Lesson 16: Financial Analysis II

Question 1

Note:

The company may retain some or all of the earnings to finance growth and increase its potential for future earnings.

Question 2

Note:

If the company retains earnings, the market value of its shares should increase to reflect its greater earnings prospects and result in capital gains to the investor when the market price of the share rise

Question 3

What is Earnings per Share?

Answer 3

EPS is a key measure of a business’ success because it shows how much the company earned for each share.

This helps to predict the future value of ordinary shares.

Question 4

What is Earnings per Share used for?

Answer 4

This ratio is often used to compare the performance of the company’s shares against another that of another company.

Earnings per share has to be disclosed to enable investors to relate earnings to the market price of the shares
(Price Earnings Ratio).

Question 5

What is Price Earnings Ratio (PER)?

Answer 5

 Refers to the amount an investor is paying to buy a dollar of earnings.

It shows the number of times above the earnings the investors are willing to pay for the shares.

It is an indication of the popularity of the shares in the market and the shareholders’ confidence in the firm.

 Refers to the number of years it would take an investor to recoup his investment
out of earnings, assuming that the current rate of earnings is maintained.

Question 6

What is Dividend Yield?

Answer 6

This measures the rate of return in the form of cash dividends for every dollar invested in the shares or the percentage of a share’s market value returned annually to shareholders’ as dividends.

It links market price of the shares with dividends received and shows how much a shareholder can expect to receive as returns on his investment.

Question 7

Note:

A company could have low dividend yield because it ploughs back profit for future
expansion and this can result in future capital appreciation of the shares

Question 8

What are the Pros and Cons of issuing shares?

Answer 8

Issuing shares creates no liabilities or interest expense and is less risky to the company.

However, issue of ordinary shares may result in some dilution of control.

Question 9

What are the Pros and cons of Borrowing?

Answer 9

Borrowings do not dilute control of the corporation but having more debt would increase the risk of the company.

Debt increases risk.

Debt requires repayment, usually on specific dates.

Failure to pay debt interest and principal on a timely basis may result in default and even bankruptcy.

Question 10

What are the types of Financing?

Answer 10

Internal and External Financing.

External financing can be classified as short term or long term in nature.

Question 11

What is Internal Financing?

Answer 11

Internal financing refers to resources raised from the business’ own assets or from profits ploughed back or are retained in the business

Question 12

What is External Financing?

Answer 12

External financing refers to resources obtained from sources outside the business through an issue of shares
or obtaining a loan from a bank.

Question 13

What is Short term Finance?

Answer 13

Short term finance refers to amounts raised which needs to be repaid within an accounting
period.

Question 14

What are the common types of Short term finance?

Answer 14

1) Bank overdraft
2) Payables

Question 15

What are the Pros and cons of Bank overdraft?

Answer 15

Bank overdrafts allows the business the flexibility to vary the amounts borrowed according to its needs for example, when its credit customers do not pay back as quickly as expected or to pay for a large delivery of inventory.

Interest charged on overdraft tends to be high and the banks can demand repayment at short notice.

Question 16

Payables

Answer 16

Payables effectively provide financing for the business if they allow the business to
use resources such as inventory and services without immediate payment.

The business can maximise the financing by stretching the repayment period.

However, the business may lose discounts for prompt payment (cash discounts) and
compromise its credit reputation if it takes too long to pay.

Question 17

What are the different types of Long term finance?

Answer 17

1) Debt financing
2) Equity financing

Question 18

What is Debt financing?

Answer 18

These are borrowings which are repayable in more than one accounting period.

Debt financing includes long term loans from banks and bonds.

Question 19

What is Equity Financing?

Answer 19

This refers to permanent finance raised by companies through the sale of shares.

Question 20

What is Included in Financial strength ratios?

Answer 20

Short term and long term indicators.

Short term indicators are called liquidity ratios

Long term indicators are called solvency ratios

Question 21

What is Debt equity ratio?

Answer 21

The debt to equity ratio compares resources provided by creditors with resources
provided by owners.

The extent to which resources of the business is financed by debt is known as gearing.

The higher the ratio, the higher is the gearing and risk of the business.

The higher gearing implies higher the claims of creditors on assets resulting in higher risk for both shareholders and creditors.

The higher the likelihood an individual creditor would not be paid if the company is unable to meet its
obligations.

Question 22

What is the Creditor viewpoint of companies with high gearing?

Answer 22

There is greater financial risk with higher gearing.

A highly geared company runs a greater risk of failing to pay the high interest charges and debts when due and facing foreclosure when there is a downturn in business.

At the extreme the company may be forced into bankruptcy and liquidation.

In the event of liquidation, there is greater risk of insufficient assets to repay the debts.

Question 23

What is the Shareholder viewpoint of companies with high gearing?

Answer 23

 Greater financial risk for the company.

