Interpretation of Financial Statements

Interpretation of Financial Statements
Horizontal analysis involves a line by line comparison of one set of data with another ? for example, the current year?s accounts with last year?s, or with this year?s budget. It is based on the fact that isolated figures are seldom of much use by themselves. Trend analysis is horizontal analysis extended over several years, often indexing the data to express the first set of figures as 100 and later periods related to that base. For example, profit is £10,000,000. Is this good or bad? (a) Profit for the previous 4 years was: £6,000,000 £7,000,000 £8,000,000 £9,000,000 (b) Profit for the previous 4 years was: £14,000,000 £13,000,000 £12,000,000 £11,000,000 ? Profit for the previous 4 years was: £10,000,000 £10,000,000 £10,000,000 £10,000,000 The comparison shows fairly clearly how the company is doing ? but even this can be improved upon. One way is to calculate the percentage increase/decrease from year to year: (a) 16.7% 14% 12.5% 11% (b) -7% -7.7% -8.3% -9% ? 0% 0% 0% 0% Using indexation: (a) 100 117 133 150 167 (b) 100 93 86 79 71 ? 100 100 100 100 100 vertical analysis
This technique requires all of the profit and loss account and balance sheet to be expressed as a percentage of critical components (generally total sales and total assets respectively). This is also called common sizing. For example, if debtors are £25 m and total assets are £100m, then debtors represents 25% of total assets. If this is compared with last year?s figure of, say, 20%, it can be seen that debtors are increasing in relative importance, and may indicate a worsening credit control situation. Example === Profit and loss accounts 1997 1998 1999 2000 £000 £000 £000 £000 Sales 1377 1269 1109 1100 Cost of sales 897 844 789 750 Gross profit 480 425 320 350 Distribution costs 247 225 210 199 Administration costs 152 103 85 100 Profit before tax 81 97 25 51 Common sized to sales 1997 1998 1999 2000 % % % % Sales 100 100 100 100 Cost of sales 65 67 71 68 Gross profit 35 33 29 32 Distribution costs 18 18 19 18 Administration costs 11 8 8 9 Profit before tax 6 7 2 5 ratio analysis ====== The major purposes of ratios can be summarised as: 1 Ascertaining the performance of the company 2 Determining the financial strength of the company 3 Comparing different companies An important technique in analysing the figures taken from company financial statements is the use of ratio analysis. Ratios are concerned with the relationships between figures in the financial statements, and are simply a way of relating two separate items together to give more meaningful information. For example, if profit is £10m and shareholders? equity is £100m, you have made a 10% profit on their funds. However, if shareholders? equity is £1000m, profitability is only 1%. The ratio shows the clear relationship between the profit made and the shareholders? funds required to make it. By using the technique of ratio analysis, data from the accounting statements can be examined and used both internally and externally to the organisation. Ratios can not only be calculated within the same company for a specific financial year but they can also be used to establish a trend of ratios over the years and also to compare figures between different companies. Using comparative ratios will highlight major changes in ratios over the years and assist in identifying possible causes and reasons for these differences. It must be stressed that ratio analysis is an extremely crude and approximate technique. The use of ratio analysis without exercising great caution will produce sweeping and often inaccurate conclusions. Ratios as calculated are merely indicators; managers? and accountants? attention is directed, scores are kept but they do not tell the whole story. The ratios guide, direct and suggest ? but they certainly do not provide definitive answers or conclusive statements. The major value of ratios lies in their ability to highlight difficulties and signpost financially deteriorating data or wave financial danger-flags to the users. Ratios can also be used in a more positive sense. If ratios are used in a discriminate sense they can assist for example, in identifying companies that exhibit growth potential in sales and earnings and have effectively utilised their assets. Ratios can also highlight companies with particularly sound (or weak) liquidity and strong (or weak) financial/investment performance. In short, ratios do not provide definitive conclusions - they merely help to identify topics of concern or interest. The financial strength of the business is particularly useful in assessing the degree of security inherent in the business. It is of particular use to external parties such as banks and other lending institutions who can attempt to assess the degree of stability and asset security for lending purposes. Other user groups such as creditors and suppliers are also interested in financial strength as an indicator of credit worthiness and to assist in the assessment of being able to meet their payment demands. Other groups such as shareholders and employees will place importance on the degree of financial strength in the business as an indicator of investment potential and for continuity of trading. It is possible to use ratios to compare successive years of data. Within the same company it is possible to establish a trend pattern over the years. It also is possible to determine variations from the norm or highlight particularly favourable or adverse ratios in a time series. If five similar sized businesses in the same line of business have similar ratios (but the sixth company is significantly different) then the analyst should be concerned. Although there may be a genuine business reason for the discrepancy, the analyst should certainly further explore the reasons for the difference. As well as comparing ratios in the same firm over successive years, it is also desirable