Financial Statement

Analysis
CHARLES H. GIBSON

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 Chapter
9

For the Investor

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classroom use.
• This chapter introduces certain types of analysis
useful to the investor, in addition to liquidity,
debt, and profitability ratios covered in prior
chapters.

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Leverage and Its Effects on
Earnings
• The use of financing with a fixed charge (interest) is
called financial leverage, has a significant impact on
earnings.
• The expense of debt financing is interest, a fixed charge
dependent on the amount of financial principal and the
rate of interest.
• Interest is a contractual obligation created by borrowing
agreement and must be paid regardless of entity’s
current profits.
• In contrast with dividends that are discretionary.
• Interest is tax deductible, reduces taxable income and
reduces income tax expense
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Financial Leverage and
Magnification Effects
• Financial Leverage is successful if the firm earns
more on the borrowed funds than it pays to use
them.
• It is not successful if the firm earns less on the
borrowed funds than it pays to use them.
• Using financial leverage resulting in a fixed
financing charge (interest) that can materially
affect the earnings available to the common
shareholders.

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 Exhibit 9-1—Dowell Company

Percentage change in net income increase [A] is greater than percentage

change in EBIT [B] due to the fixed nature of interest expense
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• The above exhibit illustrates the effect of leverage on the
return to the common stockholders.
• If EBIT increases by 10% the net income rises by 12.5%, and
If EBIT decreases by 20% the net income drops by 25%.
• In general, if financial leverage is used, a rise in EDBIT will
cause an even greater rise in net income, and a decrease in
EBIT will cause an even greater decrease in net income.
• This magnification is caused by the fixed nature of the interest
expense. While earnings available to pay interest rise, interest
remains the same, thus leaving more for the residual owners.
• The use of financial leverage, termed trading on the equity, is
only successful if the rate of earnings on borrowed funds
exceeds the fixed charges.
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 Computation of the Degree of
Financial Leverage
• The degree of financial leverage is the multiplication factor
by which the net income changes in respect to changes in
EBIT.
• The degree of financial leverage is 1.25, means any
change in EBIT will change net income by 1.25 times.
% Change in Net Income
Degree of Financial Leverage =
% Change in EBIT
• A more simple formula for degree of financial leverage
Earnings Before Interest and Tax
Degree of Financial Leverage =
Earnings Before Tax

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 Computation of the Degree of
Financial Leverage—Continued
• Degree of financial leverage calculations should exclude:
Noncontrolling interest, Equity income, and Nonrecurring items.
• The degree of financial leverage formula will not work precisely
when the income statement includes any of these items.
• So, These items should be eliminated from numerator and
denominator
Earnings Before Interest, Tax,
Noncontrolling Interest,
 All-Inclusive Degree  Equity Income, and Nonrecurring Items
 of Financial Leverage  =
  Earnings Before Tax,
Noncontrolling Interest,
Equity Income, and Nonrecurring Items
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PROBLEM 9-2

Degree of Financial Leverage = Earnings Before

Interest, Tax, Noncontrolling Interest, Equity
Income and Nonrecurring Items ÷ Earnings Before
Tax, Noncontrolling Interest, Equity Income, and
Nonrecurring Items
= ($975,000 + $70,000) ÷ $975,000 =
$1,045,000 ÷ $975,000 = 1.07

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 Problem 9-4.
a. Degree of Financial Leverage = Earnings Before Interest,
Tax, Noncontrolling Interest, Equity Income, and
Nonrecurring Items ÷ Earnings Before Tax, Noncontrolling
Interest, Equity Income, and Nonrecurring Items
= $1,000,000 ÷ $800,000 = = 1.25’
b. Increase in net income = 400,000× 10% × 1.25 = 50,000
New level of earnings = 400, 000 + 50,000 = 450,000
c. Decrease in net income = (1,000,000 – 800,000) ÷
1,000,000 = 20%
Decrease in net income = 400,000× 20% × 1.25 = 100,000
New level of earnings = 400, 000 100,000 = 300,000
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 Earnings per Common Share
(EPS)
• The amount of income earned on a share of common stock
during an accounting period.
• Applies only to common stock.
• A company is required to present it at the bottom of the
income statement, because it receives much attention from
the financial community and investors.
• Per share amounts for discontinued operations and
extraordinary items must be presented

