ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 20: Performance measurement

2.6 Investor ratios

Investor ratios are relevant to equity shareholders looking to earn dividends and/or

capital growth from their investment in a company’s shares. The ratios are also of

interest to other investors, who may be considering whether to buy shares in the

company. Four widely-used ratios are:

 earnings per share

 the P/E ratio

 dividend yield

 dividend cover.

Earnings per share (EPS)

The calculation of EPS was described in an earlier chapter. Investors hope for an

increase in EPS (’earnings growth’) from one year to the next

Price earnings ratio (P/E)

This ratio measures the share price as a multiple of EPS. Investors use the P/E ratio

to make comparisons of share prices between companies, and to assess whether a

company’s shares seem under-priced or over-priced relative to share prices of other

companies.

P/E ratio =

Current market share price

EPS

A high P/E indicates the stock market’s belief that the company will grow and

hence the share price has been set at a high level relative to its current earnings.

However, a company may also have a high P/E ratio when its earnings have

collapsed, but investors expect a recovery in earnings in the next year or so. The

expectation of a recovery means that investors are willing to pay a high P/E

multiple to buy the shares.

Note, however, that the P/E ratio is calculated from the current market price but the

annual EPS in the most recent financial statements. Since the earnings figure may be

‘out of date’, the P/E ratio may be misleading.

Dividend yield

The dividend yield measures the annual cash return (dividends) that equity

shareholders are receiving on their investment.

100%

price share market Current

credit

taxshare

per

dividend Net

=yield Dividend ×

Where there is no system of tax credits on dividend payments, the figure for

dividends is simply the annual cash dividends paid to shareholders.

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 The dividend yield can be compared with the return from other types of

investment, and the yield from shares in other companies.

 The ratio measures the company’s dividend policy, not its performance. A

company may pay a low dividend because the company has reinvested its

profits to achieve growth in earnings and dividends in the future. The share

price might be high (and the yield is therefore low) because investors are willing

to invest for the longer term in expectation of future growth.

 Similarly, a company with low profits may pay high dividends to keep

shareholders satisfied. Even so, the share price might be fairly low because

profits and earnings are low. As a result, the dividend yield will be relatively

high.

Dividend cover

The dividend cover ratio measures the earnings of a company relative to the size of

its dividend payments. Dividends are paid out of earnings, and dividends are

therefore more ‘secure’ when the dividend cover is high.

Dividend cover =

EPS

Net dividend per share

However, if shareholders expect a company to pay out a large proportion of its

profits as dividends, they would want the dividend cover to be low.

2.7 Limitations of financial ratios

Most of the data for calculating financial ratios comes from the financial statements.

 The reliability of ratios is therefore affected by the reliability of the financial

statements themselves.

 In addition, when ratios are used to compare different companies, the

comparability is affected if companies use different accounting policies to

prepare their financial statements.

In addition, when comparing a ratio against that of a competitor or the industry

average, it is important to remember that, even within an industry, companies can

have different characteristics. It is very important to remember this when you are

analysing the financial statements of a company, and possibly comparing its

performance and financial position with other companies.

Some of the factors you may need to consider are set out below.

Size of company

Large companies should be able to benefit from economies of scale and so should be

more profitable than smaller companies in the same industry and market. Larger

companies should also attract better management, so (in theory) the business should

be run more efficiently, and so should achieve higher profit margins.

Chapter 20: Performance measurement

Market area

Companies operating in the same industry may achieve very different results

because they operate in different sectors or segments of the market. For example,

two companies selling furniture might have very different profit margins because

they operate in different parts of the market. One company may be selling antique

furniture at high profit margins and the other may be selling self-assembly furniture

in larger volumes but with lower profit margins.

Stage in the supply chain

Companies operating in the same industry may operate at different stages in the

supply chain. A supplier of raw materials, a manufacturer and a retailer would be

expected to have very different financial ratios, even though they may operate in the

same industry.

For example, it would be difficult to compare the financial ratios of a timber

supplier, a furniture manufacturer and a furniture retailer.

Timing of transactions

The timing of a key transaction can distort financial ratios. For example, a company

may acquire a subsidiary at the end of the financial year. The subsidiary would then

be consolidated in the group statement of financial position but its profits would not

be included in group profit or loss because they are all pre-acquisition profits.

Ratios that compare profit figures with items in the statement of financial position

will therefore be distorted, unless a suitable adjustment is made to allow for the

transaction.

Year end date

In most countries, companies are allowed to decide for themselves what their

financial year-end date should be. The choice of dates can affect the financial ratios.

