Analysis And Communication of Accounting Information (Copy)

3.5.1: Analysis and Communication of Accounting Information – Cheat Sheet

Key Ratios for Analysis and Evaluation

1. Working Capital Cycle (in days)
   • Formula:
     Working Capital Cycle (in days) = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payables Outstanding (DPO)
   • Explanation: The working capital cycle measures the time taken between outlaying cash for the production process and receiving cash from product sales.
     • DSO = (Receivables / Sales) × 365
     • DIO = (Inventory / Cost of Goods Sold) × 365
     • DPO = (Payables / Cost of Goods Sold) × 365
2. Net Working Assets to Revenue (Sales)
   • Formula:
     Net Working Assets to Revenue = Net Working Assets / Revenue
   • Explanation: This ratio measures the efficiency of using working capital to generate sales revenue. It highlights the amount of working capital invested to generate each unit of revenue.
3. Interest Cover
   • Formula:
     Interest Cover = Operating Profit / Interest Expense
   • Explanation: The interest cover ratio indicates how easily a company can pay interest on its outstanding debt. A higher ratio suggests that the company is in a better position to pay its interest obligations.
4. Gearing Ratio
   • Formula:
     Gearing Ratio = Long-term Debt / Equity × 100
   • Explanation: This ratio measures the proportion of a company’s financing that comes from debt versus equity. A high gearing ratio indicates that the company is highly leveraged and dependent on borrowed funds.
5. Earnings Per Share (EPS)
   • Formula:
     EPS = Net Income / Number of Outstanding Shares
   • Explanation: EPS measures the profit attributable to each shareholder. It is commonly used to assess the profitability of a company on a per-share basis.
6. Price/Earnings Ratio (P/E Ratio)
   • Formula:
     P/E Ratio = Market Price per Share / Earnings Per Share (EPS)
   • Explanation: The P/E ratio compares the company’s current share price to its EPS. A high P/E ratio could indicate that the company is expected to grow at a higher rate in the future.
7. Dividend Per Share (DPS)
   • Formula:
     DPS = Total Dividends Paid / Number of Outstanding Shares
   • Explanation: DPS shows the amount of dividends a company pays out to its shareholders per share. It is a key indicator of the company’s profit distribution policy.
8. Dividend Yield
   • Formula:
     Dividend Yield = Dividend per Share (DPS) / Market Price per Share × 100
   • Explanation: The dividend yield measures the return from dividends relative to the market price of a company’s shares. A higher dividend yield indicates a better return on investment from dividends.
9. Dividend Cover
   • Formula:
     Dividend Cover = Earnings per Share (EPS) / Dividend per Share (DPS)
   • Explanation: This ratio indicates how easily a company can cover its dividend payments with its earnings. A ratio greater than 1 means that the company is generating sufficient profits to pay its dividends.

Analysis and Interpretation of Ratios

• Working Capital Cycle:
  A shorter working capital cycle indicates better efficiency in managing cash and inventory. A long cycle can indicate that the business is taking too long to turn its inventory into cash, which could lead to liquidity issues.
• Net Working Assets to Revenue:
  A lower ratio suggests that the business is efficiently using its working capital to generate revenue, while a high ratio could indicate that the business is using too much working capital, potentially tying up funds that could be invested elsewhere.
• Interest Cover:
  A high interest cover ratio indicates that the business is in a strong position to meet its interest obligations. A low ratio may signal that the company could struggle to meet interest payments, which might indicate financial stress.
• Gearing Ratio:
  A high gearing ratio indicates that the business relies heavily on debt to finance its activities, which could lead to financial risks if debt obligations are not met. A lower gearing ratio suggests that the business has a more balanced capital structure, relying more on equity funding.
• Earnings Per Share (EPS):
  A rising EPS typically indicates increasing profitability and is a positive signal for investors. A declining EPS may indicate falling profits or earnings struggles, potentially signaling a decline in company performance.
• Price/Earnings Ratio (P/E Ratio):
  A high P/E ratio suggests that investors expect the company to grow rapidly, while a low P/E ratio might suggest that the company is undervalued or has lower growth expectations. However, this ratio should be considered in context with industry norms.
• Dividend Per Share (DPS):
  A company with a high DPS is often seen as financially stable and able to share profits with shareholders. However, excessive dividends might also signal that the company is not reinvesting enough in growth opportunities.
• Dividend Yield:
  A higher dividend yield suggests that shareholders are receiving a higher return from dividends, but it may also indicate a mature company with fewer reinvestment opportunities. A very high dividend yield may require further investigation into the company’s long-term sustainability.
• Dividend Cover:
  A higher dividend cover ratio indicates that the company’s profits are more than sufficient to meet its dividend obligations, providing comfort to shareholders. A ratio below 1 may indicate that the company is paying out more in dividends than it is earning, which can be unsustainable in the long run.

Making Recommendations Based on Ratios

• If the company’s interest cover is low, you may recommend reducing debt or improving cash flow to ensure that it can meet its interest obligations.
• If the gearing ratio is high, you could suggest reducing debt and focusing on increasing equity to reduce the company’s financial risk.
• A company with a high P/E ratio might be viewed as overvalued, and you could recommend that investors be cautious. Alternatively, a low P/E ratio might indicate that the company is undervalued, and you may suggest considering it for investment.
• If a company has a high dividend yield but a low dividend cover, you could advise caution, as the company might be overextending itself in terms of dividends, and future dividend cuts might be likely.

Conclusion

• Ratios are essential tools for evaluating business performance, but they should be considered alongside other factors such as the company’s industry, market conditions, and growth potential.
• The ability to interpret these ratios allows businesses and investors to make informed decisions about the financial health and investment potential of a company.