By

Dr Mohammed Hamdan
Week 3.2
Learners will gain an overview of the:
 Features and funding of a limited company

 Types of share capital, debentures and

reserves
 Categories of financial ratios;
 Calculation
of ratios for assessing financial
performance and position of a business;
 The significance of the ratios calculated;
- A ratio simply relates one figure appearing in
the financial statements to some other figure
appearing there (for example, net profit in
relation to capital employed).

- Financial ratios provide a quick and relatively

simple means of assessing the financial
health of a business.
 Profitability - relationship between profit, revenue,
assets, equity and capital employed;
 Efficiency - how effectively and efficiently the assets
and liabilities are used;
 Liquidity - ability of business to stay solvent by
meeting its short-term financial obligations;
 Financial Gearing – relationship between debt and
equity financing, indication of risk;
 Investment – helping shareholders assess returns on
their investment.
 To get better understanding about a business’s performance.
 Inter year comparisons - to establish a trend from past
years, to provide a standard of comparison;
 Intra firm comparisons - to compare against a similar
business in the same industry;
 Benchmark - compare against industry averages.

An inexact science,
science so results must be interpreted cautiously.
One ratio may indicate something but other ratios and data are
needed to support and interpret it in order for a
meaningful evaluation.
 Offer limited liability to their shareholders (owners),
i.e., in case of insolvency, the maximum amount that
owners stand to lose is only their share of the capital
in the business.

 They may be private (Ltd) or public (Plc):

(1) PLC can quote the shares in a stock exchange
whereas the Ltd Company cannot (2) the shares of Ltd
company are normally sold to close friends and others,
and that can only be done if all the shareholders agree.

 There are large number of shareholders, especially in

the case of Plc.
 Owner/manager split: shareholders
appoint directors to run the business
on their behalf.
https://
www.netlawman.co.uk/ia/appointmen
t-removal-company-directors
 Shareholders receive share of profits
(dividends), usually in two stages, in
mid year (interim dividend) and at the
end of the ear (final dividend)
The capital in limited liability company is known as equity, it
consists of Share Capital and Reserves.
Reserves

A- Ordinary shares
When a company is set up for the first time it issues shares,
which are paid for by investors.

Shares are denominated (expressed) in units of, e.g., 25p, 50p

or £1, this is referred to as their nominal value (also par value).

For example, when a company is set up with a share capital of,

say, £100,000, it may be decided to issue:
Shareholders' equity £
£1 ordinary shares 100,000
OR 50p ordinary shares
OR 25p ordinary shares
They are most common type of shares and have the
following characteristics:

-No right to fixed dividend, alternatively, entitled to all

remaining profit (after paying preference dividend).
They own the 'equity' of the business, and any reserves

(explained later) of the business

Ordinary shareholders are thus the effective owners of

a company.
Ordinary shares normally carry voting rights.
B- Preference shares (PS):
have the following characteristics
- Right to fixed dividend (as a percentage of their
par value) with priority over ordinary shares.
-Other rights (may vary from company to company

and country to country), such as:

1- Do not have a right to vote.

2- During liquidation: preference shareholders have
a priority right over ordinary shareholders to a
return of their capital
All reserves if existed are owned by the ordinary
shareholders, who own the 'equity' in the company.

(a) Share premium

(b) Revaluation surplus
(c) Retained earning
(d) Reserves
The amount at which the shares are issued may
exceed their par value, therefore, the difference
between the issue price of the share and its par value
is called Share Premium.

For example, a company might issue 100,000 £1

shares at a price of £1.20 each. Subscribers will then
pay a total of £120,000.

The excess of £20,000 is the amount of share

premium, and the share capital of the company would
be shown in its accounts at par value, £100,000
A dividend is a payment made by a
corporation to its shareholders, usually as a
distribution of profits. When a corporation
earns a profit or surplus, it can re-invest it in
the business (called retained earnings), and
pay a fraction of this reinvestment as
a dividend to shareholders
Companies may issue debenture or loan stock.
These are long term liabilities NOT capital.
capital
They differ from shares as follows:

1- Shareholder= owner, debenture-holder=

creditor
2- The interest of debenture notes must be
paid, not so dividends.
3- Debenture notes often secured on company
assets.
Example – BP’s SOFP at 31/05/14 (£000) 2018
2017
Non-current assets 1,800
1,400
Current assets
Inventory 1,200
200
Receivables 400
800
Cash 100
100
1,700
1,100
Total assets 3,500
2,500

