Category Income Statement

How to calculate EPS (Earnings per Share)?

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Calculating earnings per share (EPS) allows us to understand how much dollars were earned on each outstanding share of common stock.

In summary, in order to find earnings per share (EPS), we need to take earnings available for common stockholders (the bottom line of the income statement ) and divide it by number of shares of common stock outstanding.

Earnings per Share (EPS) = Earnings Available for Common Stockholders/ Number of Shares of Common Stock Outstanding

Therefore, in order to determine EPS (earnings per share), we need to know earnings available for common stockholders. Earnings available for common stockholders are calculated as follows:

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

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Net Profit Margin Ratio

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Net profit margin ratio (NPMR) is one of the profitability ratios and measures how much of each sales dollar is remaining after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

Net profit margin ratio (NPMR) = Net Profit/Sales

For example, if ABC has a net profit of $300,000 and sales of $3,000,000. The NPMR is calculated as follows.

= 300,000/3,000,000

= 0.1 or 10%

Test yourself

Dillon Corporation has a net profit of $500,000 and sales of $3,500,000.

Required: Find the Net profit margin ratio (NPMR)

Solution:

The calculation of Net profit margin ratio (NPMR) of Dillon Corporation will be as follows:

= 500,000/3,500,000

= 0.14 or 14%

The higher the Net profit margin ratio (NPMR), the better it is for the company’s health.

Operating Profit Margin Ratio

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Operating profit margin ratio (OPMR) is a profitability ratio. It measures how much of each sales dollar remains after all costs, after interest, tax and preferred stock dividends are deducted. In other words it measures how efficiently a business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

Operating profit margin ratio (OPMR) = Operating Profit/Sales

Example

For example, if ABC Company has operating profit of $500,000 and sales of $3,000,000 then Operating profit margin ratio (OPMR) is calculated as follows:

= 500,000/3,000,000

= 0.167 or 16.7%

Test yourself

Dillon Corporation has operating profits of $600,000 and sales of $3,500,000.

Required: Find the Operating profit margin ratio (OPMR)

Solution:

The calculation of Operating profit margin ratio (OPMR) of Dillon Corporation will be as follows: OPMR = 600,000/3,500,000 OPMR = 0.17 or 17%

The higher the Operating profit margin ratio (OPMR) the better it is for the business.

 

Gross Profit Margin Ratio

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Gross profit margin ratio (GPMR) is one of profitability ratios. It measures how much of each sales dollar remains after costs of goods are deducted. In other words it measures the relative costs of goods sold.

Gross profit margin ratio (GPMR) = Gross Profit/Sales

EXAMPLE:

For example, if ABC has a gross profit of $1,000,000 and sales of $3,000,000, then the Gross profit margin ratio (GPMR) is calculated as follows:

= 1,000,000/3,000,000 = 0.3333 or 33%

Test yourself

Dillon Corporation has a gross profit of $1,200,000 and sales of $3,500,000.

Required: Find the Gross profit margin ratio (GPMR)

Solution:

The calculation of  Gross profit margin ratio (GPMR) of Dillon Corporation will be as follows: = 1,200,000/3,500,000 = 0.34 or 34%

Conclusion:

The higher the Gross profit margin ratio (GPMR) the lower the relative cost of goods sold. Therefore, the higher the  Gross profit margin ratio (GPMR), the better.

Times Interest Earned Ratio (Interest Coverage Ratio)

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Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:

Times Interest Earned Ratio = EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).

Example

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The Times Interest Earned Ratio (TIER) of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio (TIER) could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

Things to note about this ratio

When using the Times Interest Earned Ratio (TIER), it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio (TIER). It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.

One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios industry averages between industries. This is because different industries have different operations requirements.

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Fixed Payment Coverage Ratio

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The fixed payment coverage ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. In other words, the fixed payment coverage ratio measures the ability to service debts.

As outsiders, when analyzing the capital structure decisions of firms, we can use the fixed payment coverage ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk.

The formula for the fixed payment coverage ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT = earnings before interest and tax (operating profit)

LP = lease payments

I = interest charges

PP = principal payments

PSD = preferred stock dividends

T = tax rate

Test yourself

Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The lease payments are fixed at $20,000, principal payments are at $60,000 and preferred stock dividends are at $15,000. The corporate tax rate of ABC is 40%.

The fixed payment coverage ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The fixed payment coverage ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, the ratio should be compared to the industry average before any conclusions are drawn.

Note the following

Generally, the higher the ratio the lower the risk that  enterprise will not be able to meet its fixed-payment obligations on time. Therefore, generally, a higher ratio is better. However, as with times interest earned ratio, cognizance needs to be taken of the fact that the higher the ratio the lower the risk and lower the return.

Therefore, at some point, the fixed payment coverage ratio may be too high. This will occur if a business is unnecessarily careful with taking up more debt. This will result in very low risk, but also in lower return. This, of course, is not aligned with the overall goal of the enterprise, which is the maximization of the wealth of its shareholders.

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Debt-equity ratio analysis

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Debt-equity ratio analysis is one of several debt ratio analyses. Debt ratios measure the degree or financial leverage of the firm. The more debt the firm uses, the higher its financial leverage, the higher its financial risk (the risk of bankruptcy) and the higher the potential returns.

It measures the degree of indebtedness of the enterprise. It measures how much of equity and how much of debt a company uses to finance its assets. It is also referred to as leverage or gearing.

