Analysis And Communication of Accounting Information (Copy)

Introduction to Ratio Analysis in Advanced Accounting

• Ratio analysis is a technique used to interpret financial statements by expressing the relationship between figures as meaningful ratios.
• Helps users of accounts (shareholders, investors, lenders, managers, employees, and government) to make informed decisions.
• Goes beyond simple profitability, liquidity, and efficiency ratios (covered in 1.6) to include investment ratios, which are particularly relevant for limited companies.
• Enables comparisons:
  • Intra-firm comparisons – performance across different years.
  • Inter-firm comparisons – against competitors and industry benchmarks.
  • Standards of performance – comparing with expected budgets, standards, or required minimums.
• Ratios do not provide answers in themselves but highlight areas requiring deeper investigation.

Classification of Ratios in 3.5

• Efficiency Ratios (Working Capital Ratios)
• Financial Risk Ratios (Solvency/Gearing/Interest cover)
• Investment Ratios (Shareholder-related)

Key Ratios in 3.5

1. Working Capital Cycle (in days)

• Formula:
  Working capital cycle = Inventory days + Trade receivables days – Trade payables days
• Inventory days = (Closing inventory ÷ Cost of sales) × 365
• Receivables days = (Trade receivables ÷ Credit sales) × 365
• Payables days = (Trade payables ÷ Credit purchases) × 365
• Interpretation:
  • Shorter cycle = better efficiency and liquidity.
  • Long cycle = capital tied up in inventory and receivables, liquidity problems.
• Example:
  If inventory days = 50, receivables = 40, payables = 30 → Cycle = 60 days.
• Improvement measures:
  • Reduce inventory levels through just-in-time methods.
  • Quicker collection of debts.
  • Negotiate longer credit terms with suppliers.

2. Net Working Assets to Revenue (Sales)

• Formula:
  Net working assets to revenue = (Net current assets ÷ Revenue) × 100
• Net current assets = Current assets – Current liabilities
• Purpose: shows proportion of sales financed by net current assets.
• High ratio: excess funds tied in current assets (inefficient).
• Low ratio: efficient use of working capital, but risk of liquidity problems.
• Example:
  Net current assets = $60,000; Revenue = $300,000 → Ratio = 20%.

3. Interest Cover Ratio

• Formula:
  Interest cover = Profit from operations ÷ Finance costs
• Indicates how many times the company’s profit can cover interest expense.
• High ratio → safe for lenders, low financial risk.
• Low ratio (<2) → risk of insolvency if profits fall.
• Example:
  Profit from operations = $50,000; Interest = $10,000 → Ratio = 5 (very safe).

4. Gearing Ratio

• Formula:
  Gearing = (Non-current liabilities ÷ (Equity + Non-current liabilities)) × 100
• Measures financial risk: proportion of debt in long-term financing.
• High gearing (>50%) → risky, dependent on external debt.
• Low gearing (<25%) → conservative, less risky, but may miss growth opportunities.
• Ideal depends on industry. Utilities → high gearing is normal. Tech startups → lower gearing expected.
• Example:
  Equity = $200,000; Non-current liabilities = $100,000 → Gearing = 33%.

5. Earnings Per Share (EPS)

• Formula:
  EPS = Profit for ordinary shareholders ÷ Number of ordinary shares issued
• Shows earnings attributable to each share.
• Important for investors comparing profitability of different companies.
• Example:
  Profit for shareholders = $120,000; Shares = 60,000 → EPS = $2.00

6. Price/Earnings (P/E) Ratio

• Formula:
  P/E = Market price per share ÷ Earnings per share
• Shows how much investors are willing to pay for $1 of earnings.
• High P/E → high investor confidence, growth potential.
• Low P/E → undervalued, risk of poor growth.
• Example:
  Market price = $20; EPS = $2 → P/E = 10.