For example a manufacturer of ski equipment will probably have some very busy

trading months (during the ski-ing holiday season) and some very quiet months. If

it selects the end of the high-selling season as its year-end, its inventory levels will

be abnormally low and its receivables balance may be abnormally high.

Such ‘distortions’ in the financial statements can be eliminated by calculating ratios

using a monthly average for any measures taken from the statement of financial

position, such as inventory, receivables and trade payables.

Management strategy

Financial ratios should be interpreted in the context of all other relevant information

that is available about the company. For example, management may have decided

on a strategy of cutting profit margins in the short term in order to win market

share. This would affect the current profit margin, but in the long run should result

in higher sales and more profits.

This point is well illustrated by the following case study.

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Example

Philip Morris is the largest tobacco company in the US. However, in the early 1990s

its main brand, Marlboro, suffered a large drop in market share. The company

increased the prices of Marlboro cigarettes, hoping to maintain profits. However,

this strategy was not successful, because customers were unwilling to pay the

higher prices for premium brands, when cheaper brands were selling at much lower

prices. So on ‘Marlboro Friday’ (2nd April 1993) Philip Morris began a price war

and overnight cut the price of its Marlboro cigarettes by 20%.

$10 billion was immediately wiped off the market value of the company, but the

price war changed market behaviour. Customers switched back to the lower-priced

premium brands such as Marlboro and the cheap cigarette brands were largely

destroyed. American Tobacco decided to quit the market altogether. By 1995

Marlboro had regained its lost market share and its profits and its share price had

fully recovered.

Chapter 20: Performance measurement

Financial ratios and examination technique

 Approach to questions

 Avoiding pitfalls

3 Financial ratios and examination technique

Examination questions on financial ratio analysis usually require a certain amount

of examination technique to construct a good answer. The following guidelines

suggest the approach you should take and indicate the mistakes and pitfalls to

avoid.

At this level, you are unlikely to get a question that asks you just to calculate ratios.

It is more likely that you will get a question that asks you to consider the accounting

treatment of particular items in the financial statements and the effect that this will

have on the entity’s ratios.

For example, if an entity has incorrectly treated a sale and repurchase transaction as

a ‘genuine’ sale and not as a loan secured on an asset, then there will be a significant

effect on the entity’s ratios. For example, the gearing ratio will not show the true

position of the entity’s debt as it will exclude the secured loan. Return on capital

employed will also be affected as the incorrect treatment of the transaction removes

the asset from the statement of financial position, thus increasing ROCE.

Additionally, consider the points below which provide specific guidance on aspects

of the question that you may have to answer.

3.1 Approach to questions

Analyse the requirement

Start by recognising the person or organisation who has asked for the financial

analysis.

 Who is the user?

 What information is the user interested in? Why has the user requested the

report?

 How should the information be presented to the user – in the form of a memo or

a more formal report? Don’t forget there are presentation marks available for

well-presented reports.

Background information

Establish some of the basic ‘background’ information.

 What industry does the company operate in?

 Note the financial year end. This may possibly be significant.

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 Is the business seasonal? If so, seasonal trading may ‘distort’ the year-end

figures in the statement of financial position, particularly for inventory,

receivables, cash and payables.

 Have there been any key transactions during the year that may affect

comparisons with previous years? For example, has the company raised a

substantial amount of new finance, or has it acquired a major new subsidiary,

entered a new market with a new product, or disposed of a business operation?

Review of the financial information

Before calculating any financial ratios, perform a thorough review of the financial

information provided. Look for items that will affect the measurement of key

financial ratios.

Statement of financial position:

−

Non-current assets.

(1) Have there been any revaluations? Check the revaluation reserve. Has

it changed since the previous year? (This can also be checked by

looking at other comprehensive income in the statement of

comprehensive income.)

(2) Capital expenditure. Has the company incurred significant capital

expenditure. Look at the increase in non-current assets since the

previous year. How has the expansion been financed? Look at share

capital and reserves, and at levels of debt.

−

Investments.

(1) Has the company invested in a new industry?

(2) Has the company acquired a new subsidiary or invested in a new

associate or joint venture? If so, consider the timing of the acquisition –

if an acquisition happened in mid-year the subsidiary’s profits will

have been included in profit or loss for only six months but it will be

included in full in the year-end group statement of financial position.

−

Working capital.

(1) Has the total working capital increased or decreased in proportion

with the increase or decrease in sales turnover (compared with the

previous year)?

(2) Look at the amounts of current assets and current liabilities. Does the

company have net current assets or net current liabilities?

