Edexcel A-Level Accounting: Investment ratios (YAC11) – Revision Notes

These notes condense topic 2.2, Investment ratios, from Unit 2 of Pearson’s specification for the Edexcel International Advanced Subsidiary and Advanced Level in Accounting (XAC11/YAC11), Issue 2, September 2018. Outcome 2.2.1 and its note on the Unit 1 ratios are both included. The topic is Unit 2 (A2) only, so it is assessed for the full International A Level and not for the International AS. Companies and figures are invented; amounts are in dollars and share prices in cents.

The study guide explains every idea here at length, with bigger examples. When these notes feel secure, try the practice questions. Elsewhere on the site: the course hub for Edexcel A-Level Accounting, a checklist you can print, and free 10-minute diagnostics.

The six ratios in 2.2.1

Appendix 7 of the specification says none of these is given to you in the examinations.

Ratio	Formula	Unit	Tells the investor
Earnings per share	(Net profit after tax − Preference share dividend) / Number of issued ordinary shares	cents	Profit earned for each ordinary share
Price earnings	Market price per share / Earnings per share	times	How many years of current earnings the price represents
Dividend per share	Total ordinary dividend paid / Number of issued ordinary shares	cents	Cash paid out on each ordinary share
Dividend yield	Dividend paid per share / Market price of share (× 100)	%	Cash return on the price paid today
Dividend cover	(Profit after tax − Preference dividends) / Total ordinary dividend paid	times	How many times earnings could pay the ordinary dividend
ROCE (corporate bodies)	Net profit before interest / Capital employed × 100	%	Return on all long-term funds

The building blocks

Earnings          = profit after tax - preference dividends
Ordinary shares   = ordinary share capital / nominal value per share
Preference div.   = preference share capital x dividend rate
Capital employed  = issued shares (ordinary + preference)
                    + reserves + non-current liabilities
NPBI              = profit before finance costs (profit from operations)

Earnings is the top line of both EPS and dividend cover. Dividend per share feeds dividend yield. EPS feeds P/E.

The specification’s own wording is “net profit before interest”. The line in a company’s statement of profit or loss that sits above finance costs is profit from operations; always label which profit you have used.

Method in steps

Calculating the full set

1. Find the number of ordinary shares from the share capital and nominal value.
2. Find the preference dividend and subtract it from profit after tax to get earnings.
3. EPS = earnings / shares. Convert to cents.
4. P/E = price (cents) / EPS (cents).
5. DPS = ordinary dividends paid / shares, in cents.
6. Dividend yield = DPS / price × 100.
7. Dividend cover = earnings / ordinary dividends paid.
8. ROCE = NPBI / capital employed × 100.

Working backwards

Rearrange the formula you are given. Price = P/E × EPS. EPS = price / P/E. Earnings = dividend cover × ordinary dividends. Profit after tax = earnings + preference dividends. Maximum ordinary dividend = earnings / target cover.

Worked reminder: Ferrisgate Media plc

Profit after tax 1,386,000. 5.5% preference shares of 1,200,000. Ordinary share capital 6,600,000 in shares of 0.40 each. Ordinary dividends paid 594,000. Share price 176 cents.

Preference dividend = 1,200,000 x 5.5%        = 66,000
Earnings            = 1,386,000 - 66,000      = 1,320,000
Ordinary shares     = 6,600,000 / 0.40        = 16,500,000
EPS                 = 1,320,000 / 16,500,000  = 8.00 cents
P/E                 = 176 / 8.00              = 22.00 times
DPS                 = 594,000 / 16,500,000    = 3.60 cents
Dividend yield      = 3.60 / 176 x 100        = 2.05%
Dividend cover      = 1,320,000 / 594,000     = 2.22 times

A P/E of 22 with a yield near 2% is a growth profile: investors pay a high price for earnings they expect to rise, not for today’s cash.

Unit 1 ratios on a company (note to 2.2.1)

You need the topic 1.5 ratios as well. On a company:

• Profit for the year as a % of revenue uses profit after finance costs and tax.
• Current liabilities include tax payable and any debentures due within 12 months.
• Capital employed for ROCE adds issued shares, all reserves and non-current liabilities, not the owner’s capital.
• Margin, mark-up, inventory turnover, the credit periods and revenue to non-current assets are unchanged.

Use them to explain investment ratios: lower margins cut earnings, so EPS and cover fall; weak liquidity may force the directors to cut the cash dividend.

