Chapter 13 - Financial Analysis: Sustainable Income, Horizontal & Vertical Analysis, and Ratio Analysis

Sustainable Income, Comprehensive Income, and Quality of Earnings

• Sustainable Income Concept:

  • Definition: Sustainable income represents the most likely level of income to be obtained by a company in the future.
  • Financial Importance: The underlying valuation of a company is fundamentally a function of the amount, timing, and uncertainty of its future cash flows.
  • Difference from Reported Net Income: Sustainable income differs from actual reported net income by excluding the financial impacts of unusual revenues, expenses, gains, and losses included in current year income.
  • Analyst Utility: Financial analysts utilize sustainable income to derive an accurate estimate of future earnings capacity without the distracting "noise" of non-recurring or unusual financial items.

• Discontinued Operations:

  • Definition: Refers specifically to the disposal of a significant component of a business entity, such as the complete elimination of a major class of customers or an entire line of operating activity.
  • Financial Statement Presentation:
    • Reported on the income statement separately from the results of continuing operations.
    • Always presented net of income tax effects.
    • Divided into two distinct component calculations:
      1. Income or loss from the ongoing operations of the component prior to disposal.
      2. Gain or loss realized upon the actual disposal of the significant component.
  • Illustration — Acro Energy, Inc. (2025):
    • Income before income taxes: $800,000$
    • Corporate income tax rate: $20\%$
    • Discontinued chemical division operational loss: $160,000$ net of $40,000$ income tax savings.
    • Loss on disposal of chemical division: $80,000$ net of $20,000$ income tax savings.
    • Partial Income Statement Presentation:
      • Income before income taxes: $800,000$
      • Income tax expense ($20\% \times 800,000$): $160,000$
      • Income from continuing operations: $640,000$
      • Discontinued operations:
        • Loss from operation of chemical division, net of $20,000$ income tax savings: $(160,000)$
        • Loss from disposal of chemical division, net of $20,000$ income tax savings: $(80,000)$
        • Total discontinued operations loss: $(240,000)$
      • Net income: $400,000$
  • Knowledge Check — Starlite Example:
    • Data provided: Income from continuing operations = $25,800$; Loss from operation of discontinued division = $3,200$; Gain on disposal of discontinued division = $4,100$; Income tax rate = $20\%$
    • Tax savings on operational loss: $20\% \times 3,200 = 640$ (Net operational loss = $2,560$
    • Tax expense on disposal gain: $20\% \times 4,100 = 820$ (Net disposal gain = $3,280$
    • Partial Income Statement:
      • Income from continuing operations: $25,800$
      • Discontinued operations:
        • Loss from operation of division, net of $640$ income tax savings: $(2,560)$
        • Gain on disposal of division, net of $820$ income taxes: $3,280$
      • Net income: $26,520$

• Comprehensive Income Framework:

  • Definition: A broader, more inclusive earnings measure than traditional net income, equal to the sum of net income plus all items classified under other comprehensive income.
  • Bypassing Net Income: Includes specific gains and losses that bypass the traditional income statement and are instead reported as direct adjustments to stockholders' equity.
  • Key Example: Unrealized gains or losses on available-for-sale investment securities.

• Realized vs. Unrealized Gains and Losses:

  • Unrealized Gain or Loss: Exists when an asset has experienced a change in fair market value while still owned by the company.
  • Realized Gain or Loss: Occurs upon the actual sale of the asset, resulting in ownership transfer away from the selling entity.

• Accounting for Investment Securities:

  • Trading Securities:
    • Investment securities purchased and held primarily for sale in the near term to generate income from short-term price differences.
    • End-of-period adjustment: Adjusted to fair market value at the end of each accounting period.
    • Income Statement impact: Unrealized gains or losses are recognized directly on the income statement in the "Other expenses and losses" (or revenues) section.
    • Rationale: High probability that the company will realize the unrealized loss or gain shortly.
  • Available-for-Sale Securities:
    • Investment securities held with the intent of selling at an unspecified time in the future.
    • End-of-period adjustment: Value must be adjusted up or down to fair market value at the end of each accounting period.
    • Financial Statement impact: Unrealized gains or losses bypass net income and are reported as part of "Other comprehensive income".