to compare ratios against similar businesses in the same business area to help analyse the respective and relative performance of each firm. Although it must be stressed that ratios should only be compared against companies of a similar size in a similar line of business. It is meaningless to compare a multinational corporation with a small regional manufacturing company especially when their business strategies and interests are completely different. Ratios can be calculated from any figures that are obtained, not only from within a set of accounts, but also from other external sources, including trade and other statistical sources. Ratios can differ substantially between the size of company, type of business, markets in which the firm operates and the time of year when the ratios are calculated. Ratios are particularly useful when a pattern or trend can be established over the years. By identifying and monitoring changes in a ratio over a period, of say, five or ten years, any discrepancies or variations from the five or ten year trend-line can be easily highlighted. When selecting ratios there should be some connection or relational link between the figures. For example, it would be technically possible to compare profits to annual rainfall but in the vast majority of businesses (except perhaps umbrella manufacturers) the resulting ratio would be meaningless! For example, one feature of ratio analysis is looking at liquidity (i.e. the cash and other assets that are used in operating a business in comparison with the current liabilities ? i.e. what has to be paid out in the next twelve months). In the food sector supermarkets pay their suppliers later than is normal for other industries. A consequence of this is that the current assets look strange. There are few trade debtors, business being in a cash or nearly-cash situation and up to about six month?s trade creditors on the balance sheet. This looks rather strange at first glance. It is possible to calculate ratios linking any two items, but you will not always (or even often!) get meaningful results. But calculating the ratios is only the first step in the interpretation of results. It is necessary to use them to make sensible comparisons with, for instance: Â? past periods (to establish trends) Â? other societies and companies Â? industry or governmental statistics Â? budgets for the same period Ratios must be used with caution, as they do have some limitations: Â? differences in accounting policies (depreciation, stock valuation, goodwill, bad debt provisions) Â? change in the value of money Â? differences in trading environments Â? window dressing It is usual to group ratios into four major categories, namely: 1 Profitability 2 Liquidity 3 Efficiency 4 Investment profitability ratios ==== roce ? Return on Capital Employed This category of ratios examines the performance of a business in relationship to the amount of assets at a company?s disposal. A figure taken from a firm?s profit and loss account that reports a business as making a profit of £10,000 has very limited virtue by itself. To be of any significance the profit will need to be related to the size of the business. A common indicator of size can be the assets of the firm that are used in generating these profits. In other words the profit is compared with the assets used in generating that profit. Alternatively from an investor?s point of view this investment is sometimes called the capital employed in the firm. It can be defined as: Profit Capital employed (Conventionally, this ratio is expressed in the form of a percentage.) If the resulting return is 10 per cent then it means that for every £1 invested in the business, the company is generating 10p return. The investor must decide whether the 10 per cent return is adequate bearing in mind the investor?s perception of risk inherent in the business and potential investor will also need to decide on possible alternatives for investing their funds. For example, there might be another business that obtains a 15 per cent return with a higher risk or the investor might consider investing in a (virtually) risk free building society account but which provides only a return of 6 per cent. Ultimately, the decision must lie with the investor depending upon the level of risk that is personally acceptable. What profit? What capital? ====== There is often considerable debate as to the definition of the asset base or capital employed figure. Some analysts commonly treat net assets as net capital employed, which can be defined as fixed assets plus current assets minus current liabilities (rona ? Return on Net Assets), whilst others use gross capital employed which is defined only as fixed assets plus current assets (rota ? Return on Total Assets). Because the net total assets can vary on a month by month basis it is common practice to calculate a simple average figure (i.e. (the opening of net total assets at the beginning of the year plus the closing balance of net total assets)/2). However depreciation affects the size of the asset base and some more current writers about ratio analysis suggest that this is a weakness of using rota/rona. While rota and rona are both methods of assessing how well management has utilised the assets at their disposal in order to generate a profit, shareholders may be more interested in how good a return they are getting on their investment in the company. This return will be a mixture of managerial efficiency in managing assets and effectiveness of managing the finances ? i.e. the use of borrowing and lending. Thus the capital employed figure will not be the assets of the company (total or net) but the assets financed by the shareholders ? their equity. (roece ? Return on Equity Capital Employed.) (The above ratios are rather simplistic and can be modified by using more detailed and specific figures. Although it is often difficult to obtain agreement to standardise the definition it is important