RATIO ANALYSIS DELVING DEEPER INTO FINANCIAL STATEMENT ANALYSIS

an examination of accounting data through the comparison of two figures. Ratio analysis: an examination of accounting data through the comparison of two figures. One piece of financial information might be misleading.

1. THE CURRENT RATIO Indicates short term liquidity position by comparing current assets and current liabilities. refers to how easily an asset can be turned into cash – the easier, the more liquid. Liquidity: refers to how easily an asset can be turned into cash – the easier, the more liquid. Poor liquidity can lead to liquidation. Liquidity can be improved by… decreasing stock levels speeding up the collection of receivables (debtors) slowing down payments to payables (creditors)

Formula: Working out and answer: Current Ratio Formula: current assets : current liabilities Answer expressed as “x : 1”.

1.5 – 2 : 1 A current ratio of between 1.5 – 2 : 1 is considered the ‘ideal’ ratio. 1 : 1 A low current ratio (less than 1 : 1) suggests business not well placed to pay its debts. W.r.t the current ratio, is bigger necessarily better? NO!!! 2 : 1opportunity cost. High current ratio (above 2 : 1) represents a significant opportunity cost. Current assets do not make the business lots of money, non-current assets (the money makers!) do.

2. GEARING RATIO compares the amount of capital raised by selling shares with the amount raised through long-term loans. Gearing: compares the amount of capital raised by selling shares with the amount raised through long-term loans. Focuses on long term financial stability of a business. High level of borrowing (gearing) = high risk to a business. –payment of interest and repayment of debts are not "optional" as dividends are. Cannot pay dividends from a loss Must pay back long-term loans with interest even if a loss is made.

Formula for calculating gearing is… non-current liabilities x 100 total equity + non-current liabilities 1 The answer is expressed as a percentage.

Formula: Working out and answer: Work out the gearing ratio for Pick ‘n Pay for the years 2013 and 2014…

> 50% = “highly geared”. Gearing ratio > 50% = “highly geared”. Risk of defaulting on loans during periods of low profit Heavily affected by changing interest rates. < 25% = “low gearing”. Gearing ratio < 25% = “low gearing”. Consider borrowing more money to grow the company. Only if proposed investment gains > interest on the borrowed money. between 25% ‐ 50% = “normal”. Gearing ratio between 25% ‐ 50% = “normal”.

When is a high gearing acceptable? When long ‐ term debt is relatively cheap due to low interest rates. –In this case, increase long term loans and reduce shareholders – less profits given through dividends A well-established business producing reliable cash flows.

Arguments for reducing and raising gearing

3. RETURN ON CAPITAL EMPLOYED (“ROCE”) Shows what returns (profits) business has made on the resources available to it. ROCE is calculated using this formula… operating profit x 100 total equity + non-current liabilities 1 total equity + non-current liabilities 1 The answer is expressed as a percentage.

Formula: Working out and answer: Work out the ROCE for Pick ‘n Pay for the years 2013 and 2014…

With ROCE, the higher the better. To improve its ROCE a business can try to do two things… increase operating profit Improve the top line (i.e. increase operating profit) without a corresponding increase in capital employed reduce the value of total equity and non-current liabilities Maintain operating profit but reduce the value of total equity and non-current liabilities.

4. DIVIDEND PER SHARE shows the value of the total dividend per issued share for the financial year. Dividend / share: shows the value of the total dividend per issued share for the financial year. The formula for dividend per share is… total dividends total dividends number of issued ordinary shares cents The answer is expressed in cents/share

Formula: Working out and answer: Let’s assume that Pick ‘n Pay paid out the following dividends… 2013: R460, : R240,000 In both years, there were 500,000 shares issued Work out the dividend per share for Pick ‘n Pay for the years 2013 and 2014…

The dividend/share ratio lacks context. We don’t know, for example… Price of the shares – i.e. good/bad return on investment? How much profit for the year was distributed as a dividend.

5. DIVIDEND YIELD expresses dividend / share as a percentage of the current market price. Dividend yield: expresses dividend / share as a percentage of the current market price. Indicates rate of return on investment. The formula for dividend yield is… ordinary share dividend (in cents) x 100 ordinary share dividend (in cents) x 100 current market price (in cents) 1 current market price (in cents) 1 The answer is expressed as a percentage.

Formula: Working out and answer: To illustrate the calculation, consider this information… The average share price for 1 ordinary share of the company on the Stock Exchange during those financial years was 1415c (2013) and 1067c (2014) Work out the dividend yield for Pick ‘n Pay for the years 2013 and 2014…

What is a good dividend yield? Compare with current interest rates that you could have received from saving your money in a bank account. Should be significantly higher to account for higher risk of buying shares.