Must-know distinctions

• EPS vs DPS. EPS is profit earned per share; DPS is cash paid per share. The gap is profit retained.
• Dividend yield vs dividend cover. Yield is the investor’s return on the price; cover is the safety of the dividend.
• P/E vs EPS. EPS comes from the accounts; P/E adds the market’s opinion through the share price.
• Preference vs ordinary dividends. Preference dividends reduce earnings; only ordinary dividends go in DPS and the bottom line of cover.
• Profit for the year vs earnings. Profit for the year belongs to all shareholders; earnings is what remains for ordinary shareholders after the preference dividend. Use earnings for EPS and cover, and profit from operations for ROCE.
• Nominal value vs market price. Nominal value counts the shares; market price is used in P/E and yield.
• Bonus issue vs rights issue. A bonus issue adds shares with no cash, so EPS falls with no change in performance. A rights issue raises cash, which may later raise profit.

Reading the ratios

• High P/E: growth expected or low risk perceived. Low P/E: little growth expected, or a bargain.
• High yield with low cover: generous now, at risk if profit falls.
• Low yield with high cover: most profit retained for reinvestment.
• Rising yield because the share price fell is not good news by itself.
• Compare EPS for one company over time, not across companies.
• ROCE above the debenture interest rate means borrowed funds earn more than they cost.

Which user looks at what

User	Main concern	Ratios to lead with
Investor needing income now	Size and safety of cash dividends	Dividend yield, dividend cover, DPS trend
Investor seeking growth	Rising earnings and share price	EPS trend, P/E, ROCE, retained profit
Existing shareholder deciding to hold or sell	Whether the return still beats alternatives	Dividend yield against interest rates, P/E against similar companies
Debenture holder or bank	Ability to pay interest and repay	ROCE against the interest rate, liquidity ratios

In an “Evaluate” or “Recommend” answer, start from the user named in the question and pick the ratios that answer their concern first.

Quick self-test

1. Profit after tax 945,000; preference dividends 45,000; 6,000,000 ordinary shares. Calculate EPS.
2. Share price 342 cents; EPS 19 cents. Calculate P/E.
3. Ordinary dividends paid 1,050,000; 15,000,000 ordinary shares. Calculate DPS.
4. DPS 6.3 cents; share price 210 cents. Calculate dividend yield.
5. Profit after tax 2,240,000; preference dividends 140,000; ordinary dividends 700,000. Calculate dividend cover.
6. Ordinary share capital 2,500,000 in shares of 0.25 each. How many shares are in issue?
7. EPS 11.5 cents; P/E 22. Calculate the share price.
8. Profit from operations 1,092,000; ordinary shares 4,000,000; preference shares 1,000,000; reserves 2,200,000; debentures 1,600,000. Calculate ROCE.
9. EPS is 24 cents before a 1 for 1 bonus issue. Earnings do not change. What is EPS afterwards?
10. Dividend cover is 4 times and ordinary dividends are 900,000. What are earnings?
11. Why can a rising dividend yield be bad news?
12. Which two investment ratios share the same numerator?

Answers

1. (945,000 − 45,000) / 6,000,000 = 15.00 cents.
2. 342 / 19 = 18.00 times.
3. 1,050,000 / 15,000,000 = 7.00 cents.
4. 6.3 / 210 × 100 = 3.00%.
5. (2,240,000 − 140,000) / 700,000 = 3.00 times.
6. 2,500,000 / 0.25 = 10,000,000 shares.
7. 11.5 × 22 = 253 cents.
8. Capital employed = 8,800,000; 1,092,000 / 8,800,000 × 100 = 12.41%.
9. Shares double, so EPS halves: 12.00 cents.
10. 4 × 900,000 = 3,600,000.
11. Yield rises when the share price falls. A falling price may mean the market expects lower profits or a dividend cut.
12. EPS and dividend cover (profit after tax less preference dividends).

Where marks are usually lost

• Not deducting preference dividends before EPS or dividend cover.
• Dividing by share capital in dollars instead of the number of shares.
• Dividing a price in cents by an EPS in dollars.
• Putting preference dividends into DPS.
• Using profit before tax, or profit for the year before preference dividends, as earnings.
• Missing preference shares, share premium or debentures from company capital employed.
• Giving a ratio without its unit (cents, times, %).
• Recommending the highest yield without looking at cover, P/E or the reason the price moved.
• Comparing EPS between two companies with different share structures.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting (XAC11/YAC11) specification, Issue 2, September 2018, first teaching September 2015, published by Pearson Education Limited. Unit 2, topic 2.2 Investment ratios, and Appendix 7: Formulae.