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# Unit 2 Liquidity and Market ratios

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Current ratio, quick ratio, p/e, eps price/book and gearing

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### Unit 2 Liquidity and Market ratios

1. 1. Unit 2 Understanding Accounts Liquidity, financing and market
2. 2. A summarised balance sheet A typical UK balance sheet Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other current assets 100 Creditors (payables)<12m (350) Borrowings (750) Net assets 825 825
3. 3. Current ratio This is defined as current assets/current liabilities From our balance sheet this would be : Debtors + stocks + cash + others / creditors = (500 + 300 + 25 + 100) / 350 = 2.6
4. 4. Current ratio This is defined as current assets/current liabilities From our balance sheet this would be : Debtors + stocks + cash + others / creditors = (500 + 300 + 25 + 100) / 350 = 2.6 Current assets (by definition) are those assets we are trying to liquidate Current liabilities are those liabilities due within 12 months So we, normally, need the current ratio to be greater than 1 (there are exceptions – businesses with very strong cash flow sometimes have CR < 1, supermarkets)
5. 5. Current ratio This is defined as current assets/current liabilities From our balance sheet this would be : Debtors + stocks + cash + others / creditors = (500 + 300 + 25 + 100) / 350 = 2.6 Current assets (by definition) are those assets we are trying to liquidate Current liabilities are those liabilities due within 12 months So we, normally, need the current ratio to be greater than 1 (there are exceptions – businesses with very strong cash flow sometimes have CR < 1, supermarkets) Note that this is not a percentage
6. 6. Problem with current ratio? Current assets are those assets that are intended to be liquidated. But what if the assets will not be liquidated for some time – for example stocks (inventories). In some industries these are show as “current” even though it may be a long time before they are liquidated
7. 7. Problem with current ratio? Current assets are those assets that are intended to be liquidated. But what if the assets will not be liquidated for some time – for example stocks (inventories). In some industries these are show as “current” even though it may be a long time before they are liquidated For example, house builders. They buy land on which to build houses. As they intend to “liquidate” the land (and house) as soon as possible it counts as stock in current assets. But the project may take a few years to get planning permission, a few years to build and then a year or two to sell. The land and subsequent construction will be shown as a “current” asset for all of that time.
8. 8. Problem with current ratio? Current assets are those assets that are intended to be liquidated. But what if the assets will not be liquidated for some time – for example stocks (inventories). In some industries these are show as “current” even though it may be a long time before they are liquidated For example, house builders. They buy land on which to build houses. As they intend to “liquidate” the land (and house) as soon as possible it counts as stock in current assets. But the project may take a few years to get planning permission, a few years to build and then a year or two to sell. The land and subsequent construction will be shown as a “current” asset for all of that time. So for some businesses we would ignore stocks (as they are not imminent sources of funds) This is called the “quick ratio” = (current assets – stocks) / current liabilities = 1.8 in our example [(500 + 300 + 25 + 100-300 ) / 350 = 1.8]
9. 9. Interest Cover Summary p&l account Revenue 10,000 Operating profit 4,500 (= profit before interest and tax = pbit) Interest (500) Profit before tax 4,500 Interest cover is operating profit (or PBIT)/ interest
10. 10. Interest Cover Summary p& account Revenue 10,000 Operating profit 4,500 (= profit before interest and tax = pbit) Interest (500) Profit before tax 4,000 Interest cover is operating profit (or PBIT)/ interest In the above example this is 4500/500 = 9 In other words the company has 9 times the profits available to “cover” (pay) its interest
11. 11. A summarised balance sheet Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Capital employed 1,575 1,575 Equity Debt
12. 12. Financing Businesses need financing This is usually achieved through a combination of shareholder funding (“equity”) and borrowings (“debt”) Why have debt?
13. 13. Financing Businesses need financing This is usually achieved through a combination of shareholder funding (“equity”) and borrowings (“debt”) Why have debt? Cheaper – why? (because shareholders are at the back of the queue, so in the riskiest position, hence they need the highest return on their investment) More flexible Easier to arrange
14. 14. If debt is cheaper should we not have lots of it? (see also unit 4) Let me illustrate this with an example KevCo has borrowed £5m from OUBank, with a negative pledge. The shareholders have also put in £5m. The loan costs 7% and the shareholders want 9%.
15. 15. If debt is cheaper should we not have lots of it? (see also unit 4) Let me illustrate this with an example KevCo has borrowed £5m from OUBank, with a negative pledge. The shareholders have also put in £5m. The loan costs 7% and the shareholders want 9%. 2 years later KevCo needs to borrow another £5m. OUBank will not lend, but SasBank will do so. How do we get OUBank to waive the negative pledge?
16. 16. If debt is cheaper should we not have lots of it? (see also unit 4) Let me illustrate this with an example KevCo has borrowed £5m from OUBank, with a negative pledge. The shareholders have also put in £5m. The loan costs 7% and the shareholders want 9%. 2 years later KevCo needs to borrow another £5m. OUBank will not lend, but SasBank will do so. How do we get OUBank to waive the negative pledge? We give OUBank priority over interest payments and repayments (“senior debt”). So SasBank is “subordinated” debt.
