ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Objectives

 Define financial statement analysis and what ratios are

 Identify the key aspects of financial performance and financial position that are evaluated by the
use of ratios
 Summarize the alternative bases of comparison for ratio analysis
 Present the ratio formulae for some basic ratios
 Calculate ratios to analyze the profitability, efficiency, liquidity, gearing and investment aspects
of a given entity’s financial statements
 Interpret basic ratios for profitability, efficiency, liquidity, gearing and investment
 Discuss the limitations of ratios as a tool of financial analysis
 Understand index or percentage analysis as an alternative or complement to ratios
Definition

Financial statement analysis is the study of financial statements to obtain information about the
performance and risk of an entity for:

 Evaluation
 Prediction

Main users of financial information relating to a business organization

The importance of context in financial statement analysis

 Size of the business (problem of scale)

 Riskiness of the business
 Economic, social and political environment
 Industry trends and effects of changes in technology
 Effect of price changes

Sources of information about a business

 Chairman’s statement
 Directors’ report
 Financial Statements
 Auditor’s report

As well as other sources:

 government statistics
 trade journals
  financial press
 databases

Financial ratios

Ratios provide a quick and simple means of examining the financial health of a business.

A ratio simply expresses the relationship between one figure appearing in the financial statements with
another e.g. current assets in relation to current liabilities (responds to scale problem).

Ratios are simple enough to calculate, and a good picture can be built up with just a few, however ratios
can be difficult to interpret.

Can be expressed in various forms e.g. percentages, fractions, proportions depending on the need and
use for the information.

Key financial ratios

The key aspects of financial performance / position evaluated by the use of ratios are:

 Profitability
 Efficiency
 Liquidity
 Gearing
 Investment

Financial ratios classification

Profitability ratios - Measure of success in wealth creation. Specifically measure various levels of return
on sales, total assets employed, and shareholder investment.

Efficiency ratios – measure the effectiveness of utilization of resources (also referred to as utility or
turnover ratios).

Liquidity ratios – measure the ability to meet maturing obligations. Specifically, measure the ability of a
corporation to satisfy demands for cash as they arise in the near-term (such as payment of current
liabilities).

Gearing/leverage ratios - measure the financial structure of a corporation, its amount of relative debt,
and its ability to cover interest expense. Specifically, measure of degree of risk reflected by the
relationship between the amount financed by owners and the amount financed by outsiders (referred to
as leverage).

Investment ratios - Measure of the returns and performance of shares held as investments. Also
measure the perceptions of the stock market about the corporation’s value.
The need for comparison

What are some bases (or benchmarks) against which you could compare a ratio for a particular entity
for a particular period once you have calculated it?

Bases (benchmarks) that may be used include:

 Past Periods – Comparing current with past performance

 Planned Performance - Based on planned performance (comparing with budgets)
 Similar Businesses - Based on comparison of performance with other firms in the same industry

A calculated ratio on its own won’t tell you much about a business - it is only when it is compared with
some form of ‘benchmark’ that the information can be interpreted and evaluated.

The Key Steps in Financial Ratio Analysis

Step 1:

 Identify users and their information needs (which key indicators and relationships need to be
examined)

Step 2:

 Select and calculate the results for selected appropriate ratios

Step 3:

 Interpret and evaluate the results

Profitability ratios

Profitability ratios compare various expenses to revenues, and measure how well the assets of a
corporation have been used to generate revenue.

Gross profit margin ratio

Ratio

The gross profit ratio indicates the percentage of sales revenue that is left to pay operating expenses,
creditor interest, and income taxes after deducting cost of goods sold. The ratio is calculated as:

Gross profit margin = Gross profit/Sales x 100

Interpretation

If gross profit margin is 22.1%, for each dollar of sales the company has $0.22 of gross profit left to cover
operating, interest, and income tax expenses.

Net profit margin ratio

Ratio

The net profit ratio is the percentage of sales revenue retained by the company after payment of
operating expenses, interest expenses, and income taxes. The ratio is calculated as:

Net profit margin = Net income/Net sales = Net profit after interest and taxation/Sales x 100

Interpretation

If net profit margin is 4.0%, this means that for each $1 of sales in 2021, the company earned $0.04 of
net income.