to stress that whatever definition is chosen, it should be consistently applied consistently throughout a company or throughout your analysis.) rota (Return on total assets) Operating profit (before tax, interest and exceptional items) * 100 Average total assets rona (Return on net assets) Operating profit (before tax, interest and exceptional items) * 100 Average total assets ? current liabilities Interest must be excluded as this represents the element of the profit that ?belongs? to the lenders to the company. The rota/rona is looking at the total profit generated, regardless of how the assets were financed. It is common practice to standardise the profit by taking the operating profit before the inclusion of tax or exceptional items. The other adjustments will minimise variations and concentrate on highlighting the core or fundamental profits of the firm. This adjustment will facilitate more useful comparisons between companies. The rota/rona is important because it compares the profit against the total/net assets invested in the business. In other words, the ratio attempts to measure how successfully the firm?s management has utilized the assets under its control to generate earnings for the company. The profitability of a company broken down to its turnover and margins. Profit = Profit * Sales Capital Sales Capital margin turnover Margin These ratios will indicate it is receiving x% return on sales. For example, it a company is obtaining a 5% net return then another way of expressing this ratio is to state that for every £1 of sales, the company generates 5p in net profit. The ratio is of special use when comparing profitability margins in different business segments. It is extremely important to bear in mind that this ratio can vary greatly depending on the type of business. Turnover This ratio can be easily distorted by the amount of capital employed by each business. Some businesses may obtain a high return on sales - but only at the expense of having enormous amounts of capital employed. If the sales are £1,000 and the net assets are £250 the resulting figure of 4 (times) would indicate that the assets have been ?turned-over? 4 times during the year. Another way of expressing this ratio would be that for every £1 invested in assets in the last year, £4 worth of sales was achieved. The higher the resulting figure then the more intensively the business is utilizing its assets. Some types of business have a relatively low return but the return is compensated by high turnover, whereas other businesses have high profit/sales margins but experience a low turnover. A typical example of the former would be a food supermarket ? whereas the latter could refer to a jewellery retailer. roece (Return on Shareholders? Equity) Profit before distributions (pas) Shareholders? equity Shareholders are interested, not only in the efficient utilisation of assets, but also in the way management has organised the financing of the company. They want to know how much money the company is making on their funds. To find this ratio, we must strip out the part of the profit that ?belongs? to the lenders (the interest) and also that owing to the Inland Revenue (the tax), leaving the profit that is solely attributable to shareholders. Note that this profit figure is before dividends, as both dividends and retained profits constitute a return to shareholders ? the former being a cash return and the latter making the business bigger and (they hope) providing the potential for a capital gain on their investment. The difference between rota/rona and roece reflects the effectiveness of management?s financing policy. The roece must be greater than the rota/rona, otherwise the shareholder would be better off as a lender to the company. Generally speaking, there is a trade-off between the expected return from an investment / loan and the risk associated with it (the uncertainty of receiving that return). Lenders are (more or less) assured of the interest and the repayment of the loan. However, there is no legal obligation to pay a dividend to ordinary shareholders, and the return of the original investment will depend on the secondary capital market. Thus the return expected by shareholders will be greater than that demanded by lenders. Example: A company has net assets of £1,000,000 (i.e. FA + CA ? CL) This is financed by £200,000 10% debentures £200,000 share capital ) £100,000 share premium ) £800,000 shareholders? equity £500,000 reserves ) Operating profit for the year is £220,000. Profit after interest (ignore tax) is therefore £220,000 ? (£200,000 * 10%) = £220,000 ? £20,000 = £200,000 rona = 220,000 = 22% 1,000,000 roece = 200,000 = 25% 800,000 If the roece was not higher than the rona, then the company is making some rather costly financing decisions. See also the section on investment ratios and in particular gearing. liquidity ratios ==== Although a company must be profitable in the longer term, in the short term at least, it must have sufficient funds to meet day-to-day expenses and commitments. From a company?s perspective, liquidity can be viewed as having the cash funds to meet its debts and commitments as and when they become due for payment. In practice a liquid company should have sufficient cash funds to pay its suppliers, pay employees their remuneration and meet its debenture and loan interest payments. Liquidity can be defined as the ability of a company to meet its debts and obligations as and when they become due for payment. The importance of liquidity is evidenced from a company?s cash cycle. A company will receive cash predominantly from debtors and cash sales. At the same time the cash is being recycled by being paid out to creditors, suppliers, salaries and wages and expenses. The company must aim to keep the cash inflow and the cash outflow under a close degree of control. If the cycle becomes unbalanced or distorted the cash inflow can frequently be insufficient to meet cash