BFIN3020 CH 14

capital structure/capitalization

the distribution of debt and equity that comprise a company’s finances.

what may cause a company to refinance

large debt issue approaching maturity, and retractable securities that are exercised.

what can dilute earnings per share?

convertible securities

leveraged company

when the capital structure contains debt or preferred shares.

what effect does leverage have on earnings per share?

earnings are magnified in an upswing in the business cycle, but can lead to larger losses during downturns.

trend ratio

analysts identify trends by selecting a base period, treating the figure or ratio for that period as 100 and then dividing it into the comparable ratios for subsequent periods.

4 types of financial ratios

liquidity, risk, operating performance, value

liquidity ratios

measures a company's ability to meet its short-term obligations, e.g. current ratio

risk analysis ratios

shows how well a company can deal with its debt obligations. e.g. debt-to-equity ratio

operating performance ratios

measure how well management is using resources. e.g. net profit margin ratio

value ratios

show investors what the company’s shares are worth, or the return on owning them. e.g. price-to-earnings ratio. Measures the way a stock market rates a company by comparing its price to information in its financial statements.

working capital (net current assets)

current assets less current liabilities, indicating the liquidity available to a company for its short term obligations.

working capital ratio (current ratio) [liquidity]

determines the ability of a company to meet its obligations, expand volume of business, and take advantage of financial opportunities. Higher is better.

a current ratio of 2 to 1 means

the company has $2 of current assets to pay for every $1 of current liabilities

what current ratio is too high and indicates too much inventory or mismanagement?

5 to 1 or more

quick ratio (acid test) [liquidity]

a more conservative measure of a company’s ability to meet current obligations. Similar to current ratio, but excludes inventory from current assets.

a quick ratio of less than 1 is only acceptable if

the company has a high inventory turnover (such as retail)

asset coverage ratio [risk]

a financial ratio that shows a company’s ability to cover its debt with tangible assets after all non-debt liabilities have been satisfied. Higher is better

debt-to-equity ratio [risk]

shows the proportion of borrowed funds relative to investments made by shareholders (SHE). Lower is better.

what does a high debt-to-equity ratio indicate?

excessive borrowing and higher financial risk.

cash flow-to-total debt outstanding ratio [risk]

measures the company’s ability to repay the funds it has borrowed. Higher is better, but depends on industry standards. Short term borrowing should be paid within a year.

interest coverage ratio [risk]

measures the ability of a company to pay the interest charges on its debt. Indicates how many times the charges are covered by earnings. Higher is better.

gross profit margin [profitabilty]

measures the company’s rate of profit after allowing for the cost of sales. Higher is better.

net profit margin

measures the company’s rate of profit after allowing for both expenses and taxes. Higher is better.

return on common equity [profitability]

percentage of the amount earned relative to a company’s common shares. Tells investor how effectively their money is put to use. Higher is better.

return on common equity of 10% means

the company earned $0.10 for each dollar invested

inventory turnover ratio [operating]

the number of times that a company’s inventory is turned over in a year.

if a company’s inventory turnover ratio is too high relative to its industry, what might this indicate?

shortages resulting in lost sales.

why might a company have a low inventory turnover rate?

the inventory contains a large portion of unsaleable goods, over-bought inventory, or the value of inventory is overstated.

dividend payout ratio [value]

indicates the percentage of the company’s profit that is paid out as dividends.

what does it mean if dividend payout ratio exceeds 100%?

dividends are taken out of retained earnings, which erodes the value of shareholder equity.

earnings per common share

The portion of a company's profit allocated to each outstanding share of common stock. Important in determining an appropriate market price.

What might cause diluted EPS?

Diluted EPS may be caused by the conversion of convertible securities, the exercise of warrants, or the issuance of stock options, which increase the total number of shares outstanding.

dividend yield [value]

shows the annual dividend rate as a percent of the current market price of a stock. Represents the investor’s return on the investment (Higher is better).

equity value per common share ratio (book value per common share) [value]

measures net asset coverage for each common share if all assets were sold and all liabilities were paid. No meaningful standard.

price-to-earnings ratio [value]

[price/EPS], represents the ultimate evaluation of a company and its shares. Combines all other ratios. Represents tangible and intangible elements. Lower is better

what ratio best indicates investor confidence?

Price-to-earnings ratio (P/E)

dividend discount model (DDM)

the relationship between a stocks current price and the present value of future dividend payments. It is used to estimate the intrinsic value of a stock based on its expected future dividends. It assumes a constant growth rate.

If the DDM of a stock is $30, and the market price is $25, is the security undervalued or overvalued?

undervalued.

preferred dividend coverage ratio [profitability]

measures the amount of money a firm has available to pay dividends to preferred shareholders.

equity (book value) per preferred share

ideally, the minimum book value per preferred share should be at least 2x the dollar value of assets that each preferred share would be entitled to in the event of liquidation.

4 Tests for Preferred Share Quality Assessment

Preferred dividend coverage ratio, equity per preferred share, dividend payments, credit assessment.

Why do analysts exclude goodwill as an asset when calculating the asset coverage ratio?

goodwill is intangible, and cannot be sold into cash to service debt. Asset coverage ratio uses net tangible assets in the calculation.

Two companies of equal status in the same industry have similar prospects but different P/E ratios. Identify the correct statement regarding the company with the lower P/E ratio.

It is the better buy as it suggests undervaluation compared to its earnings potential.

ABC Corporation has a debt/equity ratio of 33%. Other things being equal, what impact will the issue of additional common shares have on the ratio?

The ratio will fall because issuing additional shares increases equity component.

Company XYZ Inc. has a policy to maintain the same dividend payment year after year. A high XYZ Inc. dividend payout rate may be the result of which factors?

Payout ratios are high with declining earnings or stable earnings.

Karim is interested investing in a company which has high returns. Identify the group of ratios that he should use to evaluate his purchase.

Value ratios

Company XYZ Inc. has a policy to maintain the same dividend payment year after year. A low XYZ Inc. dividend payout rate may be the result of which factors?

Payout ratio declines when earnings are growing or when earnings are typically high at a cyclical peak.

What is the historical relationship that has been observed between the Price-Earning (P/E) levels of stocks and the rate of inflation?

P/E levels are inversely related to the rate of inflation. If inflation is rising, an investor is more likely to pay a lower price for the earnings of the company.

ABC issues new common shares to help pay down long-term debt. What ratio will be affected immediately?

EPS, an increase in the number of common shares available will dilute the earnings available for each share, and this will lower the EPS.

A trend analysis of a company's earnings per share (EPS) shows that the trend value in the fifth year is 150. If the company's EPS in the fifth year was $1.96, what was the company's EPS in the first year?

1.31

What is the return on common equity for Company ABC if it has a profit of $2,000,000 and a total equity of $25,000,000, up from $1,000,000 in profits and total equity of $15,000,000 in the immediately previous year?

8%