Financial statement analysis course with the financial leverage topic with provide a short description to student

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2. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Chapter
9
For the Investor

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• The use of financing with a fixed charge is
termed financial leverage
• Interest as related to debt financing
– A contractual obligation
– Must be paid regardless of entity’s current profits
• Contrast with dividends that are discretionary
– Interest is tax deductible
• Reduces taxable income
• Reduces income tax expense
Financial Leverage

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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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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
• A simpler formula for degree of financial
leverage
% Change in Net Income
Degree of Financial Leverage =
% Change in EBIT
Earnings Before Interest and Tax
Degree of Financial Leverage =
Earnings Before Tax

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• Degree of financial leverage calculations should
exclude
– Noncontrolling interest
– Equity income
– Nonrecurring items
Computation of the Degree of
Financial Leverage—Continued
 
 
 
Earnings Before Interest, Tax,
Noncontrolling Interest,
All-Inclusive Degree Equity Income, and Nonrecurring Items
=
Earnings Before Tax,
of Financial Leverage
Noncontrolling Interest,
Equity Income, and Nonrecurring Items

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• The amount of income earned on a share of
common stock during an accounting period
• Required disclosure for corporate income
statements
• Pertains only to common stock
Earnings per Common Share
Net Income Preferred Dividend
Earning per Share =
Weighted Average Number of Common
Shares Outstanding


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• Per share amounts for discontinued operations
and extraordinary items must be presented
– In the income statement and the notes to the financial
statements
• Earnings per share for recurring items are
significant for primary analysis
• Retroactive recognition must be given to events
such as stock dividend and stock split
Earnings per Common Share—
Continued

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• Earnings pertain to an entire fiscal period
• Average common shares outstanding is used for
parity of information
• Current guidelines require basic and diluted
earnings per share presentation
– Diluted earnings per share is calculated the same as
basic plus the dilutive effect of potentially dilutive
securities
• Convertible securities, warrants, or other rights that upon
conversion or exercise could in the aggregate dilute earnings
per common share are potential dilutive securities
Earnings per Common Share—
Continued

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Weighted Average Common
Outstanding Shares
Months Shares Are
Outstanding
Shares
Outstanding
×
Fraction of Year
Outstanding
=
Weighted
Average
January–June 10,000 6/12 5,000
July–September 12,000 3/12 3,000
October–December 15,000 3/12 3,750
11,750

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• 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
Price/Earnings Ratio
Market Price per Share
Price/Earings Ratio =
Diluted Earnings per Share,
Before Nonrecurring Items

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• Interpretation
– High-growth-potential firms have higher P/E ratios
– P/E ratio is a function of the market
• Compare with
– Competitors
– Industry average
Price/Earnings Ratio—Continued

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• Reflects the proportion of current earnings
retained for internal growth
• Trend analysis is improved by exclusion of
nonrecurring items
• Higher percentage typically found in growth
firms
Percentage of Earnings Retained
  
 
 
Net Income Before Nonrecurring
Percentage of Items All Dividends
=
Net Income Before Nonrecurring Items
Earnings Retained

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• Measures the portion of current earnings per
common share being paid out in dividends
• A stable dividend policy is developed by
consideration of recurring earnings
• Lower payout typically found in growth firms
Dividend Payout
Dividends per Common Share
Dividend Payout ratio =
Diluted Earnings per Share
Before Nonrecurring Items

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• Indicates the relationship between the dividends
per common share and the market price per
common share
• The yield depends on a firm’s dividend policy
and market price
Dividend Yield
Dividends per Common Share
Dividend Yield =
Market Price per Common Share

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• Preferred equity should be measured at
liquidation value, if available
• Market value and book value
– Book value reflects past unrecovered asset costs
– Market value reflects the potential of the firm
Book Value per Share
Total Shareholders' Equity
Preferred Stock Equity
Book Value per Share =
Number of Common Shares
Outstanding