Return on equity - ROE

Ratio

Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity.
Return on equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested. It's a basic test of how effectively a company's
management uses investors' money.

ROE = Net income/Shareholders’ equity

Use

The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

Variations
1. Investors wishing to see the return on common equity may modify the formula above by subtracting
preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving
the following: return on common equity (ROCE) = net income - preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income by average shareholders' equity.
Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a
period to the shareholders' equity at period's end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity
figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-
of-period shareholders' equity can be used as the denominator to determine the ending ROE.
Calculating both beginning and ending ROEs allows an investor to determine the change in profitability
over the period.

Interpretation

For high growth companies you should expect a higher ROE. For most firms, an ROE level around 10% is
considered strong and covers its costs of capital.

What about companies with negative net income (i.e. net loss)? Clearly, when net income is negative,
ROE will also be negative. Need to look at cash flows. It may happen that the company had downward
revaluation of assets, or had impairment on its assets, and hence negative net income; but at the same
time positive cash flow. This will generate positive net income in next period.

Cost of capital - the cost of funds used for financing a business. Since most firms issue shares and
borrow (e.g. through bonds), cost of capital includes cost of debt and/or cost of equity.

Many companies use a combination of debt and equity to finance their businesses, and for such
companies, their overall cost of capital is derived from a weighted average of all capital sources, widely
known as the weighted average cost of capital (WACC).

The cost of debt is merely the interest rate paid by the company on such debt.

The cost of equity is more complicated, since the rate of return demanded by equity investors is not as
clearly defined as it is by lenders. Cost of equity represents the compensation the market demands in
exchange for owning the asset and bearing the risk of ownership. Theoretically, the cost of equity is
approximated by the Capital Asset Pricing Model (CAPM) or dividend capitalisation model.

The CAPM formula is: Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-
Free Rate of Return).

Dividend capitalisation formula:

Example

Let's calculate ROE for the fictional company Ed's Carpets. Ed's 2009 income statement puts its net
income at $3.822 billion. On the balance sheet, you'll find total stockholder equity for 2009 was $25.268
billion; in 2008 it was $6.814 billion.

What is company’s ROE?

To calculate ROE, average shareholders' equity for 2009 and 2008 ($25.268bn + $6.814bn / 2 = $16.041
bn), and divide net income for 2009 ($3.822 billion) by that average. You will arrive at a return on equity
of 0.23, or 23%.

Example

For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6%
rate. It has also issued bonds worth $2 million at a 7% rate. The interest on the first two loans is $50,000
and $12,000, respectively, and the interest on the bonds equates to $140,000. The total interest for the
year is $202,000. As the total debt is $3.2 million, the company's cost of debt is 6.03%.

Return on assets – ROA

Ratio

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA
gives an idea as to how efficient management is at using its assets to generate earnings.

ROA = Net income/Total assets

Use

When using ROA as a comparative measure, it is best to compare it against a company's previous ROA
numbers or the ROA of a similar company.

Interpretation

The ROA figure gives investors an idea of how effectively the company is converting the money it has to
invest into net income. The higher the ROA number, the better, because the company is earning more
money on less investment. Management’s most important job is to make wise choices in allocating its
resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers
excel at making large profits with little investment.

Few professional money managers will consider stocks with an ROA of less than 5%.

Example

Ed’s carpets earned $3.822 billion in 2009, and you can find total assets on the balance sheet. In 2009,
Ed's Carpets' total assets amounted to $448.507 billion. Its net income divided by total assets gives a
return on assets of 0.0085, or 0.85%. This tells us that in 2009 Ed's Carpets earned less than 1% profit on
the resources it owned.

ROE and ROA comparison

Similarities

Both gauge a company's ability to generate earnings from its investments.

Differences

The big factor that separates ROE and ROA is financial leverage, or value of liabilities.

If company had no liabilities, its shareholders' equity and its total assets will be the same. It follows then
that their ROE and ROA would also be the same.

But if that company takes on financial leverage, ROE would rise above ROA. Refer to accounting
equation for explanation.

Because ROE weighs net income only against owners' equity, it doesn't say much about how well a
company uses its financing from borrowing and bonds. ROA - because its denominator includes both
debt and equity - can help you see how well a company puts both these forms of financing to use.

