**8 Investment Tools: Financial Statement Analysis: Financial Ratios and Earnings per Share**

**1: Analysis of Financial Statements**

**a: Calculate, interpret, and discuss the uses of measures of a company's internal liquidity, operating performance, risk profile, growth potential, and external liquidity.**

**Measures of a company’s internal liquidity**

These ratios are the:

1. Current ratio = current assets / current liabilities.

2. Quick ratio = [cash + marketable securities + receivable] / current liabilities.

3. Cash ratio = [cash + marketable securities] / current liabilities.

The current, quick, and cash ratios differ only in the liquidity of the current assets that the analyst projects will be used to pay off the current liabilities. Other ratios ask:

1. **Does** the company collect its receivables on a timely basis?

a. Receivables turnover = sales / average receivables

b. Average receivables collection period = 365 / receivables turnover

2. **How fast** does the company move its inventory through the system?

a. Inventory turnover = cost of goods sold / average inventory

b. Average inventory processing period = 365 / inventory turnover

3. **Does **the company** **pay its current bills?

a. Payables turnover = cost of goods sold / average accounts payable

b. Average payment period = 365 / payables turnover

The cash cycle** **is the time period that exists from when the firm pays out money for the purchase of raw materials to when it gets the money back from the purchasers of the firm’s finished goods.

**Cash conversion cycle = collection period + inventory period - payment period.**

**Example: **Receivables turnover = 9, days receivables out (collection period) = 41 days, inventory turnover = 6, days inventory in stock (inventory period) = 61 days, payables turnover = 11, and days payables out (payment period) = 33 days. Cash conversion cycle = 41 days + 61 days - 33 days = 69 days.

**Measures of a company’s operating performance**

**Operating efficiency****ratios **question how efficiently management is using the assets they have at their disposal. Efficiency ratios are all sales to balance sheet item ratios.

· total asset turnover = sales / total assets

· fixed asset turnover = sales / fixed assets

· equity turnover = sales / equity

**Operating profitability ratios** look at how good management is at turning their efforts into profits.

**Gross profit margin** = gross profits / sales.

**Operating profit margin** = operating profit / sales, this ratio is also written as EBIT / sales

**Net profit margin** = EAT / sales, also know the before tax profit margin = EBT / sales

**Return on total capital** = [EAT + interest] / capital

**Return on owners equity = ROE** = EAT / equity

**Measures of a company’s risk profile**

**Business risk **is related to the firm’s industry, the variability of sales due to the firm’s products, customers and method of doing business.

1. Business risk = [standard deviation of operating income] / [mean operating income]

2. Sales variability = coefficient of variation of sales, sales variability = [standard deviation of sales] / [mean sales]

3. Operating leverage =?[ave % change in operating earn]**/**[ave % change in sales][/font]?

**Financial risk[/font]** occurs on top of business risk. Financial risk is related to the uncertainty caused by the fixed cost associated with borrowed money.

**Leverage ratios** show where the money comes from:

a. debt to equity ratio = total long-term debt / equity

b. assets to equity ratio = assets / equity also called the financial leverage multiplier

c. debt to capital ratio = total long-term debt / total long-term capital

d. total debt ratio = [long-term + short-term debt] / total capital.

**Earnings or cash flow ratios** are designed to show the earnings or cash that is available to meet the required interest and lease payments. Debt service ratios.

a. Interest coverage = operating profit / interest expense = EBIT / I

b. Total fixed charge coverage = [EBIT + lease payments]/[interest + lease payments + (preferred dividends/{1-tax rate})]

c. Cash flow / interest expense

d. Cash flow coverage = (cash flow + interest expense) / interest expense

e. Cash flow / long-term debt.

**Measures of a company’s growth potential**

**Growth analysis: **Investors and creditors are interested in the firm’s growth potential. Investors because high growth means high stock prices, and creditors because high growth means the firm’s ability to repay its obligations is improved.

1. Sustainable growth (g) = (earnings retention rate)(ROE), Where: the earnings retention rate = [1 - (dividends/net income)]

2. ROE = [EAT/sales][sales/assets][assets/equity]

**Example**: A firm has a predictable dividend payout ratio of 40%, a net profit margin of 12%, an asset turnover of 1.3 and an equity multiplier leverage measure of 1.4. Estimate the firm’s sustainable growth rate.

g = (earnings retention rate)(ROE) = (1 - dividend payout)(EAT/S)(S/A)(A/Eq)

g = (1 - .4)(.12)(1.3)(1.4) = .13 or 13%

**Measures of a company’s external liquidity**

**External liquidity **is the relative speed at which you can trade your shares with little impact on the price. The most important determinant of external market liquidity is the number of shares traded during the time period. Other measures of liquidity are:

· The size of the bid-ask spread. The smaller the spread the greater the liquidity.

