Chapter 13 and 14: Interpreting accounts

• Explain the remark "loan capital normally carries a relatively low risk for the lender"

  Default risk: loan stock capital ranks higher in the event of a wind up than equity and preference shares so can be described as relatively low risk.

  Market risk: income flow is fixed and the security is better than equities, so market price more stable. Therefore low market risk
• What is the impact on shareholders if the company is partially financed by borrowing

  Higher rate of returns as the alternative would be the sale of additional shares, diluting returns. However, security enjoyed by lenders increases the risk attributable to shareholders
• Why is risk transferred to the shareholders

  Interest has to be paid regardless of whether the company is making profits, greater proportion financed by debt, greater risk that nothing is left for the shareholders when the company fails
• Interest cover definition


  Profit on ordinary activities before interest and taxation divided by the annual interest payments due on that issue of the loan capital and all prior ranking loan capital
• Interest cover/Income cover formula

  (profit on ordinary activities before interest and taxation)/(annual interest payments due on that issue of loan stock+all prior loan stock)
• What does interest cover do?

  Measures the amount of times that the company could pay the interest out of profit before tax and interest. The higher, the less likely the company will run into difficulty
• What is a good level of interest cover?

  Risky if the company can't cover interest at least 3 or 4 times
• The limitation of interest cover

  Does not consider how volatile profits are or the length of time the loan is outstanding
• Interest priority percentages

  The slice of profit on ordinary activities before interest and tax which covers the annual interest payments due on each issue of loan capital
• Interest priority percentages formula

  If the interest for the loan stock in question is x and the interest cover for the loan stock immediately prior in ranking to the one in question is y, then the interest priority percentage for the loan stock is 1/y to 1/x
• The upper and lower interest priority percentages

  The lower percentile is the inverse of the cover figure for the previous highest ranking issue. The upper percentile is the inverse for the cover figure for the issue of loan stock being considered
• Asset cover

  A conservative estimate of the amount of money available to meet the loan stockholders demands for repayment if the company were to wind up
• Asset cover formula

  (Total assets-current liabilities-intangible assets)/(loan capital + prior ranking debt)
• Why is intangible assets deducted

  Likely to be worthless on winding up
• Why are current liabilities deducted?

  CL are repaid before the debtholders even though they make rank below the loan capital
• The main limitation of asset cover

  Current value for assets may not reflect their realisable market value if the company is wound up
• A good level for asset cover

  A min of 2x offers an arbitrary safety margin
• Asset priority percentages

  The slice of total assets less CA less ITA which is available to cover the nominal value of each issue of loan capital'
• The percentiles of asset priority percentages

  Lower percentile: inverse of the cover figure for the previous highest ranking issue.

  Upper: inverse of the cover figure for the issue of loan stock being considered
• Gearing 


  Refers to the relative proportions of long term debt and equity finance in a company. High gearing=high level of debt financing
• Asset gearing/capital gearing

  borrowings/equity or (equity+borrowing)
• Borrowings

  All forms of long term capital
• Equity

  The book value of ordinary shares
• How are preference shares treated under gearing

  Included as part of borrowing rather than equity because they carry a fixed rate of dividend and their holders are repaid before ordinary shareholders in the event of default
• Shareholders equity ratio

  (shareholders equity-intangibles)/(total assets - current liabilities -intangibles)
• what is the difference between the asset gearing and the shareholders equity ratio

  The proportion of finance provided by equity rather than debt
• Analysis of the shareholders equity ratio

  The higher the ratio, the stronger the financial position of the organisation. The lower the proportion, the more possibility of the organisation becoming over-dependent on outside providers of capital
• Income gearing formula

  Interest on borrowings / profit on ordinary activities before interest and tax
• Earnings per share formula

  earnings on ordinary activities / no. of issued ordinary shares
• EPS definition

  The amount of profit that had been earned for each ordinary share (excludes preference dividend)
• Basic earnings per shares

  Calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the period. The net profit or loss attributable to ordinary shareholders is after taxation, minority interests, extraordinary items and preference dividends
• Diluted earnings per shares

  A company could have entered into obligations that could dilute the EPS in the future.
• Price earnings ratio formula

  market price of an ordinary share/EPS
• prospective PE ratio

  Based on estimate of the earnings over the next 12 months
• Historical PE ratio

  Based on the previous year earnings
• If the price earnings ratio is high

  The company is attractive when considered as a source of revenue. The market believes: low risk investment, earnings will grow rapidly in the future
• If the PE ratio of a share is high relative to other similar companies

  Share is overvalued
• Earnings

  The amount of money generated by a company for its shareholders
• What does the PE ratio show

  How many times bigger the price of a share is than the earnings that the share produces
• Dividend yield

  The amount of current income (dividends) an investor receives per unit of investment (the share price)