Hence, need to look at both ROE and ROA.

Return on capital employed - ROCE

Ratio

ROCE reflects a company's ability to earn a return on all of the capital it employs.

Use

Unlike return on equity (ROE), which only analyzes profitability related to a company’s common equity,
ROCE considers invested capital as a whole.

Because ROCE measures profitability in relation to invested capital, ROCE is important for capital-
intensive companies, or firms that require large upfront investments to start producing goods. Examples
of capital-intensive companies are those in telecommunications, power utilities, heavy industries and
even food service. ROCE has emerged as the undisputed measure of profitability for oil and gas
companies which also operate in a capital-intensive industry.

Interpretation

ROCE doesn't just gauge profitability as profit margin ratios do. ROCE measures profitability after
factoring in the amount of capital used.

Example
Say Company A makes a profit of $100 on sales of $1,000, and Company B makes $150 on $1,000 of
sales. In terms of pure profitability, B, having a 15% profit margin and is far ahead of A, which has a 10%
margin. Let's say A employs $500 of capital, however, and B employs $1,000. Company A has an ROCE of
20% [100/500] while B has an ROCE of only 15% [150/1,000]. The ROCE measurements show us that
Company A makes better use of its capital. In other words, it is able to squeeze more earnings out of
every dollar of capital it employs. A high ROCE indicates that a larger chunk of profits can be invested
back into the company for the benefit of shareholders. The reinvested capital is employed again at a
higher rate of return, which helps to produce higher earnings-per-share growth. A high ROCE is,
therefore, a sign of a successful growth company.

Limitations

ROCE may not provide an accurate reflection of performance for companies that have large cash
reserves, which could be funds raised from a recent equity issue. Cash reserves are counted as part of
capital employed even though these reserves may not yet be employed. As such, this inclusion of the
cash reserves can actually overstate capital and reduce ROCE.
Efficiency ratios

Efficiency ratios examine how well the various resources of the business are being managed.

Average inventory turnover period

The effectiveness of management decisions relating to inventory can be analyzed by calculating the
number of days of sales that can be serviced by existing inventory levels.

The number of days of sales in inventory is calculated by dividing average inventory by the cost of goods
sold and multiplying the result by 365 days.

Inventory turnover period = Average inventory held/Cost of sales x 365

One may use simple average of opening and closing inventory levels for the year. However, in the case
of highly seasonal business, where inventories vary significantly over the year, a monthly average may
be appropriate.

Example

The calculation indicates that company is investing more in inventory in 2021 than in 2020 because
there are 98 days of sales in inventory in 2021 versus 73 days in 2020. Company has approximately 3
months of sales with its existing inventory (98 days represents about 3 months).

The increase from 2020 to 2021 may warrant investigation into its causes.

A declining number of days of sales in inventory is usually a sign of good inventory management because
it indicates that the average amount of assets tied up in inventory is lessening. With lower inventory
levels, inventory-related expenses such as rent and insurance are lower because less storage space is
often required. However, lower inventory levels can have negative consequences since items that
customers want to purchase may not be in inventory resulting in lost sales.

Increasing days of sales in inventory is usually a sign of poor inventory management because an
excessive investment in inventory ties up cash that could be used for other purposes. Increasing levels
may indicate that inventory is becoming obsolete (consider clothing) or deteriorating (consider
perishable groceries). Obsolete and/or deteriorating inventories may be unsalable. However, the
possible positive aspect of more days of sales in inventory is that there can be shorter delivery time to
customers if more items are in stock.
Average settlement period for trade receivables (accounts receivable collection period)

The calculation of the accounts receivable collection period establishes the average number of days
needed to collect an amount due to the company. It indicates the efficiency of collection procedures
when the collection period is compared with the firm’s sales terms.

Average settlement period = Average trade receivables/Credit sales x 365

Suppose the company considers that amounts are due within 30 days of the invoice date and payment
after that is an overdue payment.

Example

It can be seen that an average 25 days of sales (55 days – 30 days) have gone uncollected beyond the
regular credit period in 2021. The collection period in 2021 is increasing compared to 2020. Therefore,
some over-extension of credit and possibly ineffective collection procedures are indicated by this ratio.
Quicker collection would improve company’s cash position. It may be that older or uncollectible
amounts are buried in the total amount of receivables; this would have to be investigated.