Net Income  Preferred Dividend

Earning per Share =
Weighted Average Number of Common
Shares Outstanding
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 Earnings per Common Share—
Continued
• Since earnings belongs to an entire fiscal period, the
denominator of the equation is the weighted average number
of common shares outstanding is used for similarity of
information.
• In all computations of EPS, the weighted-average number of
shares outstanding during the period constitutes the basis for
the per share amounts reported.
• Shares issued or purchased during the period affect the
number of shares outstanding.
• Companies must weight the shares by the fraction of the
period they are outstanding. The rationale for this approach is
to find the equivalent number of whole shares outstanding for
the year.
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For example:
• Assume that a corporation had 10,000 shares of
common stock outstanding at the beginning of
the year. On July 1, it issued 2,000 shares, and
on October 1, it issued another 3,000 shares.
• Net income $100,000, and preferred dividends
$10,000.
• Required: Compute the earnings per common
share.

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• The weighted average number of shares
outstanding:
Month shares are Shares Fraction of Weighted
outstanding outstanding year average
January – July 10,000 6/12 5,000
July - September 12,000 3/12 3,000
October- December 15,000 3/12 3,750
11,750

Earnings per common share = (100,000 – 10,000) ÷ 11,750 = $7.66

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• Another method, the weighted average number of
shares outstanding can be computed using the changes
in shares outstanding during the year:
Month shares are Changes in Fraction of Weighted
outstanding Shares year average
outstanding
January – December 10,000 12/12 10,000
July - December 2,000 6/12 1,000
October- December 3,000 3/12 ,750
11,750

Earnings per common share = (100,000 – 10,000) ÷ 11,750 = $7.66

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Earnings per Common Share—
Continued
• When the common shares outstanding increase as a result
of stock dividend or stock split, Retroactive recognition
must be given to these events.
• Stock dividends and stock splits do not provide the firm
with more funds; they only change the number of
outstanding shares.
• EPS should be related to the outstanding common stock
after the stock dividend or stock split.
• Assume in the prior example that a 2 for -1 stock split took
place on December 31.
• The denominator of EPS = 11,750 × 2 = 23,500 shares.
And EPS = (100,000 – 10,000) ÷ 23,500 = $3.83
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• Current guidelines require computing basic and diluted
EPS presentation
• Diluted EPS is calculated the same as basic plus the
dilutive effect of potentially dilutive securities.
• Dilutive securities are securities that can be converted to
Common stock, that upon conversion by the holder,
reduce (dilute) EPS.
• Dilutive securities are Convertible securities such as
convertible preferred stock, convertible bonds , or other
rights that upon conversion could reduce (dilute) EPS.

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Problem 9-11.
• a.
Numerator Denominator
Net income $ 200,000
Preferred dividends (10,000)
Common shares outstanding on
January 1 20,000 shares
Common stock issue on July 1,
5,000 shares 2,500 (5,000 x ½)
Weighted average 22,500
Two-for-one stock split on
December 31 2
(a) $ 190,000 (b) 45,000 shares
• Earnings per share (a) ÷ (b) $4.27
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b
Current Year Prior Year
EPS reported for the prior year $8.00
Two-for-one stock split on
December 31 of the current year
($8.00 x 0.5) = $4.00 $4.00
EPS computed in (a) for the
current year $4.27

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PROBLEM 9-12

January 1, shares outstanding 50,000 shares

July 1, two-for-one stock split 2
Adjusted shares outstanding for the year (A) 100,000

October 1 stock issue 10,000 shares

Proportion of year that the new shares were
outstanding 0.25
Weighted average for the new shares on an annual
basis (B) 2,500
Denominator of the EPS computation
for the current year (A) + (B) 102,500

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 Price/Earnings Ratio (P/E)
• Measures the relationship between the market price of a
share of common stock and that stock’s current earnings per
share
– Use of diluted earnings per share gives a more
conservative price/earnings ratio
Market Price per Share
Price/Earings Ratio =
Diluted Earnings per Share,
Before Nonrecurring Items

If P/E ratio = (76 ÷ 4) = 19, it means that the stock has been selling for
about 19 times of earnings.

