BHG is a successful listed entity that designs and markets specialist business software. BHG's directors have decided to adopt a policy of expansion into overseas territories through the acquisition of similar software businesses possessing established shares of their domestic markets. BHG's aim is to obtain control, or at the minimum, significant influence (represented by at least 40% of issued share capital) of investee entities. Target investee entities are likely to be listed entities in their own countries, but the acquisition of unlisted entities is not ruled out.
You are a senior accountant in BHG, and you have been asked by the Chief Financial Officer (CFO) to establish a set of key accounting ratios for use in:
(i) The initial appraisal of potential acquisitions;
(ii) Ongoing appraisal following acquisitions.
The ratios will be used as part of a suite of quantitative and non-quantitative measurements to compare businesses with each other. The CFO has suggested that it would be appropriate to identify no more than five-seven key financial ratios.
One of your assistants has suggested a list of five key accounting ratios as suitable for both initial and ongoing appraisal and comparison. She has provided reasons to support the case for their inclusion as key ratios.
1. Earnings per share: 'one of the most important investor ratios, widely used by all classes of investor to assess business performance'.
2. Dividend yield: 'this ratio provides a very useful measurement that allows comparison with yields from other equity and non-equity investments'.
3. Gearing: 'this is of critical importance in determining the level of risk of an equity investment'.
4. Gross profit margin: 'allows investors to assess business performance, and is of particular use over several accounting periods within the same organization. It is also very useful for comparing performances between businesses.'
5. Asset turnover ratios: 'allow the investor to compare the intensity of asset usage between businesses, and overtime'.
Required:
(a) Discuss the extent to which each of the five suggested accounting ratios is likely to be useful to BHG for both initial and ongoing appraisal and comparison, and the extent to which your assistant's assessments of the value of the ratios are justified.
(b) Explain the problems and limitations of accounting ratio analysis in making inter-firm and international comparisons.