19 Calculation and interpretation of accounting ratios and trends

Question 1

The broad categories of ratios Broadly speaking, basic ratios can be grouped into five categories:

Answer 1

 Profitability and return  Long-term solvency and stability  Short-term solvency and liquidity  Efficiency (turnover ratios)  Shareholders’ investment ratios

Question 2

It must be stressed that ratio analysis on its own is not sufficient for interpreting company accounts, and that there are other items of information which should be looked at, for example:

Answer 2

(a) The content of any accompanying commentary on the accounts and other statements (b) The age and nature of the company’s assets (c) Current and future developments in the company’s markets, at home and overseas, recent acquisitions or disposals of a subsidiary by the company (d) Unusual items separately disclosed in the financial statements (e) Any other noticeable features of the report and accounts, such as events after the end of the reporting period, contingent liabilities, a qualified auditors’ report, the company’s taxation position, and so on

Question 3

Profit before interest and tax is therefore:

Answer 3

(a) the profit on ordinary activities before taxation; plus (b) interest charges on loan capital.

Question 4

Define Return on capital employed (ROCE)

Answer 4

It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed.

Question 5

What does a company’s ROCE tell us? What should we be looking for? There are three comparisons that can be made.

Answer 5

(a) The change in ROCE from one year to the next can be examined. In this example, there has been an increase in ROCE by about 4 percentage points from its 20X7 level. (b) The ROCE being earned by other companies, if this information is available, can be compared with the ROCE of this company. Here the information is not available. (c) A comparison of the ROCE with current market borrowing rates may be made. (i) What would be the cost of extra borrowing to the company if it needed more loans, and is it earning a ROCE that suggests it could make profits to make such borrowing worthwhile? (ii) Is the company making a ROCE which suggests that it is getting value for money from its current borrowing? (iii) Companies are in a risk business and commercial borrowing rates are a good independent yardstick against which company performance can be judged.

Question 6

Define Return on equity (ROE)

Answer 6

ROE =
Profitaftertaxandpreferencedividend / Equity shareholders funds
× 100%

Question 7

A warning about comments on profit margin and asset turnover It might be tempting to think that a high profit margin is good, and a low asset turnover means sluggish trading. In broad terms, this is so. But there is a trade-off between profit margin and asset turnover, and you cannot look at one without allowing for the other.

Answer 7

(a) A high profit margin means a high profit per $1 of sales, but if this also means that sales prices are high, there is a strong possibility that sales revenue will be depressed, and so asset turnover lower. (b) A high asset turnover means that the company is generating a lot of sales, but to do this it might have to keep its prices down and so accept a low profit margin per $1 of sales.

Question 8

It is worth considering how the analysis would change if we were dealing with financial statements based on some form of current value accounting (which we will go on to look at in Chapter 22). These are some of the issues that would arise:

Answer 8

 Non-current asset values would probably be stated at fair value. This may be higher than depreciated historical cost. Therefore capital employed would be higher. This would lead to a reduction in ROCE.  Higher asset values would lead to a higher depreciation charge, which would reduce net profit.  If opening inventory were shown at current value, this would increase cost of sales and reduce net profit.

Question 9

Long-term solvency: debt and gearing ratios Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.

Answer 9

(a) When a company is heavily in debt banks and other potential lenders may be unwilling to advance further funds. (b) When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest charges have been paid. And so if interest rates were to go up (on bank overdrafts and so on) or the company were to borrow even more, it might soon be incurring interest charges in excess of PBIT. This might eventually lead to the liquidation of the company.

Question 10

Define Debt ratio

Answer 10

The debt ratio is the ratio of a company’s total debts to its total assets. (a) Assets consist of non-current assets at their carrying value, plus current assets (b) Debts consist of all payables, whether they are due within one year or after more than one year

Question 11

Gearing or leverage is concerned with a company’s long-term capital structure. We can think of a company as consisting of non-current assets and net current assets (ie working capital, which is current assets minus current liabilities). These assets must be financed by long-term capital of the company, which is one of two things:

Answer 11

(a) Issued share capital which can be divided into: (i) Ordinary shares plus other equity (eg reserves) (ii) Non-redeemable preference shares (unusual)
(b) Long-term debt including redeemable preference shares

Question 12

The capital gearing ratio is a measure of the proportion of a company’s capital that is debt. It is measured as follows.

