Edexcel A-Level Accounting: Investment ratios (YAC11)

This study guide teaches topic 2.2, Investment ratios, from Unit 2 (Corporate and Management Accounting) of Pearson’s specification for the Edexcel International Advanced Subsidiary and Advanced Level in Accounting (XAC11/YAC11), Issue 2, September 2018, first taught from September 2015. It covers outcome 2.2.1 and the note attached to it. Everything here is Unit 2 (A2) only, so you meet it on the way to the full International A Level; the International AS does not assess it. Every company and figure here is invented, and amounts are in dollars.

Use it alongside the revision notes and a set of practice questions. For the rest of the course, open the course hub; to tick off outcomes, print the course checklist. A free 10-minute diagnostic will show you where to start.

What topic 2.2 covers

Specification reference	Skill required
2.2.1	Calculate and interpret six investment ratios: earnings per share, price earnings, dividend per share, dividend yield, dividend cover, return on capital employed
Note to 2.2.1	Be familiar with the Unit 1 ratios for profitability, liquidity and use of assets, and apply them to a limited company

The Unit 1 ratios are taught in full in our guide to topic 1.5. This page shows only what changes when you use them on a company.

Who uses investment ratios

Investment ratios look at the business from the shareholder’s seat. They answer three questions:

1. How much profit has the company earned for each ordinary share? (earnings per share, price earnings)
2. How much of that profit came to me as cash? (dividend per share, dividend yield)
3. How safe is that dividend? (dividend cover)

Return on capital employed then shows how well management used all the long-term funds, from shareholders and lenders together. The main users are shareholders deciding whether to hold or sell and potential investors deciding whether to buy.

The six formulae (2.2.1)

Appendix 7 of the specification says its formulae are not given to you in the examinations: you must know them.

Ratio	Formula	Usual unit
Earnings per share (EPS)	(Net profit after tax − Preference share dividend) / Number of issued ordinary shares	cents
Price earnings (P/E)	Market price per share / Earnings per share	times
Dividend per share (DPS)	Total ordinary dividend paid / Number of issued ordinary shares	cents
Dividend yield	Dividend paid per share / Market price of share	% (multiply by 100)
Dividend cover	(Profit after tax − Preference dividends) / Total ordinary dividend paid	times
ROCE for corporate bodies	Net profit before interest (NPBI) / Capital employed × 100	%

Fix these points before you calculate anything.

• Earnings belong to ordinary shareholders only. Preference dividends come out of profit after tax first, because preference shareholders are paid before ordinary shareholders. The same “earnings” figure is the top line of EPS and of dividend cover.
• Count shares, not dollars. Ordinary share capital of 3,000,000 in shares of 0.50 each is 6,000,000 shares: divide share capital by nominal value.
• Keep units consistent. If the share price is in cents, EPS and DPS must be in cents before you find P/E or dividend yield.
• Use ordinary dividends paid. Dividends go through the statement of changes in equity and are never an expense. Leave preference dividends out of DPS and the denominator of dividend cover.
• Capital employed for a company = issued shares + reserves + non-current liabilities. Issued shares include preference shares. Reserves include share premium, revaluation, general and retained earnings.
• NPBI. The specification gives “net profit before interest”. In a company’s statement of profit or loss, the line before finance costs is profit from operations, so this guide uses that figure. Label the profit you use in your working.

Appendix 7 also lists the gearing ratio in its investment group. Gearing itself is outcome 2.1.10 (capital gearing and its implications), part of the limited companies topic.

Worked example 1: all six ratios

Quillstone Textiles plc, year ended 30 June 2026.

Statement of profit or loss (extract)	$
Revenue	9,600,000
Cost of sales	(6,240,000)
Gross profit	3,360,000
Distribution costs and administrative expenses	(2,175,000)
Profit from operations	1,185,000
Finance costs (8% debentures)	(120,000)
Profit before tax	1,065,000
Tax	(169,000)
Profit for the year	896,000

Statement of financial position at 30 June 2026	$
Non-current assets	8,200,000
Inventory	1,140,000
Trade receivables	960,000
Cash and cash equivalents	279,000
Trade payables	(830,000)
Tax payable	(169,000)
8% debentures (repayable 2034)	(1,500,000)
Net assets	8,080,000
Ordinary shares of $0.50 each	3,000,000
7% preference shares of $1 each	800,000
Share premium	1,200,000
General reserve	500,000
Retained earnings	2,580,000
Total equity	8,080,000

During the year Quillstone paid the full preference dividend and ordinary dividends of 360,000. On 30 June 2026 an ordinary share traded at 238 cents.

Step 1: the building blocks.

Number of ordinary shares = 3,000,000 / 0.50     = 6,000,000
Preference dividend       = 800,000 x 7%         = 56,000
Earnings (ordinary)       = 896,000 - 56,000     = 840,000
Capital employed          = 3,000,000 + 800,000 + 1,200,000
                            + 500,000 + 2,580,000 + 1,500,000
                                                 = 9,580,000

Check: capital employed also equals net assets plus debentures, 8,080,000 + 1,500,000 = 9,580,000. Retained earnings check: an opening balance of 2,100,000 + 896,000 − 56,000 − 360,000 = 2,580,000.

Step 2: the ratios.