· The total market value of the outstanding securities.

· The number of shareholders.

· The trading turnover (shares traded during the period)/(number of shares outstanding).

**b: Calculate the various components of the company's return on equity using the traditional and extended duPont systems.**

Ratio analysis using the duPont system is an important tool of the analyst. The duPont system is the method of breaking down return ratios into their components. There are many variants of this breakdown.

**Traditional version of the duPont equation:**

- Start with the basic ROE ratio, (net income / equity).
- Multiplying the ROE by sales / sales gives ROE = (net income / sales)(sales / equity). Therefore, ROE = (net profit margin)(equity turnover).
- Expanding the equation further by incorporating financial leverage gives us ROE = (net income / sales)(sales / equity).
- Multiplying by assets / assets and rearranging the denominator gives us ROE = (net income / sales)(sales / assets)(assets / equity).
- Finally, we end up at (net profit margin)(asset turnover)(equity multiplier). [/list]
**Extended version of the duPont equation:**- From the income statement you will notice that EAT = EBT(1 - t), where t is the firm's average tax rate. Substituting EBT(1 - t) for EAT in the expanded ROE equation gives us ROE = (EBT / sales)(sales / assets)(assets / equity)(1 - t).
- Now look at the income statement. The relationship between EBT and EBIT is EBT = EBIT - I, where I equals the firm's total interest expense. Substituting (EBIT - I) into the ROE equation for EBT gives us ROE = [(EBIT / sales)(sales / assets) - (interest expense / assets)] (assets / equity) (1 - t).
- Restated in accounting terms: ROE = [(operating profit margin)(total asset turnover) - (interest expense rate)](financial leverage multiplier)(tax retention rate). [/list]
**c: Calculate and interpret a company's financial ratios relative to its industry, to the aggregate economy, and to the company's own performance over time.****Importance of relative financial ratios.**A single financial ratio by itself is of little use. The power of financial ratios comes from comparing them to relative ratios representing the general economy, the firm’s industry, the firm’s major competitors and even the firm’s own past performance record.1. The comparison of the firm’s ratios to the aggregate economy is important because most firms are influenced by the general business cycle.

2. It is also important to compare a firm’s ratios to its own industry ratios. Industry effects are strongest with industries having homogeneous products. It may be necessary to compare a firm to a smaller subset within the industry that has comparable characteristics. This type of analysis is called cross

**sectional analysis**.3. It is also helpful to compare a firm’s performance over time to itself to see if the firm is progressing or declining. This type of analysis is called

**time series analysis**.**d: Interpret common-size balance sheets and common-size income statements and discuss the circumstances under which the use of common-size financial statements is appropriate.**Common-size statements normalize balance sheet and income statements and allow the analyst to make easier comparisons of different sized firms. A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets. A common-size income statement expresses all income statement items as a percentage of sales.

Common-sized ratios convert the individual line items on the income statement to percentages. Raw numbers hide relevant information that percentages frequently unveil.Common-sized income statement ratios are especially useful in studying trends in costs and profit margins.

**Common-sized IS ratios = income statement account / sales**Balance sheet accounts can also be converted to common-sized ratios by dividing each balance sheet item by total assets.

**Common-sized BS ratios = balance sheet account / total assets****e: Identify and discuss the limitations of financial ratios (eg, differences in accounting treatment among companies).**- The use of accounting information that permits some choice of accounting principles. There is always a potential for earnings management or earnings manipulation.
- It is difficult to determine the appropriate industry to use in comparing firms. Many firms operate in several different lines of business, making it difficult to identify the industry.
- The necessity to consider more than one type of ratio; there are interactions among the different ratios that require considering different ratios simultaneously (e.g., liquidity and profitability.)
- Determining the approach target or comparison value for a ratio is difficult, requiring some range of acceptable values.
- You must be aware of the limitations of financial ratios. Ratios are used for internal comparisons and across firms. In conducting your analysis you must always be aware of the limitations of ratios. Ask yourself these questions:
**1)**do the firms being compared have compatible accounting practice?,**2)**when comparing divisions within a firm are the ratios comparable?,**3)**do the ratios being used give consistent readings?, and**4)**do the ratios yield a reasonable figure for the industry? [/list]**2: Dilutive Securities and Earnings per Share****a: Differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS).**·

