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Accounting Analysis
Accounting Analysis
TABLE OF CONTENTS
9.1 Purpose of Financial Statements..................... 164 9.2 Balance Sheet........................................... 164 9.2.1 Introduction ...................................................... 164 9.2.2 Accounting Equation ......................................... 164 9.2.3 Format............................................................... 166 9.2.4 Fixed Assets ...................................................... 166 9.2.5 Current Assets................................................... 168 9.2.6 Current Liabilities .............................................. 168 9.2.7 Accruals and Prepayments................................ 168 9.2.8 Capital Employed............................................... 169 9.2.9 Long-Term Liabilities ........................................ 169 9.2.10 Provisions for Liabilities and Charges ............. 169 9.2.11 Called-Up Share Capital................................... 169 9.2.12 Share Premium Account Reserve.................... 169 9.2.13 Revaluation Reserve........................................ 171 9.2.14 Other Reserves................................................ 171 9.2.15 Profit and Loss Account Reserve .................... 171 9.2.16 Minority Interests ............................................ 171 9.3 Profit and Loss Account Statement .................. 172 9.3.1 Introduction ...................................................... 172 9.3.2 Format and Terminology ................................... 172 9.3.3 Capital and Revenue Expenditure ...................... 174 9.4 Cash Flow Statement ................................... 175 9.4.1 Introduction....................................................... 175 9.4.2 Scope ................................................................ 175 9.4.3 Cash Definition .................................................. 176 9.4.4 Format and Terminology ................................... 176 9.5 Analysis of Accounts.................................... 177 9.5.1 Introduction....................................................... 177 9.5.2 Profitability Ratios............................................. 178 9.5.3 Liquidity Ratios ................................................. 179 9.5.4 Financial Gearing Ratios .................................... 180 9.5.5 Investors Ratios ............................................... 182 9.5.6 Shareholder Value Added (SVA)........................ 185 9.5.7 Enterprise Value to EBITDA ............................... 186
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Learning Objectives
Company Profit and Loss Accounts
Know the purpose of profit and loss accounts and their basic contents.
What is a profit and loss account? It usually covers a companys activities for one year. Why is it required? How does it benefit the company? Advantages to customers and shareholders. Turnover. Investment and other income. Depreciation. Interest. Dividends. Taxation. Exceptional items. Extraordinary items. Operating profit. Retained earnings. Minority interests.
What is a balance sheet? Position as at a point in time. Why is it required? How does it benefit the company? Advantages to customers and shareholders. Prepayments. Plant and machinery. Cash. Investments. Debtors. Stock and work-in-progress. Intangibles. Creditors.
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Capital reserves. Goodwill. Share capital. Share premium account.
Understand the following. Fixed assets. Intangible assets. Current liabilities. Current assets. Capital employed (Total assets Current liabilities). Net asset values.
Assets less preference capital less liabilities divided by the number of shares. Valuation, historical cost and depreciation. May be tested by simple calculations. Effect of stock splits. Problems of fluctuating values. Effect of economic cycles.
FRS 1. What is a cash flow statement? When is it required? Why is it required? Covers the period of the balance sheet. Taxation. Capital expenditure. Financing. Acquisitions and disposals. Equity dividends paid. Return on investment and servicing of finance. Management of liquid resources.
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Ratios
Understand the purpose of ratio analysis, its uses and limitations.
Used by the Board, suppliers, competitors, employees, investors. Part of an investment decision. Indication of financial efficiency. Compare to
Sector averages. Market averages. Other similar companies. Past in-house figures. Year-on-year performance.
Establish gearing position. Liquidity. Profitability. Risk if different calculation methods relied upon. Risk if figures restated.
Understand the essential basic details and their investment significance in the following areas. Gearing. Earnings per share. Net dividend yield. Dividend cover. Price/earnings ratio. Interest cover. Current ratio. Quick ratio. Return on capital employed (ROCE). EV/EBITDA. Shareholder value added (SVA).
And the benefits of EV/EBITDA and SVA over accounting ratios. Be able to calculate gearing, EPS, P/E ratio, net dividend yield, dividend cover, interest cover, current ratio, quick ratio and ROCE.
