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

48

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.