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 companys 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 firms
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 companys 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 companys risk profile

Business risk is related to the firms industry, the variability of sales due to the firms
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]

Financial risk 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 companys growth potential

Growth analysis: Investors and creditors are interested in the firms growth potential.
Investors because high growth means high stock prices, and creditors because high growth
means the firms 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 firms
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 companys 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).

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).

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 firms industry, the firms major competitors and even the firms own
past performance record.

1. The comparison of the firms 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 firms 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 firms 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?

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 years 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 owners proportionate claim on the firms 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 stocks 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 the weighted average number
of common shares outstanding during 2000.
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

11,000
Initial shares adjusted for the 10% dividend

4/1/00

4,400
Shares issued adjusted for the 10% dividend

9/1/00

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

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

Initial shares

(11,000) (12 months outstanding)

Issued shares

(4,400) (9 months outstanding)

Retired treasury shares

(3,000) (4 months retired)

132,000
39,600
-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 = $3.76

13,300

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.

1. Calculate 2001 basic EPS: (11,560 - 10,000) / 2000 = $0.78

2. Calculate diluted EPS:

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.

f: Describe the components of and calculate a company's basic and diluted EPS
in a complex capital structure.
Example: EPS with stock options
During 2001, ZZZ reported net income of $11,560 and had 2,000 shares of common stock
outstanding for the entire year. ZZZ also had 1,000 shares of 10 percent, par $100 preferred
stock outstanding during 2001. ZZZ has 1,000 stock options (or warrants) outstanding the
entire year. Each option can be exercised allowing the holder to purchase 10 shares of
common stock at $15 a share. The average market price of ZZZ's common stock during 2001
is $20 a share.
Number of common shares created if the options are exercised: 10,000 shares
Cash inflow if the options are exercised: ($15/share)(10,000) = $150,000
Number of shares that can be purchased with these funds is: ($150,000/20) = 7,500 shares
Net increase in common shares outstanding from the exercise of the stock options: 2,500
shares
Diluted EPS = (11,560 - 10,000) / (2,000 + 2,500) = $0.35

g: Describe and determine the effects of convertible securities, options, and

warrants on a company's EPS.

Dilutive stock options increase the number of common shares outstanding in the denominator
for diluted EPS. There is no adjustment to net income in the numerator. Stock options are
dilutive only when the exercise price is less than the average market price. To calculate the
adjustment to the number of shares in the denominator you must use the treasury stock
method.
Warrants: If there are restrictions on the proceeds received when warrants are exercised,
then dilutive EPS calculations must reflect the results of those agreements.
The treasury stock method reduces the total increase in shares created from the hypothetical
exercise of the options into common stock. The treasury stock method assumes that the
hypothetical funds received by the company from the exercise of the options (called the boot)
are used to purchase shares of the company's common stock in the market at the average
market price. The net increase in the number of shares outstanding (the adjustment to the
denominator) will thus be the number of shares created by exercising the options less the
number of shares repurchased.

h: Compare and contrast the requirements for EPS reporting in simple versus
complex capital structures.
The numerator of the basic EPS equation contains income available for common
shareholders (net income from continuing operations less preferred dividends). In the case of
dilutive EPS, if there are dilutive securities (e.g., convertible preferred stock, convertible
bonds, or warrants) that will cause the weighted average common shares to change then the
numerator must be similarly adjusted. If convertible preferred stock is dilutive (meaning
diluted EPS will fall), then the convertible preferred dividends must be added back to the
previously calculated income from continuing operations less preferred dividends. If
convertible bonds are dilutive, then the bonds after-tax interest would not be considered as
an interest expense for diluted EPS. Hence, interest expense multiplied by (1 - t) must be
added back to the numerator.
The denominator contains the number of shares of common stock issued, weighted by the
days that the shares have been outstanding. A share outstanding all year is counted as one
share. But a share outstanding for only a third of a year is counted as a third of a share. The
basic EPS denominator is the weighted average number of shares. When considering dilutive
securities the denominator is the basic EPS denominator adjusted for the equivalent number
of common shares created by the conversion of all outstanding dilutive securities (convertible
bonds, convertible preferred shares, plus options).