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CB1-14: Interpretation of accounts Page 1

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Interpretation of accounts
Syllabus objectives

4.2 Assess the accounts of a company or a group of companies, including the

limitations of such assessment.

1. Calculate and explain priority percentages and gearing.

2. Calculate and explain interest cover and asset cover for loan capital.
3. Describe the possible effects of interest rate movements on a highly geared
company.
4. Calculate and explain price earnings ratio, dividend yield, dividend cover
and EBITDA.
5. Explain net earnings per share.
6. Calculate and explain accounting ratios which indicate:
 profitability
 liquidity
 efficiency.

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0 Introduction

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Analysis of company accounts is useful to appraise companies for investment purposes and to

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understand how well they are being managed. This chapter introduces many of the tools needed
to analyse accounts for these purposes and in particular contains definitions of key accounting
ratios.
Accounting ratios are a useful way to make comparisons between companies. In particular, by using
a ratio rather than a single number, it is possible to make comparisons which are not distorted by
the size of the companies.

Ratios are practical tools used by investment analysts eg when deciding which share to purchase.
Consequently, there is often no ‘right’ definition of a particular ratio. Indeed, often there is no
‘right’ ratio to look at in a particular case.

In this chapter and the next we set out the most important ratios, in the form(s) in which they are
most commonly used. In other notes/textbooks there will be differences, although these should
usually be on points of minor detail.

In this chapter, we start by focusing on loan capital and the type of analysis primarily relevant to
investors in loan capital. In particular, we look at measures to assess the security of loan capital.
We then turn our attention to measures appropriate to the shareholders. We will also look at ratios
that assess profitability, liquidity and business efficiency.

To illustrate ratio calculations, throughout the chapter we will use the accounts set out below for
Cover-up Limited, a supplier of specialist equipment and technical advice. From time to time we will
refer back to the next two pages.

The examination is likely to test knowledge of accounting ratios (ie of the definitions of the ratios
and how to calculate them), but just as importantly, it will test understanding of the ratios (eg to
explain what they mean or could mean and to give possible courses of corrective action for a
company).

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Statement of profit or loss for Cover-up Ltd for the year 20X0

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£000s

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Revenue 250,000
Cost of sales:
Cost of stock used:
Raw materials purchased 95,000
Decrease in stocks of finished goods and work-in-progress 7,000
102,000
Depreciation 30,000
(132,000)

Gross profit 118,000

Administrative expenses and other overheads (85,000)
Operating profit 33,000
Finance income 2,000
Profit before interest and taxation 35,000
Finance costs (9,950)
Profit before taxation 25,050
Tax (8,267)
Profit for the year =
16,783
Profit for the year attributable to equity holders of the company
EPS for profit attributable to equity holders 10.5p

Note to the accounts:

The company proposes to make a dividend payment of £6,000,000, ie 3.75p per ordinary share, in
respect of the year ending 31 December 20X0.

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Statement of financial position for Cover-up Ltd as at 31 December 20X0

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£000

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ASSETS
Non-current assets
Intangible assets 20,000
Tangible assets 75,000
95,000
Current assets
Inventories 42,000
Trade receivables 60,000
Cash 14,000
116,000
Total assets 211,000

EQUITY AND LIABILITIES

Called up share capital (160 million shares @ 25p) 40,000
Retained earnings 20,000
Other reserves 10,000
Total equity 70,000

Non-current liabilities
10% unsecured loan stock 20X7 25,000
11% subordinated loan stock 20X4 19,000
9¾% mortgage debenture 20X5 16,000
9½% Eurosterling 20X4 40,000
Total non-current liabilities 100,000

Current liabilities
Trade payables 32,000
Taxation 9,000
Total current liabilities 41,000

Total liabilities 141,000

Total equity and liabilities 211,000

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1 Measuring risk associated with loan capital

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In general, if a company has a high level of operating profit in relation to the annual interest due on

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its loan capital, the loan interest should be secure. The higher the ratio of profits to interest
payments, the more scope there is for profits to deteriorate before a company will default on its
loan capital interest payments.

We can also consider what happens if the company does default on its interest payments. Whether
the loan stock holders get any money back depends on whether the available assets of the company
are sufficient to meet the claims of the loan capital holders.

To assess this, investors in loan capital can look at the ratio of the available assets to the amount of
the loan stock. A high ratio gives scope for future reductions in the value of the company’s available
assets without endangering the asset security for the loan capital.

So assets and income are important in this context. The two main ratios associated with loan capital
are called the interest cover and the asset cover.

Shareholders will normally regard loan capital as a mixed blessing. It is a cheap source of
finance for the company because it normally carries a relatively low risk for the lender.

Question

Explain the remark ‘loan capital normally carries a relatively low risk for the lender’.

Solution

Consider the different possible risks to the investor (ie the lender):

 Default risk – Loan stock capital ranks higher in the event of a wind-up than equity and
preference shares, so can be described as relatively low risk.
 Market risk – Because the income flow is fixed and the security is better than equities, it is
generally the case that the market price of debt securities is more stable than that of
equity capital. Therefore the market risk is relatively low.

This means that the shareholders will normally expect to enjoy a higher rate of return from
their investment in share capital if the company is partly financed by borrowing.

The alternative would be that additional finance would have been raised by the sale of
additional shares, thereby diluting the returns enjoyed by the original shareholders.

There is, however, a downside to this. The security enjoyed by the lenders has the effect of
increasing the risk attributable to the shareholders.

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This is because:

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 the interest has to be paid regardless of whether the company is making profits

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 the greater the proportion of the company’s assets that are financed by debt, the

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greater the risk that there will be nothing left for the shareholders if the company
fails.

There are a number of ratios which can be used to measure the risks borne by the
shareholders because of the company’s borrowing policy. These should not be confused
with the risks which arise because of any volatility in the underlying business itself.

1.1 Interest cover

Interest cover on an issue of loan capital is defined to be profit on ordinary activities before
interest and taxation divided by the annual interest payments due on that issue of the loan
capital and on all prior ranking loan capital.

profit on ordinary activities before interest and taxation

Interest cover 
annual interest payments due on that issue of loan stock + all prior loan stock

Put simply, it measures the number of times that the company could pay its interest out of
profit before tax and interest. The higher this multiple, the less likely that the company will
run into difficulty.

Interest cover is sometimes known as income cover. To calculate the interest cover on the
different types of loan capital issued by Cover-up Ltd, we need first to split up the ‘interest payable
on long-term debt’.

The interest payable on an issue of debt can be calculated from the nominal amount
outstanding and the interest rate shown in the financial statements.

Below we set out the split of interest in order of priority. The mortgage debenture (highest ranking)
comes first. The unsecured loan stock and Eurosterling will probably rank equally. The
subordinated loan stock will rank lowest.