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• The price-to-earnings ratio or P/E is one of the most
widely-used stock analysis tools used by investors and
analysts for determining stock valuation.
• The price-to-earnings ratio indicates the dollar amount
an investor can expect to invest in a company in order to
receive one dollar of that company’s earnings.
• This is why the P/E is sometimes referred to as the price
multiple because it shows how much investors are willing
to pay per dollar of earnings. If a company was currently
trading at a multiple (P/E) of 20, the interpretation is that
an investor is willing to pay $20 for $1 of current
earnings.
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• The P/E ratio helps investors determine the market value of a
stock as compared to the company's earnings.
• A high P/E could mean that a stock's price is high relative to
earnings and possibly overvalued.
• Conversely, a low P/E might indicate that the current stock price
is low relative to earnings.
• Companies with high growth opportunities generally have
higher P/E ratios; firms with low-growth tend to have lower P/E
ratio.
• P/E ratio is compare with Competitors, Industry average, and
Exchange averages,

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P/E ratio and Investor Expectations
• Investors view the P/E ratio as a gauge of future earning
power of the firm.
• The price/earnings ratio usually reflects investor’s
opinions of the future prospects for the firm.
• In general, a high P/E suggests that investors are
expecting higher earnings growth in the future compared
to companies with a lower P/E.
• A low P/E can indicate either that a company may
currently be undervalued or that the company is doing
exceptionally well relative to its past trends.

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 Percentage of Earnings Retained
• Reflects the proportion of current earnings retained for
internal growth, and indicates the ratio of retained earnings
to net income.
Net Income Before Nonrecurring
 Percentage of  Items  All Dividends
=
 Earnings Retained  Net Income Before Nonrecurring Items
 
• Many firms have a policy on the percentage of earnings that
they want to retain – for example between 60% and 75%.
• In general, new firms, and growing firms will have a relatively
high percentage of earnings retained.
• Many new firms, and growing firms do not pay dividends.
• Higher percentage typically found in growth firms.
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What Does the Retention Ratio Tell
You?
• The retention ratio helps investors determine how much
money a company is keeping to reinvest in the company's
operation.
• If a company pays all of its retained earnings out as dividends
or does not reinvest back into the business, earnings growth
might suffer.
• The retention ratio is typically higher for growth companies
that are experiencing rapid increases in revenues and profits.
• A growth company would prefer to plow earnings back into its
business if it believes that it can reward its shareholders by
increasing revenues and profits at a faster pace than
shareholders could achieve by investing their dividend
receipts.
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 • Investors may be willing to forego dividends if a company
has high growth prospects,
• The retention ratio refers to the percentage of net income
that is retained to grow the business, rather than being
paid out as dividends.
• It is the opposite of the payout ratio, which measures the
percentage of profit paid out to shareholders as
dividends. The retention ratio is also called the plowback
ratio. Plow ‫محراث‬

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 Dividend Payout
• Measures the portion of current earnings per common
share being paid out in dividends
• Lower payout typically found in growth firms
• Most firms hesitate to decrease dividends since this tends
to have adverse effects on the market price of the
company's stock. No rule of thumb exists for a correct
payout ratio. Some investors prefer high dividends, others
prefer to have a smaller payout ratio to allow the firm to
reinvest the earnings in hopes of higher capital gains.
Dividends per Common Share
Dividend Payout ratio =
Diluted Earnings per Share
Before Nonrecurring Items
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• Several considerations go into interpreting the dividend
payout ratio, most importantly the company's level of
maturity.
• A new, growth-oriented company that aims to expand,
develop new products, and move into new markets
would be expected to reinvest most or all of its earnings
and could be forgiven for having a low or even zero
payout ratio.
• The payout ratio is 0% for companies that do not pay
dividends, and is 100% for companies that pay out their
entire net income as dividends.

