Ratios and Analysis. Gavin Crosthwaite Mindarie Senior College. Acknowledgements: Ashley Doyle, Chris Durrant

Transcription

1 Ratios and Analysis Gavin Crosthwaite Mindarie Senior College Acknowledgements: Ashley Doyle, Chris Durrant

2 Areas of Analysis Liquidity Gearing (Stability) Profitability Efficiency Market

3 Liquidity Ratios With these ratios, we are testing the ability of businesses to pay their debts as they fall due. The two ratios we use to do this are the Current (working capital) ratio and the Quick Asset (liquid) ratio.

4 Gearing (stability) Ratios A business can purchase assets with either borrowed money (debt) or share capital/retained profits (equity). Gearing tells us the extent of borrowings of the business. The two ratios we use to do this are the Debt to Equity ratio and the Times Interest Earned ratio.

5 Profitability Ratios With these ratios, we are measuring the profitability of businesses and whether we are maximising the use of the assets that we have. The two ratios we use to do this are the Profit Margin ratio and the Rate of Return on Assets ratio.

6 Efficiency Ratios With these ratios, we can see how effective the management of the company is in relation to debtors and inventory which may give us an insight into their abilities. The two ratios we use to do this are the Debtors Collection Period ratio and the Inventory Turnover ratio.

7 Market Ratios With these ratios, investors are reviewing the performance of publicly listed companies and may use or more of the ratios to decide whether to invest. The three ratios we use to do this are the Price Earnings ratio, Earnings Per Share ratio and the Dividend Yield ratio.

8 Appraising the Performance Identify the needs of the user Obtain relevant, appropriate and timely data Analyse the data Select appropriate standards for comparison Interpret the information and decide on what action to take to improve performance

9 Current Ratio Current Ratio Current Assets Current Liabilities X Less than 100%!May struggle to pay intermediate debts!may be dealing in a business where they are dealing with money collected from sales quickly Between 100% and 200% More than 200%!Business should be able to pay its current and short term debts!should be able to comfortably pay off any short term debts!may have an excess amount of current assets that aren t being utilised by the business

10 Current Ratio Increase Slower inventory and/ or debtors turnover. Idle cash Long-term finance for current assets Decrease Improved Inventory turnover Improved Debtors turnover

11 Current Ratio Current Ratio Current Assets Current Liabilities X Bank (11 600) Accounts receivable Inventory Prepaid expenses Accounts payable Accrued expenses Term Deposit Goodwill

12 Current Ratio Current Ratio Answer Current Assets Current Liabilities X Bank (11 600) Accounts receivable Inventory Prepaid expenses Accounts payable Accrued expenses Term Deposit (due in 6 months) Goodwill Current Assets Current Liabilities Ratio 2.13:1 1.57:1

13 Quick Ratio Quick Ratio Current Assets - Inventories - Prepayments Current Liabilities - Overdraft X Less than 100%!May struggle to pay intermediate debts!may be dealing in a business where they are dealing with money collected from sales quickly Between 100% and 200% More than 200%!Business should be able to pay its current and short term debts!should be able to comfortably pay off any short term debts!may have an excess amount of current assets that aren t being utilised by the business

14 Quick Ratio Increase Reduced use of Accounts payable finance Increased sales to Accounts receivable Decrease Increased use of Accounts payable Slower cash cycle leading to increase in accounts receivable

15 Quick Ratio Quick Ratio Current Assets - Inventories - Prepayments Current Liabilities - Overdraft X Bank (11 600) Accounts receivable Inventory Prepaid expenses Accounts payable Accrued expenses Term Deposit Goodwill

16 Quick Ratio Answer Quick Ratio Current Assets - Inventories - Prepayments Current Liabilities - Overdraft Bank (11 600) Accounts receivable Inventory Prepaid expenses Accounts payable Accrued expenses Term Deposit Goodwill Current Assets - Inventories - Prepayments Current Liabilities - Overdraft Ratio 1.28:1.97:1 X 100 1

17 Debt to Equity Ratio Debt to Equity Ratio Total Liabilities Equity (end) Must be compared to Industry Average Less than 40% X 100!May be not be maximising their capital to the fullest to maximise profits!companies like Apple and E-Bay have a 0.00 Debt to Equity Ratio!Lenders feel more confident extending credit 1 Between 40% and 80% More than 80%! Business should have little trouble getting credit from outside organisations.! May not have the capability to pay long-term debt obligations!may not be as bad as it looks depending on what the debt was for.