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As we can see, the accounting equation holds the balance sheet balances.
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The four categories we have outlined are as follows.
1. Assets
These represent resources owned or controlled by the company and available for its use, such as stocks of goods for sale or production equipment. These can be sub-categorised under two headings, Fixed Assets and Current Assets.
Fixed Assets
Assets acquired for continued use in the business to earn profit, not for resale. Examples of such items would include office and production buildings and equipment. Clearly these are intended for long-term use, not simply to be sold on at a profit.
Current Assets
Assets acquired for conversion to cash during the ordinary course of business. Examples of such assets would include stocks of goods available for sale to customers, or customers account balances which will be settled for cash. By convention, assets which are to be converted into cash within 12 months are deemed to be current.
2. Liabilities
Liabilities represent amounts owed by the company to outside suppliers and lenders. These too are sub-categorised as Creditors: amounts falling due within one year. These are also known as current liabilities. Creditors: amounts falling due after more than one year. These are also known as long-term liabilities. The purpose of the above classification is to provide a clear indication of the timescales for settlement.
3. Share Capital
This is money invested in the company by shareholders, i.e. money subscribed for shares.
4. Reserves
These generally represent profits earned and retained by the company since it began trading, though there may be other types of reserves as we will see later. This is only a broad outline and in reality the balance sheet will contain much more detail. You are required to know this full detail for the exam.
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9.2.3 Format
The general format for a balance sheet is prescribed in the Companies Acts and can be illustrated by the following example.
2003 000
2002 000
Current assets Stock Debtors Investments Cash Current liabilities Net current assets Total assets less current liabilities Long-term liabilities Provisions for liabilities and charges Net Assets Capital and reserves Called-up share capital Share premium account reserve Revaluation reserve Other reserves Profit and loss account reserve
Total shareholders funds Minority interests
9.2.5 19,420 27,882 1,487 3,923 9.2.6 9.2.8 9.2.9 9.2.10 52,712 (48,817) 3,895 24,607 (3,695) (1,484) 19,428 9.2.11 9.2.12 9.2.13 9.2.14 9.2.15 9.2.16 1,743 2,237 4,687 1,204 8,557 18,428 1,000 19,428
You will notice that the balance sheet is shown for both this year end (31 December 2003) and the previous year end (31 December 2002) for comparison purposes. The section numbers referred to above (known as Notes to the Accounts) would normally provide further detailed analysis, but in this table they are being used to provide additional explanations of the terminology.
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The Companies Act requires that all fixed assets that have limited useful economic lives must be depreciated, but what is depreciation?
Example
A company buys some production machinery at a cost of 60,000. It expects, from previous experience, that it will last five years, after which time it will be sold for 5,000. It will therefore cost the company 55,000 (60,000 cost less 5,000 expected sale proceeds) to use the equipment over these five years. Applying the matching concept, this 55,000 cost should be spread over the five years, i.e. a depreciation expense of 11,000 charged against the profit each year. Depreciation is the method by which the cost of using the asset is matched against its related benefit. On the balance sheet fixed assets are usually stated at net book value (NBV), i.e. cost less the accumulated depreciation provision. Thus, at the end of each of the next five years the fixed asset will be valued in the balance sheet as follows.
Year 1 000
Cost Accumulated depreciation provision Net book value 60 (11) 49
Year 2 000
60 (22) 38
Year 3 000
60 (33) 27
Year 4 000
60 (44) 16
Year 5 000
60 (55) 5
As we can see, the balance sheet net book value of the equipment falls by 11,000 each year (as the amount is charged as an expense depreciation), until in Year 5 it has dropped to the estimated sales proceeds of 5,000. Depreciation is an example of the accounting principle known as accrual or matching. Note that the depreciation charge in the profit and loss account, of 11,000 each year, is just an accounting entry and does not appear in the cash flow statement.
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Plant and machinery. Motor vehicles. Fixtures and fittings.
Investments
These represent long-term ownership of shares in other companies and are usually reported in the balance sheet at historical cost. Additional reporting regulations apply to significant levels of shareholdings that have caused the investments to be classified as either a subsidiary (50%+) or an associate (20%-50%).