Calculation of interest cover for Cover-up Ltd

Interest on 9¾% mortgage debenture 1,560 (0.0975  16,000)
Interest on 10% unsecured loan stock 2,500 (0.10  25,000)
Interest on 9½% Eurosterling 3,800 (0.095  40,000)
Interest on 11% subordinated loan stock 2,090 (0.11  19,000)

9,950
35,000
Interest cover on mortgage debenture = = 22.4
1,560

35,000
Interest cover on unsecured loan stock = = 4.5
(1,560  2,500  3,800)

35,000
Interest cover on Eurosterling = = 4.5
(1,560  2,500  3,800)

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Question

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Calculate the interest cover for the subordinated loan stock.

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Solution

35,000
Interest cover   3.5 
1,560  2,500  3,800  2,090

It is normally considered risky if the company cannot cover interest at least three or four
times.

This is, however, a general principle. If, for example, the company has a stable, predictable
stream of profits then it could afford to operate with a lower interest cover.

In addition, there is normally a trade-off between lower security and a higher expected return.

The main limitations of interest cover are that it does not consider how volatile profits are, nor
does it take account of the length of time for which the loan is outstanding. For example consider
the likelihood of default on the following two loan stocks:

1. a 25-year loan stock issued by a company with profits that fluctuate greatly from year to
year with an interest cover of 5.

2. a 5-year loan stock issued by a food retailer (stable profits) with an interest cover of 2.

It is likely that the second is much safer than the first, despite the lower interest cover figure.

To take account of this, an investor is likely to modify the 3 or 4 rule of thumb depending upon
the stability of profits and the term of the loan stock being analysed.

It is also sensible to calculate the average interest cover from the last few years’ accounts, rather
than rely only on the latest set of accounts. This will enable the analyst to make some allowance for
the volatility of profits.

As default by the company on any of its loan stock may result in the company winding up, this may
be bad news for all of the other loan stock holders (particularly if the company’s assets are
insufficient to repay all of the loan capital).

So it is common practice to calculate interest cover on all the company’s issues of loan capital, not
just the particular issue that an investor is considering purchasing.

Question

Discuss the following comment:

‘Since a company may be able to pay interest on a loan stock even when profit before interest
and tax is negative, it is meaningless to calculate interest cover.’

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Solution

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It is true that a company may be able to pay interest on a loan stock even when profit before

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interest and tax is negative, but only if it has the spare cash (or an overdraft facility) available.

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If the losses persist, the company might run out of cash and default on the loan.

The long-run success of a company depends upon it making profits. It is therefore sensible to
consider the company’s profits (and hence interest cover) when assessing whether or not to invest
in the company.

This is particularly the case since there is no better, simpler alternative of assessing the company’s
likely future success.

1.2 Interest priority percentages

Interest priority percentages show the slice of profit on ordinary activities before interest
and tax which covers the annual interest payments due on each issue of loan capital.

If the interest cover for the loan stock in question is x and the interest cover for the loan stock
immediately prior in ranking to the one in question is y, then the interest priority percentage for the
1 1
loan stock is to .
y x

For each issue of loan capital there will be a lower and upper interest priority percentile.

The lower percentile is calculated as the inverse of the cover figure for the previous highest-
ranking issue. The upper percentile is calculated as the inverse of the cover figure for the
issue of loan stock being considered.

This may seem complex, but it will become clear with the help of an example.

This statistic is more relevant to lenders.

If the company has, say, given some lenders a fixed charge or a mortgage over specific
assets then these loans will be repaid before loans with floating charges. Unsecured loans
will be repaid after these.

This ranking will be relevant to a lender who has to decide whether the other loans that the
company has taken out will affect the risk of a further investment.

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Calculation of interest priority percentages for Cover-up Ltd

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Issue of loan capital Interest cover Interest priority

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(see above) percentages

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Mortgage debenture 22.44 0% to 4.5%

Unsecured loan stock 4.45 4.5% to 22.5%

Eurosterling 4.45 4.5% to 22.5%

Question

Calculate the interest priority percentages for the subordinated loan stock.

Solution

The interest cover figure for the unsecured loan stock and Eurosterling issues is 4.45.

The interest cover figure for the subordinated loan stock is 3.52.

The interest priority percentages for the subordinated loan stock are therefore:

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to , ie 22.5% to 28.4%
4.45 3.52

We can interpret the priority percentages in the above example as follows: Given a figure of £35,000
available to pay the interest on the loan capital:

 the first 4.5% of this amount is needed to meet the interest on the highest ranking loan
capital (the mortgage debenture)
 the next 18% (of the £35,000) is needed to pay the interest on the next highest ranking
loan capital (the unsecured loan stock and the Eurosterling)
 the next 6% is needed to pay the interest on the lowest ranking loan capital (the
subordinated loan stock).

1.3 Asset cover

Asset cover on an issue of loan capital is usually defined to be:

total assets less current liabilities less intangible assets

loan capital plus prior ranking debt

This amount will usually represent a conservative estimate of the amount of money
available to meet the loan stockholders’ demands for repayment if the company were to
wind up.

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The assumption is that assets other than intangibles will be converted into cash at their

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book values, while intangible items are likely to be worthless on winding up. This is, of

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course, dependent on the nature of the business and its assets. A valuable brand name or

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patent might well be worth more than all of the company’s other assets put together.

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Current liabilities are assumed to be repaid before the debtholders even though they may
rank below the loan capital.

It is standard practice to regard a class of loan which has an asset cover less than two or
two and a half times as high risk.

An alternative definition of asset cover which is often used in practice is:

total assets less current liabilities less intangible assets

total loan capital

However, we will be using the first definition in the following examples.

For Cover-up Ltd, total assets less current liabilities less intangible assets equals £150,000
(ie 211,000 – 41,000 – 20,000).

The idea is that the assets could be converted into cash at the balance sheet value. However,
intangible items (eg goodwill) are likely to be worthless on winding up, so they are excluded.

Current liabilities are assumed to be repaid before the stockholders even though they may rank
below the loan capital. The reason for this is that companies getting into trouble may find it
difficult to get credit from their suppliers and might have very low current liabilities anyway by
the time the company is wound up.

Calculation of asset cover figures for Cover-up Ltd

150,000
Asset cover on mortgage debenture = = 9.4
16,000

150,000
Asset cover on unsecured loan stock = = 1.9
(16,000  25,000  40,000)

150,000
Asset cover on Eurosterling = = 1.9
(16,000  25,000  40,000)

Question

Calculate the asset cover for Cover-up’s subordinated loan stock.

