Analysis of Financial Statements

COMPONENT 2

ANALYSIS OF FINANCIAL STATEMENTS

1 INTRODUCTION

In the previous component, the different financial statements published by a

company were discussed. These financial statements provide valuable information
about the company’s financial performance and position. The format used to publish
the information, however, is prescribed by accounting guidelines, and does not
always provide the information in a format that can be readily used to conduct
financial analyses of the company.

In order to analyse the financial performance and position of a company, the

information provided in the financial statements is often used to calculate financial
ratios. These ratios attempt to provide more information on certain aspects of
the company in a format that is easily comparable over time, between different
industries, and between different companies. These ratios are also more
understandable than the pure financial information contained in the statements.
When a ratio is calculated, a meaningful relationship between items from the
financial statements is investigated.

In this component, an overview of the major financial ratios is provided. In the first
part of the chapter, the focus is placed on the requirements that need to be adhered
to during the calculation and interpretation of ratios. In the second part, different
norms of comparison are discussed. The major groups of ratios are then identified.
Finally, the definitions, formulae and calculation of the different ratios are highlighted
by means of an example.

2 REQUIREMENTS FOR RATIOS

In order to effectively investigate the financial performance and position of an

enterprise, ratios need to meet the following requirements:

1. The comparison that is made needs to be meaningful. It is important to note

that the relationship that is investigated also needs to be logical. For instance,
a comparison between salaries and goodwill will not be meaningful, since the
ratio will not provide any valuable information.

2. The value of the ratio must be a true reflection of the financial performance
of the company, and only the relevant amounts need to be included during
the calculation of the ratio. Items that do not form part of the company’s normal
operating activities should therefore not be included. An example of this would
be the gain or loss generated during the disposal of PPE.

3. The values of a ratio need to be comparable over a period of time, as well as

between different industries and companies. This means that the ratio needs
to be calculated in a consistent way. If a company changes the accounting
policy used to compile its financial statements, it needs to be taken into
consideration when the ratios are calculated and compared.
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Introduction to Financial Management

3 NORMS OF COMPARISON

If the financial performance and position of a company is evaluated by means of

a ratio analysis, it is important to remember that ratios should not be interpreted
in isolation. Only by comparing the ratio with other ratios, it is possible to determine
if the financial performance and position of the company is viable or not. The major
norms of comparison used include the following:

Conventions

Certain conventions with regard to the values of some ratios have developed over
time. An example of such a convention is a current ratio equal to 2, which is often
accepted as an acceptable level. However, it is important to note that this norm of
comparison does not apply to all types of enterprises. Depending on the industry
in which the company operates, different values may be considered acceptable.

Comparison over time

Another way to evaluate ratios is to investigate the financial performance and

position of the company over a period of time. Based on this comparison it will
be possible to determine if the company’s financial situation has improved or
deteriorated. By considering the annual values of a ratio, it is also possible to
determine if any trends in the values of the ratios can be observed.

Industry norms

A third way to interpret ratios is to compare similar companies that operate in the
same industry. Based on this comparison, the competitive position of the company
relative to its competitors can be determined. Industry averages can also be
calculated for all companies in an industry, and used to determine the relative
position of a company within the industry.

4 TYPES OF RATIOS

Depending on the characteristic that needs to be investigated, ratios can be divided

into a number of categories. The major types of ratios that are discussed in this
chapter can be classified into the following broad categories:

1. Profitability
• Profitability return ratios
• Profit margins
• Turnover ratios

2. Liquidity
• Liquidity ratios
• Turnover times

3. Solvency
• Solvency ratios
• Coverage ratios

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 Analysis of Financial Statements

4. Investment ratios

In the remaining part of this chapter the different ratios, as well as their formulae
and interpretation, are discussed in greater detail. The calculations of the ratios
are illustrated by considering the financial statements of Nuta Ltd, as provided in
the previous chapter. Additional information required to calculate the ratios is
provided below:

Additional information: Nuta Ltd

• Average values (where required) are used in the calculation of the ratios. The
reason for the use of average values is to cancel the effect of changes that
occurred during the financial year. This will ensure a meaningful comparison
between statement of profit or loss and statement of financial position items.
For instance, if a company repaid a relatively large portion of its debt capital
during a financial year, it will be more meaningful to compare the average debt
capital (rather than the closing balance) to the finance cost paid during the year.
• Assume that the net revenue consists of cash revenue to the value of R11 600
and credit revenue of R11 000.
• The credit purchases amount to R7 200 for the year.
• The total rent paid amounts to R300 during the year.
• The market price per ordinary share is R5 at the end of the financial year.
• Assume 360 days per year.
• The number of ordinary shares issued is as follows:
20X1 = 3 000 shares; 20X0 = 1 800 shares.

