Analysis of

Financial
Statements
Analysis For The Investor
Leverage and Its Effects 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 affects earnings. The
higher the percentage of fixed operating
costs, the greater the variation in income as a
result of a variation in sales (revenue).
DEFINITION OF 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.
Conti
COMPUTING THE DEGREE OF
FINANCIAL LEVERAGE
The degree of financial leverage is the
multiplication factor by which the net income
changes as compared with the change in EBIT.
One way of computing it follows:
% Change Net Income / % Change EBIT
Also
Degree of Financial Leverage =EBIT/EBT
SUMMARY OF FINANCIAL LEVERAGE
Two things are important in looking at
financial leverage as part of financial analysis.
First, how high is the degree of financial
leverage? This is a type of risk (or
opportunity) measurement from the viewpoint
of the stockholder. The higher the degree of
financial leverage, the greater the
multiplication factor. Second, does the
financial leverage work for or against the
owners?
Earnings per Common
Share
Earnings per sharethe amount of income earned on a
share of common stock during an accounting period
applies only to common stock and to corporate income
statements. Nonpublic companies, because of cost-
benefit considerations, do not have to report earnings
per share. Because earnings per share receives much
attention from the financial community, investors, and
potential investors, it will be described in some detail.

Earnings per Share =Net Income Preferred Dividends /

Weighted Average Number of Common Shares
Outstanding
Price/Earnings Ratio
The price/earnings (P/E) ratio expresses the
relationship between the market price of a
share of common stock and that stocks
current earnings per share. Compute the P/E
ratio as follows:
Price/Earnings Ratio =Market Price per Share /
Diluted Earnings per Share, Before Nonrecurring
Items
Conti
Percentage of Earnings Retained
The proportion of current earnings retained
for internal growth is computed as follows:
Percentage of Earnings Retained = Net Income
Before Nonrecurring Items minus All
Dividends / Net Income Before Nonrecurring
Items
Conti
Dividend Payout
The dividend payout measures the portion of
current earnings per common share being
paid out in dividends. Compute the dividend
payout ratio as follows:
Dividend Payout =Dividends per Common
Share / Diluted Earnings per Share Before
Nonrecurring Items
Conti
Dividend Yield

The dividend yield indicates the relationship

between the dividends per common share and
the market price per common share. Compute
the dividend yield as follows:
Dividend Yield=Dividends per Common Share /
Market Price per Common Share
Conti
Book Value per Share
A figure frequently published in annual
reports is book value per share, which
indicates the amount of stockholders equity
that relates to each share of outstanding
common stock. The formula for book value per
share follows:
Book Value per Share =Total Shareholders
Equity minus Preferred Stock Equity / Number of
Common Shares Outstanding
Conti
Stock Options (Stock-Based
Compensation)
Corporations frequently provide stock options
(or other stock-based compensation) for
employees and officers of the company.
Setting aside shares for options (or other
stock-based compensation) is very popular in
the United States.
Conti
Two terms that are particularly important to
understanding SFAS No. 123 (R) are grant date and
vested. The grant date is the date at which an employer
and an employee reach a mutual understanding of the
key terms and conditions of a share-based payment
award. The employer becomes contingently obligated on
the grant date to issue equity instruments or transfer
assets to an employee who renders the requisite service
. A share-based payment award becomes vested at the
date that the employees right to receive or retain
shares, other instruments, or cash under the award is no
longer contingent on satisfaction of either a service
condition or a performance condition.
Restricted Stock
In July 2003, Microsoft Corporation announced that it
would stop issuing stock options to employees and
instead give them restricted stock. This was a defining
event in the popularity of restricted stock and the
reduction in stock option plans. With restricted stock,
employees cannot sell their shares until a certain amount
of time passes, and employees may have to forfeit their
shares if they leave before vesting. Often, a portion of the
shares vest each year for three, four, or five years. For
some restricted stock, an employee forfeits the shares if
certain financial targets are not met. With restricted
stock, the expense is booked by companies in a manner
similar to the new requirement for expensing options.
Stock Appreciation Rights
Some firms grant key employees stock
appreciation rights instead of stock options or
in addition to stock options. Stock
appreciation rights give the employee the
right to receive compensation in cash or stock
(or a combination of these) at some future
date, based on the difference between the
market price of the stock at the date of
exercise over a pre established price.