outflows. The result can cause difficulties for the company. Many businesses find maintaining a liquid position difficult. Many debtors do not pay their debts on time ? whilst creditors frequently press the company for urgent payment. In other words, the timing of cash flows is vital for virtually all businesses. For everyday operations it is imperative that companies maintain a sufficient degree of liquidity. Establishing a sufficient level of liquidity will mean that most companies will need to monitor and control such areas as: Â? Debtors: Factors to take into account include level and nature of debtors, creditworthiness of debtors, level of bad debts, terms and conditions of credit, credit control policies and practices of the company. Â? Stock: Levels of stock, monitoring and control of stocks and work-in-progress, obsolete stock and stock write-offs. Â? Creditors: Monitoring levels and dates of payment, comparing time taken to pay creditors compared with time taken by debtors, etc. In many organisations there can be a clash between a company?s profitability and its liquidity. In practice companies arrange a trade-off between these two concepts. To be as profitable as possible a company must invest all its available resources, including most liquid resources into its productive assets (i.e. factories, machinery etc). If the company over invests in the productive capacity the company can rapidly reduce its liquid (working capital) funds and become illiquid. On the other hand, if a company has excessively high levels of cash and other liquid resources (i.e. it is too liquid) then the company is under-utilising its resources. In such circumstances the company will easily be able to meet its commitments to creditors and employees but its overall profitability will be reduced because it has failed to invest sufficiently in its productive capacity (i.e. its asset base) ? which generates the company?s profits. In an attempt to determine an appropriate level of liquidity it is possible to calculate two particularly relevant ratios. Current Ratio ? Current Assets / Current Liabilities This is usually expressed as a factor ? e.g. 3 to 1 ? although it is sometimes shown as a percentage. If current assets are £1,000 and current liabilities are £600 then the resulting ratio of 1.67:1 indicates that for every £1 of liabilities there is £1.67 of current assets with which to meet these commitments. Traditional opinion has always regarded a ratio of 2:1 as being a soâ??called ideal situation since the business can meet its current liabilities twice over. In some texts it may be suggested that this figure is excessively high and nowadays it is common to find a ratio even below 1.5:1 as being acceptable. A too low ratio may indicate a lack of funds with which to operate satisfactorily; an extremely low ratio could mean that the company is unable to meet obligations as they mature. However, a low figure may not necessarily mean liquidation! Short-term loans that technically require repayment within one year may be renegotiated and extended. Also, supermarkets which operate on a primarily cash basis frequently have a ratio below 1:1 as cash is flowing in daily from the checkouts. On the other hand, an excessively high ratio can equally lead to cause for concern. Such a level of ratio would indicate that the company has ?idle? funds that are not being put to optimal effect. A high ratio might imply that there are excessive levels of stocks, debtors or bank balances in comparison with current liabilities. These excess working capital funds should not be lying idle as part of working capital but rather invested in the productive capacity of the firm, such as in plant and machinery. Particular attention should also be paid to establishing the particular breakdown of current assets and current liabilities and in identifying the constituent parts of their stocks, workâ??inâ??progress, debtors and creditors. Specific reference to the nature and relative values of each of these items should be made. (For example, the age, condition and saleability of stocks; the nature and types of debtors; and the nature and payment factors relating to creditors and other obligations.) Rather than simply calculating the absolute level of the ratio it is more important to monitor the changes in the level of the liquidity ratio over time. Careful monitoring of the CA:CL ratio will often provide an opportunity for the company to attempt to rectify the deteriorating condition. Acid Test Ratio ? Current Assets excluding Stock / Current Liabilities If the current assets have a high proportion of stock and work in progress that may not be so readily convertible into cash, the liquidity position may be more severe. In many companies it can take a relatively long period of time to convert a firm?s stock into cash. (The sales cycle is lengthy: i.e. a customer has to be found, then an order received; followed by the sending of an invoice; followed by a period awaiting payment by the debtor including the possibility of default, etc.) By removing stock from the equation, the acid test ratio highlights the immediate liquidity of the company. Again, not too much alarm must be taken of a low figure, as with a cash business, and rapidly turning over stocks, the situation may not be drastic. As with the current ratio, the quick ratio has no ?ideal? or standard answer. Traditionally a ratio of 1:1 would have been considered highly desirable. In other words all current liabilities could be paid at least from the generation of cash from the quick assets. The ratio is influenced by a variety of factors including the type of business and the nature of the firm?s debtors and creditors. Nowadays, operating on the premise that all of a company?s current liabilities do not normally have to be paid immediately â?? a figure of 0.7:1 or even 0.6:1 will not normally cause undue alarm. In a predominantly cashâ??based business this ratio can fall even lower. An