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

1. Unit 2
Understanding Accounts
Liquidity, financing and market

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Financing
Businesses need financing
This is usually achieved through a combination of shareholder funding (“equity”)
and borrowings (“debt”)
Why have debt?

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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Price earnings ratio (p/e or PER)
This is defined as :
Market Price per share/ earnings per share

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. 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. 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. 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. 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. Price to book ratio
Differences between book value and market value include?

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. Next Time
We shall look at derived cash flow