17. 17. Subordinated debt So given this scenario how much will SasBank charge? As they are in a riskier position to OUBank they will want a little more – say 7 ¼ % What are the shareholders thinking?
18. 18. Subordinated debt So given this scenario how much will HenBank charge? As they are in a riskier position to OUBank they will want a little more – say 7 ¼ % What are the shareholders thinking? They are still at the back of the queue BUT the queue just got longer – so their risk just increased – so they will require a higher return – say 9 ¼ %
19. 19. Average cost of capital So as the debt increases (which is cheaper than equity), so the average cost does not drop, due to the increased risk. It stays the same This is called Modigliani & Millers Theorem No 1.
20. 20. Average cost of capital So as the debt increases (which is cheaper than equity), so the average cost does not drop, due to the increased risk. It stays the same This is called Modigliani & Millers Theorem No 1. But this analysis ignores a key difference between debt and equity Interest on debt is tax deductible. In other words (in the UK) for every £1 of interest a company pays it gets 28p back from the government.
21. 21. Average cost of capital So as the debt increases (which is cheaper than equity), so the average cost does not drop, due to the increased risk. It stays the same This is called Modigliani & Millers Theorem No 1. But this analysis ignores a key difference between debt and equity Interest on debt is tax deductible. In other words (in the UK) for every £1 of interest a company pays it gets 28p back from the government. Equity returns (dividends) are not tax deductible This asymmetry means that debt does reduce the average cost (the effect is called the “tax shield”) until debt rises to a degree where the cost of risk outweighs the tax benefit. (M&M No 2)
22. 22. Debt & Equity So debt has some attractions if kept to a reasonable level. Therefore we need a measure of levels of debt This is called “gearing” or “leverage”
23. 23. Debt & Equity So debt has some attractions if kept to a reasonable level. Therefore we need a measure of levels of debt This is called “gearing” or “leverage” Unfortunately these terms are used interchangeably Also there are a number of different definitions So for this course pick a term and a definition
24. 24. Gearing (or leverage) From now on I shall refer to this measure as “gearing” The two most common definitions of gearing are: Debt/equity x 100 And Debt / (Debt + Equity) x 100
25. 25. Gearing In our example: Equity = share capital + retained profits = 500 + 325 = 825 Debt = 750 (you would include both short and long term) So gearing = (750 x 100)/825 = 90.9% Or (750 x 100)/(750 + 825) = 47.6%
26. 26. What is the “right” level of gearing? It depends! Some industries traditionally have very high gearing Others have low gearing You need to benchmark in the sector to assess a reasonable level. Think of an example of a highly and lowly geared industry.
27. 27. What is the “right” level of gearing? Poor security. Also why would a consultancy need high debt? Highly geared: property investment Security is relatively liquid and can appreciate in value Lowly geared: consultancy
28. 28. Earnings per share This is defined as the “earnings” ( normally = profit after tax) Divided by the average number of shares in issue EPS = profit after tax/number of shares This is the amount of distributable profit (available for dividend) made per share
29. 29. Price earnings ratio (p/e or PER) This is defined as : Market Price per share/ earnings per share
30. 30. Price earnings ratio (p/e or PER) This is defined as : Market Price per share/ earnings per share [nb if you multiply top and bottom by “number of shares” you get: Price per share x no of shares/ EPS x no shares =market capitalisation / total earnings (PAT)] What does it mean?
31. 31. P/e ratio A B Share price £10 £5 EPS £1 £1 p/e 10 5 What does a share price represent? In unit 6 we will conclude that it is the value today of the future dividends expected to be paid by a business
32. 32. P/e ratio A B Share price £10 £5 EPS £1 £1 p/e 10 5 What does a share price represent? In unit 6 we will conclude that it is the value today of the future dividends expected to be paid by a business So the market is willing to pay 10x this year’s profit for A and 5x for B’s. The market must believe that A will deliver more dividends in the future that B , but they are starting at the same point (£1). So A’s earnings/profits must GROW faster than B’s. P/e is an indicator of the market’s expectation of earnings growth
33. 33. Price to book ratio Price to book ratio = market price per share shareholders’ equity per share For example the shareholder’s equity for our balance sheet was £825. Let us assume that there are 330 shares in issue, trading at £7.50. What is the price book ratio?
34. 34. Price to book ratio Price to book ratio = market price per share shareholders’ equity per share For example the shareholder’s equity for our balance sheet was £825. Let us assume that there are 330 shares in issue, trading at £7.50. What is the price book ratio? Equity per share = £825/330 = £2.50. Price/book = £7.50/2.50 = 3. What does this mean? Note – not a percentage.
35. 35. Price to book ratio Differences between book value and market value include?
36. 36. Price to book ratio Differences between book value and market value include? Intangibles not in the accounts (eg goodwill) Fixed assets not shown at market value – especially property Investments not shown at market value Value of debt
37. 37. Next Time We shall look at derived cash flow