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When considering the risk factors involved in trading with another organisation, it can be useful to review the other party’s financial accounting reports. Ratio analysis can be applied to financial accounts to help identify where risks might exist, and to otherwise answer questions about the company’s financial position:

**• Performance: How well is the business performing? How profitable is it? How well is it
**

controlling its costs? How does the business compare with its competitors? Is performance improving or deteriorating?

**• Financial status: How financially sound is the company? Is the company solvent? How liquid is
**

it?

• Efficiency: How quickly does the company move its stock? How quickly does it collect payment

from customers? How quickly does it pay its bills?

When going through the measure we will apply them to the accounts set out below

1

000 85.176.500 320.000 24.000 $53.000 445. Paid-in Capital in Excess of Par Retained Earnings Total Owners Equity Total Liabilities & Owners Equity 2008 $20.000 40.000 17.000 221.300 $60.000 43.000 235.000 14.20 per share N.000 30.000 420.000 1.000 1.000 25.000 110.000 13.000 55.000 45.000 55.108.000 55.500 850.000 170.000 14.000 68.000 255.000 2009 $21.500 880.Balance Sheets of The Regal Café as at December 31st ASSETS Current Assets: Cash Short-term Investments Accounts Receivable Inventories Prepaid Expenses Total Current Assets Investments Fixed Assets: Land Buildings Furniture & Equipment Less: Accumulated Depreciation Operating Equipment Total Fixed Assets Total Assets LIABILITIES & OWNERS’ EQUITY Current Liabilities: Accounts Payable Accrued Income Taxes Accrued Expenses Current Portion of Long – Term Debt Total Current Liabilities Long-Term Debt: Mortgage Payable Deferred Income Taxes Total Long-Term Debt Total Liabilities Owners Equity: Common Stock @ $0.000 11.000 185.000 85.000 1.800 645.300 2 .000 70.000 68.000 90.500 810.000 145.000 22.300 1.050.500 381.800 452.500 260.000 1.200 410.176.000 207.000 42.300 517.000 110.000 20.050.000 15.000 2010 $24.000 400.200 21.000 1.300 1.000 1.000 400.000 68.000 650.000 60.000 214.048.000 40.500 32.000 659.500 192.000 208.065.500 800.000 $71.000 1.000 12.V.000 465.000 35.000 140.000 338.156.065.000 34.000 352.000 425.000 190.500 809.000 81.000 110.800 798.000 100.

500 312.300 20. 2.352.000 235.300 121.500 1.100 320.700 49.300.000 302.000 2010 1.000 282.000 255. Credit sales are 70% of total food & beverage sales for each year.017.71 2010 $6. The average share price: 3 .600 94.500 97. Purchases: 2009 $285.600 54.500 289.300 255.500 60.300 141.000 288.900 1.500 335.500 111.93 3.300 Additional notes: 1.400 97. 2010 $286.800 146.900.500 2009 $7.063.000 304.000 244.000 235.Income Statements of The Regal Café For the years ended December 31st Food & Beverage Sales Less: Cost of Sales Gross Profit Payroll & Related Costs Operating expenses Fixed Costs Operating Profit (PBIT) Interest Expense Income Before Income Taxes Income Taxes Net Income (PAT) Dividend for the year Retained profit Retained Earnings b/f 1/1 Retained Earnings c/f 31/12 2009 1.000 352.000 105.

CL Sales Average Fixed assets Sales Average Working Capital Current Assets Current Liabilities CA – (Inventory + Prepayments) Current Liabilities Average Inventory x 365 Cost of sales Average Accts. per share x 100 Share price Prior charge capital x 100 Total Owners Equity Total Liabilities x 100 Total Assets PBIT Interest 4 . Pay. x 365 Purchases Profit after tax No of Ordinary shares Share price EPS Profit after tax Ordinary Dividend Dividend Number of shares Divi.1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Return on Equity Return on Assets (ROA) Net Profit Margin (NP%) Gross Profit Margin (GP%) Asset Turnover Fixed assets Turnover Working Capital Turnover Current ratio Acid test ratio Inventory Turnover Average Collection Period Average Payback Period EPS P/E Dividend Cover Dividend per share Dividend Yield Gearing ratio Debt ratio Interest cover Ratio PBIT x100 Average Owners Equity PBIT x 100 Average Total Assets -CL PBIT x 100 Sales Gross Profit Sales x 100 Working 2009 Working 2010 Sales Average Total Assets . x 365 Credit sales Average Accts. Rec.