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 Dividend Yield
• Indicates the relationship between the dividends per common
share and the market price per common share
Dividends per Common Share
Dividend Yield =
Market Price per Common Share
• The yield depends on a firm’s dividend policy and market price
• If the firm successfully invests the money not distributed as
dividends, the price should rise. If the firm holds the dividends
at low amounts to allow for reinvestment of the profits, the
dividend yield is likely to be low.
• A low dividend yield satisfies many investors if the company
has a high return on common equity. Investors that want
current income prefer a high dividend yield.
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 Book Value per Share
• Indicates the amount of stockholder’s equity that relates to
each share of outstanding common stock.
Total Shareholders' Equity 
Preferred Stock Equity
Book Value per Share =
Number of Common Shares
Outstanding
• Preferred equity should be measured at liquidation value, if
available
– Book value is of limited use to the investment analyst
since it is based on book numbers. It reflects past
unrecovered asset costs
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• The market value of the stock reflects the potential of the
firm as seen by the investor.
• When market value is below book value, investors view
the company as lacking potential.
• A market value above book value indicates that investors
view the company as having enough potential to be
worth more than the book numbers.
• When investors are pessimistic about the prospects for
stocks, the stocks sell below book value.
• On other hand, when investors are optimistic about stock
prospects, the stocks sell above book value.

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Problem 9 - 5
a. 3 Common shareholders’ equity divided by
the number of common shares outstanding gives
book value per share.

b. 2 Book Value Per Share = {Total

Stockholders’ Equity – Preferred Stock (At Liquidation)} ÷
Number of Common Shares Outstanding
= ($1,000,000 + $1,500,000 + $500,000 + $1,100,000)
÷ 150,000 Shares = $12.67

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 problem 9 - 9
a. 1.
Percentage of Earnings Retained = (Net Income – All Dividends)
÷ Net Income
2011 2010
Cash dividends $0.80 x 25,380,000 $0.76 x 25,316,000
$20,304,000 $19,240,160
Preferred dividends + 4,567,000 930,000
= Total dividends 24,871,000 20,170,160
Net income (B) 32,094,000 31,049,000
= Net income – dividends (A) 7,223,000 10,878,840
Percentage of earnings
retained (A) ÷ (B) 22.51% 35.04%

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2. Price/Earnings Ratio = Market Price ÷ Fully Diluted Earnings Per Share
2011 2010
$12.94 ÷ $1.08 = 11.98% $15.19 ÷ $1.14 = 13.32%

3. Dividend Payout = Dividends Per Share ÷ Fully Diluted Earnings Per Share
2011 2010
$0.08 ÷ $1.08 = 74.07% $0.76 ÷ $1.14 = 66.67%

4. Dividend Yield = Dividends Per Share ÷ Market Price Per Share

2011 2010
$0.08 ÷ $12.94 = 6.18% $0.76 ÷ $15.19 = 5.00%

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5. Book Value Per Share = Common Equity ÷ Shares Outstanding
2011 2010
Total assets $ 1,264,086,000 $ 1,173,924,000
Less: total liabilities (823,758,000) (742,499,000)
Less: nonredeemable
preferred stock (16,600,000) (16,600,000)
= Common equity (A) $ 423,728,000 $ 414,825,000
÷ Shares outstanding (B) 25,380,000 25,316,000
Book value per share (A) ÷ (B) $16.70 $16.39

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b. Having the percentage of earnings retained decline provides mixed
feelings. It implies that more is going to shareholders, but at the same
time, earnings retained for growth have diminished. The rise in the
dividend payout ratio supports this position.
- The price/earnings ratio has declined as a result of the drop in price.
This decline indicates lower shareholder expectations but might also
indicate a good time to buy.
- Dividend yield is up, caused by the rise in dividends and more so by the
drop in price.
- Book value per share is up. However, book value is above market,
which shows that the investors do not view the assets as worth their
book value. This is not a good sign.
• Overall the signals are mixed. There is not enough information to
determine if this is a good security.
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 Stock Options
• Corporations frequently provide stock options as a
compensation for employees and officers of the company or to
enable a business, particularly a startup business, to recruit,
reward, and retain key personnel.
• The stock option gives the holder the right to acquire the
company’s stock at a time in the future at a specified price
(referred to as the exercise or strike price).
• Stock options are not shares they are the right to buy shares.
• Companies should recognize an expense for all employee
services received based on the fair-value-of the service they
provide (salary).