• Illustration — Stassi Company Available-for-Sale Securities (2025):

  • Background: First year of operations (2025). Purchased IBM bonds for $10,500$ classified as available-for-sale. Market value at December 31, 2025 dropped to $8,000$. Applicable tax rate = $20\%$
  • Pre-tax unrealized loss calculation:         $\text{Unrealized Loss} = 10,500 - 8,000 = 2,500$
  • Tax savings calculation:         $\text{Income Tax Savings} = 20\% \times 2,500 = 500$
  • Net unrealized loss reported in Other Comprehensive Income:         $\text{Net Unrealized Loss} = 2,500 - 500 = 2,000$
  • Statement of Comprehensive Income Presentation:
    • Net income: $300,000$
    • Other comprehensive income: Unrealized loss on available-for-sale securities, net of $500$ tax savings: $(2,000)$
    • Comprehensive income: $298,000$
  • Stockholders' Equity Section Presentation (Balance Sheet):
    • Common stock: $3,000,000$
    • Retained earnings: $300,000$
    • Total paid-in capital and retained earnings: $3,300,000$
    • Accumulated other comprehensive loss: $(2,000)$
    • Total stockholders' equity: $3,298,000$
    • Note: Accumulated Other Comprehensive Income/Loss represents the cumulative total of all prior years' OCI items and is displayed as a distinct component of equity (gains added, losses deducted).

• Comprehensive Income Reporting Formats:

  • Two permissible presentation options under GAAP:
    1. Two separate financial statements: A traditional standalone Income Statement followed immediately by a standalone Statement of Comprehensive Income.
    2. Single combined statement: A single combined statement displaying both net income components and comprehensive income components.
  • Illustration — Pace Corporation (2025):
    • Income Statement:
      • Net sales: $440,000$
      • Cost of goods sold: $260,000$
      • Gross profit: $180,000$
      • Operating expenses: $118,250$
      • Income from operations: $61,750$
      • Other revenues and gains: $5,600$
      • Other expenses and losses: $9,600$
      • Income before income taxes: $57,750$
      • Income tax expense ($66,000 \times 30\%$): $11,550$
      • Income from continuing operations: $46,200$
      • Discontinued operations:
        • Loss from operation of plastics division, net of income tax savings $12,000$ ($60,000 \times 20\%$): $(48,000)$
        • Gain on disposal of plastics division, net of $10,000$ income taxes ($50,000 \times 20\%$): $40,000$
        • Net discontinued operations loss: $(8,000)$
      • Net income: $38,200$
    • Statement of Comprehensive Income:
      • Net income: $38,200$
      • Other comprehensive income: Unrealized gain on available-for-sale securities, net of income taxes ($15,000 \times 20\%$): $12,000$
      • Comprehensive income: $50,200$

• Knowledge Check — Unusual Items Calculation (Lang Company):

  • Data provided: Income before income taxes = $86,000$; Unrealized gain on AFS securities = $4,000$; Loss from operation of discontinued division = $5,000$; Gain on disposal of discontinued division = $3,000$; Income tax rate = $25\%$
  • Income from continuing operations calculation:         $\text{Income from Continuing Operations} = 86,000 \times (1 - 0.25) = 64,500$
  • Net Income calculation:         $\text{Net Income} = 64,500 - (5,000 \times (1 - 0.25)) + (3,000 \times (1 - 0.25)) = 64,500 - 3,750 + 2,250 = 63,000$

• Changes in Accounting Principle:

  • Definition: Occurs when an accounting principle adopted in the current fiscal period differs from the principle applied in the preceding year (e.g., changing inventory costing methods from FIFO to average-cost).
  • Justification Criteria: Permissible only when company management demonstrates that the newly adopted accounting principle is preferable to the old one.
  • Reporting Treatment: Most changes must be applied retroactively. Results from both current and prior periods are restated using the new principle to ensure comparative consistency.
  • Rationale: Financial statement users rely on accounting consistency across periods to determine underlying performance changes and trend trajectories.

Horizontal and Vertical Financial Statement Analysis

• Comparative Analysis Framework:

  • Intracompany Comparisons: Evaluates financial data within a single company over multiple periods to detect changes in financial relationships and identify significant underlying trends.
  • Intercompany Comparisons: Compares financial data against rival companies to gain insight into competitive positioning.
  • Industry Average Comparisons: Compares company metrics against broader industry medians to determine relative position within the macro-economic industry environment.