18 Debt to Equity Ratio Increase Accumulated losses Excessive drawings Net borrowings Decrease Retained earnings Additional capital Repay loans

19 Debt to Equity Ratio Debt to Equity Ratio Total Liabilities Equity (end) X Current assets Current liabilities Non-current assets Non-current liabilities Leverage (debt or equity) ratio %

20 Debt to Equity Ratio Answer Debt to Equity Ratio Total Liabilities Equity (end) X Current assets Current liabilities Non-current assets Non-current liabilities Total Liabilities Equity (end) Leverage (debt or equity) ratio % 6.75: :1

21 Times Interest Earned Ratio Times Interest Earned Ratio Profit before tax + Interest Expense Interest Costs (expenses + capitalised) X The higher the times interest earned ratio, the greater the firm s ability to meet interest payment obligations. For example, a company with earnings before interest and taxes of $1.9 million and annual interest obligations of $450,000 will have a times interest earned ratio of 4.2. A times interest earned ratio between 3.0 and 5.0 is considered to be acceptable in most cases.

22 Times Interest Earned Ratio Times Interest Earned Ratio Profit before tax + Interest Expense Interest Costs (expenses + capitalised) X Sales income (net) Total finance expenses Total General & administrative expenses Total other operating expenses Calculate profit before income tax: Ratio %:

23 Times Interest Earned Ratio Answer Times Interest Earned Ratio Profit before tax + Interest Expense Interest Costs (expenses + capitalised) X Sales income (net) Total interest expenses Total General & administrative expenses Total other operating expenses Calculate profit before income tax: Ratio :

24 Profit Margin Ratio Profit Margin Ratio Profit (after income tax) Net Sales X Less than 10%!May struggle to pay intermediate debts!may be dealing in a business where they are dealing with money collected from sales quickly Between 10% and 20% More than 20%!Business should be able to pay its current and short term debts!should be able to comfortably pay off any short term debts!may have an excess amount of current assets that aren t being utilised by the business

25 Profit Margin Ratio Increase Higher gross margin or gross profit rate Improved expense control Fixed costs spread over higher turnover Lower inventory loss Decrease Lower gross margin or gross profit rate Poorer expense control Fixed costs spread over lower turnover Higher inventory loss Increased depreciation due to new asset or change in %

26 Profit Margin Ratio Profit Margin Ratio Profit (after income tax) Net Sales X Sales Sales returns Cost of sales Total expenses Profit before tax Taxable income 30% Profit after tax Profit ratio (%)

27 Profit Margin Ratio Answer Profit Margin Ratio Profit (after income tax) Net Sales X Sales Sales returns Cost of sales Total expenses Profit before tax Taxable income 30% Profit after tax Profit ratio (%) 39.2% 36.5% 25.4%

28 Rate of Return on Assets Ratio Rate of Return on Assets Ratio Profit before tax + Interest Expense Average Total Assets X Less than 100% Between 100% and 200% More than 200%

29 Rate of Return on Assets Ratio Increase More effective use of active assets Reduction in level of idle assets Improved expense control Decrease Idle assets Less effective use of active assets Poorer expense control Replacement on noncurrent assets at higher prices Benefits of expansion not yet realised Asset revalutions

30 Rate of Return on Assets Ratio Rate of Return on Assets Ratio Profit before tax + Interest Expense Average Total Assets X Sales income Total expenses (including interest) Interest expense Current assets Non current assets Ratio %: Complete the ratios for 2011 and 2012