Generally speaking. The profit margin also known as ‘return on sales’ identifies how efficient the company is at converting sales into profit. how well the company is using its assets to generate sales. increasing profit margins are good news for a business. — — Asset turnover Sales/Average Total assets . the ratio should over a period of time be higher than the company’s cost of capital. — — This ratio could be supported by calculating the Fixed asset turnover. A company that is capital-intensive (such as many manufacturing businesses) is likely to have a lower return on capital than one with fewer tangible assets (such as a PR consultancy). it might suggest a decline in efficiency for example an increase in assets not being matched by a proportionate increase in sales. What is an acceptable return? Much depends on the nature of the business. Return on capital employed is one of several ‘rate of return’ measures. It is usually measured using profit before interest and tax (that is. Asset turnover is a measure of efficiency in terms of the use of available capacity in other words.CL. However. and also the Working capital turnover. This latter figure would usually include the shareholders’ funds (including retained profits) as well as any long-term loans or bonds. an apparently ‘improved’ ratio could be achieved if a company failed to keep its plant and machinery up to date by not replacing old fixed assets. it is a measure of how effective the company is at controlling expenses. What constitutes a high profit margin depends entirely on the industry in question. though. If the figure declines. These calculations would identify the area of asset investment that is affecting the returns on capital employed 5 .Return on Owners Equity Net Income/Average Owners equity x 100 Return on capital employed (ROCE) or Return on Assets (ROA) Operating profit (PBIT) / (Average Total assets – current liabilities) x100. the operating profit) and expressing this figure as a percentage of all the long-term capital employed by the business. Net profit margin Operating Profit/Sales or ‘turnover’ (expressed as a percentage). In general terms.

For both the ‘current ratio’ and the ‘acid test’. If this ratio comes out as above 1. just as too low a figure raises questions about liquidity. Strictly speaking. When appraising a supplier. and for this reason would normally exclude stocks which may not always be easily saleable. A ‘normal’ figure (if such a thing exists) for the current ratio might be about 2:1. This refers to current assets which are quickly convertible into cash. If we look at the relevant part of the balance sheet above we can work out the ratios — Working capital or ‘efficiency’ ratios ‘When considering sources of finance we will look at working capital management as a means of generating internal finance. this is normally considered a comfortable situation. An increase in the number of days could indicate some pressure. Money invested in current assets may tie up funds that could be better used elsewhere. too high a figure might prompt questions about how efficiently the company is being run. Creditor days (Average Trade creditors/Purchases (or cost of sales)) x 365 (expressed as a number of days). ‘Acid test’ ratio Liquid assets (current assets excluding stock)/Current liabilities (expressed as a multiple or ratio. Creditor days measures how long the company is taking to pay its suppliers. but might also mean simply that the company is 6 . it takes for the company to get paid for the goods it sells. as it only uses what are known as liquid (or ‘quick’) assets. The acid test is a more rigorous test of liquidity than the current ratio. — Debtor days (Average Trade debtors/Turnover) x 365 (expressed as a number of days). for example 2 or 2:1). we can consider similar issues and assess how well they are managing their own resources: Stock turnover days (Average stock/Cost of sales) x 365 (expressed as a number of days). The current ratio measures the extent to which short-term assets are adequate to cover shortterm liabilities. The stock figure used must be viewed with caution. Stock turnover measures how quickly goods move through the business usually the quicker the better. However.Financial status or ‘liquidity’ ratios Current ratio Current assets/Current liabilities (expressed as a multiple or ratio. for instance 2 or 2:1). falling ratios are a sign of deteriorating liquidity. only credit sales should be used for a company that sells some goods for cash. particularly in a seasonal business. Debtor days shows how long. on average.