−

Loans.

(1) Have any loans been repaid in the year? If so, how was the repayment

financed?

−

Share capital and reserves

(1) Have there been any new issues of shares during the year? If so, is it

clear why the new shares were issued? For example, have new shares

been issued to raise money to repay debt? Or to finance an expansion

of the business?

(2) Have there been any significant changes in reserves during the year?

Chapter 20: Performance measurement

Statement of comprehensive income: profit or loss items

Compare sales growth with profit growth. Are they about the same rates of growth?

If not, you may need to think about reasons for the different growth rates.

−

Interest. Is the interest charge high in relation to the amount of debt in the

statement of financial position? If it is high, has any debt been repaid in year?

−

Dividends. Look at the amount of dividend payments, the dividend cover,

and the trend in dividend payments over the past few years.

−

Did the company make a profit or a loss?

−

Are there any unusual ‘one-off’ items in profit or loss? If so, what are they?

You should have an expectation in your mind about the measurements and ratios

that you should expect to find. If the actual measurements or ratios are different

from what you expect, you may need to think about the reasons for the unexpected

results.

For example, you may expect the company to be profitable. If it made a loss, you

will need to look for the reasons.

Calculate financial ratios

Having reviewed the financial information, you should calculate relevant key ratios.

 Present the ratios you have calculated as an appendix to your memo or report.

 Show the formulae and numbers you have used to calculate the ratios. Do not

just write down the ratio by copying it from your calculator. The examiner will

want to see where your figure came from, to make sure that you understand

what you are doing.

 Be selective. Only calculate a ratio if it will add to your answer. Do not simply

calculate as many ratios as possible.

 Go for variety in the ratios you select.

 If the examination question provides some financial ratios, look for ratios that

have not been given. Could any of the ‘missing’ ratios be significant?

Further information

An examination question might ask for suggestions about what further information

might be helpful. If so, set up your answer as an appendix to your memo or report,

and build your answer as you work through your answer to the question. Examples

of information that might be ‘missing’ include the following:

 Additional information to calculate further ratios, such as the share price for

calculating the P/E ratio or dividend yield

 Segmental analysis

 Industry average figures, for making comparisons with similar companies in the

same industry

 Changes in management policy (such as changes in the credit terms offered to

customers)

 The accounting policies used

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 Reasons for specific changes not explained by the information given in the

question.

Writing your answer

Make comments that are relevant to the question. Always think about the

requirements of the question when you write your answer. You will not earn marks

for anything that is not relevant.

 Make sure you answer all the requirements of the question. If you don’t you will

lose marks.

 Use short sentences and bullet points.

3.2 Avoiding pitfalls

There are a number of common mistakes in writing answers to an interpretation

question.

 Most marks in the exam are likely to be for specific, relevant comments rather

than solely for computations.

Do not calculate too many ratios as it is time-

consuming and you will not have time to write your answer. Be selective and

only calculate a ratio if it will add value to your answer.

 Good points can be identified by looking at absolute changes in the figures

between one year and the next. For example, if sales have increase 25%, it would

be expected that inventory, receivables and payables should have increased in

line with the increase in sales.

 Use all the information. Some valuable information about the company is

usually given in the introductory paragraph in an examination question. Make

sure that you read and use this information.

 When making comparisons, make sure that the ‘benchmark’ you select for the

comparison is suitable. For example, if two companies are being compared:

−

Are they the same size?

−

Do they operate in exactly the same area of the market?

−

Are their financial statements for the same time period?

 When making an observation about differences (such as differences in

comparison with another company, or the previous year), suggest reasons for

the difference. Don’t just make an observation without making a comment. For

example, stating that “There has been a fall in non-current asset” has no value on

its own. A better answer would be “Non-current assets have decreased despite a

rise in sales.” You might then go on to comment that non-current assets are

being over-used and are not being replaced, perhaps because of the poor cash

position of the company.

 The highest marks will be awarded for linking together the information that you

analyse. For example: “Interest charges have remained more or less the same as

in the previous year, despite a decrease in the debt in the statement of financial

position. This may be explained by the company repaying a large amount of

debt shortly before the year end.”

Chapter 20: Performance measurement

 Structure your answer around each of the requirements in the question. In many

cases, profitability and long term solvency could be used as main headings

within your answer.

 Use the company name in your answer. This will help you to focus your mind

on the circumstances of the company, and avoid writing about financial ratios in

general terms (and so failing to answer the question).

Paper P2: Corporate Reporting (International)

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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