important point to remember is that these liquidity ratios vary tremendously between industries, depending on the nature of the business. It is important therefore not just to consider the company in isolation, but to compare it with other companies occupied in similar activities. efficiency ratios ===== Traditional financial statements do not tell us how efficiently the Company has been managed ? i.e. how well its resources have been looked after and utilised. While profitability gives some indication, accounting profit is subject to so many arbitrary adjustments that it is somewhat less than reliable. Efficiency ratios primarily examine how productively companies utilise assets but they can also include creditors and other business aspects. Efficiency ratios can be calculated from any financial information relating to the company. But it is crucial to remember that whatever efficiency ratios are calculated, they must be relevant and meaningful. Stock Turnover (cost of sales /average stock) The stock turnover ratio is important in the measuring of the length of time that the firm has, on average, stock in its warehouse. As the normal optimum rates for different industries vary from once daily to once yearly the overall ratio cannot properly be judged without reference to the trade pattern. In the calculation of the ratio it is normal practice to use the cost price of sales (rather than selling price) as stocks are themselves shown at cost price. The ratio can be expressed either in terms of a turnover rate or indays (or months): Stock turnover (rate) = Cost of sales Ã? Average stocks Stock turnover (days) = (Average stocks * 365) Ã? Cost of Sales A stock turnover rate of 4 would indicate that the company has about 3 months of sales in stock. Again, the industry will determine what is a ?good? ratio ? retail outlets should have a higher ratio than manufacturing businesses. Firms that carry too high stock levels are not utilising their funds to optimal effect. Stocks need to be financed and excessive levels may utilise a substantial proportion of a firm?s working capital. Stocks incur financing costs in the form of interest charges on loans and overdrafts, storage and insurance costs, and there is a possibility that some stocks may age quickly and become unusable. There is also an opportunity cost in that funds used in financing excessively high stock levels cannot be used elsewhere in the company. On the other hand, if the firm has too low a level of stocks it may imply that there is a danger of a ?stockâ??out?â?? a situation that arises when the firm is unable to meet its sales orders because of insufficient stock levels of either raw materials or finished goods. A failure to meet orders can then mean a lost order and a loss of a substantial amount of customer goodwill. The stock turnover ratio has no standard answer but the management can utilise the ratio to highlight changes occurring in their firm and to compare turnover ratios in other companies. The management of each firm must determine the level of stocks to be held in the light of such factors as their own experience, rate of sales, reliability of suppliers and usage/wastage rates. The ratio can vary enormously depending on the organisational structure of the firm to the nature of the goods being stocked. A wellâ??run and efficient business with sound lines of communications between its suppliers can allow stock levels to be far lower than a firm having long delivery lead times and erratic delivery patterns. A firm stocking perishable commodities will also have considerably lower stock levels than a firm storing items with almost infinite lives. Some companies attempt to keep stocks and stockâ??holding costs to a minimum by implementing a ?justâ??inâ??time? principle of stock control. In practice, such. a policy means that a company will only replenish its stocks ?justâ??inâ??time? â?? or just before stock levels are extinguished. In fact some organisations that support just inâ??time? practices have such low stock levels that their stock turnover ratio can be measured in hours (and not days or months). Debtors Collection Period (Average trade debtors*365/ Total credit sales) Many companies conduct their business on the basis of credit. Goods are sold to customers on credit, and at a future date the debtor is expected to pay for the goods. It is useful to calculate the average number of days that debtors take in paying for the goods. An excessively long period of time in waiting for a debtor to pay a company?s invoice can result in substantial funds being tiedâ??up in debts rather than receiving cash to pay into the company?s bank account (and thence out again to pay the company?s own obligations). However, customers may be encouraged to buy more if selling prices are competitive and credit terms are generous, thus extending the debtor collection period. In some businesses in the retail sector whose customers predominantly pay cash for the goods, this ratio has only limited benefit (e.g. Tesco). Financial statements do not give a breakdown between cash and credit sales, and so there may be significant distortion of the ratio by using the surrogate ?Sales?. Creditors Payment Period (Average trade creditors*365/Total credit purchases) This is a similar ratio to the above, showing how long the company is taking to pay its debts. An increasing ratio might indicate that the company is having difficulty in finding cash to pay its creditors. However, the amount owing to creditors for goods and expenses is a form of short term capital which should be exploited as far as is financially advantageous. It must be remembered, however, that this form of finance may not be as cost-free as it appears (i.e. no interest). A poor track record of paying may lead to a breakdown in relations with suppliers, which in turn may lead to losing suppliers and/or their goodwill. Note: in both the above ratios, the average debtors and average creditors