• Core Financial Analysis Tools:

  1. Horizontal Analysis
  2. Vertical Analysis
  3. Ratio Analysis

• Horizontal Analysis (Trend Analysis):

  • Definition: An analytical technique evaluating a series of financial statement data across time to identify percentage and dollar changes.
  • Primary Purpose: Determines absolute dollar increases or decreases and relative percentage changes relative to a chosen base period.
  • Application: Commonly applied to both Balance Sheet and Income Statement comparative schedules.
  • Mathematical Formulas:

$\text{Change Since Base Period} = \frac{\text{Current-Year Amount} - \text{Base-Year Amount}}{\text{Base-Year Amount}}$

$\text{Current-Year Amount as \% of Base Year} = \frac{\text{Current-Year Amount}}{\text{Base-Year Amount}} \times 100\%$

*   **Illustration — Chicago Cereal Company Net Sales Trend (Base Year = 2021):**
    *   2021 Sales: $8,812$ thousand (Base Year = $100.0\%$)
    *   2022 Sales: $9,614$ thousand -> Percentage change = $\frac{9,614 - 8,812}{8,812} = 9.1\%$ increase ($109.1\%$ of base)
    *   2023 Sales: $10,177$ thousand -> $115.5\%$ of base
    *   2024 Sales: $10,907$ thousand -> $123.8\%$ of base
    *   2025 Sales: $11,776$ thousand -> $133.6\%$ of base
*   **Comprehensive Balance Sheet Horizontal Analysis — Chicago Cereal Company (2025 vs 2024 Base Year):**
    *   Current Assets: 2025 = $2,717$ thousand; 2024 = $2,427$ thousand; Increase = $290$ thousand ($11.9\%$).
    *   Property Assets (net): 2025 = $2,990$ thousand; 2024 = $2,816$ thousand; Increase = $174$ thousand ($6.2\%$).
    *   Other Assets: 2025 = $5,690$ thousand; 2024 = $5,471$ thousand; Increase = $219$ thousand ($4.0\%$).
    *   Total Assets: 2025 = $11,397$ thousand; 2024 = $10,714$ thousand; Increase = $683$ thousand ($6.4\%$).
    *   Current Liabilities: 2025 = $4,044$ thousand; 2024 = $4,020$ thousand; Increase = $24$ thousand ($0.6\%$).
    *   Long-term Liabilities: 2025 = $4,827$ thousand; 2024 = $4,625$ thousand; Increase = $202$ thousand ($4.4\%$).
    *   Total Liabilities: 2025 = $8,871$ thousand; 2024 = $8,645$ thousand; Increase = $226$ thousand ($2.6\%$).
    *   Common Stock: 2025 = $493$ thousand; 2024 = $397$ thousand; Increase = $96$ thousand ($24.2\%$).
    *   Retained Earnings: 2025 = $3,390$ thousand; 2024 = $2,584$ thousand; Increase = $806$ thousand ($31.2\%$).
    *   Treasury Stock (cost): 2025 = $(1,357)$ thousand; 2024 = $(912)$ thousand; Increase = $445$ thousand ($48.8\%$).
    *   Total Stockholders' Equity: 2025 = $2,526$ thousand; 2024 = $2,069$ thousand; Increase = $457$ thousand ($22.1\%$).
    *   Total Liabilities and Stockholders' Equity: 2025 = $11,397$ thousand; 2024 = $10,714$ thousand; Increase = $683$ thousand ($6.4\%$).
*   **Comprehensive Income Statement Horizontal Analysis — Chicago Cereal Company (2025 vs 2024 Base Year):**
    *   Net Sales: 2025 = $11,776$ thousand; 2024 = $10,907$ thousand; Increase = $869$ thousand ($8.0\%$).
    *   Cost of Goods Sold: 2025 = $6,597$ thousand; 2024 = $6,082$ thousand; Increase = $515$ thousand ($8.5\%$).
    *   Gross Profit: 2025 = $5,179$ thousand; 2024 = $4,825$ thousand; Increase = $354$ thousand ($7.3\%$).
    *   Selling and Administrative Expenses: 2025 = $3,311$ thousand; 2024 = $3,059$ thousand; Increase = $252$ thousand ($8.2\%$).
    *   Income from Operations: 2025 = $1,868$ thousand; 2024 = $1,766$ thousand; Increase = $102$ thousand ($5.8\%$).
    *   Interest Expense: 2025 = $321$ thousand; 2024 = $294$ thousand; Increase = $27$ thousand ($9.2\%$).
    *   Income Before Income Taxes: 2025 = $1,547$ thousand; 2024 = $1,472$ thousand; Increase = $75$ thousand ($5.1\%$).
    *   Income Tax Expense: 2025 = $444$ thousand; 2024 = $468$ thousand; Decrease = $(24)$ thousand ($-5.1\%$).
    *   Net Income: 2025 = $1,103$ thousand; 2024 = $1,004$ thousand; Increase = $99$ thousand ($9.9\%$).
*   **Knowledge Check — Wise Company Horizontal Analysis (June 30, 2025 vs June 30, 2024):**
    *   Inventory: 2025 = $98,000$; 2024 = $102,000$; Change = $(4,000)$ ($-3.9\%$).
    *   Plant Assets: 2025 = $560,000$; 2024 = $524,000$; Change = $36,000$ ($6.9\%$).
    *   Total Assets: 2025 = $1,450,600$; 2024 = $1,426,000$; Change = $24,600$ ($1.7\%$).