Solution

150,000
Asset cover   1.5 
16,000 + 25,000 + 40,000 + 19,000

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The main limitation of asset cover is that the current value shown in the statements of

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financial position for assets might not reflect their realisable market value if the company is

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wound up. The going concern concept means that there is no particular need to carry

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assets at their market values.

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The minimum of 2 cover gives a safety margin, but an arbitrary one. Also, like interest cover,
capital cover does not take account of the term of the loan stock.

An investor is likely to modify the 2 rule of thumb depending upon the likely realisable value of the
assets, the term of the loan stock being analysed and the adequacy of the interest cover.

1.4 Asset priority percentages

Asset priority percentages show the slice of total assets less current liabilities less
intangible assets which is available to cover the nominal value of each issue of loan capital.

For each issue of loan capital there will be a lower and upper percentile.

The lower percentile is calculated as the inverse of the cover figure for the previous highest-
ranking issue.

The upper percentile is calculated as the inverse of the cover figure for the issue of loan
stock being considered.

Question

Calculate the asset priority percentages for Cover-up’s subordinated loan stock and interpret the
figures.

Solution

The asset cover for the unsecured loan stock and Eurosterling issues is 1.85.

The asset cover for the subordinated loan stock is 1.50.

The asset priority percentages for the subordinated loan stock are therefore:

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to , ie 54.0% to 66.7%
1.85 1.5

This means that, if the company were wound up, the first 54% of the company’s assets would go
towards covering the company’s liabilities to the holders of the mortgage debenture, unsecured
loan stock and Eurosterling issue. The next 12.7% of the company’s assets would go to the holders
of the subordinated loan stock.

1.5 Gearing
Gearing refers to the relative proportions of long-term debt and equity finance in a
company. High gearing means that the company has a high level of debt financing.

In the US, gearing is known as ‘leverage’.

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There are many different ways of defining gearing. The common feature is that high gearing means

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that the company has a high ratio of debt finance (eg loan capital) to equity finance (ie share capital

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and reserves).

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Gearing can be measured using the statement of financial position figures for debt and equity.

Three main ratios under each type are considered below.

Asset gearing
Asset gearing is also known as ‘capital gearing’.

There are two commonly used definitions of asset gearing, either:

borrowings borrowings
or
equity borrowings + equity

The term ‘borrowings’ will usually include all forms of long-term loan capital.

This can include loan stock, Eurobonds and debentures etc. Some analysts also include any part of
an overdraft or other short-term borrowing which seems to be a permanent feature of the
company’s capital structure.

The term ‘equity’ in this definition means the book value of the ordinary shares ie ‘capital
and reserves’. It is normal to deduct the amount of any intangible assets.

By doing this, we are effectively ‘writing off’ intangible assets against reserves, which is what a lot of
firms do anyway. This is sensible since we need to be consistent between companies, only some of
which choose to show intangible assets in their statement of financial position. For example, it is
much easier to deduct goodwill from the minority of companies that show it, than to add an
unknown amount of goodwill to the statement of financial position of those companies that do not
show goodwill.

The treatment of preference shares varies. Usually they are included as part of borrowings
rather than as part of equity because they carry a fixed rate of dividend and because their
holders are repaid before ordinary shareholders in the event of default.

This is appropriate when analysing gearing from the perspective of ordinary shareholders.

This means that they are more like liabilities when viewed from the perspective of the
ordinary shareholders. The treatment of preference shares within related ratios, such as
interest cover, needs to be consistent.

A company whose gearing reached 40% using the second of the above formulae would
normally be regarded as high risk.

Where the data is available, and depending on the purpose of the calculation, some analysts like to
use market values of loan stock and share capital instead of the balance sheet values.

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Using the first definition given above (ie borrowings to equity), asset gearing for Cover-up is

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calculated as:

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25,000  19,000  16,000  40,000 100,000

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  200%

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40,000  20,000  10,000  20,000 50,000

Question

Calculate asset gearing for Cover-up using the second definition of gearing (ie debt to total
capital).

Solution

100,000
Asset gearing =  66.7%
100,000 + 50,000

So Cover-up is pretty highly geared by most measures.

The reasons for gearing increasing risk can be illustrated with the following example
involving two identical companies, one financed by 4 million ordinary shares of £1, the
other by 2m shares and £2m of 12% loan stock:

Average year

Lowgear Highgear

Earnings before interest and tax 540,000 540,000

Interest 0 (240,000)

Earnings before tax 540,000 300,000

Tax (30%) (162,000) (90,000)

378,000 210,000

No of shares 4m 2m

Earnings per share (pence) 9.45p 10.5p

Thus, the shareholders benefit from gearing in an average year because the interest rates
are relatively low and because the company enjoys the benefit of tax relief on the loan
interest.

The 12% interest on debt may not be low in absolute terms but is low relative to the return
540,000
enjoyed by the equity shareholders who contributed £4 million capital of = 13.5%.
4,000,000

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We now consider the effect if the profits double:

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Good year

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Lowgear Highgear

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Earnings before interest and tax 1,080,000 1,080,000

Interest 0 (240,000)

Earnings before tax 1,080,000 840,000

Tax (30%) (324,000) (252,000)

756,000 588,000

No of shares 4m 2m

Earnings per share (pence) 18.9p 29.4p

Times average year’s EPS 2.0  2.8 

In a good year, earnings before interest and tax have doubled.

This results in a doubling of the returns to shareholders in the low-geared company.

The high-geared company has, however, had its shareholders’ return increase 2.8 times.

This is because of the effects of the fixed payment of interest on the half of the long-term
finance which comes from borrowing.

However, if profits halve…

Bad year
Lowgear Highgear
Earnings before interest and tax 270,000 270,000
Interest 0 (240,000)

Earnings before tax 270,000 30,000

Tax (30%) (81,000) (9,000)

189,000 21,000

No of shares 4m 2m
Earnings per share (pence) 4.725p 1.05p
Times average year’s EPS 0.5  0.1 

The gearing effect is even more pronounced when the company has a poor year.

In this case, halving the earnings before interest and taxation halved the shareholders’
return in the ungeared company.

The highly geared company’s return was reduced to one tenth that of a normal year.

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The gearing ratio is important because increasing the proportion of debt in the company’s

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long-term finance tends to accentuate any volatility in the underlying business. This would

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tend to increase the total risk for shareholders.

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In extreme cases, where it might force the company to risk default, it might also create

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some risk for lenders.

An associated ratio used by financial analysts is the shareholders' equity ratio

shareholders' equity  intangibles

total assets  current liabilities  intangibles

This is similar to the second definition of asset gearing, but this ratio looks at the proportion of
finance provided by equity, rather than the proportion provided by debt.

The higher this ratio, the stronger the financial position of the organisation. The lower the
proportion, the more possibility of the organisation becoming over-dependent on outside
providers of capital.

