UNIT 5. Chapter 32. Analysis of published accounts Flashcards Preview

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What are the five main classification for accounting ratios?

• Profitability ratios (Gross Profit Ratios, Net profit ratios, Return of capital employment)
• Liquidity ratios ( Current Ratio, Acid Test Ratio)
• Financial efficiency ratios (Inventory turnover ratio, Day's sales in receivables ratio)
• Shareholder ratios (Dividend yield ratio, Dividend cover ratio, Price/ Earnings ratio)
• Gearing ratio


Def. Return on capital employed

• (Net/ Operating profit / Capital employed) x100
• The higher the value of the ratio, the greater the return on the capital invested in the business.
• The ROCE can be improved by efficient use of the assets owned by the business, which were purchased by the capital employed. (To either increase the operating profit, or reduce the capital employed.)


Def. Inventory (stock) turnover ratio [Financial efficiency ratios]

= cost of goods sold/ value of inventories
•The result is the number of times stock turns over in the time period (usually 1 year)
•The higher the number, the more efficiently the manager are in selling stock rapidly.
•Not suitable to service firms, as they do not have stock.


Def. Day's sales in receivable ratio [Financial efficiency ratios]

= (Accounts receivable x 365) / Sales turnover
• The higher the number of days, the poorer the control of debtors and repayment periods. However, high results can also be a manager strategy, as customers are attracted to businesses that give extended credit.


Def. Dividend yield ratio [Shareholder ratios]

=(Dividend per share/current share price) x100
Dividend per share = Total annual dividend/Total number of issued shares
• Measures the rate of return a shareholder gets at the current share price
• Dividend yield would fall if the share price increases (possibly due to improved prospects of the business)
• High dividend yield may not be a wise investment if the share price has fallen recently


Def. Dividend cover ratio

=Profit after tax and interest/ Annual dividends
• Number of times the ordinary share dividend could be paid out of current profits
• The greater the ratio, the more able to company to pay the proposed dividends


Def. Price/earning ratio

= Current share price/ Earnings per share
Earnings per share = Profit after tax/Total number of shares
• Reflects the confidence the shareholders have in the future prospects of the business
• Shows how much investors are willing to pay for each $1 of earnings


Def. Gearing ratio

=(Long term loans/capital employed) x100
= (Non current liabilities / (shareholders' equity + non current liabilities)) x100
• Shows the extent to which the company's assets are finance from external long term borrowing.
• Highly geared business have a result of greater than 50%
• High gearing ratio indicates greater risks because:
1. More interest must be paid -> lower dividends and retained profits
2. Interest will have to be paid out of declining profits
• Lower gearing ratio means that the business likes to 'play safe' and isn't willing to take risks.


Def. Interest cover ratio

• Usually used with the gearing ratio to see how well the business can pay their interests out of their net profits.
= Operating profit (before tax and interest / Annual interests paid


Limitations of ratio analysis (5)

• One firm is not helpful as it should be compared with values between companies and previous years
• Trend analysis need to take into account external changes (that are out of business's control)
• Companies can value assets in different ways
• Ratios results can be 'window dressed'
• Ratios do not indicate any causes of problems