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• The expense is recorded equally throughout the entire
vesting period, which is the time between the date the
company grants the options and when the individual is
allowed to exercise the option.
• During this period an employee is required to provide
service in exchange for the award ( the vesting period).

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Stock Options—Continued
• Impact of option expense can be substantial, resulting in
lower net income and earnings per share.
• Following formula is used to determine the materiality of
options:

 Net Income Before   Net Income Before 

 Nonrecurring Items not    Nonrecurring Items 
   
 Including Option Expense   Including Option Expense 
   
Net Income Before Nonrecurring Items
Not Including Option Expense

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 Restricted Stock
• Sometimes offered to employees instead of stock option plans
• Restrictions:
1. Employee cannot sell their shares until a certain amount of time
passes.
2. Employees may have to forfeit their shares if they leave
employer before vesting
3. Awards may be linked to financial goals, an employee forfeits
the shares if certain financial targets are not met.
Some employees prefer restricted stock over options because the
receive actual shares of stock. Usually, the employee receives
dividends.
With restricted stock, companies calculate and recognize expense
in a manner similar to the requirement for expensing options.
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 Stock Appreciation Rights
• Some firms grant key employees stock appreciation rights instead of
stock options or in addition to stock options.
• Stock appreciation rights give the employee the right to receive
compensation in cash or stock or in a combination of both at some future
date, Based on the difference between option price and market price
• The accounting for stock appreciation rights requires that the
compensation expense recognized each period be based on the
difference between the market value at the end of each period and the
option price.
• This compensation expense is then reduced by previously recognized
compensation expense on the stock of appreciation right.
• Stock appreciation rights can have a material influence on income,
dictating by changing stock prices.

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• For example, assume that the option price is $10 and the
market value is $15 at the end of the first period of the stock
appreciation right.
• If 100,000 shares are in the plan, then the compensation
expense to be charged to the income statement
= (15 – 10) × 100,000 = $500,000
If the market value is $12 at the end of the second period of the
stock appreciation right, expenses are reduced by $3 per share.
This is because the total compensation expense for the two years
= 12 – 10 = $2.
Since $5 of expense was recognized in the first yea, $3 of
negative compensation is considered in the second year to total
$2 of expense. The reduction in the expense is $300,000..
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Problem 9 -1
• a. 3
2011 2010 2009
EPS previously reported ----- $1.00 $.80
2011 declared a 4-for-1 stock split .25 .20
2011 reported .30 EPS .30 .25 .20
• b. 4
New EBIT $ 2,000,000
Prior EBIT 1,000,000
(a) $ 1,000,000
Financial leverage (b) 1.5
(a) x (b) $ 1,500,000

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c. 4 Adjust the shares in 2011 by adding 10% additional shares.
Divide the previous number of shares for 2011 by the new
number of shares. This is the percentage of the previous
reported earnings per share that should be reported as the
adjusted earnings per share. For illustration, assume the
following;
(A) Previous shares 100,000
10% stock dividend 10,000
(B) New number of shares 110,000
(A) ÷ (B) 100,000/110,000 = .909

d. 3 The price/earnings ratio usually reflects investor’s opinions of

the future prospects for the firm.
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e. 4 Degree of financial leverage gives a perspective
on risk in the capital structure.
f. 3 The earnings per share ratio is computed for
common stock.
g. 2 Increasing financial leverage can be a risky
strategy from the viewpoint of stockholders of
companies having low and falling profits.
h. 1 10% x 1.3 = 13%
i. 2 Dividend yield represents dividends per common
share in relation to market price per common share.
j. 5 Book value per share may not approximate market
value per share because of all of the reasons listed.
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product or service or otherwise on a password-protected website for classroom use.