The term shareholders’ equity in this definition means the statement of financial position value of
the capital and reserves. It is normal to deduct the amount of any intangible assets.

Question

Calculate the shareholders’ equity ratio for Cover-up.

Solution

70,000  20,000
Shareholders' equity ratio =  33.3%
170,000  20,000

Income gearing
The most commonly used definition of income gearing is:

interest on borrowings
profit on ordinary activities before interest and tax

‘Interest on borrowings’ will usually include all forms of interest payable on debt.

This includes interest on loan capital, and on overdrafts.

The treatment of preference shares again varies. When they are included as part of ‘interest
on debt’, they should be grossed up at the company’s rate of corporation tax.

So the definition would be:

preference dividends
interest on borrowings +
(1  corporation tax rate)
profit on ordinary activities before interest and tax

Dividends are grossed up at the corporation tax rate because preference share dividends are paid
out of tax profits and we are assessing how much interest cost the company is bearing.

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The true cost to the company of £x of preference dividends at the before tax level is £x/(1 – t)

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(assuming a corporation tax rate of t).

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Question

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Calculate income gearing for Cover-up Ltd.

Solution

9,950
Income gearing =  28.4%
35,000

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2 Ratios involving share information

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We will look at the following sets of ratios for shareholders:

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 ratios involving share information
 profitability ratios
 liquidity ratios
 efficiency ratios.

Investors in ordinary shares are entitled to receive dividends, which may be very large
relative to the issue price of the shares if the company is successful. Equally, the dividends
may not be paid at all if the company is unsuccessful.

Whilst ordinary shareholders may look at the cover and gearing ratios we have covered so far,
income and capital cover will not be their main concern.

They will want to know about a company’s profitability, efficiency, earnings for ordinary
shareholders and dividends.

2.1 Earnings per share

In principle, earnings per share is a simple concept:

earnings on ordinary activities

earnings per share =
number of issued ordinary shares

Within this context, earnings on ordinary activities are usually taken to mean earnings for
ordinary shareholders.

The earnings per share (EPS) ratio is the amount of profit that has been earned for each
ordinary share.

It is customary to calculate this ratio by taking the net profit after taxation and, since it is
concerned with the ordinary shareholders' position, it excludes any preference dividend.

In other words, the payments in respect of preference dividend are deducted from the earnings
before the calculation of the ratio.

Businesses whose shares are publicly traded are required to disclose two versions of
earnings per share.

Basic earnings per share

This is calculated by dividing the net profit or loss for the period attributable to ordinary
shareholders by the weighted average number of ordinary shares outstanding during the
period.

The net profit or loss attributable to ordinary shareholders is after taxation, minority
interests, extraordinary items and preference dividends.

‘Minority interests’ was described earlier as ‘non-controlling interests’.

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Diluted earnings per share

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The basic EPS takes into account only those equity shares in issue that were outstanding

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during the period.

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However, a company may have entered into obligations that could dilute the EPS in the
future. In such cases, the basic EPS should be adjusted for the effects of all dilutive
potential ordinary shares.

The calculation should be made on the assumption that any conversion rights or options
had been exercised in full on the first day of the accounting period. (If the date of issue of
the securities giving rise to the rights or options is later, a weighted average calculation
should be performed.)

For example, consider a company which has earnings on ordinary activities of £75m for the year
ending 31 December.

During the year, there were 500m ordinary shares in issue. On 1 July, £50m of convertible loan
stock was issued, with the option to convert into ordinary shares in five years’ time. Under the
conversion terms, if all of the loan-stock holders take the option to convert, 100m new ordinary
shares will be issued.

£75,000,000
The earnings per share for the year are = 15p per share.
500,000,000

Since we had 500,000,000 shares for six months and a potential 600,000,000 for the second six
months, the weighted average number of shares allowing for conversion rights is:

0.5 × 500,000,000 + 0.5 × 600,000,000 = 550,000,000

Therefore, the diluted earnings per share are

£75,000,000
= 13.6p per share
550,000,000

There are various other ways of calculating EPS. For example, some companies provide
additional EPS figures that exclude exceptional items or exclude discontinued operations.

It is difficult to see why the EPS ratio should command so much attention. The number of
ordinary shares is, after all, a meaningless number. A company wishing to raise £1m of
share capital could, for example, issue 1m £1 shares, 2m 50 pence shares or 10m 10 pence
shares.

It is important as it is used as the basis for the calculation of the Price / Earnings (P/E) ratio.

Question

A company’s pre-tax profits have doubled over the past four years but EPS have hardly grown at
all. Give two reasons why this might have occurred.

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Solution

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Possible reasons would include:

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 acquisitions by the issue of shares
 a higher tax charge than in earlier years.

2.2 Price earnings ratio

market price of an ordinary share
price earnings ratio =
earnings per share

The earnings per share figure used in this ratio can be historical or prospective.

Some analysts calculate a PE ratio based on their best estimate of the company’s earnings over the
next 12 months. This is known as a prospective PE ratio. Other analysts calculate the PE ratio based
on the previous year’s earnings. This is known as a historical PE ratio.

Where companies have convertible shares, warrants or share options that may at some point be
converted into new shares, it is common to calculate the PE ratio on a ‘full conversion basis’ using
diluted earnings per share.

The market price of the share encapsulates everything that the market knows about the
company. Relating this to earnings gives an insight into the market’s opinion of the
company’s performance.

If the price earnings ratio is high then that would suggest that the company is relatively
attractive when considered as a source of revenues. This might imply that the market
believes:

 that the company is a relatively low risk investment, or

 earnings will grow rapidly in the future.

If the P/E ratio of a share is high relative to other, similar companies (taking the above
factors into account) it may mean that the share is overvalued.

Use of the price earnings ratio

Earnings are the amount of money generated by the company for its shareholders. These are of
fundamental importance in determining the income a shareholder receives and also the potential
for growth of the company.

The price earnings ratio shows how many times bigger the price of a share is than the earnings
that the share produces.
There are two main reasons why investors might be prepared to pay a bigger multiple of the
earnings for one share than for another share:
1. they expect earnings to grow rapidly, so are paying for expected high future earnings
2. the earnings are considered to be less risky.

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To use this ratio sensibly, we could consider the likely growth prospects of the company, and so

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derive the PE ratio that the share should have. The share is then expensive (cheap) if the actual PE

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ratio is higher (lower) than the estimated PE ratio.

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One way of estimating the PE ratio that a company should have is to consider what is normal for the
industry to which the company in question belongs. A company whose shares have a PE above the
norm for the industry may be considered expensive (or to have above average growth prospects).