7. Dividend Per Share (DPS)

• Formula:
  DPS = Total ordinary share dividends ÷ Number of ordinary shares issued
• Shows actual cash return to each shareholder.
• Example:
  Dividends = $30,000; Shares = 60,000 → DPS = $0.50

8. Dividend Yield

• Formula:
  Dividend yield = (Dividend per share ÷ Market price per share) × 100
• Shows % return from dividends relative to market price.
• Higher yield = attractive to income-seeking investors.
• Lower yield = company may be reinvesting profits into growth.
• Example:
  DPS = $0.50; Market price = $10 → Yield = 5%.

9. Dividend Cover

• Formula:
  Dividend cover = Profit for ordinary shareholders ÷ Total ordinary dividends
• Shows how many times profit covers dividends.
• High cover (>2) → company retains profits for reinvestment.
• Low cover (<1.5) → risky, may not sustain dividends.
• Example:
  Profit = $100,000; Dividends = $40,000 → Cover = 2.5

Interrelationships Between Ratios

• Ratios should not be studied in isolation.
• Example 1: High EPS but low DPS → profits retained for expansion. Investors may see growth potential or be dissatisfied by low cash return.
• Example 2: High gearing + low interest cover → very risky.
• Example 3: Low working capital cycle + high dividend yield → efficient operations benefiting shareholders.
• Example 4: High P/E ratio + high EPS → strong investor confidence in growth.

Analysis and Evaluation of Ratios

• Ratios highlight strengths, weaknesses, and trends.
• Must be compared with:
  • Previous years (trend analysis).
  • Competitors (benchmarking).
  • Industry standards.
• Limitations:
  • Ratios use historical data (not future).
  • Different accounting policies (e.g., depreciation, inventory valuation) reduce comparability.
  • Inflation distorts comparability across years.
  • Non-financial factors (e.g., employee morale, brand strength) are ignored.
  • Window-dressing may artificially improve ratios.

Recommendations to Stakeholders Based on Ratios

Shareholders

• High EPS + good DPS → attractive investment.
• High gearing → warn of risk of insolvency.
• Low dividend cover → dividends may be cut.

Management

• High working capital cycle → need better credit control.
• Low interest cover → restructure debt.
• Low gearing → may consider raising debt to finance growth.

Creditors & Banks

• Interested in liquidity (working capital cycle, interest cover).
• High gearing may discourage lending.

Employees

• Strong profitability ratios → job security, wage growth.
• Poor liquidity → risk of delayed payments.

Government

• Ratios showing high profitability → higher tax collection.
• High gearing + risk of insolvency → regulatory concern.

Possible Measures for Improvement

1. Working Capital Cycle
   • Reduce inventory through efficient supply chain.
   • Offer cash discounts to encourage quick payment.
   • Negotiate longer credit terms with suppliers.
2. Interest Cover
   • Reduce interest costs through refinancing.
   • Increase profitability by boosting sales.
3. Gearing
   • Repay debt using retained earnings.
   • Issue more shares to raise equity capital.
4. EPS & P/E Ratio
   • Improve profits through efficiency and cost reduction.
   • Manage investor confidence through transparency.
5. Dividend Ratios
   • Maintain stable dividend policy to attract investors.
   • Retain sufficient earnings to fund future growth.

Worked Example

A company reports the following:

• Revenue: $500,000
• Cost of sales: $350,000
• Operating profit: $100,000
• Interest: $20,000
• Equity: $300,000
• Non-current liabilities: $200,000
• Profit after tax: $60,000
• Dividends: $20,000
• Shares issued: 100,000
• Market price per share: $3

Calculations:

• Gearing = 200,000 ÷ (300,000 + 200,000) × 100 = 40%
• Interest cover = 100,000 ÷ 20,000 = 5 times
• EPS = 60,000 ÷ 100,000 = $0.60
• DPS = 20,000 ÷ 100,000 = $0.20
• Dividend cover = 60,000 ÷ 20,000 = 3
• Dividend yield = (0.20 ÷ 3) × 100 = 6.67%
• P/E ratio = 3 ÷ 0.60 = 5

Interpretation:

• Low P/E (5) → undervalued, cautious investors.
• Healthy gearing (40%) but manageable due to good interest cover (5).
• EPS reasonable, dividend policy conservative with cover of 3.