Equity and liabilities

Ordinary share capital (@ £0.50) 1,200
500
Share premium 600
0
BP’s Income Statements (£000) 2018 2017
Revenue 2,000 1,000
Cost of sales (1,300) (700)
Gross profit 700 300
Distribution costs (260) (90)
Administration expenses (100) (60)
Operating profit 340 150
Interest (100) (60)
Profit before taxation 240 90
Taxation (50) (20)
Profit after taxation 190 70
Ordinary dividends (90) (50)
Retained profit for the year 100 20
Profit and loss b/fwd 100 80
Profit and loss c/fwd 200 100

Share price (£) 1.30 1.26

Industry information:
Industry PE ratio 22 20
Industry average growth in EPS (%) 12 8
 Most of the ratios are calculated based on the
average figures.
 It is preferable to use an average figure, as

this might be more representative.

However….

For purpose of simplification, we will use the

closing balance figure in our calculation.
We will look at:
1. Return
on Ordinary Shareholders’ Funds %
(ROSF)/Return on Equity
2. Return on Capital Employed % (ROCE)
3. Operating profit margin %
4. Gross profit margin %
ROSF = Profit after tax and preference dividends x 100%
Ordinary share capital + reserves

 Measuring how much profit a company generates for

its ordinary shareholders with the money they have
invested in the company.

Example – BP:
2018 2017
ROSF = 190/2,000 70/600
9.5% 11.7%
Higher ROSF means that a business is more efficient than
another in investing the business’s equity.

Too high: company has been borrowing aggressively, it

can increase ROE because equity is equal to assets minus
debts (i.e. net assets).

Too low: the company might be conservative in its

borrowing or less effective management.
If a company has a net loss, ROE should not be
calculated.
 ROCE = Operating profit (PBIT) x 100%
Capital employed*
* Usually where Capital Employed = Debt & Equity,
(i.e. Share Capital + Reserves + Non-current
liabilities)
Measuring how efficiently a business is using the
funds available from all sources of long-term
finance.
Example – BP:
2018 2017
ROCE = 340/3,000 150/1,200
11.33% 12.50%
Unlike ROSF, which only analyses profitability
related to a company’s common equity, ROCE
considers debt and other liabilities as well. 
This provides a better indication of financial
performance for companies with significant
debt.

Investors tend to favour companies with stable

and rising ROCE numbers over companies
where ROCE is volatile and bounces around
from one year to the next.
Operating profit % = Operating profit x 100%
Sales Revenue
 Measuring the profit from trading operations (net
profit, before interest and tax) in relation to the sales
revenue for a period.
Example – BP:
2018 2017
Op Profit % = 340/2,000 150/1,000
17% 15%
It is also known as return on sales.

It is a good indicator of how well it is being

managed and how risky it is.

It shows the proportion of revenues that are

available to cover non-operating costs like paying
interest.

Highly variable operating profit margins are a prime

indicator of business risk. 
 Gross profit % = Gross profit x 100%
Sales Revenue
 Measuring the gross profit (where GP = sales
revenue – cost of sales) in relation to the sales
revenue for a period.
Example – BP:
2018 2017
Gross Profit % = 700/2,000 300/1,000
35% 30%
It should be stable unless there have been
changes to the company's business model. 

Cases

- If a company automates certain supply chain

functions, the cost of goods sold is much lower
due to lower labour costs.

- Industry changes in regulation 

- Changes in a company's pricing strategy 

We will look at:
5.Inventory turnover period (days)
6.Receivables settlement period (days)
7.Payables payment period (days)
8.Sales
revenue to capital
employed/Asset Turnover (times)
 Inventory = Closing inventories held x 365
turnover period Cost of Sales

 The number of days inventory is held for. A

longer inventory turnover period indicates either
a slowdown in trading, or possible excessive
investment in inventory.
Example – BP:
2018 2017
Inventory turnover= 1,200/1,300 x 365 200/700 x365
337 days 105 days
 - Calculating inventory turnover can help
businesses make better decisions on pricing,
manufacturing runs, how to leverage promotions
to move excess inventory, and how and when to
purchase new inventory.

-  A low ratio implies either strong sales or

insufficient inventory, which leads to lost
business. 

- A high ratio may indicate a problem with the

goods being offered for sale or be a result of too
little marketing.
 Receivables = Trade Receivables x
365
settlement period Credit Sales Revenue
Average time taken for debtors to pay us. Useful to
compare against a benchmark. Average in UK is 30 days,
but if international trade, it will take longer. Ideally this
should be shorter than trade payables days, and the lower
the period, the better.

Example – BP:
2018 2017
Receivables period= 400/2,000 x 365 800/1,000 x 365
73 days 292 days
Any Question