In theory (and almost certainly in practice) the P/E ratio will vary as a result of changes in
the share price. Unfortunately, many directors behave as if the relationship has been
inverted. They seem to assume that the P/E ratio is fixed (or is at least ‘sticky’) and that the
share price can be improved by overstating the EPS.

2.3 Dividend yield

dividends per share
dividend yield =
market price of an ordinary share

Use of dividend yield

In theory, the value of a share is the discounted present value of the proceeds obtained from
owning it. If held forever, the present value of a share can be taken to be the discounted value of all
future dividends. Thus dividends are of key importance to shareholders.

The dividend yield measures the amount of current income (dividends) an investor receives
per unit of investment (the share price). A low dividend yield may mean that:
1. investors expect dividends to grow rapidly, or
2. the share is overvalued.

The dividend yield cannot be interpreted as the expected return on a share because it
shows only part of the return for an investor  it ignores any potential capital gain.

2.4 Dividend cover

earnings per share
dividend cover =
dividends per share

This way of calculating cover is not directly comparable with the interest cover used for
loan capital.

Question

Explain why the calculations are not entirely consistent.

Solution

Interest cover and asset cover are calculated by dividing the total income (or assets) available by
the loan stock + all prior debt.

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To be consistent, when calculating dividend cover, we would have to calculate the total income

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available to equity shareholders + all prior ranking capital (debt, preference, …) and divide by the

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dividends on ordinary shares + all prior capital. This is not what is done.

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The inverse of the dividend cover is the payout ratio.

1 dividend per share

payout ratio = 
dividend cover earnings per share

Use of dividend cover

Dividends are paid out of earnings. In the long run, a company will not be able to maintain
dividends if they are not covered by earnings.

In contrast, a company with a high level of dividend cover has more scope to increase
dividends in the future.

So, for a given dividend yield on a share, a high dividend cover figure suggests better value
for money than a share with low dividend cover.

There is a relationship between the PE ratio, the dividend yield and dividend cover:

market price dividend per share dividend per share

 =
earnings per share market price earnings per share

ie PE ratio × dividend yield = payout ratio

2.5 EBITDA
The statement of profit or loss shows how operating profit reflects revenue less the cost of
sales, distribution costs, administrative expenses and other operating income.

The operating profit plus finance income is sometimes referred to as earnings before
interest and taxation (EBIT).

The figure does, however, allow for depreciation and amortisation charges.

Some analysts feel that these are not well measured in statements of profit or loss, since
the amounts charged are based on subjective analysis and may therefore be seen as
discretionary. They prefer to focus on earnings before interest, taxation, depreciation and
amortisation (EBITDA). This is often referred to as ‘cashflow from operations’.

(The evaluation of depreciation charges was covered previously. Amortisation is a similar

exercise in respect of intangible assets such as goodwill, advertising and research and
development, R&D.)

EBITDA can be used to calculate an alternative version of earnings per share. This can then be
used to compare different companies or to look at trends over time for a particular company if
tax, depreciation or amortisation might otherwise distort the comparison.

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Question

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Calculate the following ratios for Cover-up Ltd, given that its current share price is 200p.

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(i) EPS

(ii) EBITDA per share

(iii) PE ratio (using net earnings)

(iv) dividend yield

(v) dividend cover.

Assume that the dividend proposed is approved and paid.

Solution

16,783
(i) EPS =  10.49p
160,000

35,000  30,000
(ii) EBITDA per share =  40.63p
160,000

market price of an ordinary share

(iii) PE ratio =
earnings per share

200
=  19.1 
10.49

6,000  100 1
(iv) dividend yield =   0.019 or 1.9%
160,000 200

earnings 16,783
(v) dividend cover: =   2.8 
dividends 6,000

Question

A company made £5m pre-tax profit last year. It paid a dividend for the year of £0.02 per share.
It has 100m shares in issue currently priced at £1.

Assuming corporation tax is charged at 20%, calculate:

(i) earnings per share

(ii) dividend cover

(iii) dividend yield

(iv) PE ratio.

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Solution

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Post-tax profits is £5m  (1 – 0.2) = £4m. Divided between 100m shares, this gives earnings

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(i)

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per share of 4.0p.

4
(ii) Dividend cover =  2.00 
2

2
(iii) Dividend yield = = 2%
100

100
(iv) The price earnings ratio is  25.0 
4

2.6 Net asset value per share

The formula for net asset value per share is:

ordinary shareholders' equity  intangible assets

number of issued ordinary shares

Comments on definition
‘Ordinary shareholders’ equity’ means called up share capital, other reserves including
share premium account and revaluation reserve and retained earnings.

If a company has convertible preference shares or convertible loan capital, it is normal to re-work
the statement of financial position assuming that conversion occurs immediately to give a ‘fully
diluted’ net asset value.

Intangible assets are excluded because they are treated differently by different firms and also
because they may be worth nothing if the company is wound up.

Purpose
This shows the book value of the tangible assets backing each share, net of all liabilities to
non-ordinary shareholders. It is approximately what the ordinary shareholders would
receive for each share they hold if the company was immediately wound up (assuming the
book values are reliable).

The main problem with the ratio is that the book values in historical cost accounts do not
necessarily reflect the true value of the assets.

For a highly geared company, the net asset value is the small difference between two big numbers,
tangible assets and liabilities. So problems of inaccurate valuation of assets may be very acute.

Often, net asset value will be compared to the share price.

If the net asset value is much greater than the share price, then the shares may be undervalued.

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Net asset value per share is particularly useful when looking at property companies and investment

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trusts where the share price should be closely related to the net asset value (because the value of

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such a company is generally just the value of the underlying assets).

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Net asset value is also used in take-overs, as the target company’s assets are being acquired. So the
net asset value gives a guide as to what should be paid (or possibly the minimum fair value). If a
company’s share price is below the net asset value, it may be worthwhile taking over the company
simply to acquire its assets cheaply.

The realisable value of the assets for a company in liquidation will often be a long way below the
value placed on them in the statement of financial position. Accounts are usually compiled, and
assets valued, on the assumption that the company will be a going-concern.

The share price may exceed the net asset value if the share price is more dependent upon the
company’s ability to generate profits (eg due to a good customer image and/or management) than
the value of the assets. For many companies, it is the discounted value of future dividends that
determines the share price, not the net asset value.

A good example might be an advertising agency (or any other ‘people’ based industry) where the
value of the firm’s tangible assets may be tiny. However, a low asset value relative to the share
price may suggest that the share price is too high.

Variations
Most analysts can partially overcome the problem of historical cost values. They do this by
replacing the balance sheet value of land with the market value (remember that this needs to be
disclosed in the directors’ report if it is not shown in the statement of financial position). The move
away from historical cost towards fair value accounting is reducing the extent to which these
kinds of adjustments by users of the accounts are necessary.