Stock goods held available for sale. Within this category, stocks can be further re-classified into raw materials, work-in-progress (WIP) and finished goods. Debtors amounts owed to the company, perhaps as a result of selling goods on credit (this will include prepayments, see Section 9.2.7). Debtors will also include unpaid share capital, as well as debtors that are receivable in more than 12 months. Investments shares held in the short term with the intention of reselling, e.g. short-term speculative investments. Cash in hand and at bank.
In valuing current assets the fundamental accounting principle of prudence is applied, in that they are valued at the lower of
Costs; or Net realisable value (NRV), i.e. estimated selling price less any cost incurred in order to sell.
Accruals
An accrual is an amount due in respect of goods and services used during the year but not yet invoiced. Since the amount is owed even though it has not yet been invoiced for, it has to be shown as part of the liabilities. Accruals are therefore shown as part of current liabilities.
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Prepayments
Prepayments are amounts paid before the balance sheet date which relate to the period after that date. Since we have paid the money over but not yet received the benefit due from the expenditure, we still have an asset at the balance sheet date. Prepayments are therefore shown as part of debtors, within current assets.
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Example
A company could raise 20,000 by issuing 5,000 new 1 ordinary shares at an issue price of 4 each. This results in a premium of 3 per share (issue price of 4, less nominal value of 1). Under the Companies Act, the company must record the issue of these shares by increasing the called-up share capital by only the nominal value of the shares issued, i.e. 5,000. The premium of 15,000 must be added to the share premium account reserve. The impact on the accounting equation is
000 Impact on Net Assets Cash +20 +20 Impact on Shareholders Funds Share capital Share premium account reserve +5 +15 +20
Having been created, the share premium account reserve can only subsequently be reduced in five circumstances without a courts permission. 1. To issue bonus shares. Bonus shares are issued by a company when it feels that the share price has gone too high. A bonus issue, like a rights issue, is made to the existing shareholders and gives them a number of free shares proportionate to their existing holding. For example, a 1 for 2 bonus issue, with the cash bonus share price at 9, would give the owner of two shares one new share.
*
2. 3. 4. 5.
Any surplus over the value of the share premium would have to go to other reserves. Note that it is not just the share premium account reserve that can be used to finance a bonus issue any reserve will do.
To write off preliminary expenses of forming a company. To write off expenses of issue of shares or debentures. To charge the premium on repayment on debentures. To charge the discount on issue of debentures. The share premium account reserve can never be reduced to pay dividends to the shareholders, as it is one of the companys non-distributable reserves.
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However, it only owns 80% of ABC Ltds net assets, with the other 20% being owned by the minority interest. XYZ plc recognises this fact by analysing the total shareholder financing into two separate entities group shareholders funds and minority interest. The minority interest shows how much of the net assets belong to the minority shareholders in ABC Ltd.
XYZ plc Group Profit and Loss Account for the Year Ended 31 December 2003
Notes Turnover Cost of sales Gross profit Distribution costs Administrative expenses Other operating income Operating profit Exceptional items
Income from fixed asset investments Interest receivable and similar income Interest payable and similar charges
2003 000
135,761 (85,604) 50,157 (22,961) (19,620) 100 7,676 (270) 7,406 100 30
2002 000
141,013 (91,011) 50,002 (21,636) (16,752) 200 11,814 (1,296) 10,518 100 161 (3,521) 7,258 (2,000) 5,258 (20) 5,238 (6,527) (1,289) 9.06p
Profit on ordinary activities before taxation Tax on profit on ordinary activities Profit on ordinary activities after taxation Minority interests Extraordinary items Profit/(loss) for the financial year Dividends paid and proposed Retained profit/(loss) for the financial year Earnings per ordinary share
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Terminology
In accordance with the accruals or matching principle, income and expenses are recognised in the profit and loss account statement when earned regardless of when paid. Any difference between the recognition of these items and the corresponding cash flow will be reflected in a balance sheet debtor or creditor.
Turnover
The turnover or sales figure represents the total value of goods or services provided to customers during the accounting period whether they have been paid for or not, in accordance with the accruals principle.
2 3
Cost of Sales
The cost of sales represents the total cost to the business of buying or making the actual items sold.