there is the risk of overcapitalisation. The Debt Ratio = Total Debt/Total Assets x 100 These are other measures of financial risk. leverage. The higher the proportion of fixed interest capital. 7 . static figures that may not change even when the company’s true position is deteriorating. A high-geared company is one in which equity capital (including reserves) is less than fixed interest capital. This occurs when a business actually has more invested in working capital than it really needs. This could take the form of having too much stock. A company is in low gear if the gearing ratio is less than 100%. concerns almost the opposite scenario. The most commonly used measure of gearing is based on the balance sheet values of fixed interest and equity capital. Here the risk is that cash flows coming into a business are insufficient to meet payment obligations when they arise. If company expands. Gearing = Prior charge capital Total Owners Equity x 100 The term “prior charge capital” refers to securities on which interest or dividends must be paid before arriving at the earnings for ordinary shareholders. but does not invest sufficiently in the extra working capital needs that go along with expansion. An interest cover of less than 3 is considered low. There are two main risks associated with working capital. and because it ties up capital that is of no real benefit has a financial price. the higher the gearing. — The second risk factor. Such a situation suggests inefficiency.managing its cash flow better by delaying payment. indicating that profitability is too low given the high gearing of the company. on the other hand. 50% is considered as a safe limit of debt. Gearing ratio The ratio between ordinary share capital and fixed interest-bearing securities is called financial gearing. The balance sheet ratios are. A company in high gear must earn sufficient profits to cover its interest charges before any is available to equity. and highly geared if the ratio is above 100% Interest cover = Operating Profit/Interest This gives a direct indication of the ability of the company to meet its interest commitments because it is the possibility of a company failing to pay interest that represents the greatest danger of high gearing When profit measures are calculated over several years. The amount of gearing will influence the value of earnings attributable to ordinary shareholders. it may find itself what is known as ‘overtrading’. A company that is financed mainly by equity is said to be low geared. the results give a more dynamic picture of the effects of gearing. for example. or a disproportionately high level of debtors. though. It includes both preference shares and loans. or as it is termed in the USA. First.

sales) by the number of employees as disclosed in the financial accounts.Employee ratios Other frequently used measures consider financial results compared with the number of employees in a business. — Cash flow per share (Cash flow/Weighted average number of shares). however. Cash flow to current liabilities (Net cash flow from operating activities/Average current liabilities) x 100.g. for example: • sales per employee • operating profit per employee • output per employee. and pay less attention the cash flow statement.3 Investment ratios Another category of ratios relate to share prices and are normally calculated with the shareholder and investors in mind. They are also often good indicators of the overall financial status of a company. we will use data from Perco Plc. Growth ratios Additionally. — Cash flow ratios Most traditional ratios focus on the profit and loss account/balance sheet relationship. and involve measuring the year-on-year growth of particular aspects of a business for example sales growth. These three measures are calculated simply by dividing the appropriate figure (e. one could consider the total cash flow. There are. They will form a key part of an investor’s decision making — whether to buy or sell shares in a particular company. The following data is relevant: • Perco made a profit after tax of £70 million. Some of the ratios reflect the market’s view of a company. The ‘cash flow’ figure used will depend on what is being examined for example. This looks at how much cash is generated per share that exists in the company. In looking at these measures. a number of ratios which have become more widely used in recent times and which bring cash flow figures into play. measures that reflect the growth of a business can often be useful. These are often referred to as ‘growth ratios’. This measure considers how easily a business is able to meet its current liabilities out of the cash it generates from its operations an extension to the liquidity theme discussed above. • The average number of ordinary shares in the company over the last year was 500 million. — 3. Perco has recently announced its results. profit growth and net asset growth. 8 . a fictitious UK listed company. but alternatively limit it to the cash flow generated from operations. An increase therefore suggests improvement. which can be a good indicator of future prospects.