EPS            = 840,000 / 6,000,000         = $0.14  = 14.00 cents
P/E            = 238 / 14.00                 = 17.00 times
DPS            = 360,000 / 6,000,000         = $0.06  = 6.00 cents
Dividend yield = 6.00 / 238 x 100            = 2.52%
Dividend cover = 840,000 / 360,000           = 2.33 times
ROCE           = 1,185,000 / 9,580,000 x 100 = 12.37%

Read them together. Investors pay 17 times this year’s earnings, so they expect profits to grow. The cash return on today’s price is modest at 2.52%. The dividend is covered 2.33 times, so the company keeps more than half its earnings for reinvestment.

Bringing in the Unit 1 ratios (note to 2.2.1)

The specification’s note says you must be familiar with the Unit 1 ratios for profitability, liquidity and use of assets. Every one of them applies to a company. What changes is where the figures come from.

Unit 1 ratio	Company adjustment	Quillstone 2026
Gross profit as a % of revenue	None	3,360,000 / 9,600,000 × 100 = 35.00%
Profit for the year as a % of revenue	Uses the figure after finance costs and tax	896,000 / 9,600,000 × 100 = 9.33%
Current ratio	Tax payable is a current liability	2,379,000 / 999,000 = 2.38 : 1
Liquid (acid test) ratio	As above, less inventory	1,239,000 / 999,000 = 1.24 : 1
Revenue to non-current assets	None	9,600,000 / 8,200,000 = 1.17 times

Mark-up, inventory turnover and the credit periods work as in Unit 1. Use them to explain investment ratios: a falling gross margin reduces earnings, and so EPS and dividend cover.

Interpreting each ratio

Ratio	Higher usually means	But check
EPS	More profit earned per share	Compare one company over time only; share numbers and nominal values differ between companies
P/E	The market expects growth or sees low risk	A low P/E may be a bargain or a warning
DPS	More cash paid per share	Whether profit supports it
Dividend yield	Bigger cash return on the price paid	It rises when the share price falls
Dividend cover	Dividend is safer; more profit retained	Very high cover may disappoint income seekers
ROCE	Better use of all long-term funds	Compare with the interest rate on debentures and with other companies

Different investors want different things. An investor who needs income now looks first at yield and cover. An investor seeking growth accepts a low yield if retained profits are reinvested at a good ROCE.

Worked example 2: choosing between two companies

Brackenholt Pumps plc has 21,000,000 ordinary shares, no preference shares, profit after tax of 2,310,000, ordinary dividends paid of 1,680,000 and a share price of 132 cents.

EPS            = 2,310,000 / 21,000,000 = 11.00 cents
P/E            = 132 / 11.00            = 12.00 times
DPS            = 1,680,000 / 21,000,000 = 8.00 cents
Dividend yield = 8.00 / 132 x 100       = 6.06%
Dividend cover = 2,310,000 / 1,680,000  = 1.38 times

	Quillstone	Brackenholt
P/E	17.00	12.00
Dividend yield	2.52%	6.06%
Dividend cover	2.33 times	1.38 times

Evaluation for a retired investor who needs income. Brackenholt’s yield is more than twice Quillstone’s, so each dollar invested earns more cash now. However, Brackenholt pays out about 73% of earnings, leaving a cover of only 1.38 times. A modest fall in profit would force a dividend cut. Its lower P/E shows the market values its earnings less highly, possibly because growth prospects are weaker. Quillstone’s dividend is smaller but better protected, and its retained profits can fund growth. Judgement: Brackenholt suits the income need today, but the investor should accept the risk knowingly or spread the money across both. Do not compare EPS: 14.00 cents against 11.00 cents says nothing, because the companies have different share structures.

Worked example 3: working backwards and a bonus issue

Glenshiel Foods plc has 12,000,000 ordinary shares and pays preference dividends of 90,000 a year. Its share price is 252 cents and its P/E is 14.

EPS                = 252 / 14                      = 18.00 cents
Earnings           = 0.18 x 12,000,000             = 2,160,000
Profit after tax   = 2,160,000 + 90,000            = 2,250,000

The directors want dividend cover of 3 times:

Maximum ordinary dividend = 2,160,000 / 3          = 720,000
DPS                       = 720,000 / 12,000,000   = 6.00 cents
Dividend yield            = 6.00 / 252 x 100       = 2.38%

Glenshiel then makes a 1 for 3 bonus issue (outcome 2.1.7). Shares rise to 16,000,000, but no cash comes in and earnings do not change.

EPS after the bonus issue = 2,160,000 / 16,000,000 = 13.50 cents

EPS falls by a quarter because the same earnings are shared across more shares. If the market’s P/E stays at 14, the price would move to about 189 cents: three shares worth 756 cents become four shares worth the same. EPS comparisons over time must allow for changes in the number of shares.

Limitations of investment ratios

• The market price changes daily, so P/E and dividend yield depend on the date chosen.
• Profit after tax depends on accounting policies such as depreciation and inventory valuation.
• The ratios use past results; investors are buying future profits.
• Issues of shares change EPS and DPS without any change in performance.
• Ratios ignore non-financial factors, such as management quality, ethics and the economy.

Common errors

• Forgetting to deduct preference dividends from profit after tax.
• Using share capital in dollars as the number of shares.
• Mixing dollars and cents in P/E and dividend yield.
• Using profit before tax in dividend cover.
• Including preference dividends in DPS.
• Leaving preference shares or debentures out of company capital employed.
• Calling a high yield “good” without checking cover and why the share price is low.
• Comparing EPS between two different companies.

Where to go next

Shrink this page to recall cards with the revision notes and test it with the practice questions. Revisit the Unit 1 ratios in the guide to topic 1.5, see how company statements are built in financial statements of organisations, and plan your revision with the exam preparation page.

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.