Gross Profit
Gross profit is the difference between the value of the sales and the value of the cost of goods sold. One measure frequently used in determining the performance of the business is to consider its gross profit margin, which can be calculated as follows.
Clearly, the higher the margin for a particular level of operations, the higher the profit. However, this does not mean that low margins result in low profits. A number of businesses generate very healthy profits through selling very large numbers of items (achieving correspondingly large turnover) at low margins.
These costs include all other expenses incurred in generating the turnover for the period by way of administrative involvement and delivery/distribution.
Exceptional Items
Exceptional items are unusually large items of income or expense arising during the year. They are separately classified as exceptional items to highlight their one-off nature. An exceptional item
Is material.
Derives from events or transactions that fall within the ordinary activities of the business. Needs to be separately disclosed by virtue of its size or incidence if the financial statements are to give a true and fair view.
Interest Payable
In common with most other business expenses, any interest payable goes to reduce the companys profit before tax and hence taxable profit by the gross amount payable. For example, if a company has in issue 100,000 of 10% loan stock, then the interest charge in its accounts each year will be 10,000.
UK companies pay corporation tax on their taxable profits. The element of the total tax charge shown here is the tax on the ordinary activities of the business, excluding any extraordinary items.
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Minority Interests
Minority interests arise in a similar way as in the balance sheet. Where XYZ plc owns 80% of ABC Ltd, it will include all of ABC Ltds profit after tax in its own consolidated accounts on the basis that it controls all of ABC Ltds operations. However, it does not own all of that profit, with 20% belonging to the minority interests. The 20% of ABC Ltds profit after tax that belongs to the minority interests is deducted from the profit after tax, leaving the amount of profit attributable to the shareholders in XYZ plc.
Extraordinary Item
An extraordinary item is a large one-off item, similar to an exceptional item, that requires separate disclosure in order to ensure that the truth in the accounts (the trends, ratios, etc.) is not distorted. An extraordinary item Is material. Possesses a high degree of abnormality which arises from events or transactions that fall outside the ordinary activities of the business.
Is not expected to recur.
Note that this definition is exceedingly restrictive and it is highly unusual that a profit and loss account statement will have an extraordinary item shown. For that reason our illustrative accounts have shown the positioning of the item in the accounts but given a nil amount. In such a case, a company would dispense with the line altogether. Tax is payable on extraordinary items. The figure that would be shown on the face of the profit and loss account would be a net of tax figure.
Dividends
These represent the cash dividends paid out or proposed to be paid out to shareholders net of starting rate income tax. Most of the time companies pay out dividends which are less than their profits after tax, i.e. the dividend is being paid from this years profits and is said to be covered. However, it is not essential for a dividend to be covered. It may be financed from previously retained profits which, as we have seen, are accumulated in the balance sheet profit and loss account reserve balance. XYZ plcs dividend for 2002 is uncovered in our example. In most cases, UK companies pay dividends in two stages.
Interim dividend paid this is paid out during the year based on the half years performance. Final dividend proposed this is paid to shareholders following the approval of the year end accounts at the AGM.
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Revenue Expenditure
Revenue expenditure is expenditure incurred in Acquiring assets to be sold for conversion into cash, e.g. stock. Manufacturing, selling, distributing goods, e.g. wages. Day-to-day administrative expenses, e.g. electricity, telephone. Maintenance of fixed assets, e.g. repairs. Revenue expenditure is charged directly against profits for the period to which it relates.
The scope, i.e. who must prepare cash flow statements. Cash, i.e. what is and what is not cash. The format to be adopted in cash flow statements.
9.4.2 Scope
FRS 1 applies to all financial statements intended to give a true and fair view, excluding
Small companies where a small company is defined as one which fulfils two of the following three criteria.
Not more than 5.6m Not more than 2.8m Not more than 50
Subsidiaries of parents, where 90% or more of the voting rights are controlled within the group, who file publicly available versions of their consolidated financial statements. Mutual life assurance companies. Pension Funds. Open-ended investment funds.