can be found as a simple average, i.e. ((opening balance + closing balance) Ã?2). If the opening balance information is not available then the use of the closing balance only is permissible. Also, with two years? financial data, it may be preferable to have two ratios for comparison rather than just the one. Fixed Assets Turnover Ratio (Total sales revenue / Fixed assets at nbv) The more times that the fixed assets are covered by sales revenue, the greater the recovery of the investment in fixed assets. This ratio gives some indication of productivity in use of property but is affected by the pattern of asset book values. A high ratio is not necessarily indicative of high productivity for it may reflect the excessive utilisation of old written-down assets. Conversely, a low ratio is not necessarily a bad feature for it may reflect the higher value of newly acquired assets that is likely to represent a progressive and enterprising development policy. The depreciation method also has a bearing on this ratio. investment ratios ===== It may be useful to begin this section with a question. Why do investors invest in companies? Of course the quick answer to this is to earn a return or a reward on their investment. The two basic rules of investment can be summarised as follows: Â? A higher level of perceived risk in an investment should be compensated to the investor by a higher level of return. Â? A shareholder?s return arises in two ways: Share Price Growth andDividend Payments (Income). A shareholder can sell shares at any time and obtain a market price for these shares. If this is higher than the price paid then this counts as part of the investor?s return. Whilst holding the shares the investor is entitled to a discretionary payment from the company. This is a distribution of the profit from the company to its owners (i.e. the shareholders) and is called a dividend. A company?s profits or earnings are often regarded as one of the major indicators of its financial performance. However, because there are many ways by which a company?s profit can be calculated (e.g. before or after tax, before or after debenture interest etc.) it is possible to standardise the definition by using a more precise definition of earnings. A company?s earnings are based on its profit after deducting taxation, preference share dividends, dividends to minority groups and extraordinary items. In other words, earnings are the profits attributable to the ordinary shareholders of the company. But the absolute level of earnings of a company means very little. To have meaning and relevance a company?s earnings should be related to a ?yardâ??stick? or some basis of measurement. A common method is to use the number of shares. Earnings Per Share (eps) (Earnings / number of ordinary shares) Company A and company B have total earnings of £100. Company A has 1,000 ordinary shares and company B has 2,000 ordinary shares. The eps for company A is 1Op (£100/1,000) and the eps for company B is 5p (£100/2,000) The fact that company A?s eps is twice that of company B?s eps does not necessarily mean or imply that company A has superior performance. It could simply mean that company A was formed with a far fewer number of shares. However it is saying that the same amount of earnings must be shared with more shareholders in Company B than Company A. The factor that is significant is the yearâ??onâ??year rate of increase or decrease. If, in the previous year, company A had reported an eps of 8p and company B reported an eps of 3p, it would imply that A?s eps had increased by 25 per cent and B?s increased by 67 per cent â?? giving company B superior earnings growth performance. These percentage changes form the basis of far more significant information on which to interpret the company?s financial performance affairs. Price earnings ratio or P/E Ratio Market price per share / eps The eps figure is also extremely important in the calculation of the price-earning ratio (P/E ratio). The P/E ratio is a comparison of the market price of the company?s share with its eps. For example, if the listed share price of company A is 80p and its eps is 10p the P/E ratio would be 8 times (80p/10p) or more frequently just referred to as a P/E ratio of 8. In other words, at today?s level of earnings (i.e. 10p) it would take 8 years for the aggregate earnings to be equal to today?s share price. Effectively, the P/E ratio is a measure of the perceived degree of risk or perceived degree of confidence in the company. The higher the P/E ratio the greater the number of years that an investor is prepared to wait for the total earnings to be equal to the share price. So implicitly there is a higher measure of perceived confidence (and hence by implication lower risk) in the company. For example, if company A has a P/E ratio of 10 and company B has a P/E ratio of 25, ceteris paribus, investors will have a greater degree of confidence and lower perception of risk in company B than company A. It is possible that the reason that company A?s P/E ratio is lower is because of a poorer earning performance â?? which is not fully or immediately reflected in its share price. However in many ways P/E ratio is not a measure of performance, it is used to identify opportunities for investment. This can cause confusion for the reader of the Financial Times attempting to spot companies to invest in because of a company?s P/E ratio. Not only can a high P/E ratio indicate that a company is among the top performers in its industry but if the P/E ratio is significantly higher than the sector norm it can suggest that the share is ?overpriced? and is being valued on too high a multiple of earnings. Similarly, a low P/E ratio may suggest that a share is either undervalued or perhaps indicates that the market has little confidence in the company?s prospects and is regarded as a poor investment. As well as examining the P/E ratio based on the latest financial statements (the historical