Learning area 9 Chapter 12: Interpretation of accounts Lecture 1

You should be able to… Interpret AFS by using ratio analysis and discuss the limitations of the above interpretation Calculate ratios Explain ratios NB: apply ratios and evaluate results by using ratios Discuss limitations of ratios used above Why applicable to actuaries? Appraisal of companies for investment purposes Understand employers’ AFS

Outlay Lecture 1: Sections 1 – 4 (p2 – 19) Lecture 2 & 3: Sections 5 – 8 (p20 – 45)

Introduction pages Only read p2 – 3 (Introduction) We will use the AFS per p4 and 5… please bring these along to class! NB!! To be meaningful ratios should be compared to: Prior years (over time), Companies in the same industry, Norm and/or Budget or management expectation (same strategy)

1. Measuring risk associated with loan capital (page 6) What is loan capital? It is finance obtained from lenders and to be paid back to the lender e.g. Long-term borrowings/ loans Preference share capital Debentures What is to be paid to lenders? Interest ‘Capital’- portion (balance on BS)

1. Measuring risk associated with loan capital (page 6) What is the risks to the lender? Not sufficient profits to pay interest Not sufficient assets to pay loan capital Ratios: Income (interest) cover (2.1) and income priority percentages (2.2) Asset cover (3.1) and asset priority percentages (3.2)

2. Interest cover (page 7) 2.1 Interest cover How many times do a company’s profit before interest and tax (PBIT) cover its interest payments? Interest cover (Income cover) = PBIT interest payments (or expense) due to specific lenders + to all prior loan stock Prior loan stock = loan stock towards which interest payments needs to be made before applicable lenders may be paid Secured…. / mortgaged always first Then all others Lastly subordinated (last paragraph of page 7)

2. Interest cover (page 8) cont… Cover-up Ltd Step 1: Split interest payments LoanCalculationInterest paid 9.75% Mortgage debenture 2014 (9.75% * ) % Unsecured loan 2015(10% * ) % Euro-sterling 2016(9.5% * ) % Subordinated loan stock 2013(11% * )2 090 Total interest9 950

2. Interest cover (page 8) cont… Step 2: Calculate interest cover for each of the loans: LoanCalculationIncome cover 9.75% Mortgage debenture 2014 (35 000/1 560)22.4x 10% Unsecured loan 2015 (35 000/ ( ) 4.5x 9.5% Euro-sterling 2016 (35 000/ ( ) 4.5x 11% Subordinated loan stock 2013 (35 000/( ) 3.5x

2. Interest cover (page 8) cont… What ratio will be acceptable? >= 3 or 4 times, but depend on stability of profit Main limitations of interest cover: Does not consider how volatile profits are Does not take into account the length of time for which loan is outstanding (see example bottom page 8) Why calculate interest cover on all the company’s issues of loan capital? Default on any of its loan stock may result in the company winding up!

2. Interest priority percentages (page 9) 2.2 Interest / income priority percentages: Skip page 9 from 2.2 “Interest priority percentages” to page 10

3. Asset cover and asset priority percentages (page 11) 3.1 Asset cover How many times do net tangible assets cover its long-term liabilities? Asset cover = total assets – current liabilities – intangible assets specific loan capital + prior loan capital Does a company have sufficient assets that if all were sold its liabilities can be paid Less conservative asset cover : = total assets – current liabilities – intangible assets total loan capital Risky:Asset cover less than 2 or 2.5 times

3.1 Asset cover (page 12) cont… Cover-up Ltd Net tangible assets = – – = LoanCalculationAsset cover 9.75% Mortgage debenture 2014 ( /16 000)9.4x 10% Unsecured loan 2015 ( / ( ) 1.9x 9.5% Euro-sterling 2016 ( / ( ) 1.9x 11% Subordinated loan stock 2013 ( /( ) 1.5x

3.1 Asset cover (page 12) cont… The main limitation of asset cover: The current value shown in the B/S for assets might not reflect their realisable market value if the company is wound up. Like income cover, capital cover does not take into account the term of the loan stock. 3.2 Asset priority percentages: Skip page “Asset priority percentages”

4. Gearing (leverage) (page14) NB!! Proportion of long-term debt to equity High gearing means that company has a high level of debt financing Measurements: 1.Asset gearing (capital gearing) 2.Income gearing

4.1 Asset gearing (page 14) = borrowings or borrowings equityborrowings + equity Borrowings (long-term liabilities): Per the statement of financial position (B/S) Include preference share capital! Include bank overdraft if ‘permanent’ Equity = capital and reserves per the Statement of Financial Position, but exclude preference share capital! And ‘write off’ intangible assets High risk (highly geared): Formula 1: if > 67% Formula 2: if > 40%

4.1 Asset gearing (page15) Cover Up Ltd Asset gearing per second formula: = = 66.7%

4.1 Asset gearing (page 16) What is the effect of gearing on profitability and on risk? Example on page 16 and 17 Highly geared: Shareholders benefit (higher returns, but Higher risk…still needs to pay interest even in a bad year

4.1 Asset gearing p18 Shareholders equity ratio: shareholders’ equity - intangibles total assets – current liabilities – intangibles Measures the proportion of finance provided by equity (rather than the proportion provided by debt) The higher the ratio stronger the financial position of company The lower the ratio more possibility of company over dependent on outside sources of capital

Shareholders’ equity ratio Question 12.8 (40’ + 20’+ 10’) – (211’ – 41’ – 20’) = 33.3%

4.2 Income gearing (page 19) Income gearing = interest on borrowings Profit on ordinary activities before interest and tax If a company has preference shares: Interest on debt + Pref share dividends/(1-t) Profit on ordinary activities before interest and tax

4.2 Income gearing p19 Cover-up Ltd Income gearing = = 28.4%

Consultation hours – this week Wednesday from 9:00 – 12:00 Thursday from 14:30 – 16:15