Business Funding & Financial Awareness
Financial Ratios
J R DaviesMay 2011
Financial Ratios
J R DaviesMay 2011
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Role of Financial Ratios• Accounting values in isolation cannot tell us very much - they need
to be put into context
• By relating one financial value to another ratios provide a basis for standardisation – allowing a company’s position or performance to be compared with– Its past position or performance – The position or performance of comparable companies
• It is often useful to take an overall view of the company – its growth, profitability, liquidity, and financial policy – and then use this overview to put particular ratio into context (though it is through the ratios that the overall view is developed in the first instance !)
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Financial Ratios: Classification
• Profitability or performance ratios
• Liquidity ratios
• Asset management or activity ratios
• Gearing ratios or debt management ratios
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100
xdebttermlongreservescapitalShare
taxationandinterestbeforeprofitNetROCE
Provides an overall view on performance of the company using the capital it at its disposal. It focuses on the level of profits in relation to overall capital employed to produce these profits. It is independent of the company’s financing policies..
Profitability Ratios(1) The return on capital employed
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ReservescapitalShare
taxerest and after intprofitNet
Profitability Ratios(2) Return on Shareholders’ Capital after Tax
This measure indicates how well the company employs the owners’ capital to generate income, the return should provide adequate compensation for both businessand financial risk.
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This ratio provides an overall measure of acompany’s profitability, focusing on assets rather than the capital provided.
Profitability Ratios(3) Return on Assets (ROA)
assets Total
taxbeforeProfit
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100
Sales
SalesofCostSales
100(%)Revenue
itGross prof it Margin Gross Prof
The gross profit margin will depend on the prices a company charges for its products and the cost of goods sold.
Profitability Ratios(4)Gross Profit Margin
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100
(%)100
Sales
ExpensesSalesofCostSales
Sales
ProfitNetMarginProfitNet
The net profit margin will depend on the prices a companycan charge, the costs of goods sold, and the company’s overall operating efficiency.
Profitability Ratios(5) Net Profit Margin
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Profitability Ratios - Rate of Return on Capital Employed
Profit margin and asset turnover
Employed Capital
Profit Net
Employed Capital
Sales
Sales
ProfitNet
Turnover AssetMargin Profit Net
ROCE
This indicates that rate of return on capital employed depends on the net profit margin and the ability to use the assets of the
company effectively to generate sales.
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Asset management or activity ratios (1)(See later slide)
Asset Turnover :
AssetsNet
SalesTurnoverAsset
How much sales is generated by each unit of net assets?
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CurrentRatio
Current Assets Current Liabilities
=
Liquidity Ratios(1)Current Ratio
The current ratio indicates the level of assets that will be turned into cash within a year in normal circumstances, in relation to the company’s obligations that will fall due within the same time period. It is sometimes more questionably viewed as a measure of a company’s ability to meet its short term obligations.
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Quick Assets Current Liabilities
=QuickRatio
This ratio is like the current ratio but excludes currentassets such as inventories that may be difficult to convert quickly into cash. Quick assets are cash, marketable securities, and debtors (receivables).
Liquidity Ratios(2) Quick Ratio
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Debtors Turnover
• All else being equal the lower the debtors turnover period the better– Lowers the capital requirements of the business and its
interest charges– Poor payers are attracted to companies with liberal
credit policies – a low ratio may be a sign of other problems
• But all else may not be equal– Tight credit policies may lose sales and profits
365SalesAnnual
DebtorsPeriodTurnoverDebtors
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Creditors Turnover
365PurchasesAnnual
CreditorsPeriodTurnoverCreditors
Creditors can be a cheap form of funding but from the outside the company with a high level of creditors may be interpreted as risky and short of other forms of funding.
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Asset management or activity ratios (1)
Asset Turnover :
AssetsNet
SalesTurnoverAsset
How much sales is generated by each unit of net assets? How hard is the company making its assets work?Are assets being used to their full capacity?Are assets being used as effectively as possible?
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Asset management or activity ratios (2)
Sales to Capital Employed:
ASSETS SALES PROFITS
Pressure
?
EmployedCapitalTermLong
SalesEmployedCapitalToSales
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Gearing Ratios(1)Debt Ratio
This provides a This provides a mmeasure of easure of a company’s gearing. a company’s gearing. The greater the percentage of assets that are financed by debt, the higher the return on equity as long as the business is profitable – but there are added risks to the company as well as for creditors from the employment of debt.
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Debt\Equity Ratio =Long Term Borrowing ÷Shareholders' Capital
Gearing Ratios(2)Debt\EquityRatio
How much debt is being employed for each unit of shareholder capital ?
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ExpenseInterest
TaxAndInterestBeforeProfitsCoverInterest
This ratio focuses on the profit and ability to pay interest rather than on the proportion of assets financed by debt and the security this offers. It would probably be more appropriate to consider the cash flow rather than profit, but the profit figure is more readily available in a company’s financial statements. The ratio more indicative of the potential to get into difficulties rather than the ability to deal with a problem should it arise.
