Analysis and communication of accounting information

Accounting A2 · Financial accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

These ratios answer three questions. How well is working capital managed? The working capital cycle is the number of days between paying suppliers and receiving cash from customers. A shorter cycle is better.

How risky is the financing? Gearing shows how much of the long-term capital is borrowed. A highly geared company must pay interest whatever its profit, so interest cover shows how safely the interest can be paid.

How good is the return to shareholders? Earnings per share, the price/earnings ratio, dividend yield and dividend cover are the investor ratios. A ratio means little alone. Compare it with earlier years or with similar companies, and remember that ratios use past figures.

Rules to remember

Working capital cycle (days) = inventory turnover (days) + trade receivables turnover (days) − trade payables turnover (days).
Net working assets to revenue = (inventories + trade receivables − trade payables) ÷ revenue × 100. Cash is left out.
Interest cover = profit from operations ÷ interest payable, in times.
Gearing = non-current liabilities ÷ (issued ordinary share capital + all reserves + non-current liabilities) × 100.
Earnings per share = profit for the year ÷ number of issued ordinary shares. Price/earnings ratio = market price per share ÷ earnings per share.
Dividend per share = total ordinary dividend ÷ number of issued ordinary shares. Dividend yield = dividend per share ÷ market price per share × 100.
Dividend cover = profit for the year ÷ total ordinary dividend, in times.

Common mistake

Students use the nominal value of the share in dividend yield and the price/earnings ratio. Both use the market price per share.

Worked example

A company has 800 000 issued ordinary shares. Profit for the year is $240 000 and the total ordinary dividend is $96 000. The market price is $3.60 per share. Calculate the earnings per share, price/earnings ratio, dividend yield and dividend cover.

Earnings per share = $240 000 ÷ 800 000 = $0.30.
Price/earnings ratio = $3.60 ÷ $0.30 = 12.0 times.
Dividend per share = $96 000 ÷ 800 000 = $0.12, so dividend yield = $0.12 ÷ $3.60 × 100 = 3.33%.
Dividend cover = $240 000 ÷ $96 000 = 2.5 times.

Answer: EPS $0.30, P/E 12.0 times, dividend yield 3.33%, dividend cover 2.5 times.

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