31 Rate of Return on Assets Ratio Answer Rate of Return on Assets Ratio Profit before tax + Interest Expense Average Total Assets X Sales income Total expenses (including interest) Interest expense Current assets Non current assets Profit before Tax + Interest Expense Average Total Assets Ratio %:

32 Earnings Per Ordinary Share Ratio Earnings Per Ord. Share Ratio Profit after Tax - Preference Dividends Weighted Average Number of Ord Shares Issued Investors should look for high EPS growth rates. The higher the EPS growth the faster the company is potentially growing the amount each share is earning each year.

33 Earnings per Share Ratio The EPS figure by itself has little significance. A company may not pay this amount out as a dividend or it could include non-recurring items. It is crucial that when analyzing this information to look at net profit after tax before any of these nonrecurring times referred to as abnormal items. After calculating the current EPS, you want to look for trends. Has the EPS been rising or falling, and how much of this is from normal operations rather than one-time events? If the EPS is about the same as last year, has there been an increase in the shares on issue?

34 Earnings Per Ordinary Share Ratio Earnings Per Ord. Share Ratio Profit after Tax - Preference Dividends Weighted Average Number of Ord Shares Issued CJ HR Profit before income tax Income tax expense Share Capital: Ordinary shares Preference shares Retained Earnings: Dividends paid ordinary Dividends paid preference Calculation of income after tax: Cents per share:: All shares issued are $1.00 each fully paid

35 Earnings Per Ordinary Share Ratio Answer Earnings Per Ord. Share Ratio Profit after Tax - Preference Dividends Weighted Average Number of Ord Shares Issued CJ HR Profit before income tax Income tax expense Share Capital: Ordinary shares Preference shares Retained Earnings: Dividends paid ordinary Dividends paid preference Calculation of income after tax: Profit after tax - Preference Dividends Cents per share::

36 Price Earnings Ratio Price Earnings Ratio Market Price per Ordinary Share Earnings Per Ordinary Share A higher P/E means an investor is paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E. Likewise a lower P/E means you are paying less for each unit of net income. Normally, stocks with high earnings growth are traded at a higher P/E.

37 Price Earnings Ratio It is usually not enough just to look at the P/E of one company. It is important to look at a company s P/E compared to the industry it is in, the sector it is in, as well as the overall market. This will provide you with an idea of how the company you re interested in compares to other companies within the sector. Also, during a bull market, P/E s will rise due to investor sentiment. The same company in a bull market, will trade at a higher P/E than it would during a bear market, simply due to market sentiment. Always use the P/E of next years earnings as the previous years P/E can be deceptive and not a true reflection of the value of the business.

38 Price Earnings Ratio Price Earnings Ratio Market Price per Ordinary Share Earnings Per Ordinary Share 2010 Profit Retained Earnings: Dividends paid ordinary Dividends paid preference Ratio: Additional information: Over the year, issued ordinary share were Ordinary shares are currently selling for $6 per share. The cash dividend on ordinary shares which have been paid out is $0.65 per share. Tax has been calculated

39 Price Earnings Ratio Answer Price Earnings Ratio Market Price per Ordinary Share Earnings Per Ordinary Share 2010 Profit Retained Earnings: Dividends paid ordinary Dividends paid preference Profit after tax - preference dividends Weighted Ordinary Share issued Market Price Per Share 6.00 Earning Per Share $2.33 P/E Ratio 2.57 Additional information: Over the year, issued ordinary share were Ordinary shares are currently selling for $6 per share. The cash dividend on ordinary shares which have been paid out is $0.65 per share.

40 Dividend Yield Ratio Dividend Yield Ratio Annual Dividend per Ordinary Share Market Price Per Ordinary Share Historically, investors prefer stocks with higher dividend yields; however this ratio must also be used in conjunction with other assessment tools. Investors need to consider - is the dividend able to be maintained? What is the dividend growth going forward? Does the dividend have imputation (tax) credits? Can I get a better dividend yield elsewhere?