P/E ratio), it is also possible to calculate the prospective P/E ratio. Many analysts will attempt to estimate the future or prospective P/E ratio based upon the estimated or projected earnings for the coming year. The major weakness in using prospective P/E ratios is the degree of subjectivity and estimation involved and hence the degree of reliability and accuracy. The value of using P/E ratio comes from comparing P/E ratios in the same markets or business sectors. For example, it is quite common to find that food supermarket chain stores have higher P/E ratios than high technology computer hardware companies. The general perception of risk is far higher in computer technology than in food lines. Computer technology can change extremely rapidly and adversely affect the company?s longâ??term prospects; whereas changes in food retailing products are considerably slower â?? resulting in lower perception of risk for these companies. Gearing Ratio (LT Loans / Equity) The gearing (or sometimes referred to as leverage) ratio identifies the extent that a business is financed by elements of debt and equity. In particular it compares the amount of loans and debentures (the firm?s indebtedness) to the shareholders? funds (i.e. the equity plus reserves). A company that is financed by a higher proportion of debt is deemed to be more highly geared than a company that is financed predominantly by the shareholders? own funds. The two normal sources of financing for a business are through equity and debt (loans and debentures). Since the gearing of a company is the relationship between these two funding sources (i.e. debt and equity) â?? gearing has an important effect on the longâ??term financial stability of a company. The importance of this ratio can be viewed in the context of the practical and legal nature of these two sources of funding. The debt normally consists of a fixed return (the interest) to debenture holders and lenders. The interest to the debt holder must normally be paid irrespective of the level of profitability that is obtained. In contrast, the return to equity holders is in the form of dividends. The level of these dividends can vary with the level of profit obtained and the amount of dividends that the directors decide to pay. As a result, in times of trading adversity, the debt holders must still be paid but there is no similar obligation to pay dividends to shareholders. In such circumstances a relatively low geared company will have the advantage of being in a better position to survive by cutting its (optional) dividends. In similarly difficult trading conditions, a high geared company will still have to attempt to meet its relatively high debt servicing obligations. However in practice the setting of a dividend is recognised as a signal by the market. No dividend at all would most reflect a company already in some difficulty or the news of a cut in the level dividend might be a mid-term signal that a company has some difficult times ahead. In times of trading prosperity, a higher geared company can achieve superior results. Since a large proportion of the business will usually be funded by fixed (or reasonably constant) interest debt (at say a rate of interest of 15 per cent) the available profits can be apportioned over a proportionally smaller amount of shareholders. Example: Two companies A and B both have earnings before interest of £20,000. Company A has equity of £100,000 (100,000 £1 ordinary shares) and debt of £10,000, i.e. A is 10% geared. Company B has £10,000 equity (10,000 £1 ordinary shares) and £100,000 debt, i.e. 1,000% geared. In both cases the debt servicing charges are 15%. Company A Company B Earnings £20,000 £20,000 Interest (£1,500) (£15,000) Available for distribution to shareholders £18,500 £5,000 Earnings per share 18.5p 50p In times of trading difficulties, for example, if profits before interest fall below £15,000 company B will be unable to meet its interest commitments â?? with the possibility of the company facing failure. Because company A has a low gearing, a drop in earnings to £15,000 has little impact on the firm?s ability to pay its £1,500 interest. Accounting Gearing (LT Loans * 100 / Capital employed) There are a number of commonly used and acceptable definitions of gearing. Again it is useful to stress a consistency in approach. A traditional method of calculation is termed accounting gearing. Here the gearing is expressed as the percentage of total capital represented by debt. Other ratios The above formulae are frequently considered too simplistic and can be subject to a number of modifications. There are other methods of calculating gearing. A common alternative is to include preference share capital in the calculations. Preference shares normally have a dividend attached which must be paid before dividends to the ordinary shareholders. Effectively, this preference dividend commitment is similar, in practical terms (but not in legal terms), to the paying of interest. Accordingly preference dividends are treated in the same manner as loan and debenture interest in the gearing ratio. The company?s reserves are also usually included in the denominator to identify the total amount of shareholders? funds. (In a legal sense the reserves belong to the company?s shareholders.) 