Answer 12

Gearing =
 Interest bearing / (debt Shareholders’equity interest bearing debt)
× 100%

Question 13

Define Leverage

Answer 13

Leverage is an alternative term for gearing; the words have the same meaning. Note that leverage (or gearing) can be looked at conversely, by calculating the proportion of total assets financed by equity, and which may be called the equity to assets ratio

Question 14

Equity to assets ratio

Answer 14

Equity to assets ratio =
Shareholders’equity/ (Shareholders’equity + interest bearing debt)
× 100%
or
Shareholders’equity / Total assets less current liabilities
× 100%

Question 15

Define interest cover

Answer 15

The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in PBIT would then have a significant effect on profits available for ordinary shareholders.

Question 16

Cash flow ratio: The cash flow ratio is the ratio of a company’s net cash inflow to its total debts

Answer 16

(a) Net cash inflow is the amount of cash which the company has coming into the business from its operations. A suitable figure for net cash inflow can be obtained from the statement of cash flows. (b) Total debts are short-term and long-term payables, including provisions. A distinction can be made between debts payable within one year and other debts and provisions

Question 17

Short-term solvency and liquidity Profitability is of course an important aspect of a company’s performance and gearing or leverage is another. Neither, however, addresses directly the key issue of liquidity.
Liquidity is the amount of cash a company can put its hands on quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).
Liquid funds consist of:

Answer 17

(a) Cash (b) Short-term investments for which there is a ready market (c) Fixed-term deposits with a bank or other financial institution, for example, a six month high-interest deposit with a bank (d) Trade receivables (because they will pay what they owe within a reasonably short period of time) (e) Bills of exchange receivable (because like ordinary trade receivables, these represent amounts of cash due to be received within a relatively short period of time)

Question 18

In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are:

Answer 18

 All current assets without exception  All current assets with the exception of inventories

Question 19

The cash cycle To help you to understand liquidity ratios, it is useful to begin with a brief explanation of the cash cycle. The cash cycle describes the flow of cash out of a business and back into it again as a result of normal trading operations. Cash goes out to pay for supplies, wages and salaries and other expenses, although payments can be delayed by taking some credit. A business might hold inventory for a while and then sell it. Cash will come back into the business from the sales, although customers might delay payment by themselves taking some credit. The main points about the cash cycle are:

Answer 19

(a) The timing of cash flows in and out of a business does not coincide with the time when sales and costs of sales occur. Cash flows out can be postponed by taking credit. Cash flows in can be delayed by having receivables. (b) The time between making a purchase and making a sale also affects cash flows. If inventories are held for a long time, the delay between the cash payment for inventory and cash receipts from selling it will also be a long one. (c) Holding inventories and having receivables can therefore be seen as two reasons why cash receipts are delayed. Another way of saying this is that if a company invests in working capital, its cash position will show a corresponding decrease. (d) Similarly, taking credit from creditors can be seen as a reason why cash payments are delayed. The company’s liquidity position will worsen when it has to pay the suppliers, unless it can get more cash in from sales and receivables in the meantime.

Question 20

Efficiency ratios: control of receivables and inventories A rough measure of the average length of time it takes for a company’s customers to pay what they owe is the accounts receivable collection period

Answer 20

The estimated average accounts receivable collection period is calculated as: Trade receivables/ Sales * 365

Question 21

The figure for sales should be taken as the sales revenue figure in the statement of profit or loss. Note that any cash sales should be excluded – this ratio only uses credit sales. The trade receivables are not the total figure for receivables in the statement of financial position, which includes prepayments and non-trade receivables. The trade receivables figure will be itemised in an analysis of the receivable total, in a note to the accounts. The estimate of the accounts receivable collection period is only approximate.

Answer 21

(a) The value of receivables in the statement of financial position might be abnormally high or low compared with the ‘normal’ level the company usually has. (b) Sales revenue in the statement of profit or loss is exclusive of sales taxes, but receivables in the statement of financial position are inclusive of sales tax. We are not strictly comparing like with like.