Some analysts divide net asset value per share by the company’s share price, to make the
comparison between book value and market value explicit. If this ratio is less than 1, it means the
market value exceeds the book value.

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3 Introduction to other accounting ratios

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There are four main groups of ratios:

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1. Those which measure profitability

2. Those which measure liquidity

3. Those which measure business efficiency

4. Those which relate to the business’ financial structure (as discussed above).

We have already discussed the ratios which relate to financial structure (gearing, etc) earlier
in this chapter.

The ratios we will look at are:

1. Profitability
– return on capital employed
– profit margin
– asset utilisation ratio
2. Liquidity
– current ratio
– quick ratio (also called acid test or liquidity ratio)
3. Efficiency
– inventory turnover ratio
– trade receivables turnover ratio
– trade payables turnover ratio.
These will help to indicate how successful the company is in various parts of its operations.
For many ratios, there is no single agreed definition and many variations are used.

As well as defining each ratio, we’ll look at its purpose and, where appropriate, any problems in
calculating it along with some of the common variations.

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4 Profitability ratios

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The profitability ratios are used to check that the company is generating an acceptable

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return for its owners.

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A number of benchmarks can be used: previous years’ figures, ratios calculated for similar
businesses, industry averages, etc.

Management should consider the reasons for any ratios which are poorer than expected to
see whether they imply that performance could be improved.

4.1 Return on capital employed

Definition
Return on capital employed is the most important profitability ratio – indeed it is often
referred to as the ‘primary ratio’ or ‘return on investment’.

It measures the relationship between the amount invested in the business and the returns
generated for those investors.

The calculation of return on capital employed is complicated by the fact that capital employed
can be measured in a number of different ways. It is vitally important that the figure for
‘return’ is calculated in a consistent manner with that for ‘capital employed’.

The two main formulae for return on capital employed are:

profit before tax and interest

× 100
share capital + reserves + long- term debt

and

profit before tax

× 100
share capital + reserves

The first formula defines capital employed in terms of the total amount invested in the
company, both by shareholders and lenders. In order to be consistent, the figure for return
must show the total amount generated on behalf of these investors. That is why interest has
been added back.

The second formula defines equity capital employed, in terms of the amount invested by
shareholders only. In order to be consistent, interest is excluded in the denominator as this is
return for bondholders, not shareholders.

The important thing is consistency between denominator and numerator. The two main rules
to obey are:

(i) if, and only if, an asset is included in the denominator, should the income it gives rise
to be included in the numerator.

(ii) if a liability is deducted from the denominator the income paid to it should be
deducted from the numerator.

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Comments on definition

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This ratio is normally expressed as a percentage.

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The term ‘before interest’ means before interest payable but after interest receivable.

The denominator (often called ‘capital employed’) is virtually the same figure as is used when
calculating asset cover. The definition above uses ‘share capital plus reserves plus long-term
debt’ which equals ‘total assets less current liabilities’. Ignoring any intangibles, the two
definitions are the same.

The ratio is dependent upon the value placed on the assets. Assets revalued upwards might lead
to a higher denominator and a lower numerator, since the depreciation charge would probably
increase in future years.

Purpose
The ratio can be used to indicate how efficiently managers of different firms are using the
funds at their disposal.

It is therefore useful when comparing companies for investment.

A decrease in the ratio would be cause for concern and further investigation eg to determine
whether profit margins have fallen, sales have fallen or capital has increased without any increase
in profits. Return on capital employed is likely to decrease during recessions, and increase during
booms.

The ratio can be compared with the cost of borrowing.

Return on capital employed can be calculated for parts of a business. If a particular branch
activity produces a very low (high) return on capital employed, then funds should be diverted
away from (towards) that activity.

The ROCE can be broken down into two ‘secondary’ ratios:

(i) asset utilisation ratio

revenue (turnover)
share capital + reserves + long-term debt

reflecting the intensity with which assets are employed and:

(ii) profit margin (or return on sales ratio)

profit before tax and interest

revenue (turnover)

This is an attempt to look at the profits made per unit of sales. It is normal to multiply the
answer by 100 to express it as a percentage.

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ROCE is the product of these two ratios as follows:

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profit before tax and interest

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ROCE =

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share capital + reserves + long-term debt

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revenue profit before tax and interest
= ×
share capital + reserves + long-term debt revenue

= asset utilisation ratio × profit margin

This shows that a fall in the ROCE can result from two main sources:
 a fall in the profit per unit of sales (measured by the profit margin)
 or a fall in the sales generated by the assets (measured by the asset utilisation ratio).

Once management has identified the general cause, more ratios can be examined, such as
administration costs per unit of sales, or sales generated by the fixed assets.

Having identified the cause, management can suggest a number of policies, eg pricing policy,
advertising, cost control.

4.2 Profit margin

Variations
We have seen one definition of profit margin above. It is also possible to calculate other sorts of
profit margin, eg the gross profit margin or the operating profit margin.

Operating profit is sometimes called trading profit.

Remember that operating profit does not include interest receivable. This means that the operating
profit margin is of limited use for most financial companies.

Some analysts look at operating profit before depreciation has been deducted.

Purpose
Profit margins are useful when analysing the profit made per unit of sale. The difference between
the gross profit margin and the operating profit margin is accounted for by expenses as a
percentage of revenue.

Different industries exhibit vastly different profit margins. In the retailing industry, turnover can
be high and profit margins will often be narrow. However in the drug industry, the margin on a
successful patented drug is much higher.

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Low margins relative to other firms in the industry may indicate a wide range of things, for

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example:

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

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a more down market product range

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 a ‘low margin high volume’ marketing strategy

 an attempt to increase market share

 poor management/excessive costs

 temporarily low profits and/or high costs (eg as a new product is launched)
 subnormal profits are being made, so that the firm will exit the industry in the long run.

Changes in the profit margin from year to year will also be of interest to analysts. Such
changes could indicate changes in any of the items mentioned above.

Clearly, it is impossible to tell whether a high ratio is good or bad without some further
information to provide context. A higher ratio could be achieved by increasing selling
prices. Unfortunately, that could also have the effect of over-pricing the company’s
products relative to its competition.

It is also important to bear in mind that different accounting policies can lead to different
profitability ratios.

For example, in the IT software industry, one company can seem very much more profitable than
another simply because the latter is prudently writing off unsuccessful or out-of-date software
development costs on software it believes to be out of date.

Many analysts use the profit margin and an estimate of future sales to derive a profits forecast:
Operating profit margin × estimated revenue = estimated operating profit.