5 PROFITABILITY

Profitability refers to the efficiency with which an enterprise utilises its capital to
generate income. It is possible to calculate the profitability (return) of different capital
items. It is important, however, to ensure that a relevant comparison between a
capital item and the corresponding income or profit figure is made. The higher
the return on a capital item, the more efficient the company utilised that capital item.

The major profitability ratios are provided below:

5.1 PROFITABILITY RETURN RATIOS

5.1.1 RETURN ON TOTAL ASSETS

The return on total assets measures how efficiently the total assets (or the total
capital) of an enterprise are utilised to generate income. The relevant income items
that need to be compared to the total capital are the operating profit plus the
investment income, since it represents the total income generated by the
company’s total assets. The return on total assets for Nuta Ltd can be calculated
with the following ratio:

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Introduction to Financial Management

Operating profit + Investment income 100

Ro = 
Average total assets 1

4 000 + 250 100

= 
0,5(11 500 + 15 000 ) 1

= 32,08%

This value indicates that the company generated a return of 32,08% on the total
capital invested in the enterprise. The higher the return on total assets, the more
efficient the total assets were utilised. When comparing the values of the ratio
over time, an increase indicates an improvement in the efficiency with which the
assets are utilised.

In order to improve the return on total assets (or any profitability ratio), a company
needs to either improve the income figure, reduce the amount of assets, or achieve
a combination of the two. However, a company needs to be careful not to reduce
the total assets too much, since it may impact negatively on its activities. The
short-term minimisation of total assets in order to increase the return on total assets
could also have a serious negative effect on the future profitability of the company.

Profitability in the broader and narrower sense

When the return on total assets ratio is calculated, it is possible to distinguish

between figures that are calculated in the broader or the narrower sense. The
values of the ratios in the broader sense refer to profitability ratios where the
assets, as well as the investments, and all income generated by the assets and
the investments are taken into consideration. It is also possible to calculate a
profitability figure in the narrower sense. If this is the case, only those assets that
are actually utilised within the enterprise are taken into consideration. Furthermore,
only the income generated by these assets is included in the calculation. Any assets
that are utilised outside the enterprise (financial assets, like share investments for
instance) and the income generated by them (investment income, like dividends
received) should not be included. The return on total assets for Nuta Ltd in the
narrower sense is therefore calculated as follows:

Operating profit 100

R o (narrower sense) = 
Average total assets - Average financial assets 1

4 000 100
= 
0,5(11 500 + 15 000) - (1 850 + 2 300 ) 1

= 35,79%

The value of the return on total assets in the narrower sense provides the
management of a company with an indication of the efficiency with which they have
managed the assets under their direct control. In the case of Nuta Ltd, we can

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 Analysis of Financial Statements

therefore see that the investments made outside the enterprise generated a lower
return than the assets employed inside the company.

5.1.2 RETURN ON EQUITY

As described in the previous chapter, equity consists of the ordinary share capital
plus the preference shares and the non-controlling interest. It constitutes the own
capital of the enterprise, i.e. the capital contributed by the “owners” of the company,
and the greater this contribution, the safer it is for outsiders to provide the company
with debt capital. When calculating the return on equity, the compensation paid
to the providers of debt capital (finance costs) will be excluded from the calculation.
For Nuta Ltd the calculation is as follows:

Return on equity (Re)

Operating profit + Investment income - Finance costs 100

= 
Average equity 1

4 000 + 250 - 550 100

= 
0,5(9 450 + 7 400 ) 1

= 43,92%

5.1.3 RETURN ON SHAREHOLDERS’ EQUITY

The return on the shareholders’ equity provides an indication of the return generated
on the shareholders’ equity invested in the company. Since the objective of any
company should be the maximisation of shareholder value, this ratio provides an
important contribution to the financial evaluation of a company.