Whether the increase in collection period is good or bad depends on several factors. For instance, more
liberal credit terms may generate more sales (and therefore profits). The root causes of the change in
the ratio need to be investigated. However, the calculation does provide an indication of the change in
effectiveness of credit and collection procedures between 2020 and 2021.

Also note that ratio is based on average figures and can be distorted by the fact that few large clients
pay well beyond the average settlement period.

Average settlement period for trade payables

The ratio measures how long on average the business takes to pay its creditors.

Average settlement period = Average trade payables/Credit purchases x 365

As in the case of average settlement period for trade receivables, the figure can be distorted by the
extra-long payment period taken for one or two large suppliers.
As trade creditors provide a free source of finance for the business, it is not surprising that some
businesses attempt to increase/lengthen their average settlement period for trade payables. This
strategy if taken to extremes, may of course damage the goodwill of the supplier.

Asset turnover period ratio

Asset turnover ratio is the ratio of the value of a company’s sales or revenues generated relative to the
value of its assets. The Asset Turnover ratio can often be used as an indicator of the efficiency with
which a company is deploying its assets in generating revenue.

Ratio

Average asset turnover period = Average total assets employed/Sales x 365

Interpretation

A lower asset turnover period is preferred to a higher period.

A lower turnover period implies that assets are being used productively in the generation of revenue.
However a very low turnover period may suggest that the business is ‘overtrading on its assets’, i.e. has
insufficient assets to match the level of sales achieved.

Note about all efficiency ratios

We can alternatively express efficiency ratios as the number of times an asset turns over on average
during the year. E.g. if we know turnover period (e.g. 114 days), we can get turnover by dividing 365
days by the turnover period. That way we get 3.2 times as turnover figure.
Liquidity ratios

Liquidity is the ability of a corporation to satisfy demands for cash as they arise in the near-term (such as
payment of current liabilities).

Liquidity ratios are sometimes expressed in terms of the ability or speed with which assets can be
converted to cash.

The important liquidity ratios are:

 Current ratio;
 Acid test (quick) ratio;
 Cash flow from operations ratio.

Liquidity crisis and cash flow insolvency

Liquidity crisis is inability to pay its current liabilities as they come due.

Even though a company may be earning net income each year, it may still be unable to pay its current
liabilities as needed because of a shortage of cash.

Why does this happen?

As a general rule, long-term financing should be used to finance long-term assets. But sometime
companies use short-term financing to finance long-term assets. Example is as follows:

Suppose that part of current liabilities is $382,000 of accounts payable that may bear no interest and
$825,000 of borrowings that also need to be repaid within one year. The risk is that management will
likely need to replace current liabilities with new liabilities. If creditors become unwilling to do this, the
ability of company to pay its short-term creditors may be compromised.

Working capital

Working capital is the difference between a company’s current assets and current liabilities at a point in
time.
Working capital amounts to $178,000 at December 31, 2021. Between 2019 and 2021, working capital
decreased by $158,000 ($336,000 – 178,000). The company is less liquid in 2021 than in 2019, though its
liquidity position has improved since 2020 when it was only $67,000.

In addition to calculating an absolute amount of working capital, ratio analysis can also be used.

Current ratio

Ratio

The current ratio expresses working capital as a proportion of current assets to current liabilities and is
calculated as:

Current ratio = Current assets/Current liabilities

Example

Interpretation

This ratio indicates how many current asset dollars are available to pay current liabilities at a point in
time. The expression “1.14:1” is read, “1.14 to 1”, or “1.14 times”. In this case it means that at
December 31, 2021, $1.14 of current assets exist to pay each $1 of current liabilities.

This ratio is difficult to interpret in isolation. There are two types of additional information that could
help.
First, what is the trend within company over the last three years? The ratio declined between 2019 and
2020 (from 1.91 to 1.07), then recovered slightly between the end of 2020 and 2021 (from 1.07 to 1.14).
The overall decline may be a cause for concern, as it indicates that in 2021 the company had fewer
current assets to satisfy current liabilities as they became due.

A second interpretation aid would be to compare company’s current ratio to a similar company or that
of industry as a whole. Information is available from various trade publications and business analysts’
websites that assemble financial ratio information for a wide range of industries.

