READING MATERIALS
READING
1.1.2
Introduction to accounting
1 INTRODUCTION
Accounts are essential financial reports prepared for all who have an interest in a business or other organisations. Treasury can have a significant impact on reported financial performance and how a business is seen externally by stakeholders such as lenders, investors and regulators. For this reason, treasurers need to understand how the impact of their activities will be reported in the financial statements.
6 RATIO ANALYSIS
Financial ratio analysis enables the analysis to be undertaken on the stability and performance of a business. Ratios on their own often do not provide much insight. Instead they should be benchmarked against past periods and also against relevant peers in a similar sector.
The figures needed to calculate many ratios can be found on the income statement or statement of financial position. For some ratios there is a need to scrutinise the detailed notes in financial accounts.
In addition to the numbers set out in the examples above, the following information is needed if you wish to verify the ratio calculations which appear later.
USD
*Note that current liabilities of USD120m include short-term debt and other non-debt liabilities. Therefore, when calculating debt-based ratios use 100m as this is the amount of short-term debt.
6.1 PERFORMANCE RATIOS
These ratios are used to analyse how profitable a company is. Examples of three common ratios are provided below.
Return on capital employed (ROCE)
There are a number of different definitions used when calculating capital employed. Throughout your ACT studies the following definition is used:
Operating profit/Capital employed.
Where Capital employed = Total Equity + Long-term debt + Short-term debt – Cash.
ROCE = 150/(700 + 300 + 100 – 20) = 13.89%.
The ratio indicates how efficiently the company is using its capital. In the example above thirteen percent profit is made for each dollar of capital (or 13 cents for each dollar). A company would wish to see an increasing ratio.
Operating profit margin (OM)
Operating profit/Revenue.
OM = 150/950 = 15.79%.
This is an indicator of how profitable the company is. In the example, 15.79 cents profit is generated for each dollar of revenue. An increasing ratio would indicate an improving performance.
Return on equity (ROE)
Profit after tax/Total Equity.
ROE = 80/700 = 11.43%.
This simply compares the after-tax profit to the equity. A higher ratio is preferred.
6.2 DEBT AND LIQUIDITY RATIOS
The main purpose of liquidity ratios is to assess whether a company can afford to pay its debts as they fall due. They are also valuable in determining how well a company uses available funds.
Gearing
There are many ways of calculating a gearing ratio. Throughout your ACT studies the following definition is used:
Net debt/Total Equity.
Where Net debt = Long-term debt + Short-term debt – Cash.
(300m + 100m – 20m)/700m = 54.29%.
The ratio shows the capital structure of the company, and indicates the proportion of the financing that is debt, relative to the funding provided by equity (shareholders). In the example, the ratio means that the company has 54.29 cents of debt, compared to each dollar of funding that is provided by equity. Although it may seem that it is advantageous for a company to have little or no debt, there can be benefits for the shareholders if the company has debt. These benefits are discussed in a later reading.
Net debt/EBITDA
Net debt/EBITDA.
(300m + 100m – 20m)/(150m + 15m) = 2.30.
Note: 15m is the depreciation and amortisation being added back onto operating profit.
The ratio provides an indication of whether a company will be able to pay its debts. A low ratio is preferable. Using the example, a ratio of 2.30 indicates that net debt could be paid off in two years and four months if all EBITDA was used for this purpose. A ratio of one implies that the debt will be paid in exactly a year. Ratios of above four would cause prospective lenders to analyse the accounts in detail, as they might be concerned about whether the company will be able to pay its debts.
Current ratio
Current assets/Current liabilities.
100m/120m = 0.83.
This ratio compares current assets (that includes cash, and assets which can relatively quickly become cash), to current liabilities which are payable in the short-term.
It can be used to assess whether a company can pay off its short-term debts if it has to.
In the example above, the company has 83 cents of current assets compared to each dollar of short-term liabilities. In theory a ratio of one, or anything above one, is advantageous.
In reality companies survive and prosper with a ratio of less than one, e.g. retailers who are paid quickly and who pay suppliers relatively slowly.
The ratio is most useful when assessing whether a company which has run into difficulties can survive. In this case the ratio would give a valuable indicator as to whether the company is worth doing business with, or investing in.
Quick ratio
This is calculated by dividing current assets minus inventories, by current liabilities.
(Current assets – Inventory)/Current liabilities.
(100m -60m)/120m = 0.33.
This deducts inventories from current assets, because it is assumed that, in the event of difficulties, the stock can’t be sold quickly. In the example the company has 33 cents of current assets compared to each dollar of short-term liabilities. Once again, in theory a ratio of one or above might be considered advantageous. However, the argument offered under the current ratio above applies, i.e. the ratio is most useful when assessing whether a company which has run into difficulties can survive.
Interest cover
Operating profit/Financing cost: 150m/60m = 2.50.
Or
EBITDA/Financing cost: (150m + 15m)/60 = 2.75.
The EBITDA method is preferred given EBITDA is a good proxy for actual cash generation. In practice many lenders will use EBITDA/interest expense as a key metric for determining the credit worthiness of a corporate borrower and/or their borrowing capacity.
It is also important to note that where financing cost is made available this should be used as opposed to net financing cost.
The ratio shows whether a company can meet its interest payment obligations and a ratio of below one would mean that it isn’t making enough operating profit / EBITDA to meet them. In the example the ratio of 2.75 means that the company is making enough profit (EBITDA) to pay interest 2.75 times over. A higher ratio would usually be preferred, unless it means that opportunities to borrow more and expand are being missed.
6.3 SHAREHOLDERS RATIOS
As the name implies, these are mainly used by shareholders who wish to assess an investment they have made, or by people who are considering investing in a company. Three common ratios are shown below.
Earnings per share
Profit after tax/Number of shares in issue.
80m/120m = 0.67 cents.
This shows how much profit is generated for each share. In the example 67 cents profit has been made for each share. Shareholders and potential investors would like the ratio to be improving year-on-year. As the number of shares issued varies from company to company, it is the trend in earnings per share which is significant, rather than the absolute value.
Dividend cover
Profit after tax/Total dividends paid.
80m/50m = 1.60 times.
This ratio shows the relationship between profit after tax and dividends. A ratio of 1.6 means that the company could afford to pay its dividends 1.6 times over. A ratio of around two is typical. This means that a company pays half of the profit after tax as dividends. The rest of the profit is retained in new assets or in reserves for difficult times.
Price earnings ratio
Market price per share/Earnings per share.
8/0.67 = 11.94 times.
The ratio shows the price of a share relative to the profit after tax which is being generated for each share. A high ratio means that investors are willing to pay a relatively high share price because they anticipate good returns in the future. In the example the ratio of 11.94 means that investors are willing to pay a price that is nearly twelve times higher than current earnings per share, which shows a lot of confidence in their growth prospects. The ratio should be compared to that for the sector and to past years.
First published 2016. Updated and republished 2022.
Published by: ACT (Administration) Limited www.treasurers.org
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