1. Longâ??term debt and preference shares can be used in the numerator: Debentures and longâ??term debt + preference shares * 100 Ordinary share capital + reserves 2. All of the company?s debt (both longâ?? and shortâ??term debt) can be included, All types of debt * 100 Capital + reserves 3. It is also possible to use the ratio on a net debt basis. In this method any cash balances in the company are offset against any indebtedness. All types of debt minus cash/bank balances minus shortâ??term investments Capital + reserves Interest Cover (Profit before interest and tax / Interest payable) This ratio is useful in providing an indication of the extent to which profits can fall before the payment of interest is placed at risk. It shows the number of times the interest could have been paid out of current earnings. If profits are fluctuating, a high figure is desirable to ensure that current interest commitments are met. The advantage of this ratio is that is incorporates interest rates as well as the absolute amount of loans held. It also highlights the danger area of gearing ? the potential inability to pay interest. For example, a company with profits before tax and interest of £1,000 and interest payable of £500 has an interest cover ratio of two times â?? the firm can pay its interest twice over from its profits. Another way of examining its position is that the firm?s profits can fall by a half (£1,000 to £500) before the payment of interest is threatened. The higher the ratio the greater the degree of interest cover safeguard (or safety margin) for the firm. Businesses that have high gearing and operate in rather volatile trading conditions will find greater financial comfort and security by having a higher rather than a lower figure. Firms in such situations would prefer to have a ratio of four or five times rather than once or twice. There is no golden rule about the level of gearing a company should have. It varies from market to market internationally and from industry to industry. It also should vary according to the economic cycle. In a recession then the higher the interest cover the more secure both the lender and the shareholder will feel. However the level of comfort of the investor and the level of concern expressed seems to be almost a question of perceived taste or fashion. Dividend per share (Gross dividend / number of shares) The dividend decision is an important one, as it determines the amount of assets (cash) to be taken out of the company and given to shareholders. Thus it impacts on the retained profits, and the decision to expand the business. As mentioned above, the psychological impact of the dividend policy must be taken into account ? the level of dividend is seen as a signal to the market. If a company distributes £25,000 ordinary dividends and has 100,000 £1 shares, then the dps = 25p. Dividend yield (dps * 100 / market price of share) The dividend yield ratio explains the gross dividend that an investor will receive in relation to the share valuation. The ratio is only concerned with the income (i.e. dividends) that results from ownership of a share. Assuming a market share price of 400p, the dividend yield will be: (25p Ã? 400p) x 100 = 6.25% If an investor invests £1 in this company he will receive a return on this investment in income terms of 6.25p. This ignores share price or capital growth. Dividend cover (Profits available for ordinary shareholders / ordinary dividends paid) The dividend cover ratio examines the amount by which profits could fall before the payment of dividends is placed at risk. For example, in company xyz, the profits available for distribution this year are £10m and the company proposes to distribute £4m in ordinary dividends to the qualifying shareholders. The dividend cover ratio is 2.5 times (£10m/£4m). In theory, the year?s profits could fall from £10m to £4m before the payment of dividends (out of this year?s profits) is placed in jeopardy. If the profits were £3m and the company still wishes to pay a £4m dividend the resulting dividend cover of 0.75 implies that the company cannot distribute a dividend from this year?s profit. If the company is still determined to pay a £4m dividend the company will need to find the excess (i.e. £1m) from its previously accumulated profits, i.e. its distributable reserves. This will certainly send a signal to analysts in the market. In these circumstances the company would hope that maintaining a dividend of £4m would be sending a positive message about its future prospects. It is important to remember that dividends represent only a part of the shareholders? return. Any profits not distributed (retained in the business) should increase the size of the business and therefore lead to enhanced profits in future years. Another factor to be considered in the dividend decision is the availability of cash. If all the assets of the business are tied up in buildings, stock, debtors, etc. then it may be necessary to borrow in order to find the cash to pay shareholders ? another cost. limitations OF ratio analysis ========= It must be emphasised again that ratios are merely an indication or pointer. They can highlight particularly favourable or adverse figures in a business. By themselves ratios are not definitive or absolute statements. Ratios form a basis for further investigation and research. They must not form the sole foundation or only criteria for decisionâ??making. The ratios must be treated with a considerable degree of caution and apprehension. The user / analyst frequently requires forecast information that has predictive value, but most information obtained from the financial statements is historical in nature. Information from financial statements is often in summarised form and details regarded by the company as confidential will not be published. Furthermore the underlying statistical assumptions applied in ratio analysis may not be valid. Assumptions may be made that ratios are normally distributed for companies within a particular sector or that the ratio is proportional for all sizes of companies and has a zero intercept. The analysis may be particularly prone to error if these assumptions are applied to companies with unusual absolute values applied in ratio analysis; e.g. computing roce for a company with a very small total of capital or net assets in its balance sheet. Nevertheless, provided the ratios are used with a discriminate application, they can provide a useful analytical tool and act as a starting point to conduct further investigation into a business.

Interpretation of Financial Statements 7.7 of 10 on the basis of 3071 Review.