Limitations

No one current ratio is applicable to all entities; other factors—such as the composition of current
assets—must also be considered to arrive at an acceptable ratio.

Example

The companies have the same dollar amounts of current assets and current liabilities. However, they
have different short-term debt paying abilities because Corporation B has more liquid current assets
than does Corporation A. Corporation B has less inventory ($10,000 vs. $37,000) and more in cash and
accounts receivable. If Corporation A needed more cash to pay short-term creditors quickly, it would
have to sell inventory, likely at a lower-than-normal gross profit.

Acid test (quick) ratio

It is a more rigid test of liquidity.

To calculate this ratio, current assets are separated into quick current assets and non-quick current
assets.
Inventory and prepaid expenses cannot be converted into cash in a short period of time, if at all.
Therefore, they are excluded in the calculation of this ratio.

Acid ratio = Quick current assets/Current liabilities = Current assets (excl. inventory and
prepayments)/Current liabilities

Example

Company’s acid-test ratio trend is worrisome. There was $0.48 of quick assets available to pay each $1
of current liabilities in 2021. This amount appears inadequate. In 2020, the acid test ratio of $0.52 also
seems to be too low. The 2019 ratio of $0.93 is less than 1:1 but may be reasonable.

Interpretation

Acid test ratio indicates how many quick asset dollars exist to pay each dollar of current liabilities. It is
generally considered that a 1:1 acid test ratio is adequate to ensure that a firm will be able to pay its
current obligations. However, this is a fairly arbitrary guideline and is not appropriate in all situations.
Lower ratio (but not too low) than 1:1 can often be found in successful companies.
Leverage/gearing ratios

Although shareholders own a corporation, they alone do not finance the corporation; creditors also
finance some of its activities. Together, creditor and shareholder capital are said to form the financial
structure of a corporation.

Gearing ratios of various sorts

Gearing ratios look at the proportion of creditor to shareholders’ claims.

Several versions are available:

 Gearing ratio = Long-term liabilities/(Share capital + Reserves + Long-term liabilities) x 100

 Gearing ratio = Total liabilities/Total assets
 Gearing ratio = Total liabilities/Total owners’ equity
 Gearing ratio = Long-term liabilities/Total owners’ equity

Example of the third version

Company has $1.02 of liabilities for each dollar of shareholders’ equity at the end of its current fiscal
year, 2021. The proportion of debt financing has been increasing since 2019. In 2019 there was only
$0.35 of debt for each $1 of shareholders’ equity. In 2021, creditors are financing a greater proportion
of the company than are shareholders. This may be a cause for concern.

Advantages and disadvantages of debt-financing

Issuing additional shares might require existing shareholders to give up some of their control of the
company.

Creditor financing may also be more financially attractive to existing shareholders if it enables company
to earn more with the borrowed funds than the interest paid on the debt.

On the other hand, management’s increasing reliance on creditor financing increases risk.

Interest cover ratio (Times interest earned ratio)

Ratio

This ratio indicates the amount by which income from operations could decline before a default on
interest may result.

The ratio is calculated as:

Interest cover ratio = Profit before interest and taxation/Interest expense = Income from
operations/Interest expense

Example

The larger the ratio, the better creditors are protected. Company’s interest coverage has decreased
from 2020 to 2021 (3.37 times vs. 4.49 times), but income would still need to decrease significantly for
the company to be unable to pay its obligations to creditors. The analysis does indicate, though, that
over the past two years interest charges have increased compared to income from operations. Creditors
need to assess company plans and projections, particularly those affecting income from operations, to
determine whether their loans to the company are at risk. As discussed above, it may be that significant
investments in assets have not yet generated related increases in sales and income from operations.
Investment/market ratios

Investors frequently consider whether to invest or divest in shares of a corporation. There are various
ratios that help them make this decision.

Earnings per share – EPS

Measures of efficiency can focus on shareholder returns on a per-share basis. That is, the amount of net
income earned in a year can be divided by the number of common shares outstanding to establish how
much return has been earned for each outstanding share.