The ratio is calculated by determining the earnings attributable to all the shareholders
(ordinary and preference), and comparing it to the capital they invested in the firm.
Non-controlling interest, however, represents an after-tax amount. It is therefore
necessary to convert it into a before-tax amount by dividing it by (1-t), where t is
the tax rate. For Nuta Ltd, the return on shareholders’ equity is calculated as follows:

Return on shareholders’ equity (Ra)

Non - controlling interest

[Link] + Investment income - Finance costs -
(1 - t) 100
= 
Average shareholders' equity 1

100
4 000 + 250 - 550 -
0,6 100
= 
0,5(6 400 + 8 450 ) 1

= 47,59%

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5.1.4 RETURN ON ORDINARY SHAREHOLDERS’ EQUITY

While the previous ratio focused on the return realised on the shareholders’ equity,
this ratio focuses only on the ordinary shareholders’ equity. Since the ordinary
shareholders’ equity does not include the preference shareholders, the preference
dividends are subtracted during the calculation of the ratio. Similar to the non-
controlling interest, these preference dividends represent an after-tax amount,
and it is therefore necessary to convert it into a before-tax figure by dividing it by
(1-t), where t is the tax rate.

Return on ordinary shareholders’ equity (Rb)

Non - controlling interest PS div

[Link] + Invest. income - [Link] - -
=
(1 - t) (1 - t )  100
Average ordinary shareholders' equity 1

100 50
4 000 + 250 - 550 - -
0,6 0,6 100
= 
0,5(5 400 + 7 750 ) 1

= 52,47%

5.1.5 COST OF DEBT

The cost of debt calculates the average cost associated with the debt capital
used by the company. The debt capital consists of all interest-bearing borrowings
(long-term loans, mortgages, debentures etc.). Furthermore, all current liabilities
are also included. Note that the deferred tax liabilities and the retirement
obligation benefit do not form part of the debt capital. Although deferred tax
is included as part of the non-current liabilities, it only represents an accounting
book entry that is not considered part of the debt capital. The retirement obligation
benefit refers to the obligations the firm has towards its employees once they retire,
and is also not considered a form of debt capital.

The finance cost consists of all interest paid on the debt capital. For instance, the
interest paid on the bank overdraft, debentures, loans, etc. should be calculated
and included as the enterprise’s finance cost.

Finance cost 100

Cost of debt (R v ) = 
Average debt capital 1

550 100
= 
0,5(3 800 + 5 050 ) 1

= 12,43%

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5.1.6 RETURN ON FINANCIAL ASSETS

The return on financial assets provides an indication of the average return

earned on the company’s external investments. The financial assets include all
investments, such as share investments (listed as well as non-listed), investments
in associates, as well as long-term and short-term loans granted by the company.
Other investments, such as debenture investments, will also be included as part
of the financial assets. Investment income includes all dividends and interest
received.

Investment income 100

Return on financial assets (R bel ) = 
Average financial assets 1

250 100
= 
0,5(1 850 + 2 300 ) 1

= 12,05%

5.1.7 FINANCIAL LEVERAGE FACTOR

Financial leverage refers to the effect that the use of debt capital could have on
the return on equity. If a company is able to effectively utilise debt capital, it could
result in increased returns for the shareholders. If the utilisation of the debt capital
is not efficient, however, the use of debt capital will have a negative effect on the
return on equity.

The financial leverage factor is calculated in order to determine the working of the
financial leverage. It is important for all companies to determine whether positive,
negative or no financial leverage is present. This becomes especially important
when the financing of the company is considered since it will determine if additional
debt capital should be used or not. The financial leverage factor for Nuta Ltd can
be calculated as follows:

Return on equity (R e )
Financial leverage factor =
Return on total assets (Ro )

43,92 %
=
32,08 %

= 1,37

In this example, the value of the financial leverage factor is greater than one,
which is an indication that positive financial leverage occurs. The implication of
this value is that, if the return on total assets should increase by 1%, the return
on equity will increase by 1,37%. If the value was less than one, it would have
pointed towards negative financial leverage. A value of exactly one indicates that
no financial leverage is experienced.