*A simple capital structure*is one that contains*no*potentially dilutive securities. A simple capital structure contains only common stock and non-convertible senior securities.·

*A complex capital structure*contains*potentially dilutive securities*such as options, warrants, or convertible securities.**b: Describe the components of EPS and calculate a company's EPS in a simple capital strucutre.**The basic earnings per share calculation

*does**not*consider the effects of any dilutive securities in the computation of EPS. It is the only EPS for firms with simple capital structures and is one of the two earnings per share calculations presented for firms with complex capital structures.Basic EPS =

Net Income - Preferred Dividends

Weighted Average Number of Common Shares Outstanding

The current year’s preferred dividends are subtracted from net income because EPS refers to earnings

*available to the common shareholder*. Preferred dividends are paid from net earnings before common dividends. Net income minus preferred dividends is the income accruing to common stockholders. Common stock dividends are*not*subtracted from net income.**c: Define and calculate a company's weighted average number of shares outstanding.**The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding.

In computing weighted average number of shares, stock dividends and stock splits are only changes in the units of measurement,

*not*changes in the ownership of earnings. Stock dividends and splits do not change the owner’s proportionate claim on the firm’s earnings.**d: Describe and determine the effect of stock dividends and stock splits on a company's weighted average number of shares outstanding.**The effect of stock dividends and splits is applied retroactively to the beginning of the year or the stock’s issue date and is not weighted by the portion of the year after the stock dividend or split occurred.

**Example:**During 2000, R & J, Inc., had net income of $100,000 and paid dividends of $50,000 to its preferred stockholders and $30,000 to its common shareholders. R & J's common stock account showed what appears below.*Compute*1/1/00

Shares issued and outstanding at the beginning of the year

10,000

4/1/00

Shares issued

4,000

7/1/00

10% stock dividend

9/1/00

Shares repurchased for the treasury

3,000

**Step 1**: Adjust the number of pre-stock dividend shares to their post-stock dividend units to reflect the 10 percent stock dividend by multiplying all share numbers prior to the stock dividend by 1.1. Shares issued or retired after the stock dividend are not affected.1/1/00

Initial shares adjusted for the 10% dividend 11,000

4/1/00

Shares issued adjusted for the 10% dividend 4,400

9/1/00

Shares of treasury stock re purchased (no adj.) - 3,000

**Step 2:**Compute the weighted average number of post-stock dividend shares:Initial shares

(11,000) (12 months outstanding)

132,000

Issued shares

(4,400) (9 months outstanding)

39,600

Retired treasury shares

(3,000) (4 months retired)

-12,000

Total share-month

159,600

Average shares

159,600 / 12=

13,300

**Step 3**: Compute basic EPS.Basic EPS =

Net Income - Pref Div

Wt. Ave. Shares of Common

=

$100,000 - $50,000

13,300

= $3.76

**e: Define and distinguish between dilutive and antidilutive securities.**If a firm has a complex capital structure containing dilutive securities (convertibles and options), then diluted EPS will treat these securities as if they were converted to common stock from the first of the year (or when issued if issued during the current year).

Basic EPS does not consider these dilutive securities in its computation, and both basic and diluted EPS do not consider antidilutive securities in their computations.

Each issue of potential common shares (potentially dilutive financial instruments) must be considered separately. Only income from continuing operations (excluding discontinued operations, extraordinary items, and accounting changes) is considered in determining diluted EPS.

**Example: EPS with convertible preferred stock**. During 2001, ZZZ reported net income of $11,560 and had 2,000 shares of common stock and 1,000 shares of preferred stock outstanding for the entire year. ZZZ's 10 percent, $100 par value preferred stock shares are each convertible into 20 shares of common stock. The tax rate is 40 percent.- Calculate 2001 basic EPS: (11,560 - 10,000) / 2000 = $0.78
- Calculate diluted EPS: [/list]
- Compute the increase in common stock outstanding if the preferred stock is converted to common stock at the beginning of 2001. (1,000)(20) = 20,000 shares.
- If the convertible preferred stock were converted to common stock, then there would be no preferred dividends paid. Therefore, you should add back the convertible preferred dividends that had previously been subtracted out.
- Compute diluted EPS as if the convertible preferred stock were common stock. Diluted EPS = [(net income - preferred dividends + convertible preferred dividends) / (weighted average shares + convertible preferred common shares)].
- Diluted EPS = [(11,560 - 10,000 + 10,000 / 2,000 + 20,000)] = $0.53
- Check to see if diluted EPS is less than basic EPS (0.53 < 0.78). If the answer is yes, the preferred stock is dilutive and should be considered in diluted EPS.