EPS = Net income/Number of common shares outstanding

If there are preferred shareholders, they have first rights to distribution of dividends. Therefore, when
calculating EPS, preferred shareholders’ claims on net income are deducted from net income to
calculate the amount available for common shareholders:

EPS = (Net income – Preferred share dividends)/Number of common shares outstanding

Example

EPS has remained relatively constant over the three-year period because both net income and number
of outstanding shares have remained fairly stable. Increasing sales levels and the resulting positive
effects on net income, combined with unchanged common shares issued, has generally accounted for
the slight increase from 2019 to 2020.

Comparisons

It is not helpful to compare earnings per share of one company with EPS of the other company, since
companies may have totally different financing structures.

Operating cash flow per share

In the short-run, it can be argued that operating cash flows provide better picture regarding ability to
pay dividends and make planned expenditures than earnings figure.

Operating cash flow per share = (Operating cash flows – Preference dividends)/Number of ordinary
shares on issue

It may happen that operating cash flow per share is higher than earnings per share. This is the case
when depreciation is added back to derive operating cash flows.
Price-earnings ratio – P/E

Ratio

A price at which a common share trades on a stock market is perhaps the most important measure of a
company’s financial performance. The market price of one share reflects the opinions of investors about
a company’s future value compared to alternative investments.

Price-earnings ratio = Market price per share/Earnings per share

Interpretation

This ratio is used as an indicator of the market’s expectation of a company’s future performance.
Assume Company A has a current market value of $15 per share and an EPS of $1 per share. It will have
a P/E ratio of 15. This means that for every $1 of net income generated by Company A, investors are
willing to invest $15. The higher is P/E ratio, the more valuable is the company, because the company is
expected to earn greater returns in the future.

Example

P/E ratio has increased each year. Although industry and competitor’s P/E ratio comparisons would be
important, company’s increasingly positive ratio also indicates that investors are “bullish” on company.
That is, the stock market indicates that it expects company to be increasingly profitable in the coming
years. Despite a relatively constant EPS ratio from 2019 to 2021, investors are willing to pay more and
more for the company’s common shares.

Earnings yield as reciprocal of P/E ratio

A share with P/E ratio of 10 would have an earnings yield of 10%, while a share with P/E ratio of 20
would have an earnings yield of 5%.

Dividend yield

Ratio

Some investors’ primary objective is to maximize dividend revenue from share investments, rather than
realize an increasing market price of the shares. This type of investor is interested in information about
the earnings available for distribution to shareholders and the actual amount of cash paid out as
dividends rather than the market price of the shares.

Dividend yield ratio = Dividend per share/Market price per share

This ratio indicates how large a return in the form of dividends can be expected from an investment in a
company’s shares.

Example

The dividend yield ratio is therefore:

The company’s dividend yield ratio decreased from 2019 to 2021. In 2019, investors received $0.15 for
every $1 invested in shares. By 2021, this had decreased to $0.13 for every $1 invested. Though the
decline is slight, the trend may concern investors who seek steady cash returns.

Note that dividend yield ratio can also be defined as:

Dividend yield = (Dividends per share/(1-t))/Market price per share

In New Zealand investors pay income tax, while companies also pay taxes. To avoid double taxation,
imputation credit system is adopted. Under the system, investor who receives dividend from a company
also receives a tax credit, effectively the amount of income tax that would be payable by the company.
I.e. dividend is deemed to have been paid out of profits taxed at the company tax rate.

Dividend payout ratio

Ratio

The dividend payout ratio is the percentage of earnings paid to shareholders in dividends.

Dividend payout ratio = Dividend announced for the year/Earnings for the year available for dividends

Interpretation

The dividend payout ratio provides an indication of how much money a company is returning to
shareholders, versus how much money it is keeping on hand to reinvest in growth, pay off debt or add
to cash reserves.

The level of the ratio depends on the maturity of the company.

A new, growth-oriented company that aims to expand, develop new products and move into new
markets would be expected to reinvest most or all of its earnings and could be forgiven for having a low
or even zero payout ratio.

On the other hand, an older, established company that returns a pittance to shareholders would test
investors' patience and could tempt activists to intervene.

A steadily rising ratio could indicate a healthy, maturing business, but a spiking one could mean the
dividend is heading into unsustainable territory.