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The financial leverage factor and its relevance to the financing decision, will be
discussed in more detail in Component 5.

5.2 PROFIT MARGINS

Profit margins provide an indication of the percentage of the revenue that eventually
realises as profit after all deductions have been made.

5.2.1 GROSS PROFIT MARGIN

The gross profit margin provides an indication of the portion of the revenue that is
realised as gross profit. The calculation is as follows:

Gross profit 100

Gross profit margin = 
Revenue 1

10 600 100
= 
22 600 1

= 46,90%

In this example, 53,10% of the company’s revenue consists of the cost of sales,
and only 46,90% of the revenue remains after it has been subtracted.

5.2.2 MARKUP PERCENTAGE

The mark-up percentage is utilised to estimate the selling price of a product relative
to the costs directly incurred to produce or acquire the product. The gross profit is
thus expressed as a percentage of the cost of sales. The calculation is as follows:

Gross profit 100

Markup percentage = ×
Cost of sales 1

10 600 100
= ×
12 000 1

= 88,33%

In this example, 88,33% can be added to the cost of sales to determine the revenue.

5.2.3 OPERATING PROFIT MARGIN

The operating profit margin provides an indication of the percentage of the revenue
that realises as profit after provision has been made for all normal operating expenses.

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 Analysis of Financial Statements

Operating profit 100

Operating profit margin = 
Revenue 1

4 000 100
= 
22 600 1

= 17,70%

If a company’s operating profit margin decreases, it is an indication that the

operating expenses have increased as a percentage of the revenue. An increase
in the value of this margin is an indication that the company’s operating (primary)
activities are performed more efficiently and at a lower cost.

5.2.4 EBIT-MARGIN

This profit margin provides an indication of the profit that was realised before taking
any finance cost and tax into consideration.

Profit before tax + Finance cost 100

EBIT - margin = 
Revenue 1

3 500 + 550 100

= 
22 600 1

= 17,92%

The difference between this profit figure and the enterprise profit margin is that
gains and losses realised from the disposal of PPE or intangible assets are included
in this calculation.

5.2.5 NET PROFIT MARGIN

The net profit margin indicates which part of the revenue is available to the
shareholders of the enterprise. This figure is of great importance to the
shareholders, since it indicates which part of the revenue can be paid as dividends,
or can be reinvested as part of the reserves.

Profit after tax 100

Net profit margin = 
Revenue 1

2 100 100
= 
22 600 1

= 9,29%

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5.3 TURNOVER RATIOS

Turnover ratios provide an indication of the speed at which an investment in assets

is converted into revenue. The higher the value of the ratio, the more
times per year the investment is utilised to generate revenue, and the higher the
total profit will become. It is therefore to the benefit of an enterprise to achieve
a higher turnover ratio.

Example:

An enterprise invests R500 in inventory. The sales price is R750 per item. The
inventory is sold after 15 days. The inventory can be sold on either cash or
credit terms. If only cash sales are allowed, the income will be received
immediately, and it can be reinvested in inventory. If credit sales are allowed,
the trade receivables will only be repaid after another 15 days.

The effect of the two sales methods on the profit of the enterprise can be
calculated as follows:

Cash sales:

Turnover ratio of inventory = 2 times per month

Profit per transaction = R750 – R500
= R250
→ Total profit for the month = 2 × R250
= R500

Credit sales:

Turnover ratio of inventory = 1 time per month

Profit per transaction = R750 – R500
= R250
→ Total profit for the month = 1× R250
= R250

It is clear that the higher turnover ratio associated with the cash sales results
in a higher total profit level than is the case for the credit sales.

