INTERPRETING FINANCIAL STATEMENTS 89
Liquidity
Improvements in the working capital and acid test ratios are the result of changing
the balance between current assets and current liabilities. As the working capital
cycle in Figure 6.1 showed, money changes form between debtors, stock, bank
and creditors. Borrowing over the long term in order to fund current assets will
improve this ratio, as will profits that generate cash flow. By contrast, using liquid
funds to repay long-term loans or incurring losses will reduce the working capital
used to repay creditors.
Gearing
The gearing ratio reflects the balance between long-term debt and shareholders’
equity. It changes as a result of changes in either shareholders’ funds (more shares
may be issued), raising new borrowings or repayments of debt. As debt increases
in proportion to shareholders’ funds, the gearing ratio will increase.
Interest cover may increase as a result of higher profits or lower borrowings
(and reduce as a result of lower profits or higher borrowings), but even with
constant borrowings changes in the interest rate paid will also influence this ratio.
Activity/efficiency
Asset turnover improves either because sales increase or the total assets used
reduce, a similar situation to that described above for ROCE. The efficiency with
which debtors are collected, inventory is managed and creditors paid is also an
important measure.
Shareholder return
Decisions made by directors influence both the dividend per share and the
dividend payout ratio. Dividends are a decision made by directors on the basis
of the proportion of profits they want to distribute and the capital needed to be
retained in the business to fund growth. Often, shareholder value considerations
will dictate the level of dividends, which businesses do not like to reduce on a per
share basis. This is sometimes at the cost of retaining fewer profits and then having
to borrow additional funds to support growth strategies. However, the number of
shares issued also affects this ratio, asshare issues will result in a lower dividend
per shareunless the total dividend is increased.
As companies have little influence over their share price, which is a result of
market expectations as much as past performance, dividend yield, while influenced
by the dividend paid per share, is more readily influenced by changes in the market
price of the shares.
Earnings per share is influenced, as for profitability, by the profit but also
(like dividends) by the number of shares issued. As for the dividend yield, the
price/earnings (P/E) ratio is often more a result of changes in the share price than
in the profits reflected in the earnings per share.
Explanations for changes in ratios are illustrated in the following case study.