are 2 limitations of interest cover?

Answer 5

• it doesn’t consider how volatile profits are
  -doesn’t take into account the length of time for which the loan is outstanding

Question 6

Interest priority %’s

Answer 6

shows the slide of profit on ordinary activities before interest & tax which covers the annual interest payments due on each issue of loan capital.
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same MUES applies
_use up to as lower percentile and then current as upper percentile
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1/interest cover

Question 7

What does asset cover represent?

Answer 7

Represents a conservative estimate of the amount of money available to meet the loan stockholders’ demands for repayment if the company were to wind up.
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If a class of a loan has an asset cover less than 2 or 2.5 times, it’s considered as high risk

Question 8

What is the main limitation of asset cover?

Answer 8

The current value shown in the statements of financial position for assets might not reflect their realisable market value if the company is wound up, the going concern means there is no particular need to carry assets at their MV.

Question 9

Give the definition of gearing and the 2 types.

Answer 9

def: relative proportions of LT debt & equity finance in a company. (high gearing means that the company has a high level of debt financing)
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types:
1) Asset gearing
2) Income gearing

Question 10

Why is the gearing ratio important?

Answer 10

Because increasing the proportion of debt in the co’s LT finance tends to accentuate any volatility in the underlying business. This would tend to increase the total risk for SH’.

Question 11

What does the shareholders’ equity ratio tell us?

Answer 11

The higher the ratio, the stronger the financial position of the organisation. The lower the proportion, the more possibility of the organisation becoming over-dependent on outside providers of capital.

Question 12

Businesses whose shares are publicly traded are required to disclose two versions of EPS (earnings per share), what are they?

Answer 12

1) Basic EPS - calculated by dividing the net P/L (after tax) for the period attributable to OSH’s by the weighted average number of OS’s o/s during the period.
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2) Diluted EPS - basic EPS adjusted for the effects of all dilutive potential OS

Question 13

A company’s pre-tax profits have doubled over the past 4 years but EPS have hardly grown at all. Give 2 reasons why this might be the case.

Answer 13

i) acquisitions by the issues of shares
ii) higher tax charge than in earlier years

Question 14

What does the price earnings ratio tell us?

Answer 14

if the P/E ratio is high then that would suggest that the co is relatively attractive when considered as a source of revenues. This might imply that the market believes:
-that the co is relatively low risk investment, or
-earnings will grow rapidly in the future
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if the P/E ratio of a share is high relative to other, similar companies then it may mean that the share is overvalued.

Question 15

What does the dividend yield measure?

Answer 15

It measures the amount of current income an investor receives per unit of investment (the share price). A low dividend yield may mean that:
i) investors expect dividends to grow rapidly, or
ii) share is overvalued

Question 16

Uses of dividend cover

Answer 16

Dividends are paid out of earnings. In the long run, a company will not be able to maintain dividends if they are not covered by earnings
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In contrast, a co with a high level of dividend cover has more scope to increase dividends in the future
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So, for a given dividend yield on a share, a high dividend cover figure suggests better value for money than a share with low dividend cover

Question 17

EBITDA

Answer 17

Earnings before interest, tax, depreciation & amortisation
(known as cashflow from operations)

Question 18

4 types of profitability ratios

Answer 18

• ROCE (return on capital employed)
  -Profit margin
  -Asset utilisation ratio
  -ROE (return on equity)

Question 19

ROCE

Answer 19

measures the relationship between the amount invested in the business & the returns generated for those investors.

Question 20

What are the 2 rules to obey w.r.t consistency between the denominator & numerator?

Answer 20

i) iff an asset is included in the denominator, should the income it gives rise to be included in the numerator.
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ii) iff a liability is deducted from the denominator the income paid to it should be deducted from the numerator

Question 21

What is the purpose of ROCE?

Answer 21

It can be used to indicate how efficiently managers of different firms are using their funds at their disposal. (it’s more useful when comparing companies for investment)

Question 22

ROCE can be broken down into which 2 ‘secondary’ ratios?

Answer 22

Asset utilisation * Profit margin

Question 23

What may low profit margins relative to other firms in the industry indicate?

Answer 23

• a more down market product range
• a ‘low margin high volume’ marketing strategy
• an attempt to increase market share
• poor management/excessive costs
  -temporarily low profits and/or high costs (as a new product is launched)

Question 24

What 2 ratios can be used to test liquidity?

Answer 24

1) current ratio
2) quick ratio (or acid test or liquidity ratio)

Question 25

Current ratio

Answer 25

def: used to assess whether the company will be able to pay its bills over the next few months
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a low ratio may indicate that the company may have problems paying its creditors. An excessively high ratio may indicated that the management has too much money tied up in unproductive ST assets
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difficult to know what a low/high exact figure is - look over a period of time & normally 2:1 should be considered appropriate

Question 26

Quick ratio

Answer 26

looks at short-term liquidity
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considers what would happen if all creditor & debtor accounts were settled immediately (it focuses on readily realisable cash)
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quick ratio < 1 means that the company may struggle to pay its creditors (however, some companies are able to survive with a ratio of much less than 1)
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it’s often departures from the normal level of the ratio rather than the absolute level of the ratio which will interest analysts

Question 27

pg 32- 36 + WC(not all is kept check CMP 2024)