When investigating a company’s profitability, it is important to consider the effect

that the turnover ratio and profit margins can have on the overall profitability.
If, for instance, a company is able to utilise its assets more efficiently (i.e. increase
the turnover ratio), while profit margins remain constant, it should experience
an increase in its profitability. The following example provides an illustration of this:

Example:

Assume that the following information with regard to Company A is provided:

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 Analysis of Financial Statements

Revenue = R100 000

Profit before finance cost and tax = R 20 000

20 000 100
→ EBIT-margin =  = 20%
100 000 1

Total assets = R50 000

100 000
→ Total asset turnover ratio = = 2 times per year
50 000

20 000 100
Return on total assets = 
50 000 1
= 40%

It is also possible, however, to calculate the return on the total assets as the
product of the EBIT-margin and the total asset turnover ratio (assuming that
there are no gains or losses on the disposal of PPE and intangible assets):

Return on total assets = 20% × 2

= 40%

By increasing the total asset turnover ratio to 3 times per year, the company’s
return on total assets will increase to 60%.

Turnover ratios can be calculated for different asset items. In this chapter, the focus
is placed on the following turnover ratios:

5.3.1 TOTAL ASSETS

The total asset turnover ratio provides an indication of the efficiency with which
a company’s total assets are utilised to generate revenue. The higher the value
of the total asset turnover ratio, the more times per year the investment in total
assets is converted into revenue. For Nuta Ltd, the value is calculated as follows:

Revenue
Total asset turnover ratio =
Average total assets

22 600
=
0,5 (11 500 + 15 000)

= 1,71 times

If an enterprise is able to improve its total asset turnover ratio while maintaining
the same profit margins, it should result in an increase in its return on total assets.

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Introduction to Financial Management

5.3.2 CURRENT ASSETS

The turnover ratio of the current assets provides an indication of the number of
times per year that the investment in the current assets is converted into revenue.
The calculation is as follows:

Revenue
Current asset turnover ratio =
Average current assets

22 600
=
0,5 (5 250 + 5 700)

= 4,13 times

5.3.3 INVENTORY

The inventory turnover ratio focuses on the investment in inventory. Since the
cost of sales is determined by the amount of inventory that is sold, this ratio does
not focus on the revenue, but the cost of sales is used:

Cost of sales
Inventory turnover ratio =
Average inventory

12 000
=
0,5 (2 100 + 1 750 )

= 6,23 times

5.3.4 TRADE RECEIVABLES

This ratio investigates the number of times per year that the investment in the
company’s trade receivables is converted into credit revenue. Please note that
only the credit revenue, and not the net revenue, is used, since it is the credit
revenue that results in the creation of the trade receivables.

Credit revenue
Trade receivables turnover ratio =
Average trade receivables

11 000
=
0,5 (650 + 1 200 )

= 11,89 times

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 Analysis of Financial Statements

6. LIQUIDITY

Liquidity refers to an enterprise’s ability to honour its short-term obligations.

Sufficient liquidity is therefore achieved when enough current assets are available
to cover the current liabilities. If a company’s liquidity is insufficient over the long
term it may eventually lead to problems with solvency, which could ultimately
threaten the survival of the enterprise. By calculating ratios such as the current ratio,
the acid-test ratio, the cash ratio, and turnover time ratios, the liquidity of a company
can be investigated.

6.1 LIQUIDITY RATIOS

6.1.1 CURRENT RATIO

In the current ratio, the current assets and the current liabilities are compared. If
a company maintains acceptable levels of liquidity, the value of this ratio should
be more or less equal to two. If a value of less than one is obtained, it indicates
that there is less than R1 of current assets available to cover every R1 of current
liabilities, and this could be an indication that the company’s liquidity is insufficient.

Current assets
Current ratio =
Current liabilities

5 700
=
2 050

= 2,78

6.1.2 ACID TEST RATIO (QUICK RATIO)

During the calculation of the acid test ratio, the focus is again placed on the
company’s current liabilities. Unlike the current ratio, however, not all current
assets are included in its calculation. Since it normally takes time to sell inventories,
the investment in the inventories may not be immediately available to redeem the
current liabilities. In the majority of cases, prepayments can also not be reclaimed,
and are therefore also not available to cover the current liabilities. When calculating
the acid-test ratio, these two items are therefore excluded from the current assets:

Current assets - inventories - prepayments

Acid test ratio =
Current liabilities

5 700 - 1 750 - 900

=
2 050

= 1,49

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Usually a value equal to 1 would be considered acceptable, but similar to the

current ratio, the value of this ratio may differ between enterprises and industries.