Put another way. where the owner can decide on dividend and retention policy. The PIE ratio shows how much of a multiple of EPS one has to pay when acquiring shares in a particular company. In other words. Earnings per share Earnings per share (EPS) is the profit attributable to shareholders divided by the number of ordinary shares in issue (expressed in cash amount).4 years to recoup the amount invested if future profits remain the same. and describes how much profit has been made by the company for each share it has issued. Interpretation of PIE ratios requires particular caution.4p if buying the shares at this point in time. that is a company that is the subject of a possible takeover bid by another company. A company with a high PIE ratio is not necessarily better than one with a low one.4 times. In other words. • There are no preference dividends. EPS is a figure that is published as part of a company’s annual results. The P/E ratio thus relates earnings per share to a share’s value. The EPS of the target company is multiplied by the bidding company’s P/E ratio so as to value the target company’s shares. putting it another way still. somebody buying Perco shares at 160p is paying 11. the EPS will be: £70 million/500 million shares = l4p. it will take an investor 11. P/E ratio = Market value of the share EPS 9 . the bidding company. This is a common method of valuing a controlling interest in a company. The ‘profit’ element — or ‘earnings’ — is the profit that is attributable to the ordinary shareholders of the company. and is often used to assess value in a share price. And. if the PIE ratio is relatively low. however. as they are not payable to the ordinary shareholders. the price/earnings ratio. but it is a figure that is central to the next ratio we look at. The P/E ration may be used to value the shares of a target company. Thus it is the profit that has been made after interest and tax have been deducted — but also after any preference dividends. The earnings per share (EPS) figure is not itself a ratio. It simply means that the shares are more highly rated. This ratio can be ‘historic’ (based on the most recent published financial results) or ‘prospective’ (based on expected future EPS). For example. l4p profit has been earned.60. In the case of Perco. for every share that exists in the company.• The company’s latest annual dividend is 8p per share.4 times the amount of profit made for each share in the company. how many years it will take to recoup (in the form of profits) the price paid for the shares — assuming that future profitability remains the same. each penny of Perco profits will cost a new shareholder 11. It is a useful measure of comparison between companies. So. the shares might represent value at the prevailing price. • The latest share price is £1. based often on expectations of future growth. In other words. in the case of Perco. the following figures are relevant: • Latest share price: 160p • Latest EPS: l4p • P/E ratio 160/14 = 11. Price/earnings ratio The price/earnings (P/E) ratio is the market price per share divided by the EPS (expressed as a multiple).

It may be better to use an adjusted industry P/E ratio. We will now consider the part of that profit that is paid out to shareholders — the dividend. the profit attributable to shareholders). A bidder company may sometimes use their higher P/E ratio to value a target company. Example: application of the P/E ratio in valuing a target company Earth plc has earnings of 70 cents per share with a market value of $5.22 = $1. at least partly. Wind Ltd has an EPS of 22 cents. Answer: Earth plc P/E ratio = 5. An adjusted industry P/E would normally be taken as 1/2 to 2/3 of the industry average. This assumes that the bidder can improve the target’s business.25 per share. which may be a dangerous assumption to make. The falling share price in turn may suggest difficulties — and possibly reduced dividends in the future. this measure looks at the relationship between the latest dividend paid out per share. The calculation works as follows: Earnings per share (EPS)/Dividend per share (expressed as a multiple). and the price of that share. For a given EPS figure. and it represents that part of the profit that the company is distributing rather than retaining in the business. and future dividends stay at 8p. This is the cash amount that is paid out to shareholders.65 Dividend yield Dividend yield is the dividend per share divided by the market price per share (expressed as a percentage).5 x 0. out of reserves (basically.70 = 7.25 0. the cash return on the investment will be 5%. Dividend yield measures the percentage return on the market price of a share.Market value per share = EPS x P/E ratio The EPS could be a historical EPS or a prospective future EPS. Using the price/earnings method calculate the price per share that Earth plc would offer investors in Wind Ltd to complete the takeover. going back to Perco. Earth plc proposes a takeover bid for Wind Ltd. So. profits made in previous years). or some other method. A high dividend yield can represent an attractive investment — but it may just reflect a falling share price. in terms of the dividend paid. Whereas EPS looks at the profit made per share. we are told that the dividend being paid is 8p per share. Dividend Cover Dividend cover indicates how well a dividend is covered by the company’s earnings (that is. the EPS was 14p and the dividend was 8p. dividends are being paid.5 Wind Ltd share value = P/E ratio x EPS = 7. Dividend cover is therefore: 14p/8p = 1. if an investor buys Perco shares at today’s price of 160p. Where dividend cover is less than 1. In the case of Perco.75 times 10 . This needs to be compared to the latest share price: So. a higher P/E ratio will result in a higher price. So far we have looked at measures that consider the overall profit made for shareholders. Such an approach cannot continue indefinitely.

11 .Profit levels are sufficient to cover the dividend payout — but less than half the profits made are being retained by the business.

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