• Vertical Analysis (Common-Size Analysis):
  • Definition: A financial statement analysis technique that expresses each line item on a financial statement as a percentage of a designated base amount.
  • Base Amounts Specified:
    • Balance Sheet Base: Total Assets ($100.0\%$).
    • Income Statement Base: Net Sales ($100.0\%$).
  • Key Utility: Facilitates meaningful comparative evaluation between companies of vastly different sizes (intercompany analysis).
  • Comprehensive Balance Sheet Vertical Analysis — Chicago Cereal Company:
    • Current Assets: 2025 = $2,717$ thousand ($23.8\%$); 2024 = $2,427$ thousand ($22.6\%$).
    • Property Assets (net): 2025 = $2,990$ thousand ($26.2\%$); 2024 = $2,816$ thousand ($26.3\%$).
    • Other Assets: 2025 = $5,690$ thousand ($50.0\%$); 2024 = $5,471$ thousand ($51.1\%$).
    • Total Assets: 2025 = $11,397$ thousand ($100.0\%$); 2024 = $10,714$ thousand ($100.0\%$).
    • Current Liabilities: 2025 = $4,044$ thousand ($35.5\%$); 2024 = $4,020$ thousand ($37.5\%$).
    • Long-term Liabilities: 2025 = $4,827$ thousand ($42.4\%$); 2024 = $4,625$ thousand ($43.2\%$).
    • Total Liabilities: 2025 = $8,871$ thousand ($77.9\%$); 2024 = $8,645$ thousand ($80.7\%$).
    • Common Stock: 2025 = $493$ thousand ($4.3\%$); 2024 = $397$ thousand ($3.7\%$).
    • Retained Earnings: 2025 = $3,390$ thousand ($29.7\%$); 2024 = $2,584$ thousand ($24.1\%$).
    • Treasury Stock (cost): 2025 = $(1,357)$ thousand ($-11.9\%$); 2024 = $(912)$ thousand ($-8.5\%$).
    • Total Stockholders' Equity: 2025 = $2,526$ thousand ($22.1\%$); 2024 = $2,069$ thousand ($19.3\%$).
    • Total Liabilities and Stockholders' Equity: $100.0\%$ both years.
  • Comprehensive Income Statement Vertical Analysis — Chicago Cereal Company:
    • Net Sales: 2025 = $11,776$ thousand ($100.0\%$); 2024 = $10,907$ thousand ($100.0\%$).
    • Cost of Goods Sold: 2025 = $6,597$ thousand ($56.0\%$); 2024 = $6,082$ thousand ($55.8\%$).
    • Gross Profit: 2025 = $5,179$ thousand ($44.0\%$); 2024 = $4,825$ thousand ($44.2\%$).
    • Selling and Administrative Expenses: 2025 = $3,311$ thousand ($28.1\%$); 2024 = $3,059$ thousand ($28.0\%$).
    • Income from Operations: 2025 = $1,868$ thousand ($15.9\%$); 2024 = $1,766$ thousand ($16.2\%$).
    • Interest Expense: 2025 = $321$ thousand ($2.7\%$); 2024 = $294$ thousand ($2.7\%$).
    • Income Before Income Taxes: 2025 = $1,547$ thousand ($13.2\%$); 2024 = $1,472$ thousand ($13.5\%$).
    • Income Tax Expense: 2025 = $444$ thousand ($3.8\%$); 2024 = $468$ thousand ($4.3\%$).
    • Net Income: 2025 = $1,103$ thousand ($9.4\%$); 2024 = $1,004$ thousand ($9.2\%$).
  • Intercompany Common-Size Income Statement Comparison (2025) — Chicago Cereal vs. Giant Mills, Inc.:
    • Chicago Cereal (figures in thousands) vs. Giant Mills, Inc. (figures in millions):
      • Net Sales: Chicago = $11,776$ ($100.0\%$) | Giant Mills = $17,910$ ($100.0\%$)
      • Cost of Goods Sold: Chicago = $6,597$ ($56.0\%$) | Giant Mills = $11,540$ ($64.4\%$)
      • Gross Profit: Chicago = $5,179$ ($44.0\%$) | Giant Mills = $6,370$ ($35.6\%$)
      • Selling & Admin Expenses: Chicago = $3,311$ ($28.1\%$) | Giant Mills = $3,474$ ($19.4\%$)
      • Income from Operations: Chicago = $1,868$ ($15.9\%$) | Giant Mills = $2,896$ ($16.2\%$)
      • Interest Expense: Chicago = $321$ ($2.7\%$) | Giant Mills = $196$ ($1.1\%$)
      • Income Before Income Taxes: Chicago = $1,547$ ($13.2\%$) | Giant Mills = $2,700$ ($15.1\%$)
      • Income Tax Expense: Chicago = $444$ ($3.8\%$) | Giant Mills = $876$ ($4.9\%$)
      • Net Income: Chicago = $1,103$ ($9.4\%$) | Giant Mills = $1,824$ ($10.2\%$)
  • Knowledge Check — Wise Company Vertical Analysis (2025 vs 2024):
    • 2025: Inventory = $98,000$ ($6.8\%$ of Total Assets $1,450,600$); Plant Assets = $560,000$ ($38.6\%$ of Total Assets).
    • 2024: Inventory = $102,000$ ($7.2\%$ of Total Assets $1,426,000$); Plant Assets = $524,000$ ($36.7\%$ of Total Assets).
    • Summary Finding: Inventory concentration decreased from $7.2\%$ to $6.8\%$ of total assets, while plant assets concentration increased from $36.7\%$ to $38.6\%$.