6.1.3 CASH RATIO

The acid test ratio excludes some of the current assets, since it may not be
possible to convert the items into cash over the short term. When calculating
the cash ratio, the focus is placed on only the cash and cash equivalents. This
ratio indicates if sufficient cash is available to cover the current liabilities. In most
enterprises the investment in cash would not be sufficient to cover the current
liabilities (see the chapter on cash management, where more attention to the
management of cash is given).

Cash and cash equivalents

Cash ratio =
Current liabilities

1 050
=
2 050

= 0,51

NB: Remember that marketable securities form part of the cash and cash equivalents.

6.2 TURNOVER TIMES

A second component that is important when evaluating a company’s liquidity is the

turnover time of its current assets and current liabilities. The turnover time of current
assets provides an indication of how long it takes to convert the investment in the
current asset into revenue. The longer it takes, the weaker the company’s liquidity
will be. For current liabilities, the turnover time provides an indication of the average
period of time before the liability is redeemed. Shorter turnover times indicate
that current liabilities are paid earlier, which will have a negative effect on liquidity.

6.2.1 TURNOVER TIME OF TRADE RECEIVABLES

The turnover time of trade receivables indicates the average time that it takes
to convert the investment in trade receivables into credit revenue. This represents
the average collection period of the trade receivables, i.e. how long on average
credit customers take to repay their accounts. If a company observes an increase
in the value of this ratio over time, it could be a sign of a decline in liquidity. It
could also be an indication that the credit terms that are applied are too lenient.

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 Analysis of Financial Statements

Average trade receivables 360

Trade receivable turnover time = 
Credit revenue 1

0,5 (650 + 1 200 ) 360

= 
11 000 1

= 30,27 days

6.2.2 TURNOVER TIME OF INVENTORY

The inventory turnover time calculates the average time it takes to convert the
investment in inventories into revenue. It therefore provides the average age of
the inventories (how long an item of inventory has been in the enterprise before
it is sold). Similar to the inventory turnover ratio, this ratio is calculated by using
the cost of sales. An increase in the inventory turnover time will have a negative
effect on the liquidity of an enterprise.

Average inventories 360

Inventory turnover time = 
Cost of sales 1

0,5 (2 100 + 1 750 ) 360

= 
12 000 1

= 57,75 days

6.2.3 TURNOVER TIME OF TRADE PAYABLES

The benefit of this ratio is that it indicates the average period of time that it takes
before the trade payables are repaid. If the turnover time decreases, it means that
the trade payables are repaid earlier. This will have a negative effect on the liquidity
of the enterprise, while an increase in the turnover time will improve the liquidity.

Average trade payables 360

Trade payables turnover time = 
Credit purchases 1

0,5 (600 + 700 ) 360

= 
7 200 1

= 32,50 days

7. SOLVENCY

Solvency refers to an enterprise’s ability to cover all its obligations when it eventually
closes down its operating activities. The comparison between the total assets
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and the total debt capital is, therefore, of great importance. Two main solvency
ratios include the debt-to-assets and debt-to-equity ratio. Coverage ratios can also
be utilised to examine the solvency of a company.

7.1 SOLVENCY RATIOS

7.1.1 DEBT-TO-ASSETS RATIO (DEBT RATIO)

The relationship between the debt capital and the total assets provides an indication
of the portion of the total capital requirement that is being financed by means of
debt capital. The higher the value of the ratio, the weaker the enterprise’s solvency
position becomes. If the value of the ratio exceeds 50%, it is an indication that the
enterprise does not have sufficient assets to easily cover its debt capital obligations.

Debt 100
Debt - to - assets ratio = 
Total assets 1

Debt 100
OR = 
Total capital 1

5 050 100
= 
15 000 1

= 33,67%

NB: Remember that the deferred tax liabilities and retirement benefit obligation are
not considered as part of the debt capital.

