Revise Lecture 17

Financial Ratios

Ownership ratios• Ownership ratios assist the stockholder in

analyzing present and future investments in a company. Shareholders are interested in the way certain variables affect the value of their holdings.

• By analyzing ownership ratios, the shareholder is able to analyze the likely future market value of the stock

Ownership ratios

Three major groupings of ownership ratios:

1) Earnings Ratios: These provide information on the earnings of the firm and how earnings affect the price of common stock.The earnings ratios are earnings per share, price-earnings ratio and capitalization rate

Ownership ratios

.2) Capital structure ratios: A firm’s capital structure is the relation of debt to equity as sources of the firm’s assets. The two ratios that reflect capital structure are the debt-equity ratio and the debt-asset ratio

Ownership ratios

3) Dividend ratios: These provide measures of the adequacy of dividend payments. • The two ratios are 1. Dividend payout 2. Dividend yield.

Ownership ratios

Earnings per Share (EPS)• Shareholders are concerned about the

earnings that will eventually be available to pay them dividends or that are used to expand their interest in the firm because the firm retains the earnings.

• These earnings may be expressed on a per-share basis

Ownership ratios

Earnings Per share• Earnings per share is calculated by = Net Income / number of shares outstanding

Shares authorized, issued and repurchased (treasury stock) are omitted from the calculations

Ownership ratios

Earnings per share• A year-to-year comparision of earnings per

share can be very informative to the investor.

• Example

EPS – Example p116

Ownership ratios

Price Earnings ratio (P/E)• The price earning ratio (P/E) is calculated by EPS / Market price of shareIt is the most important measure of value used by investors in the marketplace. Many investors consider no other factor prior to making purchases

Ownership ratios

Price-earnings ratios• The P/E ratio is used as a going-concern methods of

valuing share.• As long as the firm is a viable business entity, its

real or going-concern value is reflected in the profit.

• If share has a low P/E multiple, for example 4/1, it may be viewed as an undervalued share.

• If the ratio is 20/1, it may be considered overvalued

Ownership ratios

The P/E ratio may be used several ways:

1. To determine expected market value of a share

2. To determine future market value of a share3. To determine capitalization rate of a share

(rate of return investors demand before they purchase a share)

Ownership ratios

Capital structure ratios• Two ratios are important in analyzing the

relationship between the debt and equity component of the firm’s capital structure:

1) Debt-Equity ratio: This is calculated by Total debt / Total equity2) Debt-Asset ratio: This is calculated by Total debt / Total assets

Ownership ratios

Capital structure ratio• These ratios show how much of the firm’s

assets are financed by debt and equity and give important information about prospects for future financing.

• If a firm has excessive debt, it will experience difficulty in locating additional debt financing.

The firm will be able to borrow only at high interest rates .

Ownership ratios

Capital structure ratio• On the other hand if the ratio is low (virtually no

debt) it may indicate a failure to use relatively lower cost borrowed funds to raise the return earned on the common stock.

• Analyst differ on whether short-term debt should be included in the capital structure ratios.

• One group reasons that accounts payable and similar short-term liabilities are not (or should not) really a form of borrowing to finance the firm’s resources.

Ownership ratios

Capita structure ratio

• Second group, current liabilities are included in the debt-equity and debt-asset ratios.

• Reasoning is that careful management of the short-term debt accounts allows the firm to take advantage of inexpensive (and frequently free) funds that it would otherwise have to borrow at higher costs.

Ownership ratios

There are three major uses of capital structure ratios:1) To identify sources of funds• The firm finances all its resources from debt or

equity sources. The amount of resources from each source is shown by these ratios

Ownership ratios

2) To Measure financing risk• One measure of the degree of risk resulting

from debt financing is provided by these ratios.

• If the firm has been increasing the % of debt in its capital structure over a period of time, this may indicate an increase in risk for its shareholders.

Ownership ratios

3) To forecasts borrowing prospects:• If the firm is considering and needs to raise additional

money, the capital structure ratios offer an indication of whether debt funds will be available.

• If the ratios are too high, the firm may not be able to borrow• As general guideline, the debt should not exceed 50% of the

total sources of funds. It should be less than 50% for a firm in a risky business that produces wide swings in operating income.

• Thus, a debt-equity ratio of 1:1 or a debt-asset ratio 0.5:1 should be the maximum for industrial firms.

Ownership ratios

Book value per shareThe book value of a firm’s common share is calculated by shareholder’s equity / the number of shares outstanding

Book value is the reflection of the accounting records of the firm rather than a strong measure of the real value of the firm’s assets.

Ownership ratios

Three valid uses of book value may be identified:

1. Liquidation value2. Market price near book value3. Legal proceedings