Académique Documents
Professionnel Documents
Culture Documents
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
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%
The size of the bid-ask spread. The smaller the spread the greater the liquidity.
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:
Multiplying the ROE by sales / sales gives ROE = (net income / sales)(sales / equity).
Therefore, ROE = (net profit margin)(equity turnover).
Multiplying by assets / assets and rearranging the denominator gives us ROE = (net
income / sales)(sales / assets)(assets / equity).
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).
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.
The use of accounting information that permits some choice of accounting principles.
There is always a potential for earnings management or earnings manipulation.
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?
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.
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
4,000
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.)
Issued shares
132,000
39,600
-12,000
Total share-month
159,600
Average shares
159,600 / 12=
13,300
Basic EPS =
13,300
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.
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)].
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
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).