7.1.2 DEBT-TO-EQUITY RATIO

This solvency ratio places the debt capital in direct relation to the equity. A ratio
equal to 100% implies that for every R1 of debt there is R1 of equity. As soon as
the debt exceeds the equity (>100%), the company’s solvency is placed under
pressure. Any ratio of less than 100% indicates that the solvency is healthy and
provides space for further financing by means of debt, especially if the return on
total assets is higher than the cost of debt (i.e. if a positive financial leverage exists).

Debt capital 100

Debt - to - equity ratio = 
Equity capital 1

5 050 100
= 
9 450 1

= 53,44%

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 Analysis of Financial Statements

7.2 COVERAGE RATIOS

Another aspect that needs to be considered when evaluating the solvency of

a company is its ability to meet certain obligations. If a company is not able to
cover some obligations, it may eventually result in problems with solvency. In order
to determine if sufficient profits are available to cover these obligations, a number
of ratios can be calculated. All of these ratios focus on an obligation, and then
compares it to the profits that are available to pay that obligation.

7.2.1 FINANCE COST COVERAGE

Finance cost usually represents a legally enforceable obligation. If a company does

not pay the finance cost on its debt capital, the debt capital providers can take
legal action to collect it. The finance cost coverage indicates if sufficient profits
are available to pay the finance cost. The relevant profit figure is the profit before
finance cost and tax (EBIT).

Profit before finance cost and tax

Finance cost coverage =
Finance cost

3 500 + 550
=
550

= 7,36 times

In this example the finance cost coverage is sufficient, since an amount of R7,36 is
available for each R1 of finance cost that needs to be paid.

7.2.2 FIXED OBLIGATION COVERAGE

Fixed obligations refer to those obligations that a company always need to honour.
If these obligations are not covered, it could result in the termination of the
company’s activities. Fixed obligations consist of finance cost, the rent paid (lease
payments), and capital redemption. Capital redemption is calculated as the
decrease in any capital, i.e. any decreases in the ordinary share capital, preference
share capital, non-controlling interest and any long-term or short-term interest-
bearing borrowings (excluding bank overdraft).

The profit available is calculated by adding the finance cost and the rent paid
(which is normally included as part of the company’s operating expenses) to
the profit before tax. Since capital redemption is financed with after-tax funds, it
needs to be converted to a before-tax figure by dividing it by (1-t).

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Profit before tax + finance cost + rent paid

Fixed obligation coverage =
Capital redemption
Finance cost + rent paid +
(1- t )

3 500 + 550 + 300

=
300 + 250
550 + 300 +
(1- 0,4)

= 2,46 times

For Nuta Ltd, an amount of R2,46 is therefore available for each R1 of fixed
obligations it needs to cover. A value of less than one indicates that insufficient
profits are generated to meet the fixed obligations, and consequently, reserves
will have to be used (if available). Alternatively, additional capital will have to be
obtained to meet the fixed obligations.

7.2.3 PREFERENCE DIVIDEND COVERAGE

The preference dividend coverage ratio determines if sufficient earnings are

available to pay the preference dividends. The relevant profit figure is therefore
the profit after tax and non-controlling interest, since preference dividends can
only be paid after provision has been made for all other obligations.

Profit after tax - non - controlling interest

Preference dividend coverage =
Preference dividend

2 100 - 100
=
50

= 40,00 times

7.2.4 ORDINARY DIVIDEND COVERAGE

The ordinary shareholders have the last claim on the earnings of an enterprise.
When the ordinary dividend coverage is therefore calculated, the focus is placed
on the attributable earnings (i.e. after all other obligations have been paid). Usually,
a company will only declare dividends if sufficient earnings are available to pay
the dividends. If the ordinary dividend coverage ratio is less that one, reserves from
the previous years will have to be used to pay the dividends. Alternatively, additional
debt capital will have to be obtained to finance the dividends.

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 Analysis of Financial Statements

Profit after tax - non - controlling interest - PS div

Ordinary dividend coverage =
Ordinary dividend

2100 - 100 - 50
=
800

= 2,44 times

8. INVESTMENT RATIOS

The following group of ratios is of great importance to the current and potential
shareholders of an enterprise. Usually these ratios provide an indication of the
benefits an investor obtains from his investment in a company’s shares.