4.3 Asset utilisation ratio

revenue
This is defined as:
share capital + reserves + long-term debt

Purpose
This measures the revenue that has been generated by the company’s assets. If this has fallen,
the company should investigate the reasons, perhaps:

 the company has increased its assets but has not used them efficiently
 the company has encountered production problems
 revenue has fallen due to a rise in price, a fall in advertising, increased competition or a
recession.
This ratio should be investigated alongside the profit margin. A company might adopt a ‘low
margin high volume’ strategy which would give the company a high asset utilisation ratio but a
low profit margin.

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5 Liquidity ratios

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While it is important for a business to be profitable, profit is not sufficient on its own to

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guarantee survival. There must be sufficient liquid assets available to ensure that short-

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term commitments can be met. Otherwise the company could be forced into liquidation.

5.1 Current ratio

current assets
current ratio =
current liabilities

Purpose
This ratio is used to assess whether the company will be able to pay its bills over the next
few months.

It provides a comparison of an estimate of the amount of money due to be received in the

short term with an estimate of the amount of money to be paid.

Liquidity is important. Many profitable firms have:

 had to go to their shareholders to raise extra cash when liquidity has become a problem
 been wound up because they have had insufficient cash to meet their short-term liabilities.

Normally, a low ratio might indicate that a company may have problems paying its creditors.
An excessively high ratio may indicate that the management has too much money tied up in
unproductive short-term assets.

Unproductive assets could include assets such as excessive stocks or idle cash balances. ‘Too
high’ will vary according to the nature of the industry, eg whether large stocks are needed or
what the normal credit terms are for doing business with suppliers and customers.

It is difficult to know exactly what a low or high figure is for any given company. Different
industries can have very different ‘normal’ levels. In general, a ratio of 2:1 is considered to
be optimal.

This could, however, be excessive for businesses which have rapid turnover of inventory
and steady cash inflow (a supermarket being the classic example). By the same token, a
ratio of 2:1 might be inadequate for a business which has irregular cash inflows.

Because of this, many analysts use the ratio to look at trends over a number of years. A
sudden change would be cause for further investigation.

The company’s creditors may also be very interested in using the current ratio to assess a firm’s
short-term solvency.

Comments on definition
The accounts are usually only available several weeks or months after the date at which they are
completed and so short-term figures such as current asset and liabilities may be out of date by
the time the accounts are published.

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A key liquidity factor for many companies is the size of their unused overdraft limit. However, this is

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something that only a few companies choose to report. The current ratio is therefore a very crude

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indicator of a company’s ability to meet its short-term debts.

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The term ‘current liabilities’ will usually be taken to mean ‘creditors falling due within one
year’.

The figures in the statement of financial position will only include those assets and liabilities which
exist at that date.

There is no guarantee that the time span of the current assets is the same as the time span of the
current liabilities. So a company with an apparently satisfactory current ratio might still have
trouble paying a liability due tomorrow. In particular, inventories are included in the numerator, but
it may take some time to complete and sell the finished product, and then await payment.

As with all ratios, usefulness depends upon the reliability of the values shown in the accounts. In
particular, the value placed on inventories will depend upon the accounting methods used. The
current ratio may therefore be slightly misleading when used to compare different firms.

5.2 Quick ratio

current assets  inventories
quick ratio =
current liabilities

The quick ratio is also known as the acid test, or the liquidity ratio.

Purpose
This is another ratio aimed at looking at short-term liquidity.

The quick ratio considers what would happen if all creditor and debtor accounts were
settled immediately. It focuses on readily realisable cash.

The idea is that only cash and trade receivables (debtors) can be quickly turned into cash, but any
of the current liabilities could become payable within a few months.

A quick ratio of much less than one might be a sign that the company may struggle to pay
its creditors. However some companies are able to survive with a ratio of much less than
one.

This is because their customers pay in cash, but they agree and continually roll-over, say, 90-day
credit terms with their suppliers without any problems.

Again, it is often departures from the normal level of the ratio rather than the absolute level
of the ratio which will interest analysts.

And again, true liquidity is often more dependent upon agreements with bankers, than on the ratio.

Variations
Any marketable investments could be included in the numerator. However, these are often ignored
in practice (and in exams) since the information to decide on the marketability of an investment
may not be available.

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6 Efficiency ratios

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The efficiency ratios are related to the liquidity ratios.

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They give an insight into the effectiveness of the company’s management of the
components of working capital (current assets less current liabilities).

These ratios tend to be multiplied by 365 and so expressed as a period of time.

Most of the ratios below assume we are examining annual accounts and hence include a ‘  365 ‘
factor. If we are examining monthly accounts (eg internal management accounts) we should adjust
accordingly for the different day count, eg replace the ‘  365 ‘ by ‘  365 / 12 ‘ or ‘  31 ‘. Chapter 16
builds on these ratios and considers a company’s working capital management in more detail.

6.1 Inventory turnover period

The inventory turnover period is defined as:

inventories
Inventory turnover period =  365
cost of sales

Purpose
This is an attempt to assess how much inventory the company holds in relation to the scale
of the company’s operations. The ratio attempts to show how long inventory is held for on
average.

Inventory turnover period of, say, 1/12 of 365 days would suggest that the average item of
inventory is held for one month.

An inventory turnover period that is less rapid than other companies in the same industry
might indicate an inefficiently large inventory holding.

An increasing ratio might indicate that slow sales and stockpiling of unsold goods.

This ratio will vary enormously between businesses.

The inventory turnover ratios of a ship builder and a fresh fish retailer, for example, are likely to be
very different.

Inventory turnover is meaningless when considering a financial institution such as a bank.

Comments on definition
Inventories include finished goods, work-in-progress and raw materials.

One difficulty with the ratio is that the figure for inventories may be subject to seasonal
variation.

So using end-year statement of financial position values is potentially misleading. There is very
little that an analyst can do about this.

Also, the value placed on inventories will depend upon the accounting method used.

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The figure for inventories comes from the statement of financial position, and the revenue figure

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from the statement of profit or loss. Some analysts will use the latest available figure for

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inventories, others will use an average of the start and end-year figures.

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Question

Explain why it is a good idea to use an average of the start and end-year statement of financial
position figures for inventories when calculating the inventory turnover period.

Solution

Stock turnover is one of the accounting ratios that use a combination of figures from the statement
of financial position and figures from the statement of profit or loss.

The statement of financial position is a set of figures that are correct on a particular date, whereas
the statement of profit or loss covers a period of time (normally a year).

Some analysts therefore use an average figure for this item in the statement of financial position in
order to attempt to reconcile this discrepancy in timing between the two sets of accounts.

Question

Explain what the inverse of the inventory turnover period (multiplied by 365) tells the analyst.

Solution

The inverse of the inventory turnover period tells the analyst how many times the inventory is
turned over in an accounting period.