The payout ratio is also useful for assessing a dividend's sustainability. Companies are extremely
reluctant to cut dividends, since it can drive the stock price down and reflect poorly on the
management's abilities. If a company's payout ratio is over 100%, it is returning more money to
shareholders than it is earning and will probably be forced to lower the dividend or stop paying it
altogether.

Dividend payouts vary widely by industry, and like most ratios, they are most useful to compare within a
given industry.

Dividend per share – DPS

Ratio

The dividends per share ratio relates the dividends declared during the period to the number of shares
outstanding during the period.

DPS = Dividends declared during the period/Number of shares outstanding

The ratio indicates the cash return an investor receives from holding shares in a company.

Interpretation

DPS is a partial measure, as dividends received represent only a proportion of the total earnings
generated by the company that are available to shareholders. E.g. it does not include retained earnings
reinvested.

DPS can be calculated for each class of shares issued by the company.

In practice we look at the average number of shares on issue for the period, instead of number of shares
on issue. The calculation of the latter can be quite complex (timing issues, type of issue – placement or
rights, treasury purchases etc).

DPS varies considerably between companies. Factors that influence dividends distributions include –
cash availability, future commitments and investor expectations.

Example
ABC company paid a total of $237,000 in dividends over the last year of which there was a special one-
time dividend totaling $59,250. ABC has two million shares outstanding, so its DPS is ($237,000-
$59,250)/2,000,000 = $0.09 per share. Having a growing DPS can be a sign that the company's
management believes that the growth can be sustained.
Limitations of ratio analysis

Quality of financial statements

Financial ratios are derived from financial statements, meaning that if here are problems with
statements there will also be problems with financial ratios.

First case, financial statements may be deliberately made incorrect and misleading.

Second case, some of the important values are omitted from financial statements due to application of
conservatism (prudence) principle. E.g. internally generated intangible assets are not included in assets
on the balance sheet. They however represent capital. If they are not included, capital/assets are
understated and respectively ratios such as ROA or ROCE are overstated (as capital stays in denominator
of the ratio).

Effects of inflation

In the case of hyperinflation or inflation that accelerates by day, any calculation of the ratios will be
meaningless, as it would be impossible to compare ratios across periods.

The problem will persist even with moderate inflation.

 Remember that inflation (or deflation) affects cost of inventories and COGS and therefore profit.
 Inflation also creates disparity between historical cost of assets/capital and the current value of
asset. For instance, it may happen that current value of asset is higher (and ROA and ROCE are
lower) solely due to inflation factor.
 Also remember that company does not buy all inventories or all assets at once – instead it buys
them gradually at a range of prices. And this will affect the values of ratios.

Relative nature of ratios

Ratios show the relationship between variables (e.g. profit vs. sales), but they don’t show absolute level
of profits and absolute value of sales.

It therefore makes sense to look at absolute/actual values too.

Basis for comparison

Ratios are used for comparing performance of the businesses. To do this appropriately, one needs to
compare like with the like – e.g. businesses in the same industry, in the same region. If this is not done,
the comparison will be meaningless.

Also note that no two businesses are identical – there may be differences in accounting policies,
financial year ends, methods of financing etc.

Ratios relating to the statement of financial position

Statement of financial position is only a snapshot at particular date. Therefore, any ratios based on the
statement of financial position, such as liquidity ratios may not be representative of the financial
position of the business for the year as a whole.

Example, it is common for a seasonal business to have a financial year end to coincide with a low point
in business activity. As a result inventories and trade receivables may be low at the year end. This will
mean that liquidity ratios will be low as well.

Trend analysis

Trends may be identified by plotting key ratios on a graph, giving a visual representation of changes
happening over time.

Intra-company trends may be compared against industry trends.

Key financial ratios are often published in companies annual reports as a way to help users to identify
important trends.

Index or Percentage Analysis

Index or Percentage analysis simply allows monetary figures to be replaced with an index or a
percentage.

There are three alternative index or percentage methods:

 Common size reports (also known as vertical analysis)

 Trend percentage
 Percentage change (also known as horizontal analysis)

Common size statements

Common-size statements express:

 The balance sheet as a percentage of an item in the statement, such as assets or net assets, and
 The income statement as a percentage of an item in the statement, such as sales or revenue.

Trend percentage

In trend statements items are expressed as a percentage of the figure in a base year

Selection of an appropriate base year is vital