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Disclosure
The cash flow statement must show a total for each class. Note that the cash flow does not include depreciation as that is an accounting entry in the profit and loss account. The cash flow statement must cover the period between the companys balance sheet dates, i.e. the same period as the profit and loss account.
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Format
The illustration below shows how a cash flow statement should appear in the account of XYZ plc.
XYZ plc Group Cash Flow Statement for the Year Ended 31 December 2003
2003 000 Net cash inflow from operating activities Returns on investments and servicing of finance Interest received Dividends received/(paid) Interest paid 2002 000
11,766 261 1,021 (3,521) (2,239) (3,110) (662) (3,750) 2,235 (2,177) (10,089) (5,545) (421) 532 111 20,682 (17,892) (131) 6,705 9,364 (1,919)
Taxation Capital expenditure Payments to acquire intangible assets Payments to acquire tangible assets Receipts from sales of tangible fixed assets
Acquisitions and disposals Purchase of subsidiary undertakings Equity dividends paid Management of liquid resources Purchase of Treasury bills Sale of Treasury bills Financing Issue of ordinary share capital Repurchase of debenture loan Expenses paid in connection with share issues Loans taken out
Decrease in cash
(16,743)
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The financial statements are primarily prepared for company shareholders. However, they may have several other users, such as the Board, suppliers, competitors and employees. Each of these groups will use the accounts to provide an indication of the Returns they are receiving. Risks they are facing. A number of fairly standard ratios have been developed to assist with this process, and these can be grouped under four headings.
Profitability Ratios
Ratios that assess the trading or operating performance of the company, i.e. levels of trading profits generated, and the productivity of trading assets.
Liquidity Ratios
Ratios that assess the risk that the company may be unable to pay its creditors as they fall due with cash and assets generated from trading.
Investors Ratios
Ratios that assess the returns to the providers of finance, who may be either shareholders or lenders. Ratios are rarely useful when viewed in isolation. However, they can be used to assess a company by comparison to sector averages, market averages or other similar companies. A companys progress can also be measured by comparing ratios with past in-house figures (for internal assessment) or previous published accounts to give a picture of year-on-year performance. However, as there are no official rules concerning ratio calculation, there is a risk that, if two ratios from different sources are being compared, slightly different calculation methods may have been used, giving rise to some distortion in the comparison. Also, changes in accounting policies and restatement of prior year figures may lead to changes in ratios, which are not necessarily indicative of underlying performance. Throughout our review of ratios, we will draw examples from the balance sheet and profit and loss account data for Illustration plc, which can be found at the end of this chapter.
Basic Calculation
The return on capital employed is calculated as follows.
Profit
This profit figure can be viewed as operating profit, i.e. the profits that management have generated from the resources they have available. It is specifically before interest payable since this will clearly be dependent on the financing of the business the larger the loan, the larger the interest payable.
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In the examination, you may be given the profit before tax figure and the interest payable and be asked to calculate operating profit, as follows.
Capital Employed
Capital employed could be viewed from the financing side as
ROCE = 17.3%
Current Ratio
This ratio is calculated from using the companys year-end position. The ratio calculates whether assets recoverable within one year are sufficient to cover liabilities falling due within that year.
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Quick ratio =
Considerations
We consider only interest-bearing debt since this is what is causing the risk to profit before tax, hence ultimately the profits after tax and amounts available for payment as dividends to our shareholders.
Debt to equity =
Debt to equity = 13.5% Equity shareholders funds are given by the equity share capital and all of the reserves.
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Debt (as above) Cash and current asset investments 100% Equity shareholders' funds
Considerations
We should consider the ability of the company to use the cash it has available to repay debt.
Interest Cover
Basic Calculation
This ratio considers gearing from the viewpoint of the profit and loss account statement and measures the capacity of the firm to meet its interest obligations.
Considerations
The interest cover provides a measure of the ability of the company to pay the fixed interest on borrowings from profits for the year. Clearly, the higher the level of interest cover, the less risk there is to either shareholders or lenders. However, there is no optimal level.
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Earnings are defined as consolidated profit after Tax. Minority interests. Extraordinary items. Preference dividends. Earnings therefore represent the remaining profits available to the ordinary shareholders.