8.1 EARNINGS PER SHARE

The earnings per share (EPS) is an indication of the attributable earnings that was
earned per ordinary share during the year.

Profit after tax - non - controlling interest - PS div

Earnings per share =
Average number of issued ordinary shares

2 100 - 100 - 50
=
0,5 (1 800 + 3 000)

= 81,25c per share

A total amount of 81,25 cent per share is therefore available to the ordinary
shareholders. Usually, only a portion of this is distributed as an ordinary dividend.

8.2 EARNINGS-YIELD

The earnings-yield compares the EPS with the market price per share. The value
of this ratio indicates what return is earned on the market price of the share.

EPS 100
Earnings - yield = 
Market price per share 1

81,25 100
= 
500 1

= 16,25%

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Introduction to Financial Management

8.3 DIVIDEND PER SHARE

The dividend per share indicates what amount investors received per share in the
form of dividends.

Ordinary dividends declared

Dividend per share =
Average number of issued ordinary shares

800
=
0,5 (1 800 + 3 000)

= 33,33c per share

8.4 DIVIDEND-YIELD

The dividend-yield compares the market value of the share with the dividend per
share received. It provides an indication of the percentage return earned on the
investment in the form of dividends.

Dividend per share 100

Dividend - yield = 
Market price per share 1

33,33 100
= 
500 1

= 6,67%

8.5 DIVIDEND PAYOUT RATIO

This ratio indicates the percentage of the attributable earnings that is paid out
as dividends. If the ratio is less than 100%, then there are sufficient earnings
to cover the dividend. A low payout ratio indicates that a large portion of the
earnings is being reinvested. This is a beneficial form of financing for a fast
growing young company. Investors that are dependent on dividends as their
source of income will however not appreciate a low payout ratio.

Ordinary dividends declared 100

Dividend payout ratio = 
Attributable earnings 1

800 100
= 
1 950 1

= 41,03%

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 Analysis of Financial Statements

8.6 PRICE-EARNINGS RATIO

The price-earnings ratio (P/E ratio) indicates how many Rands investors are
prepared to pay for each R1 earnings per share that is earned by the company.

Market price per ordinary share

Price - earnings ratio =
Earnings per share

500
=
81,25

= 6,15

8.7 MARKET-TO-BOOK VALUE

The market-to-book value ratio is predominantly utilised to gauge how investors in

the market perceive a company’s share value. Remember that a company’s market
value (market capitalisation) is equal to the number of issued ordinary shares
multiplied by the market price of the share. This ratio can indicate to what extent
the market price of the share is overvalued or undervalued. Various factors, such
as investor sentiment, for example, can contribute to higher/lower market-to-book
ratios. High values will occur at the peak of a bull market when sentiment is typically
high, whilst the value could drop to below one during a bear market when investors'
sentiment is low. The effectiveness of a company’s management could also impact
this ratio. If management is creating value for their stakeholders, investors may be
willing to pay a higher market price for the shares of this particular company.

Market capitalisation of ordinary shares

Market − to − book value =
Book value of ordinary shares

3 000  R5
=
7 750

= 1,94

8.8 NET TANGIBLE ASSET VALUE PER ORDINARY SHARE

The net tangible asset value per ordinary share calculates the statement of
financial position value of the ordinary shares if all debt capital is redeemed.
Intangible assets, such as goodwill, manufacturing licenses and patent rights, are
also excluded since the valuation of these items are problematic. All other
statement of financial position items should also be adjusted as far as possible in
order to provide an accurate indication of the fair values of the items.

Net tangible asset value per share

Ordinary shareholders' equity - Intangible assets

=
Number of issued ordinary shares

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Introduction to Financial Management

7 750 - 1 600
=
3 000

= R2,05 per share

9 SUMMARY

In this chapter, the focus was placed on the calculation and interpretation
of a number of financial ratios. The major advantage of these ratios is that
information from the financial statements is converted into an understandable
and comparable format, which can be used to evaluate the financial performance
and position of an enterprise. Because of the relative simplicity of the ratios,
they normally form the basis of any financial evaluation. Consequently, a thorough
understanding of these ratios is of great importance for any manager.

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