Financial Ratio Analysis

• Overview and Analytical Purpose:

  • Ratios evaluate relationships among select financial statement items to reveal underlying financial health, operational efficiency, and risk profiles.
  • Single ratio values lack context; meaningful interpretation requires multi-dimensional comparisons:
    • Intracompany trends (comparing performance across multiple periods within the same firm).
    • Industry benchmarks (comparing against industry median averages).
    • Intercompany comparisons (evaluating directly against a key competitor).
  • Concept Verification Check:
    1. "Liquidity ratios measure the ability of the company to survive over a long period of time" — False (Solvency ratios measure long-term survival; liquidity measures short-term ability to pay obligations).
    2. "Intracompany comparisons are used to compare one company with another" — False (Intercompany comparisons compare across different entities; intracompany evaluates within the firm).
    3. "Ratios can provide clues to underlying conditions that may not be apparent from the individual financial statement components" — True.

• Liquidity Ratios (Short-Term Solvency):

  • Definition: Measure the short-term ability of a company to satisfy maturing obligations and absorb unexpected cash flow demands. Primary users are short-term creditors, including suppliers and commercial banks.
  • Working Capital:$\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$
    • Interpretation: Measures total liquid buffer available to meet short-term debt obligations. Higher positive values indicate superior liquidity.
  • Current Ratio:$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$
    • Interpretation: Evaluates relative coverage of short-term obligations by current assets. Higher ratios signal stronger short-term solvency.
  • Accounts Receivable Turnover:$\text{Accounts Receivable Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Net Accounts Receivable}}$
    • Interpretation: Measures how many times per period, on average, a business collects its trade receivables balance. Higher turnover reflects greater liquidity.
  • Average Collection Period:$\text{Average Collection Period} = \frac{365\,\text{days}}{\text{Accounts Receivable Turnover}}$
    • Interpretation: Measures the average number of days required to collect trade receivables. Shorter collection periods indicate swift cash collection; period length should not significantly exceed credit payment terms.
  • Inventory Turnover:$\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$
    • Interpretation: Measures the frequency with which inventory is sold and replaced during the accounting period. Higher turnover signifies better liquidity and reduced carrying costs.
  • Days in Inventory:$\text{Days in Inventory} = \frac{365\,\text{days}}{\text{Inventory Turnover}}$
    • Interpretation: Measures the average number of days inventory remains on hand prior to sale. Lower days indicate efficient inventory management and faster sales velocity.

