Chapter

For the Investor

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Financial Leverage
• 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

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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
% 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
– Nonrecurring items
Earnings Before Interest, Tax,
Noncontrolling Interest,
æ All-Inclusive Degree ö Equity Income, and Nonrecurring Items
ç of Financial Leverage ÷ = Earnings Before Tax,
è ø
Noncontrolling Interest,
Equity Income, and Nonrecurring Items
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Earnings per Common Share
• 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

Net Income - Preferred Dividend

Earning per Share =
Weighted Average Number of Common
Shares Outstanding

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Earnings per Common Share—
Continued
• 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

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Earnings per Common Share—
Continued
• 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

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Weighted Average Common
Outstanding Shares

Months Shares Are Shares Fraction of Year Weighted

× =
Outstanding Outstanding Outstanding 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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Price/Earnings Ratio
• 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

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

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Percentage of Earnings Retained
• 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
Net Income Before Nonrecurring
æ Percentage of ö Items - All Dividends
ç Earnings Retained ÷ = Net Income Before Nonrecurring Items
è ø

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Dividend Payout
• 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

Dividends per Common Share

Dividend Payout ratio =
Diluted Earnings per Share
Before Nonrecurring Items

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Dividend Yield
• 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
Dividends per Common Share
Dividend Yield =
Market Price per Common Share

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Book Value per Share
• 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

Total Shareholders' Equity -

Preferred Stock Equity
Book Value per Share =
Number of Common Shares
Outstanding

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Stock Options
• Recognize an expense for all employee services
received in share-based payment transactions,
using a fair-value-based method
– Similar to SFAS No. 123 (R)
• Allocate option fair value to the service period
– Date of grant through vesting date
• Noncompensatory plans
– Encourage widespread ownership by employees
– Slight discount from fair value
– No compensation expense is recognized
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Stock Options—Continued
• Impact of options can be substantial
– It may result in lower net income and earnings per
share
• Following formula is used to determine the
materiality of options:
æ Net Income Before ö æ Net Income Before ö
ç Nonrecurring Items not ÷ - ç Nonrecurring Items ÷
ç ÷ ç ÷
ç Including Option Expense ÷ ç Including Option Expense ÷
è ø è ø
Net Income Before Nonrecurring Items
Not Including Option Expense

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Restricted Stock
• Sometimes offered to employees in lieu of stock
option plans
• Restrictions
– Employee cannot sell stock for a specified period of
time
– Employees may forfeit their shares if they leave
employer before vesting
– Awards may be linked to financial goals

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Stock Appreciation Rights
• Gives the employee right to receive
compensation in cash or stock or in a
combination of both
– Based on the difference between option price and
market price
• Expense is a function of market price
– Year-end spread is measured
– Compensation expense is spread minus prior
recognition, multiplied by number of shares of stock
appreciation rights outstanding

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