Read Prentice Hall's one-day MBA in finance & accounting Online

Authors: Michael Muckian,Prentice-Hall,inc

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47

F I N A N C I A L R E P O R T I N G

Figure 4.5 shows four profit ratios for the business example; each ratio equals the profit on that line divided by sales revenue. These return-on-sales profit ratios are
not
required to be disclosed in the income statement. Generally speaking, businesses do not report profit ratios with their external income statements, although many companies comment on one or more of their profit ratios elsewhere in their financial reports. Managers should pay very close attention to the profit ratios of their business of course.

The company’s net income return on sales ratio is 4.0 percent ($1,585,587 net income ÷ $39,661,250 sales revenue =

4.0%). From each $100.00 of its sales revenue, the business earned $4.00 net income and had expenses of $96.00. The net income profit ratio varies quite markedly from one industry to another. Some businesses do well with only a 1 or 2

percent return on sales; others need more than 10 percent to justify the large amount of capital invested in their assets.

A popular misconception of many people is that most businesses rip off the public because they keep 20, 30, or more percent of their sales revenue as bottom-line profit. In fact, very few businesses earn more than a 10 percent bottom-line profit on sales. If you don’t believe me, scan a sample of 50 or 100 earnings reports in the
Wall Street Journal
or the
New
York Times.
The 4.0 percent net income profit ratio in the
Profit

Income Statement

Ratios

Sales revenue

$39,661,250

Cost-of-goods-sold expense

$24,960,750

Gross margin

$14,700,500

37.1%

Selling and administrative expenses

$11,466,135

Earnings before interest and income tax

$ 3,234,365

8.2%

Interest expense

$

795,000

Earnings before income tax

$ 2,439,365

6.2%

Income tax expense

$

853,778

Net income

$ 1,585,587

4.0%

FIGURE 4.5
Return-on-sales profit ratios.

48

I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S

example is not untypical, although 4.0 percent is a little low compared with most businesses.

Serious investors watch all the profit ratios shown in Figure 4.5. The first ratio—the gross margin return-on-sales ratio—is the starting point for the other profit ratios. Gross margin (also called
gross profit
) equals sales revenue minus only cost-of-goods-sold expense. The company’s gross margin equals 37.1 percent of sales revenue (see Figure 4.5). If its gross margin ratio is too low, a business typically cannot compensate for this serious deficiency in gross margin by cutting other operating expenses, so its bottom line suffers. An inadequate gross margin cascades down to the bottom line, in other words. Therefore investors keep a close watch for any slippage in a company’s gross margin profit ratio. Investors and stock analysts keep a close eye on year-to-year trends in profit ratios to test whether a business is able to maintain its profit margins over time. Slippage in profit ratios is viewed with some alarm. A business’s profit ratios are compared with its main competitors’ profit ratios as a way to test of the comparative marketing strength of the business. Higher than average profit ratios are often evidence that a business has developed very strong brand names for its products or has nurtured other competitive advantages.

BOOK VALUE PER SHARE

Suppose I tell you that the market price of a stock is $60.00

per share and ask you whether this value is too high, too low, or just about right. You could compare the $60.00 market price with the stockholders’ equity per share reported in its most recent balance sheet—which is called the
book value per
share.
The book value per share in the business example (see Figure 4.2) equals $31.19 ($13,188,483 total owners’ equity ÷

422,823 capital stock shares = $31.19). Book value per share has a respectable history in securities analysis. The classic book,
Security Analysis,
by Benjamin Graham and David Dodd, puts a fair amount of weight on the book value behind a share of stock.

Just the other day I read an article in the business section of the
New York Times
that was very critical of a business.

Among several cogent points discussed in the article was the
49

F I N A N C I A L R E P O R T I N G

fact that the current market price of its stock was 29 percent below its book value. Generally speaking, the market value of stocks is higher than their book values. The reason for the comment in the article is that when a stock trades below its book value, the investors trading in the stock are of the opinion that the stock is not worth even its book value. But book value is backed up by the assets of the business.

To illustrate this point, suppose the business in the example were to liquate all its assets at the amounts reported in its balance sheet, then pay off all its liabilities, and finally distribute the money left over to its stockholders. Each share of stock would receive cash equal to the book value per share, or $31.19 per share. So book value is a theoretical liquidation value per share. From this point of view, the market value of the shares should not fall below $31.19. But the profit prospects of the business may be very dim; the stockholders may not see much chance of improving profit performance in the near future. They may think that the business could not sell off its assets at their book values and that no one would pay book value for the business as a whole.

Of course, most businesses do not plan to liquidate their assets and go out of business in the foreseeable future. They plan to continue as a going concern and make a profit, at least for as far ahead as they can see. Therefore the dominant factor in determining the market value of capital stock shares is the
earnings potential
of the business, not the book value of its ownership shares. The best place to start in assessing the earning potential of a business is its most recent earnings performance.

Suppose I owned 10,000 capital stock shares of the business in the example and you were interested in buying my shares. What price would you offer for my shares? You’ve studied the financial statements of the business, and you predict that the business will probably improve its profit performance in the future. So you might be willing to pay $40, $50, or higher per share for my stock, which is based on your assessment of the future earnings potential of the business. Private corporations have no readily available market value information for their capital stock shares. So you’re on your own regarding what price to pay for my stock shares.