Gearing Ratios(4)Debt Ratios – Times Covered
Nature of Equity Financing
Equity financing is the ownership capital of the company and is assumed that the company is run in the interests of the shareholders
There is no formal commitment to pay shareholders a specific dividend – but there is an implicit contract to utilise the company’s earnings in the interests of the shareholders
– Earnings may be retained to fund the growth of the company– Dividends may be paid out to shareholders– Companies are reluctant to cut or omit dividends, but can do so if the company
runs into financial difficulties
The cost of equity capital is the shareholders’ required rate of return – the return available to investors on other similar risk investments
It is a relatively high cost but low risk form of financing for a company.
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Nature of Debt Financing
Debt financing involves an explicit contract – funds are received on the understanding that the lender will be paid a specified interest rate on the debt and the loan will be re-paid according to agreed schedule
For the lender the provision of debt financing is less risky than the provision of equity financing by the shareholders – as a result the return required by debt holders is lower and this implies a lower cost of capital to the company
For a company the use of debt involves risk – a failure to meet its contractual commitments can result in bankruptcy and possibly the liquidation of the company’s assets
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Capital Structure Issues
Can the use of debt lower the cost of capital?Does the use of gearing create value?Are there tax advantages in using debt ?What are the disadvantages of using debt ?How does the use of debt affect the beta of the
equity and the equity cost of capital ?
Earnings per share analysis
All Equity GearedEBIT 200 200Interest 0 -32Proit before Tax 200 168Tax -80 -672Profit after Tax 120 100.8
Number of Shareholders 1000 600Earnings per share 0.12 0.168
All equity – 1000 shares issuedGeared - 600 shares
Company has expected earnings of 200, assets valued at 1000, and 1000 shares outstanding. It isconsidering borrowing 400 at 8 per cent and using the proceeds of the loan to buy back 400 shares.
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Capital structure and earnings per share
EPS
EBIT
EPS (U)
EPS (G)
E (EBIT)
E (EPS [G])
E (EPS [U])
Disadvantage to debt
Advantage to debt
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EPS and Capital Structure
• As long as the rate of return on capital is higher than the interest rate EPS will be higher for a geared capital structure than it would be for an ungeared capital structure.
• But EPS will be more variable (more risky) under a geared capital structure.
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Weighted Average of Cost of CapitalTraditional Perspective
152. 100
4008.
100
6020.
DebtEquity
Debtk
DebtEquity
EquitykkWACC ieO
Lower the cost of capital by substituting cheap debt for expensive equity ?Assume that the required rate of return on equity is 20 per cent, whereas the cost of debt is only 8 per cent
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Cost of Capital :Traditional Perspective
WACC
Cost of debt
Cost of equity
Cost of capital
Debt / EquityOptimal Debt/Equity Ratio
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Gearing: Use of debt to push up the expected return on equity (a)
Expected Return/Cost of capital
Assets
Assume £1000 of assets and 100 per cent equity finance
20 % return on equity anticipated
100% Equity 1000Funding
0.20
Expected Profit = 200
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Gearing: Use of debt to push up the expected return on equity (b)
Expected Return
Funding/ Assets
Surplus accrues to the Equity
Assume £1000 of assets and financing
28%
20%
8%
Debt Equity
£400 £600
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Gearing: Use of debt to push up the expected return on equity (c)
Expected Return
Assume capital re-structuring 40% debt @8% and 60% equity.
Debt (400) Equity (600)
28%
20%
8%
Interest =32
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48
120
168/600=0.28
Assets
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Do the higher expected returns as a result ofgearing produce shareholder value?
• Gearing involves the division of the earnings of a company between the debt holders and the ordinary shareholders.
• The shareholders’ expected return and eps is pushed up as the interest rate on debt capital is lower than the required return on assets
• Can this create value?
• The higher expected return to the equity can be thought of as compensation for added risk - the equity holders have to accept exposure to most of the risk of the capital provided by the debt holders
• No increase in value can be anticipated unless the use of debt increases the overall level of earnings available for distribution
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Gearing and the Redistribution of Risk (a)
Av. Risk
Risk is more difficult to measure than the expected return – and not given sufficient weight in non-analytical discussions of the
issue.
Risk
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Gearing and the Redistribution of Risk (b)
Risk
Debt Equity
Each unit of debt carries no risk.Each unit of equity carries a higher level of risk than a unit of capital.
Equity risk
Asset or business risk
Assets
Risk Transfer
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Gearing and the Redistribution of Risk (d)
Risk
Debt Equity
Each unit of debt carries no risk.Each unit of equity carries a higher level of risk than a unit of capital.
Equity risk
Asset or business risk
Assets
Financial risk
Business risk
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Limitations of Ratio Analysis
• Ratio analysis can be employed mechanically and divert attention from nature of the underlying companies and their circumstances
• Ratios are clearly affected by choices of accounting policies
• Ratios may be affected by revaluations and other adjustments to accounts.
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