A variation on the definition of inventory turnover period is to use sales revenue as the
denominator, ie:

inventories
inventory turnover period =  365
sales revenue (turnover)

6.2 Trade receivables turnover period

trade receivables
trade receivables turnover period =  365
credit sales

Purpose
This is a measure of the average length of time taken for trade receivables to settle their
balance.

Again, it is desirable for this period to be as short as possible. It will be better for the
company’s cashflow if those owing the company money pay as quickly as possible. It can,
however, be difficult to press for speedier payment. Doing so could damage the company’s
relationship with its customers.

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Comments on definition

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This ratio indicates the average number of days credit that is extended to customers paying by

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credit.

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‘Credit sales’ refers only to that part of the total sales of the company which were transacted on
credit, excluding the sales for cash.

If the company sells goods for cash and for credit then it is important to divide the trade
receivables figure by credit sales only.

The split between sales for credit and sales for cash is not often published.

If you are analysing a real set of financial statements then many companies will have sales
that are generally either all on credit or all for cash (in which case the ratio would not apply).

Where it is realistic to assume that all sales are on credit, the ratio can be simplified to:

trade receivables
trade receivables turnover period = × 365
sales

If sales cannot be broken down then the ratio will be distorted.

However if the proportion of cash versus credit sales remains constant from year to year, the figures
for different years can be compared, even if there is a theoretical distortion.

6.3 Trade payables turnover period

A similar ratio can be used to assess trade payables:

trade payables
trade payables turnover period =  365
credit purchases

This ratio indicates the average number of days credit that a company has from its suppliers. A
high ratio indicates that the company is taking a long time to pay its bills. This may be because it
has been able to obtain a long credit period from its suppliers, which will be of benefit to its
cashflow.

Comments on definition
It can be difficult to calculate this ratio in the real world because companies do not disclose
their purchases figure.

In some cases it will be reasonable to assume that all purchases involve some form of credit and
so use total purchases (ie inventory used plus increase in stock over the year) instead.

It is possible to obtain a crude estimate of the period by using cost of sales as a surrogate
for purchases.

Another commonly used variation is to use sales revenue as the denominator. This results in sales
revenue potentially being used as the denominator in each of the three efficiency ratios, even
though it is not the ideal choice for any of the three when other figures are available.

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Question

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(i) Calculate the following for Cover-up Ltd:

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(a) net asset value per share
(b) current ratio
(c) quick ratio
(d) inventory turnover period
(e) profit margin
(f) return on capital employed
(g) trade receivables turnover period (assume 80% of the sales are for credit)
(h) trade payables turnover period (assume all purchases are for credit).

(ii) Interpret each of the figures for each ratio.

Solution

(i)(a) net asset value per share:

70,000  20,000
NAV per share (using £000) = = 31p
160,000

116,000
(i)(b) current ratio = = 2.8
41,000

116,000  42,000
(i)(c) quick ratio = = 1.8
41,000

42,000
(i)(d) inventory turnover period =  365 = 116 days
132,000

35,000
(i)(e) profit margin = = 14%
250,000

35,000
(i)(f) return on capital employed =  20.6%
170,000

60,000
(i)(g) trade receivables turnover period =  365 = 110 days
0.8  250,000

32,000
(i)(h) trade payables turnover period =  365 = 123 days
95,000

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(ii)(a) This could be compared with the share price, to determine whether investment in Cover-up

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seems good value.

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(ii)(b) The current ratio gives an estimate of the company’s liquidity. It compares money due to

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be received soon with money due to be paid soon. The figure of 2.8 indicates that Cover-up
is able to cover its short-term debt.

(ii)(c) The quick ratio also gives a measure of liquidity. It uses only the cash or near-cash items in
the statement of financial position (as stocks may take a while to sell). A ratio of 1.8
indicates that the company is solvent in the short term.

(ii)(d) The inventory turnover period shows how quickly the company is selling its output. The
figure indicates that the company is turning over its inventory every 116 days
ie approximately every four months.

(ii)(e) The profit margin looks at profits per unit of sales. The figure of 14% can be compared with
other firms in the same industry.

(ii)(f) Return on capital employed represents how efficiently the firm’s capital is being used to
make profits. It can be compared with the opportunity cost of the capital, and also with
other firms in the same industry. A ROCE of 20.6% would seem to cover the cost of capital.

(ii)(g) The trade receivables turnover period indicates the number of days credit that is extended
to customers who request payment on credit. The ratio of 110 days is quite high, indicating
that the company is not operating its credit control function effectively.

(ii)(h) The trade payables turnover period is also quite high at 123 days. Cover-up may have been
able to negotiate good credit terms from its suppliers.

A typical long (20-mark) examination question might give accounting information for two
companies or for one company for two years and require an evaluation of the relative
performance of the company (or companies) with the help of ratio analysis. Remember to
comment on the ratios as well as calculate them!

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Chapter 14 Summary

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Ratios involving debt

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profit on ordinary activities before interest and taxation
Interest cover 
annual interest payments due on that issue of loan stock + all prior loan stock

Interest priority percentages show the slice of profit on ordinary activities before interest
and tax which covers the annual interest payments due on each issue of loan capital.

total assets less current liabilities less intangible assets

Asset cover =
loan capital plus prior ranking debt

Asset priority percentages show the slice of total assets less current liabilities less intangible
assets which is available to cover the nominal value of each issue of loan capital.

borrowings borrowings
Asset gearing = or
equity borrowings + equity

shareholders' equity  intangibles

Shareholders' equity ratio =
total assets  current liabilities  intangibles

interest on borrowings
Income gearing =
profit on ordinary activities before interest and tax

Ratios involving share information

earnings on ordinary activities
Earnings per share =
number of issued ordinary shares

market price of an ordinary share

Price earnings ratio =
earnings per share

dividends per share

Dividend yield =
market price of an ordinary share

earnings per share

Dividend cover =
dividends per share

dividends per share 1

Payout ratio = =
earnings per share dividend cover

ordinary shareholders' equity  intangible assets

Net asset value per share =
number of issued ordinary shares

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Profitability ratios

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profit before tax and interest

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Return on capital employed =

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share capital + reserves + long-term debt

revenue (turnover)
Asset utilisation ratio =
share capital + reserves + long-term debt

profit before tax and interest

Profit margin =
revenue (turnover)

gross profit
Gross profit margin =
revenue (turnover)

Liquidity ratios
current assets
Current ratio =
current liabilities

current assets  inventories

Quick ratio =
current liabilities

Efficiency ratios
inventories inventories
Inventory turnover period = × 365 or × 365
cost of sales revenue

trade receivables
Trade receivables turnover period =  365
creditsales

payables
Payables turnover period =  365
credit purchases

For monthly accounts, replace ‘×365’ by ‘×365/12’.

© IFE: 2019 Examinations The Actuarial Education Company