CHAPTER

INTERPRETETION OF ACCOUNTS

Analysis of company accounts is useful to appraise companies for investment

purposes and to 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.

Measuring risk associated with loan capital

1) In general, if a company has a high level of operating profit in relation to the
annual interest due on its loan capital, the loan interest should be secure.
2) 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.
3) 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.
4) To assess this, investors in loan capital can look at the ratio of the available
assets to the amount of the loan stock.

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.
The two main ratios associated with loan capital are called the interest cover and the asset cover.

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
→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. (mcq)

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.

(Important limitation)
 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.

1.2 Asset cover

→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.

→The assumption is that assets other than intangibles will be converted into
cash at their book values, while intangible items are likely to be worthless on
winding up.

→Current liabilities are assumed to be repaid before the debtholders even

though they may rank below the loan capital.

(LIMITATION)
The main limitation of asset cover is that the current value shown in the
statements of financial position for assets might not reflect their realisable
market value if the company is wound up. The going concern concept means
that there is no particular need to carry assets at their market values.

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.

Asset gearing
Asset gearing is also known as ‘capital gearing’. There are two commonly used definitions of asset
gearing, either:

→The term ‘borrowings will usually include all forms of long-term loan capital.
→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.
→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
→A company whose gearing reached 40% using the second of the above
formulae would normally be regarded as high risk.

[EXTRA RATIO]
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.

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

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.

2) Ratios involving share information

2.1 Earnings per share

→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.
→Businesses whose shares are publicly traded are required to disclose two
versions of earnings per share.
- Basic earnings per share
- Diluted 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.
→ simply divide net profit after tax by total no of o/s shares (only equity) for
calculation of basic earnings per share.

Diluted earnings per share

→The basic EPS takes into account only those equity shares in issue that were
outstanding during the period.
→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.
→
2.2 Price earnings ratio

→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
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.

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

Uses of dividend cover
→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.

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

Introduction to other accounting ratios

Profitability ratios
→The profitability ratios are used to check that the company is generating an
acceptable return for its owners.

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.
[IMPORTAT]
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.

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.

Operating profit is sometimes called trading profit. [MCQ]

 Liquidity ratios
While it is important for a business to be profitable, profit is not sufficient on
its own to guarantee survival. There must be sufficient liquid assets available to
ensure that short term commitments can be met. Otherwise, the company
could be forced into liquidation.

Current ratio

Purpose
→This ratio is used to assess whether the company will be able to pay its bills
over the next few months.
→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.
→. Different industries can have very different ‘normal’ levels. In general, a
ratio of 2:1 is considered to be optimal.
→The company’s creditors may also be very interested in using the current
ratio to assess a firm’s short-term solvency.

→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.
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
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.

Efficiency ratios
→The efficiency ratios are related to the liquidity ratios.
→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.

Inventory turnover period

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.
→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.

Trade receivables turnover period

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.

Trade payables turnover period

→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.
→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.

SUMMARY
DO ALL THE QUESTIONS OF THE CHAPTER FROM CB1 BOOK
DO ALL THE RATIOS PRIORITY PERCENTAGES QUESTIONS
DO ALL THE REASONING QUESTIONS

SEE PAGE NUMBER 35