Annual reports and financial statements

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MODULE 7 UNIT 2 Advanced ratio analysis

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Table of contents 1. Introduction 3 2. Investor ratios 3

2.1 Earnings per share 3 2.2 Dividend per share 4 2.3 Price earnings ratio 5 2.4 Dividend payout ratio 5 2.5 Dividend yield 6 2.6 Example: Calculating investor ratios 6

2.6.1 Earnings per share 6 2.6.2 Dividend per share 7 2.6.3 Price earnings ratio 7 2.6.4 Dividend payout ratio 7 2.6.5 Dividend yield 7

3. Evaluating financial performance using ratio analysis 8 3.1 Profitability ratios 8

3.1.1 Gross profit margin 8 3.1.2 Net profit margin 9 3.1.3 Return on total assets 9 3.1.4 Return on equity 10

3.2 Liquidity ratios 10 3.2.1 Current ratio 10 3.2.2 Quick ratio 11

3.3 Efficiency ratios 11 3.3.1 Inventory turnover 11 3.3.2 Accounts receivable turnover 11 3.3.3 Accounts payable turnover 12

4. Conclusion 12 5. Bibliography 12

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Learning outcome:

LO4: Calculate and interpret advanced financial ratios.

1. Introduction You were introduced to basic financial ratios in Module 5, and will recall that ratios identify the relationship between different elements of the financial statements. Ratios provide information that is not necessarily evident just by looking at financial statements, and they help users identify underlying problems that must be addressed to improve the performance of the business, or strengths that the business can build on.

This set of notes introduces more advanced ratios that are useful for current and potential investors when evaluating their investments. These notes will analyse financial ratios in more detail, and discuss the actions a business manager can take to improve ratios that are lower than expected.

2. Investor ratios Investor ratios show potential or current investors what return they can expect on their investments. They can use this information to decide whether they should invest (or continue to invest) in the business, or whether they should move their money to another investment that will yield better returns. Five investor ratios are explored in this section, and Section 2.6 includes examples demonstrating how each of these ratios is calculated.

2.1 Earnings per share Earnings per share (or net income per share) indicates how much of the profit a business makes in a financial period can be allocated to each share (if all profits were to be paid out to shareholders). The formula for calculating earnings per share is as follows:

Earnings per share = Net income − Preferred dividends Number of ordinary shares issued

Ordinary shares vs preference shares:

A company may raise funds by issuing ordinary shares or preference shares. Shareholders holding preference shares usually do not have voting rights, but they receive fixed dividends. Ordinary shareholders have a say in how the business is run, but they only receive dividends at management’s discretion. If a business did not achieve its performance targets during a particular year, preference shareholders will still receive dividends, while management might decide not to pay out any dividends to ordinary shareholders.

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Dividends paid out to preference shareholders are deducted from net income when calculating earnings per share, as this calculation focuses on the profit that can be allocated to ordinary shares.

The earnings per share ratio may be of limited use to investors, as it only indicates how much money could potentially be paid out per share, instead of showing what is actually paid out in the form of dividends.

However, it is useful for determining the profitability of an investor’s investment over the long term. Shareholders cannot simply assume that their return on investment will increase if the business’s profits increase, as the number of shares issued might also have increased. For example, if a business declared a profit of £1,000,000 in one year, and declared a profit of £2,000,000 in the next year, the profit that can be allocated to shares has seemingly doubled. However, if the number of outstanding shares increased from 20,000 to 50,000 in the same period, the earnings per share will have decreased from £50 to £40.

The earnings per share ratio can be compared to industry averages to determine whether it is satisfactory. To improve the earnings per share ratio, a business can do the following:

• It can increase net income by increasing sales or decreasing costs.

• It can decrease the number of preference shares in issue by buying them back. However, this will influence the funds the company has available to finance its activities.

• It can decrease the number of ordinary shares issued, by buying them back and making use of loans to fund its activities instead. However, this may have a negative effect on the current ratio if the loan is payable within the next year (i.e. it is a current liability). The company will also be obligated to pay interest on the loan and repay it at a specific time, whereas it can choose whether or not to pay dividends to ordinary shareholders.

The current ratio:

You will recall from Module 5 that the current ratio is calculated by comparing current assets to current liabilities. Should a business decrease its share capital and instead take out a loan, its current liabilities amount will increase if the loan is a current liability (and thus not long term). This will have a negative effect on the current ratio, as there will now be more liabilities compared to assets than was previously the case. Even if a long-term loan does not influence the current ratio directly, the interest payable on the loan will increase current liabilities and reduce current assets once paid.