EPS = 12.3p
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Analysis Points
The significance of a P/E ratio can only be judged in relation to the ratios of other companies in the same type of business. If the median P/E ratio for an industry sector was 8, a ratio of 12 for a particular company would suggest that the shares of that company were in great demand, possibly because a rapid growth of earnings was expected. Note that growth (and therefore a high P/E) can be generated by retaining a large proportion of earnings and paying low dividends and reinvesting the earnings to grow the business. A low ratio, say 4 for example, would indicate a company not greatly favoured by investors which probably has poor growth prospects. Alternatively, a high P/E ratio might indicate that a company is overpriced (overvalued), and a low P/E ratio might indicate that a company is underpriced (undervalued).
Net dividend per share 100% Current market price per share
Analysis Points
A high dividend yield suggests that the company is paying reasonable levels of income. However, a high yield may be due, in part, to a relatively low share price, indicating that the company has low growth prospects. Investors who believe that the company has good growth prospects would buy the share, driving the price up and reducing the yield. Therefore, it is also true that companies with high P/E ratios tend to have low dividend yields, and vice versa.
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Dividend Cover
Dividend cover is used to assess the likelihood of the existing dividend being maintained. The dividend cover is calculated as follows.
Analysis Points
An unusually high dividend cover implies that the company is retaining the majority of its earnings, presumably with the intention of reinvesting to generate growth. A company may choose to pay a larger dividend than that years earnings (in which case dividend cover will be <1). Where this occurs, the company is drawing on past reserves and is said to be paying an uncovered dividend.
= 1.76
Considerations
Net assets attributable to ordinary shareholders should exclude the book value of any preference share capital the company has in issue. The net asset value could show an unrealistic figure if a strict policy of historical cost accounting has been applied. The shareholders may be more interested in asset values if the company adopts a revaluation policy. Net asset value will also be reduced proportionately if the company performs a stock split or capitalisation issue, as the number of shares will increase with no corresponding change in net assets.
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Other factors that would have an impact on asset valuation include Depreciation method influencing book value of assets. Assets with volatile values, e.g. property. Effect of economic cycles. Asset-based valuation will be appropriate for investment trusts, property companies and capital-based industries where a large proportion of the value of the business is tied up in the value of assets owned. It will be less useful for service industries with a large amount of intangibles, which are not represented on the balance sheet.
Definition
SVA is defined as
Formula to Learn: SVA = Net operating profit after tax - Cost of capital
Cost of Capital
Formula to Learn: Cost of capital = Value of the capital invested Weighted average cost of capital
That is, the after-tax cost to the company of servicing its finance based on the required returns of equity and debt investors and the market values of these sources of finance. If the SVA is a positive value, then value is being added by the management of the company. Although you are required to understand the basic details of SVA, you will not be asked to calculate this ratio in your exam.
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Enterprise Value
Enterprise value is the total value of all the ordinary shareholders equity, preference shares and net debt.
Formula to Learn:
Enterprise value = Market value of ordinary shares + Market value of preference shares + Market value of debt - Cash and investments EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) Earnings Add: corporation taxes Add: net interest expense Add: depreciation and amortisation EBITDA x x x x x
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Illustration Plc
Balance Sheet as at 31 December
000 000
Fixed assets Intangible Tangible Investments Current assets Stock Debtors Investments Cash Current liabilities Trade creditors Tax Others Net Current Assets Total assets less current liabilities Long-term liabilities Secured loans Unsecured loans
Net Assets
3,926 18,731 842 23,499 19,420 36,307 926 1,000 57,653 35,781 1,625 6,260 43,666 13,987 37,486 2,073 2,372 (4,445) 33,041 18,762 2,455 2,681 9,143 33,041
Share Capital 1 (NV) ordinary shares Reserves Share premium account reserve Revaluation reserve Profit and loss account reserve
Shareholders Funds
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Turnover Cost of sales Gross profit Distribution costs Administration costs Operating profit Interest paid Profit before tax Tax Profit after tax Dividends Retained profit Earnings per share Dividend per share
135,761 (83,604) 52,157 (22,961) (22,712) 6,484 (2,811) 3,673 (1,372) 2,301 (1,204) 1,097 12.3p 6.42p
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