Question 22

The trend of the collection period over time is probably the best guide. If the collection period is increasing year on year, this is indicative of a poorly managed credit control function (and potentially therefore a poorly managed company). T/F

Answer 22

The trend of the collection period over time is probably the best guide. If the collection period is increasing year on year, this is indicative of a poorly managed credit control function (and potentially therefore a poorly managed company).

Question 23

Another ratio worth calculating is the inventory turnover period. This is another estimated figure, obtainable from published accounts, which indicates the average number of days that items of inventory are held for. As with the average receivable collection period, however, it is only an approximate estimated figure, but one which should be reliable enough for comparing changes year on year

Answer 23

The inventory turnover period is calculated as: Inventory/Cost of sales * 365 days

Question 24

This is another measure of how vigorously a business is trading. A lengthening inventory turnover period from one year to the next indicates:

Answer 24

(a) A slowdown in trading; or (b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is becoming excessive.

Question 25

Generally the higher the inventory turnover the better, ie the lower the turnover period the better, but several aspects of inventory holding policy have to be balanced.

Answer 25

(a) Lead times (b) Seasonal fluctuations in orders (c) Alternative uses of warehouse space (d) Bulk buying discounts (e) Likelihood of inventory perishing or becoming obsolete

Question 26

Accounts payable payment period

Accounts payable payment period is ideally calculated by the formula:

Answer 26

Trade accounts / payable *365

Question 27

It is rare to find purchases disclosed in published accounts and so cost of sales serves as an approximation. The payment period often helps to assess a company’s liquidity; an increase is often a sign of lack of long-term finance or poor management of current assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on. t/f

Answer 27

It is rare to find purchases disclosed in published accounts and so cost of sales serves as an approximation. The payment period often helps to assess a company’s liquidity; an increase is often a sign of lack of long-term finance or poor management of current assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on

Question 28

Shareholders’ investment ratios
Ratios such as EPS and dividend per share help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of a company.

Answer 28

They are: (a) Earnings per share (b) Dividend per share (c) Dividend cover (d) P/E ratio (e) Dividend yield

Question 29

Dividend cover SHOWS

Answer 29

the proportion of profit for the year that is available for distribution to shareholders that has been paid (or proposed) and what proportion will be retained in the business to finance future growth

Question 30

A significant change in the dividend cover from one year to the next would be worth looking at closely. For example, if a company’s dividend cover were to fall sharply between one year and the next, it could be that its profits had fallen, but the directors wished to pay at least the same amount of dividends as in the previous year, so as to keep shareholder expectations satisfied. . t/f

Answer 30

A significant change in the dividend cover from one year to the next would be worth looking at closely. For example, if a company’s dividend cover were to fall sharply between one year and the next, it could be that its profits had fallen, but the directors wished to pay at least the same amount of dividends as in the previous year, so as to keep shareholder expectations satisfied.

Question 31

A high P/E ratio indicates strong shareholder confidence in the company and its future, eg in profit growth, and a lower P/E ratio indicates lower confidence. The P/E ratio of one company can be compared with the P/E ratios of

Answer 31

Other companies in the same business sector  Other companies generally It is often used in stock exchange reporting where prices are readily available

Question 32

Dividend yield is the return a shareholder is currently expecting on the shares of a company.

Answer 32

(a) The dividend per share is taken as the dividend for the previous year. (b) Ex-div means that the share price does not include the right to the most recent dividend. Shareholders look for both dividend yield and capital growth. Obviously, dividend yield is therefore an important aspect of a share’s performance.

Question 33

Group aspects: Ratios based on consolidated financial statements can obscure the performance of the parent or the subsidiary. It is particularly important to be able to isolate the effects of acquisitions or disposals of subsidiaries on the financial statements and on the ratios t/f

Answer 33

Ratios based on consolidated financial statements can obscure the performance of the parent or the subsidiary. It is particularly important to be able to isolate the effects of acquisitions or disposals of subsidiaries on the financial statements and on the ratios

Question 34

When are ratios relevant

Answer 34

Acquisitions: Disposals

Question 35

Presentation of financial performance

Answer 35

However many ratios you can find to calculate numbers alone will not answer a question. You must interpret all the information available to you and support your interpretation with ratio calculations