2.2 Dividend per share Earnings per share is the amount that could potentially be paid out for each share, should the business decide to pay out all profits to shareholders. However, a business usually only pays out part of its profits to shareholders in the form of dividends. The remaining profits are kept in the business as retained earnings, ensuring that the business has

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enough money available should a good investment opportunity present itself or any unforeseen expenses arise.

Dividend per share is calculated using the following formula:

Dividend per share = Ordinary dividend declared

Number of issued ordinary shares

This amount indicates to shareholders how much money they can expect to receive in cash for every share they hold. Potential investors may find it useful to track this amount over a period of time, as it indicates whether or not the company is committed to paying out dividends to its shareholders. Fluctuations in this ratio might shake investor confidence, prompting them to seek investments in a different company’s shares that may guarantee a more reliable income. However, shareholders can earn a return on their investment not only through dividends paid to them, but also through an increase in value of their shares over time. The prospect of shares increasing in value over the long term might result in shareholders being willing to accept lower dividends in the short term.

Once again, dividend per share can be compared against industry averages to determine whether it is satisfactory. If not, it can be improved by:

• Increasing the dividend declared (either by increasing profit, or by changing the dividend policy); or

• Decreasing the number of ordinary shares in issue by buying back the shares, thereby increasing the dividend per share of the remaining shares.

2.3 Price earnings ratio This ratio compares the earnings per share (explored in Section 2.1) with the market value of the share.

Price earnings ratio = Current market price per ordinary share

Earnings per share

A high price earnings ratio usually shows that investors are expecting high growth in the share value in the future, and are therefore willing to pay more for the shares than what the earnings per share currently is. The price earnings ratio may also indicate that shares are overvalued or undervalued in the market. If they are overvalued, an investor might be better off investing in another company. If they are undervalued, an investor should consider buying more of the shares, as they are worth more than the asking price.

2.4 Dividend payout ratio The dividend payout ratio compares the earnings per share with the dividends paid out per share. It is calculated as follows:

Dividend payout ratio = Dividend per share Earnings per share

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This ratio indicates to shareholders how much of the profit that was made (and thus potentially could have been paid to shareholders) ended up being paid out in the form of dividends, and how much was kept as retained earnings. While the dividend per share ratio shows the monetary value that is paid out to a shareholder, the dividend payout ratio indicates whether or not a company is paying out a reasonable dividend considering the profit made.

2.5 Dividend yield As mentioned before, shareholders can earn a return on their investment through dividends paid or through an increase in the value of their shares. The dividend yield ratio shows the portion of the return on investment of each share that can be attributed to dividends.

Dividend yield is calculated as follows:

Dividend yield = Dividend per share

Current market price × 100

A high dividend yield indicates that the company does not keep a lot of profit as retained earnings to grow business activities in the future. Instead, it pays out most of its profit to shareholders in the form of dividends. An investor who is more interested in receiving high dividends in the short term (rather than waiting for shares to increase in value over the long term) might prefer a high dividend yield. An investor who is interested in shares increasing in value over the long term might prefer for the company to keep more profit as retained earnings.

2.6 Example: Calculating investor ratios French Flair recorded a net profit of £1,000,000 in their income statement for the current financial year. They have 20,000 ordinary shares in issue, and declared a dividend of £600,000 for the financial year (£200,000 of which is payable to preference shareholders). Shares in French Flair are currently trading at £100 per share.

Calculate the different investor ratios.

2.6.1 Earnings per share

Earnings per share = Net income − Preferred dividends Number of ordinary shares issued

= £1,000,000 − £200,000

20,000

= £40 per share

If all profits earned during the year were paid out to the shareholders, they would receive an amount of £40 per share.

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2.6.2 Dividend per share

Dividend per share = Ordinary dividend declared

Number of issued ordinary shares

= £600,000 − £200,000

20,000

= £20 per share

A holder of ordinary shares will receive an amount of £20 for every share held.

2.6.3 Price earnings ratio

Price earnings ratio = Current market price per ordinary share

Earnings per share

= £100 £40

= 2.5

The current market price per share is 2.5 times that of the profitability of the share. This could either indicate that the shares are overvalued in the market, or that the market expects the earnings per share to grow in the future. Read more about using the price earnings ratio to evaluate shares.

2.6.4 Dividend payout ratio

Dividend payout ratio = Dividend per share Earnings per share

= £20 £40

= 0.5

This indicates that for every £2 of profit earned per share, £1 (or 50%) was paid out to shareholders in the form of dividends.

