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ANALYSIS FOR THE INVESTOR

CHAPTER # 10
LEVEARAGE AND EFFECT ON EARNINGS

• The use of debt, called financial leverage, has


a significant impact on earnings.

• The existence of fixed operating costs, called


operating leverage, also effects earnings.

• The higher the percentage of fixed operating


costs, the greater the variation in income as a
result of a variation in sales (revenue).
FINANCIAL LEVERAGE AND MAGNIFICATION
EFFECTS
• The use of financing with a fixed charge (such as
interest) is termed financial leverage.
• financial leverage is successful if the firm earns
more on the borrowed funds than it pays to use
them.
• It is not successful if the firm earns less on the
borrowed funds than it pays to use them.
• using financial leverage results in a fixed financing
charge that can materially affect the earnings
available to the common shareholders.
Cont.

If financial leverage is used, a rise in EBIT


will cause an even greater rise in net income,
and a decrease in EBIT will cause an even
greater decrease in net income.
COMPUTATION OF THE DEGREE OF
FINANCIAL LEVERAGE

The degree of financial leverage is the


multiplication factor by which the net income
changes as compared to the change in EBIT.

Degree of financial leverage


D.F.L. = EBIT / EBT
%CHANGE IN NI / % CHANGE IN EBIT
.
Cont

The degree of financial leverage formula will not work


precisely when the income statement includes any of
the following items:
1. Minority share of earnings
2. Equity income
3. Nonrecurring items
a. unusual or infrequent items
b. discontinued operations
c. extraordinary items
d. cumulative effect of change in an accounting principle.
SUMMARY OF FINANCIAL LEVERAGE
Two things are important at financial leverage as part of
financial analysis.

1. How high is the degree of financial leverage? This


is the type of risk( or opportunity) measurement
from the view point of the shareholder. The higher
the degree of financial leverage, the greater the
multiplication factor.

2. Does the financial leverage work for or against the


owners?
EARNING PER COMMON SHARE

Earning per share – the amount of income earned


on a share of common stock during an
accounting period- applies only to common stock
and to corporate income statements.
FORMULA
Computing earning per share initially involves net
income, preferred stock dividends declared and
accumulated, and the weighted average number
of shares outstanding.

earning per common share =( Net income –


preferred dividends) / weighted Average Number
of common share outstanding
PRICE / EARNINGS RATIO

The price / earnings ratio expresses the relationship


between the market price of share of common stock
and that stock’s current earnings per share.

Price / Earnings ratio = Market price per share /


diluted earning per share
PERCENTGE OF EARNINGS
RETAINED

The proportion of current earnings retained for


internal growth is computed as follows:

percentage of earnings retained =


(Net income – All Dividends) / Net Income
DIVIDEND PAYOUT
The dividend payout ratio measures the portion of
current earnings per common share being paid
out in dividends.

dividend payout = Dividends per common share /


diluted Earning per share
DIVIDEND YIELD

The dividend yield indicates the relationship


between the dividends per common share and the
market price per common share.

Dividend Yield = Dividends per common share /


Market price per common share
BOOK VALUE PER SHARE

Book value per share which indicates the amount of


stockholder’s equity that relates to each share of
outstanding common stock.

Book value per share = (Total stock holder’s equity –


preferred stock Equity) / Number of common shares
outstanding
STOCK OPTIONS

A basic understanding of stock option accounting is


needed in order to assess the stock option disclosure
of a company.
There are two types of stock option.
1. A non compensatory Plan
2. A compensatory plan
Non compensatory Plan:

Attempts to raise capital or encourage general


ownership of the corporation’s stock among
officers and employees.

compensatory Plan:

is available only to select individuals, such as


officers of a company.
Materiality of Options = stock Options
Outstanding / Number of shares of Common
stock outstanding