• Solvency Ratios (Long-Term Survival):

  • Definition: Measure the financial stability and ability of a company to survive over an extended timeframe, fulfilling interest obligations as due and returning debt principal at maturity. Primary users are long-term debtholders and equity investors.
  • Debt to Assets Ratio:$\text{Debt to Assets Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$
    • Interpretation: Measures the percentage of total assets financed through debt obligations (financial leverage). Lower ratios indicate greater financial stability and lower default risk. Closely aligned with the debt-to-equity ratio in evaluating borrowed capital reliance.
  • Times Interest Earned:$\text{Times Interest Earned} = \frac{\text{Net Income} + \text{Interest Expense} + \text{Income Tax Expense}}{\text{Interest Expense}}$
    • Interpretation: Evaluates the firm's capacity to cover periodic interest payments out of earnings before interest and income taxes. Higher values reflect superior interest coverage. Combined low debt-to-assets and high times interest earned indicate optimal long-term solvency.
  • Free Cash Flow:$\text{Free Cash Flow} = \text{Net Cash Provided by Operating Activities} - \text{Capital Expenditures} - \text{Cash Dividends}$
    • Interpretation: Quantifies discretionary operating cash flow remaining after funding necessary capital investment and common dividend distributions. High free cash flow facilitates business expansion and debt payback.

• Profitability Ratios (Operating Success):

  • Definition: Measure the overall earnings success and operational efficiency of a firm over a given period. Directly influences the firm's capability to secure equity and debt financing, sustain liquidity, and support growth.
  • Profitability Interrelationships (DuPont Framework):

    *   Return on Common Stockholders' Equity is determined by Return on Assets and Financial Leverage (Debt to Assets Ratio).
    *   Return on Assets is determined by Profit Margin and Asset Turnover.
*   **Return on Common Stockholders' Equity (ROE):**

        $\text{Return on Common Stockholders' Equity} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Average Common Stockholders' Equity}}$ * Interpretation: Measures dollar earnings generated per dollar of common equity invested. Preferred dividends are deducted to isolate net income belonging exclusively to common shareholders. Higher ratios indicate superior equity return. * Return on Assets (ROA):$\text{Return on Assets} = \frac{\text{Net Income}}{\text{Average Total Assets}}$ * Interpretation: Measures net earning efficiency per dollar invested across all asset categories. * Trading on Equity at a Gain: Occurs when borrowed funds are obtained at an interest rate lower than the return generated on the assets purchased with those funds. Management leverages non-owner capital to elevate equity returns. * Profit Margin:$\text{Profit Margin} = \frac{\text{Net Income}}{\text{Net Sales}}$ * Interpretation: Measures the percentage of net sales revenue converted into net profit. High-volume businesses (e.g., retail grocery) typically operate with low profit margins, while low-volume businesses (e.g., luxury retail) operate with high profit margins. * Asset Turnover:$\text{Asset Turnover} = \frac{\text{Net Sales}}{\text{Average Total Assets}}$ * Interpretation: Measures how effectively asset holdings generate net sales revenue. Varies widely by industry sector. * Gross Profit Rate:$\text{Gross Profit Rate} = \frac{\text{Gross Profit}}{\text{Net Sales}}$ * Interpretation: Indicates the firm's capacity to maintain product selling prices well above direct cost of goods sold. Declines as industry market competition intensifies. * Earnings Per Share (EPS):$\text{Earnings Per Share} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted-Average Common Shares Outstanding}}$ * Interpretation: Measures net income realized per individual common share. Useful for individual investors, but cannot be meaningfully compared across different companies due to differing share counts. * Price-Earnings (P-E) Ratio:$\text{Price-Earnings Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings Per Share}}$ * Interpretation: Reflects market sentiment and investor expectations regarding future profit potential. High ratios indicate market optimism. * Payout Ratio:$\text{Payout Ratio} = \frac{\text{Cash Dividends Declared on Common Stock}}{\text{Net Income}}$ * Interpretation: Measures the percentage of net earnings paid out as cash dividends to common shareholders. Controlled directly by board decisions. A decline in net income with stable total dividend payments results in an increased payout ratio.

• Knowledge Check — Ratio Classification Summary:
  • Free Cash Flow: Solvency
  • Inventory Turnover: Liquidity
  • Return on Assets: Profitability
  • Price-Earnings Ratio: Profitability
  • Asset Turnover: Profitability
  • Debt to Assets Ratio: Solvency
  • Average Collection Period: Liquidity