Understanding Business Accounting For Dummies, 2nd Edition (109 page)

Book value per share

Book value per share
is one measure, but it's certainly not the only amount, used for determining the value of a privately-owned business's shares. As discussed in Chapter 6, book value is not the same thing as market value. The asset values that a business records in its books (also known as its
accounts
) are
not
the amounts that a business could get if it put its assets up for sale. Book values of some assets are generally lower than what the cost would be for replacing the assets if a disaster (such as a flood or a fire) wiped out the business's stock or equipment. Recording current market values in the books is really not a practical option. Until a seller and a buyer meet and haggle over price, trying to determine the market price for a privately-owned business's shares is awfully hard.

You can calculate book value per share for publicly-owned businesses, too. However, market value is readily available, so shareholders (and investment advisers and managers) do not put much weight on book value per share. EPS is the main factor that affects the market prices of stock shares of public companies - not the book value per share. We should add that some investing strategies, known as
value investing
, search out companies that have a high book value per share compared to their going market prices. But by and large, book value per share plays a secondary role in the market values of stock shares issued by public companies.

Although book value per share is generally not a good indicator of the market value of a private business's shares, you do run into this ratio, at least as a starting point for haggling over a selling price. Here's how to calculate book value per share:

Total owners' equity ÷ total number of stock shares = book value per share


The business shown in Figure 14-2 has issued 795,000 shares: Its £15.9 million total owners' equity divided by its 795,000 shares gives a book value per share of £20. If the business sold off its assets exactly for their book values and paid all its liabilities, it would end up with £15.9 million left for the shareholders, and it could therefore distribute £20 per share. But the company will not go out of business and liquidate its assets and pay off its liabilities. So book value per share is a theoretical value. It's not totally irrelevant, but it's not all that definitive, either.

Return on equity (ROE) ratio

The
return on equity (ROE) ratio
tells you how much profit a business earned in comparison to the book value of shareholders' equity. This ratio is useful for privately-owned businesses, which have no way of determining the current value of owners' equity (at least not until the business is actually sold). ROE is also calculated for public companies, but, just like book value per share, it plays a secondary role and is not the dominant factor driving market prices. (Earnings are.) Here's how you calculate this key ratio:

Net income ÷ owners' equity = ROE


The owners' equity figure is at book value, which is reported in the company's balance sheet. Chapter 6 explains owners' equity and the difference between share capital and retained earnings, which are the two components of owners' equity.

The business whose profit and loss account and balance sheet are shown in Figures 14-1 and 14-2 earned £1.9 million net income for the year just ended and has £15.9 million owners' equity. Therefore, its ROE is 11.95 per cent (£1.9 million net income ÷ £15.9 million owners' equity = 11.95 per cent). ROE is net income expressed as a percentage of the amount of total owners' equity of the business, which is one of the two sources of capital to the business, the other being borrowed money, or interest-bearing debt. (A business also has non-interest-bearing operating liabilities, such as creditors.) The cost of debt capital (interest) is deducted as an expense to determine net income. So net income ‘belongs' to the owners; it increases their equity in the business, so it makes sense to express net income as the percentage of improvement in the owners' equity.

Current ratio

The
current ratio
is a test of a business's
short-term solvency
- its capability to pay off its liabilities that come due in the near future (up to one year). The ratio is a rough indicator of whether cash-on-hand plus the cash flow from collecting debtors and selling stock will be enough to pay off the liabilities that will come due in the next period.

As you can imagine, lenders are particularly keen on punching in the numbers to calculate the current ratio. Here's how they do it:

Current assets ÷ current liabilities = current ratio


Note:
Unlike with most of the other ratios, you don't multiply the result of this equation by 100 and represent it as a percentage.

Businesses are expected by their creditors to maintain a minimum current ratio (2.0, meaning a 2-to-1 ratio, is the general rule) and may be legally required to stay above a minimum current ratio as stipulated in their contracts with lenders. The business in Figure 14-2 has £17.2 million in current assets and £7,975,000 in current liabilities, so its current ratio is 2.16, and it shouldn't have to worry about lenders coming by in the middle of the night to break its legs. Chapter 6 discusses current assets and current liabilities and how they are reported in the balance sheet.

Acid-test ratio

Most serious investors and lenders don't stop with the current ratio for an indication of the business's short-term solvency - its capability to pay the liabilities that will come due in the short term. Investors also calculate the
acid-test ratio
(also known as the
quick ratio
or the
pounce ratio
), which is a more severe test of a business's solvency than the current ratio. The acid-test ratio excludes stock and prepaid expenses, which the current ratio includes, and limits assets to cash and items that the business can quickly convert to cash. This limited category of assets is known as
quick
or
liquid
assets.

You calculate the acid-test ratio as follows:

Liquid assets ÷ total current liabilities = acid-test ratio


Note:
Unlike most other financial ratios, you don't multiply the result of this equation by 100 and represent it as a percentage.

For the business example shown in Figure 14-2, the acid-test ratio is as follows:

Cash £3,500,000

Marketable securities none