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Financial Accounting
Module code: MAN2907L


Investor Ratios & Corporate Failure
Lecture 9
Three Pillars of Wisdom for
investors
In circumstances where the economy
delivers:
Rising corporate earnings
Benign inflation and interest rates
Reasonable valuations
Investment in the stock markets is likely to
prove profitable
INVESTOR RATIOS
RETURN ON SHAREHOLDER'S EQUITY
net profit after tax before ordinary dividend
(EATOS) / ordinary share capital + reserves

EARNINGS PER SHARE
net profit before extraordinary items less
preference dividend / weighted average
ordinary shares in issue during year

PRICE/EARNINGS RATIO
market price of share / earnings per share
INVESTOR RATIOS - cont.

DIVIDEND COVER
net profit before ordinary dividend /
ordinary dividend

DIVIDEND YIELD %
latest annualised dividend / market price
of share (gross or net?)

ILLUSTRATION OF INVESTOR RATIOS
Income statement
Sales
less: Costs

Less: Corporation tax

Dividends payable
Retained profit for the year
10,000
(6,625)
3,375
(1,200)
2,175
(1,000)
1,175
,000
Current market price of ordinary shares
Most recent declared dividend
Number of ordinary shares in issue
3.00
10p per share
10 million
Other information:
Earnings per share
Price earnings ratio
Dividend cover
Dividend yield
?
EARNINGS PER SHARE
How much profit has the company made
for the investors on each share?


= 2,175,000/10,000,000 = 21.75p
EPS =
net profit after tax (EATOS)
average number of ordinary shares issued
PRICE/EARNINGS RATIO
P/E = Price per share
Earnings per share
i.e. - how many years of earnings you
would pay for
Shows how long it will take to recover the
share price out of profits at current levels
PRICE/EARNINGS RATIO
P/E = current share price / EPS
= 300p/21.75p
= 13.8 times
A high P/E compared to that of similar
companies implies that earnings growth is
expected

A low P/E compared to that of similar
companies implies that flat earnings are
expected

PRICE/EARNINGS RATIO
PE A Measure of Market
Confidence
Market price takes into account anticipated changes in
the earnings arising from assessment of macro events,
such as
Political factors, e.g. imposition of trade embargoes or
sanctions
Economic factors, e.g. downturn in manufacturing
activity
Companyrelated events, e.g. possibility of organic or
acquired growth and the implication of financial
indicators for future cash flow estimates.
11
PE Ratio Implication of
Financial Indicators
Statement of Financial Position:
change in debt/equity ratio in relation to prior periods
new borrowings to finance expansion
debt restructuring following inability to meet current repayment terms
adequacy of working capital
low acid test (quick) ratio in relation to prior periods indicating liquidity
difficulties
change in current ratio in relation to prior periods, i.e. higher indicating a
build-up of slow-moving inventory and lower possible inventory-outs
contingent liabilities that could be damaging if they crystallize non-
current assets being increased or not being replaced
12
Income statement:
change in sales trend
limited product range, products moving out of patent
protection period
expanding product range
changes in technology beneficial or otherwise to company
high or low capital expenditure/depreciation ratio indicating
that productive capacity is not being maintained
loss of key suppliers/customers, e.g. loss of longstanding
Marks & Spencer contracts
change in ratio of R&D to sales
PE Ratio Implication of
Financial Indicators
DIVIDEND COVER & YIELD
Dividend per share 1M / 10M = 10p

Dividend Cover
EPS / DPS = 21.75p / 10p
= 2.1 times
Dividend Yield
DPS / SP x 100 = 10 / 300 x 100
= 3.3%
BELLWARD plc - SUMMARY
EPS 2,175,000 = 21.75p
10,000,000

P:E 300p = 13.8 times
21.75

Dividend cover 2,175,000 = 2.175 times
1,000,000

Dividend Yield 10/300 = 3.3%

What is it?.........
Administration
Liquidation
Distress
Restructuring
Refinancing
Takeover
COMPANY FAILURE
Identification of risk and avoidance
- Management
Mitigation of consequences
- Investors
Identification of going concern problem
- Auditors
PREDICT FAILUREWHY?
Study of root causes

Identify contributory factors

Statistical modelling
APPROACHES TO PREDICTION
Study of root causes
Business cycle
Major misjudgments
Areas of weakness
Attitudinal problems
APPROACHES TO PREDICTION
Identify contributory factors
Inherent risk
Fast aggressive growth
Youth/size
Dominant personality(s)
APPROACHES TO PREDICTION
(Statistical) modelling
Univariate (traditional)
Multivariate
Z-scores
Financial numbers; combine by
ranking/weighting
A-scores (non-statistical)
Financial environment; assesses defects,
mistakes and symptoms
APPROACHES TO PREDICTION
Z-scores
Altman
Taffler
A-scores
Argenti

APPROACHES TO PREDICTION
Professor E.I.Altman 1968
Identified five key factors and combined them
into a composite multivariate score by using
different weightings. The factors related to:
Profitability
Efficiency/Productivity
Liquidity
Capital structure (gearing)
Asset utilisation
ALTMANS Z-SCORE
Z = 0.012X
1
+ 0.014X
2
+ 0.033X
3

+ 0.006X
4
+ 0.999X
5

X
1
is - working capital/total assets (L)
X
2
is - retained earnings/total assets (G)
X
3
is - operating profit (PBIT)/total assets (P)
X
4
is - mkt value of equity/book value of debt (G)

X
5
is - sales/total assets (E)
ALTMANS Z-SCORE FORMULA
Over 2.7 OK under 1.8 bad!

ALTMANS Z-SCORE

JJB sports, once Britains highest sports
retailer, collapsed into administration on
1
st
October 2012.

Could this have been predicted??

JJB financial statements available on
blackboard.
Z = C
0
+ C
1
R
1
+ C
2
R
2
+ C
3
R
3
+ C
4
R
4
(C is secret!)

R
1
is - PBIT/ current liabilities (53%)
R
2
is - current assets/total liabilities (13%)
R
3
is - current liabilities/total assets (18%)
R
4
is - no credit interval how long can the
company trade with no money coming in
(16%)
TAFFLER/TISSHAW Z-SCORE
Over 0.2 OK under 0.2 bad!
Argentis thesis is that most failed companies follow a
similar 3-stage path:

Inherent defects
company management
accounting systems
response to change
Major mistakes
over-gearing
overtrading
the big project
Final symptoms
poor ratios & a rise in creative accounting
ARGENTIS A-SCORING
lacks any underlying theory that is useful to specify
the variables to be included in the models
described as brute empiricism
is based mainly on historical cost accounts
results in self fulfilling prophecy
is situation specific
lacks post-analysis evidence
analysis is based upon a distorted balance of failed
and non-failed companies
the future is always different


CRITICISMS OF MULTIVARIATE ANALYSIS


ANY QUESTION?