41 Dividend Yield Ratio A stock may have a high dividend yield, but its share price could be dropping while the dividend is staying the same, hence the high yield, but the company may not be able to afford to pay a dividend in the future. In general, older, well-established companies tend to payout a higher percentage than do younger companies. For a value investor, who is looking for dividend income, the dividend yield is a useful measurement.

42 Dividend Yield Ratio Dividend Yield Ratio Annual Dividend per Ordinary Share Market Price Per Ordinary Share Profit before income tax Income tax expense Share Capital: Ordinary shares Preference shares Retained Earnings: Dividends paid ordinary Dividends paid preference Annual Dividend Market Price Ratio Additional information: The cash dividends for ordinary shares were 4 cents per share 2010 and 6 cents per share for The market price of $1.10 per ordinary share for 2010 and was $0.80 for 2009.

43 Dividend Yield Ratio Answer Dividend Yield Ratio Annual Dividend per Ordinary Share Market Price Per Ordinary Share Profit before income tax Income tax expense Share Capital: Ordinary shares Preference shares Retained Earnings: Dividends paid ordinary Dividends paid preference Annual Dividend Market Price Ratio 3.6% 7.5% Additional information: The cash dividends for ordinary shares were 4 cents per share 2010 and 6 cents per share for The market price of $1.10 per ordinary share for 2010 and was $0.80 for 2009.

44 Debtors Collection Period Ratio Debtors Collection Ratio Average Debtors Net Credit Sales X Less than 30 days! Good collection procedures! Mainly cash sales! Little reason for concern! Good economic conditions Between 30 and 60 days More than 90 days! A more stringent credit policy could be developed!better credit checks!send letters more regularly!offer discounts for early payments! Employ a debt collector! Revisit credit policy! Poor economic conditions

45 Debtors Collection Period Ratio Increase Introduction of cash discounts Reduced credit terms Stricter credit approvals More efficient billing and collection procedures Improved economic conditions Decrease Change in credit terms - no further cash discounts or longer credit terms More lenient credit approvals Poorer collection procedures Poorer economic conditions

46 Debtors Collection Period Ratio Debtors Collection Ratio Average Debtors Net Credit Sales X Accounts receivables Allowance for doubtful debts Credit sales Cash sales Calculation of net debtors ` Number of days: The Accounts Receivable for 2011 was

47 Debtors Collection Period Ratio Answer Debtors Collection Ratio Average Debtors Net Credit Sales X Accounts receivables Allowance for doubtful debts Credit sales Cash sales Calculation of net debtors Net Credit Sales Number of days: days 28.6 days The Accounts Receivable for 2011 was

48 Inventory Turnover Ratio Inventory Turnover Ratio Cost of Sales Average Inventory

49 Inventory Turnover Ratio Increase Write off obsolete inventory lines Better product mix - get rid of slow moving lines Higher inventory leading to more sales Better inventory control Improved advertising More inventory loss Decrease Increased holding of obsolete inventory Increase in slowmoving lines Too high inventory level Increased competition Change in valuation methods Too low inventory level causing loss of sales

50 Inventory Turnover Ratio Inventory Turnover Ratio Cost of Sales Average Inventory Sales Sales returns Cost of sales Accounts payable Inventory Number of times: Inventory for 2011 was and the industry average is 3 times

51 Inventory Turnover Ratio Answer Inventory Turnover Ratio Cost of Sales Average Inventory Sales Sales returns Cost of sales Accounts payable Inventory Average Inventory Number of times: 1.8 times 2.02 times Inventory for 2011 was

52 Limitations of Ratios Ratios do not identify the cause of the problems Ratios by themselves are of limited value unless they are compared to an industry average or previous years. Limited disclosure can make it impossible to calculate some ratios Can be hard to compare ratios when different accounting methods are used. It gives past and current trends, not future ones. Impact on inflation is not reflected in ratios as they use old historical data.