MSIN0045 Finance I 21-22 - Topic #4 Seminar

UCL School of Management
MSIN0045 Finance I
Topic #4 Financial ratios.
Seminar #4
4th February 2022
Lynsie Chew [email protected]

Agenda
▪ Finishing off Investment ratios and thoughts about
predicting financial distress/failure. (Slides already
available in the full lecture deck)
▪ Activity – Threads Ltd.
▪ Reading Week Assessment.
Investment Ratios
▪ Earnings per share
▪ Price/earnings ratio
▪ Dividend cover ratio or dividend payout
▪ Dividend yield ratio
Let’s use KwikBuck Ltd to work through each ratio…

(Basic)
Expressed in pence
Earnings per share (EPS)
Ordinary shareholders’ earnings £18m / 100m

Number of ordinary shares in issue = £0.18p
Where you see diluted EPS within annual reports, this

indicates what the EPS would be if all convertible
securities were exercised/taken up (i.e., if these securities
were to be converted, there would be more ordinary shares
to split the profits between). Hence the EPS would become
lower (diluted) than the (basic) EPS.
Price earnings (P/E) ratio
Expressed as a multiple
Market Price Per Share £0.60 / £0.18p

Earnings Per Share = 3.33 times
Dividend cover Expressed as a multiple
Ordinary shareholders’ earnings available for dividend

Paid and proposed ordinary dividends
£18m / £5m = 3.6 times
(Note: another way of expressing this - dividend pay out percentage

ratio which is just the inverse of dividend cover.)
Dividend yield
Dividend per share* £0.05 / £0.60
x 100 = 8.33%
Market value per share
*Dividend per share is the:

Proposed dividend / number of shares
= £5m / 100m shares = £0.05p per share
Using Ratios To Help Predict Financial
Distress
▪ Financial distress/failure generally means a company is either being forced
out of business or is unable to meet its financial obligations.
▪ This is often referred to as going bankrupt. However, note that in the UK
bankruptcy is the term used for individuals, while the term insolvency is
used for businesses.
▪ Current and past ratios are often used to try and predict financial distress.
▪ However, this type of analysis is also dependent on the judgement and
opinion of the analyst!
Average (Mean) Ratios of Failed and Non-failed Businesses
Non-failed businesses Failed businesses Beaver, Journal of

Accounting Research 1966
Other significant ratios:
- Net income/Total assets
- Total debt/Total assets
- Cash from
operations/Maturing
obligations
+ work by Zmijewski,
1983
Single ratios: Univariate

analysis
Z-Score: Altman’s 1968 Model: Public companies
Z = 0.012a + 0.014b + 0.033c + 0.006d + 0.999e Combinations

of Ratios:
a = Working capital/total assets The lower the score
the greater the Multiple
b = Accumulated retained profits/total assets
c = Operating profit/total assets
probability of failure. Discriminate
According to Altman:
d = Market value* of equity/total liabilities at Analysis
Businesses with a Z-
book value score of less than
e = Sales revenue/total assets 1.81 tend to fail.
score higher than 2.99
tend not to fail.
Z-Score: Altman’s Revised (2000) Model: Private companies
Z = 0.717a + 0.847b + 3.107c + 0.420d + 0.998e Combinations

of Ratios:
a = Working capital/total assets The lower the score
the greater the Multiple
b = Accumulated retained profits/total assets
c = Operating profit/total assets
probability of failure. Discriminate
According to Altman:
d = Book value* of ordinary and preference Analysis
shares/total liabilities at book value score of less than
e = Sales revenue/total assets 1.23 tend to fail.
score higher than 4.14
*For d, book value is equal to balance sheet
tend not to fail.
value for ordinary and preference shares; this is
just the total equity figure. Note: There are
industry specific Z-
scores.
Activity – Threads Ltd guide solution
*note that the credit purchases figure is not available for each year concerned. So in this case and whenever you are unable
to work out the purchases figure for all periods you are doing the analyses for, we use the next best figure as an
approximation which is the Cost of Sales figure.
Some comments…
▪ A supplier seeking to sell a substantial amount of goods to
the business will be concerned with both liquidity and longer-
term viability (where there is a continuing relationship) as
measured by profitability ratios.
▪ The supplier will also be interested in the average time taken
by the business to pay its current suppliers.
▪ The liquidity ratios reveal an apparent improvement over the two years.
However, for a manufacturing business, the liquidity ratios seem low and
the supplier may feel some concern. The increase in inventories over the
period has led to a greater improvement in the current ratio than in the liquid
(acid test) ratio. The improvement in the acid test ratio has not been very
great and some concern over the business’s liquidity position must remain.
▪ The average credit period allowed to credit customers (trade receivables)
has increased substantially last year. This may be a deliberate policy.
However, if this is the case, the effect of a more liberal credit policy has not
proved to be very successful as there has only been a slight increase in
sales revenue last year.
▪ The credit period increase may be due, on the other hand, to other factors
such as poor credit control or particular customers experiencing financial
difficulties. The effect of this change in the trade receivables ratio should be
carefully noted by the supplier as the increase in trade receivables
outstanding seems to be partly financed by an increase in the average
period taken to pay trade payables.
▪ The inventories’ turnover period has increased significantly last year.
This might be due to inventories building in anticipation of future
sales revenue. However, it might indicate that certain products are
not selling as well as expected and are therefore remaining in
inventories.
▪ The gross profit margin and operating profit margins are both lower
last year. Lower margins have, in turn, led to a lower return on
capital employed. The lower operating profit margins, the increase
in the average credit period allowed to trade receivables and the
increase in the inventories’ turnover period may suggest that the
business has a product range that is becoming obsolete and
therefore more difficult to sell. It might, however, also suggest a more
competitive business environment.
▪ The ratios calculated do not indicate any serious problems for the
business. However, it is clear that last year proved to be a more
difficult year than the previous year. Things may well improve in
the future though. At this point, however, the supplier would be well
advised to be cautious in his/her dealings with the business.
Certainly, the supplier should not rely too heavily on Threads Ltd for
future sales revenue.

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UCL School of Management

Lynsie Chew [email protected]

Let’s use KwikBuck Ltd to work through each ratio…

Ordinary shareholders’ earnings £18m / 100m

Where you see diluted EPS within annual reports, this

Market Price Per Share £0.60 / £0.18p

Ordinary shareholders’ earnings available for dividend

£18m / £5m = 3.6 times

(Note: another way of expressing this - dividend pay out percentage

*Dividend per share is the:

Non-failed businesses Failed businesses Beaver, Journal of

Single ratios: Univariate

Z = 0.012a + 0.014b + 0.033c + 0.006d + 0.999e Combinations

Z = 0.717a + 0.847b + 3.107c + 0.420d + 0.998e Combinations

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