2.6.5 Dividend yield

Dividend yield = Dividend per share

Current market price × 100

= 20

100 × 100

= 20%

This means that 20% of the market value of each share is attributable to dividends. The other 80% is attributable to the increase in value of the share over time.

https://www.thebalance.com/using-price-to-earnings-356427

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3. Evaluating financial performance using ratio analysis Investors and the managers of a business can use ratio analysis to determine whether the business is in a healthy financial state, and whether it will be able to achieve its strategic objectives.

Ratio analysis is often used in benchmarking, which is the process of comparing a business’s performance with that of another similar business in the industry. Alternatively, trend analysis is used to compare the same business’s performance from one year to the next, with the goal of identifying certain trends. Any significant changes may indicate underlying problems, or strengths that the business should aim to build on.

This section gives you the opportunity to analyse all the financial ratios you learnt about in Module 5, identifying what these ratios mean for your business, and which steps you can take to improve them. It also provides more insight into the matters you should consider before deciding to invest in another business.

3.1 Profitability ratios Profitability ratios show how well a business is using its resources to generate a profit. Each ratio is analysed in more detail in the following sections.

3.1.1 Gross profit margin The gross profit margin indicates a business’s ability to cover its operating expenses, and is calculated as follows:

Gross profit Sales

× 100

Refer to Module 5 to revise calculating the gross profit margin. The higher the gross profit margin, the better a business’s chances of covering all its operating expenses with the amount of money it earns through sales. Gross profit margins vary significantly between businesses, and from one industry to the next, so there is not a standard gross margin that a business should aim to achieve. A business should set target margins based on what it needs to meet its strategic goals, and then measure its performance to determine whether it achieved the margin it planned for.

If a business’s gross profit margin is not met, it could improve by:

• Changing its sales mix by selling more products with high gross profit margins; or

• Reducing production costs by improving its manufacturing processes or negotiating better prices with suppliers.

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3.1.2 Net profit margin Net profit margin shows the percentage of sales that remains after all expenses have been deducted. These expenses may include rent, salaries, and insurance, as well as tax and interest. Net profit margin is calculated as follows:

Net profit after tax Sales

× 100

Refer to Module 5 to revise calculating the net profit margin. Once again, there is a not an industry standard that a business should aim to achieve, but the higher this percentage is, the better. A high percentage indicates to the market that the business is profitable and is managing its expenses efficiently.

To increase the net profit margin, a business can do the following:

• It can change its sales mix by selling more products with a high net profit margin.

• It can reduce its overall expenses (and not just production expenses as was the case with gross profit margin). You will often hear that businesses are trying to reduce their “overheads”, which are the expenses incurred that do not relate directly to sales. Salaries, rent, staff benefits, and utilities are examples of expenses that can be reduced to increase net profit margin.

3.1.3 Return on total assets Return on total assets measures how well a business is using its assets to generate profits, and is calculated as follows:

Net profit after tax Total assets

Refer to Module 5 to revise calculating return on total assets. The greater the return on total assets, the better. To determine whether the return on assets ratio is acceptable, it is usually compared to the industry average (as different industries will require different levels of investment in assets). It can also be compared to the rate the business could have earned elsewhere by investing the money currently tied up in assets.

If the ratio is lower than the industry average or what the business could have earned on another investment, the following steps can be taken to improve it:

• Increasing net profit by increasing sales or reducing production and general expenses

• Investing less in inventory if forecasts show that sales will decline

• Selling assets that are no longer being used, or have become obsolete

• Outsourcing activities if it would be cheaper than investing in the assets needed to complete those activities in-house

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3.1.4 Return on equity Return on equity shows how much profit an investor makes on every pound invested, and is calculated as follows:

Net profit after tax Total equity

× 100

Refer to Module 5 to revise calculating return on equity. Once again, this ratio can be compared to the industry average, or to the rate shareholders could have earned by investing their money elsewhere. The following actions can be taken to improve an unsatisfactory return on equity ratio:

• The business can increase net profit by increasing sales or reducing production and general expenses.

• The business can buy back some of the issued shares, and instead make use of loans to finance business activities. This will reduce the number of shareholders and thus increase the profit made by the remaining shareholders of the business.

3.2 Liquidity ratios The two liquidity ratios you learned about in Module 5 are the current ratio and the quick ratio.

3.2.1 Current ratio The current ratio shows whether a business would be able to pay its short-term creditors using the assets that it expects to convert into cash in the short term. It is calculated as follows:

Current assets Current liabilities

A current ratio of 2:1 is usually the industry standard, so anything lower than that must be improved.