 Fluctuations in profits can result in sharp increases and decreases in returns to ordinary shareholders.

If profit increases, EPS will rise at a faster rate, but if profit falls, EPS will fall at a faster rate than a low – geared company.

Besides, if profit plunges, there is greater risk that the company might not be able to cover the
large amount of interest and thereby, sustaining a loss.

 If returns earned on assets or resources of the business is higher than the interest on borrowed funds, higher gearing will result in higher returns to ordinary shareholders, as earnings are spread over a smaller number of shares.

Question 24

Note:

 High gearing poses greater risks to ordinary shareholders.

When profit falls, it may not be adequate to cover the large amount of interest and preference dividend that have to be paid before any ordinary dividend can be paid.

Therefore, the ordinary shareholders may suffer losses.

 Besides, if profit falls, returns to the ordinary shareholders will fall at a faster rate for a highly geared company.

 However, if profit increases, ordinary shareholders will benefit as EPS will increase at a faster rate than a low geared company.

 Hence, a feature of a highly geared company is that any fluctuation in profit can lead to sharp increases or fall in the EPS.

Question 25

Importance of gearing in financing decisions

Answer 25

 The higher the gearing, the greater the risk of the company being unable to pay the interest and the debts.  Fluctuations in earnings can lead to wide fluctuations in returns to ordinary shareholders in highly geared company and hence affects the market value of the shares.  If the return on assets employed is greater than the interest rate, the higher gearing will result in a higher return to ordinary shareholders.

Question 26

What is Interest coverage ratio (Times-interest-earned-ratio)?

Answer 26

It refers to the number of times interest is covered by operating profit(NPBI). It shows the extent that profit can fall before the company is unable to cover interest charges. The higher the cover, the better the firm’s ability to pay interest and the safer the position of the creditors.

Question 27

Note: If the ratio is < 1, this means that the firm has not even generated enough profits to cover the interest expenses. The lower the ratio, the more risky the firm is considered to be as it may not be able to meet its fixed and mandatory interest obligations. If a firm is unable to meet these obligations, it will be in default, and its creditors may seek immediate payments and in most cases, this would force a firm into liquidation.

Answer 27

Interest coverage ratio

Question 28

Note: Long term liabilities should not be avoided just because they result in compulsory interest charges. This is because interest charges are tax deductible. Hence, even though risk is involved in using leverage, firms with stable earnings can consider having more debt in their capital structure as external financing can be positive for the business.

Question 29

What are the uses of Financial analysis?

Answer 29

a) Many figures in the financial statements are only meaningful when related to other figures, For example, to gauge whether a profit of $50 000 is a`good‘ result, we need to relate it to some measure of the size of the business, such as sales, etc. b) Using a small number of key ratios simplifies the analysis of the mass of data contained in the financial statements. c) Comparing ratios of different periods helps in identifying past trends which may serve as a basis of forecasting for the future (horizontal or time Series analysis). d) Comparing ratios of a firm with those of other firms in the same industry or with the industry averages / norms highlights the company’s comparative strengths and weaknesses.

Question 30

What are the limitations of Financial analysis?

Answer 30

A. Inherent limitations of Financial analysis 1) Financial statements are prepared based on historical data which may not serve as a useful basis of predicting future performance because of changes in future conditions eg. Management, economic climate, political conditions, etc. 2) Different companies adopt different accounting policies in the preparation of its financial statements eg. Valuation of property, depreciation, inventory valuation. It is thus, misleading to compare ratios of firms applying different accounting policies. 3) Financial statements are not adjusted for changes in price – levels over the years. This can distort comparison over time (horizontal analysis). B. Lack of Universal Standard Ratios can only be used to compare like with like. Due to the variations in trade, size and mode of operations, it is not possible to compare and establish an ideal for everyone. 1) In analysing the ratios, one should be clear about the nature of the company’s business. Different kinds of businesses have different acceptable ratios. For example, current ratio of 2:1 is acceptable for normal trading businesses but not for a bank. 2) It is unrealistic to compare small firms with big firms. However, industry averages are based on the results of small, medium and big firms. 3) A capital intensive firm and a labour intensive firm will obviously differ in ratios involving the use of asset figures. C. Availability of Data 1) Some of the data required are generally not available to outsiders of the business. For example, companies may be highly diversified in activities but are listed under a particular industry. The results of different divisions of the company are summarised and it is not possible for users to separate the results of one division from another. Also, the accuracy of the ratios depends on the quality of the information from which they are calculated; the required information is not always disclosed in the accounting statements and account headings can be misleading. D. Ratios only compare the results of carrying on a business. They do not reveal the exact causes of the poor ratios. They only indicate areas for further investigation. Furthermore, interpretation needs careful study of the changes in the numerator and denominator to avoid arriving at the wrong conclusions, eg. A high stock turnover figure could either mean that goods are fast moving or inadequate stock is held. (seasonal trends)