Stockholders in public corporations have market value information at their fingertips, which is reported in the
Wall
50

I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S

Street Journal,
the
New York Times, Barron’s, Investor’s Business Daily,
and many other sources of financial market information. They know the prices at which buyers and sellers are trading stocks. The main factor driving the market price of a stock is its
earnings per share.

EARNINGS PER SHARE

The income statement presented in Figure 4.1 includes
earnings per share
(EPS), which is $3.75 for the year just ended.

Privately owned businesses whose capital stock shares are not traded in public markets do not have to report their earnings per share, and most don’t. I include it in Figure 4.1 because publicly owned businesses whose capital stock shares are traded in a public marketplace (such as the New York Stock Exchange or Nasdaq) are required to report EPS.

Earnings per share (EPS) is calculated as follows for the business (see Figures 4.1 and 4.2 for data):

$1,585,587 net income available for stockholders

ᎏᎏᎏᎏᎏᎏᎏ

422,823 total number of outstanding capital stock shares

= $3.75 basic EPS

For greater accuracy, the
weighted average
number of shares outstanding during the year should be used to calculate EPS—which takes into account that some shares may have been issued and outstanding only part of the year. Also, a business may have reduced the number of its outstanding shares during part of the year. I use the ending number of shares to make it easier to follow the computation of EPS.

The numerator (top number) in the EPS ratio is
net
income available for common stockholders,
which equals bottom-line net income minus dividends paid to preferred stockholders of the business. Many business corporations issue preferred stock shares that require a fixed amount of dividends to be paid each year. The total of annual dividends to the preferred stockholders is deducted from net income to determine net income available for the common stockholders.

The business in the example has issued only one class of capital stock shares. It has not issued any preferred stock, so all its net income is available for its common stock shares.

51

F I N A N C I A L R E P O R T I N G

Basic and Diluted EPS

Please notice the word
basic
in the preceding EPS calculation.

Basic means that the
actual number
of common stock shares in the hands of stockholders is used as the denominator (bottom number) for calculating EPS. If a business were to issue more shares, the denominator would become larger and EPS

would decrease. The larger number of shares would dilute EPS. In fact many business corporations have entered into contracts that oblige them to issue additional stock shares in the future. These shares have not yet been issued, but the business is legally committed to issue more shares in the future. In other words, there is the potential that the number of capital stock shares will be inflated and net income will have to be divided over a larger number of stock shares.

Many public businesses award their high-level managers
stock options
that give them the right to buy stock shares at fixed prices. These fixed purchase prices generally are set equal to the market price at the time the stock options are granted. The idea is to give the managers an incentive to improve the profit performance of the business, which should drive up the market price of its stock shares. When (and if) the market value of the stock shares rises, the managers exercise their rights and buy stock shares at the lower prices fixed in their option contracts. Managers can make millions of dollars by exercising their stock options. There is a wealth transfer from the nonmanagement stockholders to some of the management stockholders because the market price per share is lower than it would have been if shares had not been issued to the managers.

The calculation of basic EPS does
not
recognize the addi-DANGER!

tional shares that may be issued when management stock options are exercised in the future. Also, some businesses issue convertible bonds and convertible preferred stock that at the option of the security holders can be traded in for common stock shares based on predetermined exchange rates.

Conversions of senior securities into shares of common stock also cause dilution of EPS.

To alert investors to the potential effects of management stock options and convertible securities, a
second
EPS is calculated by public corporations, which is called the
diluted
EPS.
This lower EPS takes into account the effects on EPS that
52

I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S

would be caused by the issue of additional common stock shares under terms of management stock option plans and convertible securities (plus any other commitments a business has entered into that requires it to issue additional stock shares in the future). Both basic EPS and diluted EPS (if applicable) are reported in the income statements of publicly owned business corporations. The diluted EPS is a more conservative figure on which to base market value.

MARKET VALUE RATIOS

The capital stock shares of more than 10,000 business corporations are traded on public markets—the New York Stock Exchange, Nasdaq, and other stock exchanges. The day-to-day market price changes of these shares receive a great deal of attention, to say the least. More than any other factor, the market value of capital stock shares depends on the earnings per share performance of a business—its past performance and its future profit potential. It’s difficult to prove whether basic EPS or diluted EPS is the driver of market value. In many cases the two are very close and the gap is not significant. In some cases, however, the spread between the two EPS figures is fairly large.

In addition to earnings per share (EPS) investors in stock shares of publicly owned companies closely follow two other ratios: (1) the
dividend yield ratio
and (2) the
price/earnings
ratio
(P/E). The dividend yield and P/E ratios are reported in the stock trading tables published in the
Wall Street Journal,
which demonstrates the importance of these two market value ratios for stock shares.

Dividend Yield Ratio

The dividend yield ratio equals the amount of cash dividends per share during the most recent, or trailing, 12 months divided by the current market price of a stock share. The dividend yield ratio is the measure of cash income from a share of stock based on its current market price. The annual return on an investment in stock shares includes both the cash dividends received during the period and the gain or loss in market value of the stock shares over the period. The calculation
53

F I N A N C I A L R E P O R T I N G

of the historical rate of return for a stock investment over two or more years and for a stock index such as the Dow Jones 30

Industrial or the Standard & Poor’s 500 assumes that cash dividends have been reinvested in additional shares of stock.

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