To improve the current ratio, you should either increase current assets or decrease current liabilities, by taking the following steps (among others):

• You can improve the cash flow of the business by, for example, offering debtors a discount if they settle their debts early.

• Take out more long-term loans instead of relying on short-term debt. You may however end up paying more interest on a long-term loan, making this a costly option.

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3.2.2 Quick ratio The quick ratio measures whether or not a business would be able to pay its short-term debt without having to sell its inventory. It is calculated as follows:

Current assets − Inventory Current liabilities

A quick ratio of 1 or more is usually the industry standard. The same steps that can be taken to improve the current ratio can be applied to improve the quick ratio, but the quick ratio can also be improved by decreasing the amount of inventory held (which can be achieved by improving sales).

3.3 Efficiency ratios As you will recall from Module 5, efficiency ratios measure the efficiency with which assets are converted into cash.

3.3.1 Inventory turnover Inventory turnover shows whether the business is managing its inventory effectively, by indicating how many times it has converted inventory into sales during a specific period. It is calculated as follows:

Cost of sales Average inventory

Inventory turnover varies between businesses, so there is no industry standard the business should aim to achieve. However, a high inventory turnover indicates that a business is controlling its inventory well, and is not buying too much stock. It also indicates that the business’s sales function is efficient, and that it can sell most of the inventory bought.

A business can improve its inventory turnover ratio be keeping less inventory in stock. However, sales requirements must be considered, as the business is at risk of running out of stock if it keeps inventory levels too low.

3.3.2 Accounts receivable turnover Accounts receivable turnover measures how many times a business can turn its accounts receivable into cash during a specific period. It is calculated as follows:

Credit sales Average accounts receivable

The higher this ratio, the better, as it shows that the business is effective at collecting outstanding amounts from debtors. It also decreases the risk of the business having to write off bad debts.

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A business can improve its accounts receivable turnover by taking the following steps:

• Providing debtors with incentives (such as discounts) to settle their debts on time

• Decreasing the number of days debtors are granted to pay their debts, by changing the business’s credit terms (though this could result in debtors deciding to buy from another business that offers more favourable terms)

• Improving internal processes to ensure that outstanding debts are followed up

3.3.3 Accounts payable turnover Accounts payable turnover is a measure that shows how quickly a business pays off its suppliers. It is calculated as follows:

Credit purchases Average accounts payable

The lower this ratio is, the better, as it illustrates that the business can make maximum use of cash on hand before paying it over to other parties.

A business can improve its accounts payable turnover by negotiating better terms with suppliers.

4. Conclusion In this set of notes, you discovered how investors can analyse the information included in the financial statements of a business to determine if they should continue with their investment. As a business manager, you could use these ratios to assist you in evaluating potential investment opportunities, or help you identify areas that the shareholders of your business concentrate on when planning their investments. The business can take certain steps to improve investor ratios, which may result in more investors buying shares in the business, as the business will be regarded as a good investment that delivers high returns.

You also explored in greater detail the financial ratios introduced in Module 5, discovered when these ratios are deemed unsatisfactory, and looked at the things a business can do to improve these ratios. Watch the video included in this unit to learn how to calculate and interpret the gearing ratio, which indicates how much long-term debt a business has relative to the amount of capital it has raised by issuing shares.

5. Bibliography Atrill, P. & McLaney, E. 2017. Accounting and finance for non-specialists. 10th ed.

Edinburgh Gate: Pearson Education Ltd.

Weetman, P. 2016. Financial accounting: An introduction. 7th ed. Edinburgh Gate: Pearson Education Ltd.

MODULE 7 UNIT 2

Advanced ratio analysis

Table of contents
1. Introduction
2. Investor ratios

2.1 Earnings per share
2.2 Dividend per share
2.3 Price earnings ratio
2.4 Dividend payout ratio
2.5 Dividend yield
2.6 Example: Calculating investor ratios

2.6.1 Earnings per share
2.6.2 Dividend per share
2.6.3 Price earnings ratio
2.6.4 Dividend payout ratio
2.6.5 Dividend yield

3. Evaluating financial performance using ratio analysis

3.1 Profitability ratios

3.1.1 Gross profit margin
3.1.2 Net profit margin
3.1.3 Return on total assets
3.1.4 Return on equity

3.2 Liquidity ratios

3.2.1 Current ratio
3.2.2 Quick ratio

3.3 Efficiency ratios

3.3.1 Inventory turnover
3.3.2 Accounts receivable turnover
3.3.3 Accounts payable turnover

4. Conclusion
5. Bibliography