The formula is as follows:

Debt-equity ratio = Total liabilities/Shareholders equity

This formula is sometimes presented simply as:

Debt-equity ratio = Debt/Equity

Example of a debt-equity ratio analysis

Assume Gold Co. currently has total debt of $1,000,000 and shareholders equity of $1,800,000. The debt-equity ratio for the Gold Company is conducted as follows:

$1,000,000/$1,800,000=0.56

The result is less than 1 and indicates that business uses mainly equity to finance its operations. The financial risk of Gold Company seems to be under control. However, it is possible that company may have lower than possible returns due to being too careful with using debt financing. However, a closer investigation is required before any conclusions can be made.

Things to note about this ratio

If the debt-equity ratio shows a result of less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that the debt is mainly used for financing of operations. If the result of debt-equity ratio analysis is equal to one, then it means that a half of financing comes from debt and a half comes from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher the potential return. Financial risk refers to the risk of the firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

The results should be compared to industry averages, to the firm’s past ratio trends and to a similar analysis of leading competitors within the industry.

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The debt ratio

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A direct measure of debt of the firm is the debt ratio. Debt ratio measures how many of the firm’s assets are financed by debt. The higher the debt ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk and potential return.

The formula for the debt ratio is as follows:

Debt Ratio = Total liabilities/Total assets

If the debt ratio is higher than 1 than it means that an enterprise has more debt than assets. If the debt ratio is lower than 1 than it means that an enterprise has more assets than debt.

EXAMPLE:

Assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Test yourself

Dillon Corporation has total liabilities of $4,000,000 and total assets of $5,500,000.

Required: Find the debt ratio of Dillon Corporation

Solution:

The ratio is calculated as follows:

$4,000,000/$5,500,000 = 73%

This means that Dillon Corporation’s capital structure is 73% of debt and 27% of equity. A debt ratio of 73% is generally considered to be a very high debt ratio and may indicate a problem of a very high indebtedness and very high financial risk. However, as with all financial ratios, the debt ratio of Dillon Corporation should be compared to the industry average before any conclusions are drawn.

 

Acid-Test Ratio

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The acid-test ratio, along with the current ratio analysis, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (excluding inventory). In other words, the ratio allows us to determine the ease with which business can pay its bills as they come due. It is also sometimes referred to as the quick ratio.

A declining ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy increases further if the ratio falls significantly below 1. A ratio below 1 indicates a situation whereby current assets (excluding inventory) can no longer cover current liabilities.

The formula for the ratio is as follows:

Acid-test ratio = (Current assets – Inventory)/Current liabilities

Example of an acid-test ratio analysis

Assume Dynasties Inc. has current assets of $550,000, inventory of $300,000 and current liabilities of $300,000. The acid-test ratio of the of Dynasties Inc. is calculated as follows:

$550,000-$300,000/$300,000=0.8

This could indicate a ratio which may be too low. However, acceptable ratio values vary between industries. Therefore, the result must always be used in context via a comparison to industry averages as well as in comparison to the ratio of leading firms in the industry and Dynasties own historical ratio analysis.

Things to note about this ratio

A positive ratio is a must. A ratio of 1 or greater is generally advisable. If a company has a ratio of 1, it means that it has current assets (excluding inventory) which would be able to cover current liabilities once.

An acid-test ratio is similar to the current ratio. However, it differs from the current ratio because the former excludes inventory when calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Therefore, it is assumed the acid-test ratio shows a better representation of a firm’s liquidity for businesses which experience slow conversion of inventory into cash.

It is also important to note the acid-test ratio analysis ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business as an healthy acid-test ratio. However, most of its current assets are in accounts receivable, which can only be converted into cash in 4 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy acid-test ratio, a business’s liquidity may be unsatisfactory to meet short-term commitments of the business.

Lastly, as per the above, one should compare the ratios of individual firms to industry averages to obtain a better understanding. There is a large variability of ratio values between industries. This is because different industries have different operating requirements.

Current Ratio Analysis

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Current ratio analysis, along with the acid-test ratio, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (such as cash, marketable securities and inventory). In other words, current ratio analysis allows us to determine the ease with which business can pay its bills as they come due.

A declining current ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy especially increases if the current ratio falls below 1 (a point at which current assets can no longer cover current liabilities). Current ratio analyses is also sometimes referred to as working capital ratio, real ratio, cash ratio, liquidity ratio and cash asset ratio.

The formula for current ratio analyses is as follows:

Current ratio = Current assets/Current liabilities

Example of current ratio analysis

Assume Dynasties Inc. has current assets of $550,000 and current liabilities of $300,000. The current ratio of the of Dynasties Inc. is calculated as follows:

$550,000/$300,000 = 1.8

Current ratio analyses of the Dynasties Inc. could indicate that the ratio may be too low. However, an acceptable current ratio value varies between industries. Therefore, the result must always be assessed in the context of industry averages as well as to current ratios of leading firms in the industry and the Dynasties own historical current ratio analysis.

Things to note about current ratio analysis

A positive current ratio is a requirement. A current ratio of two is generally advisable. If a company has a current ratio of two, it means that it has current assets which would be able to cover current liabilities at least twice.

Current ratio analyses is similar to the acid test ratio. However, an acid-test ratio differs from current ratio because an acid-test ratio excludes inventory in calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Acid-test ratio shows a better representation of firm’s liquidity for businesses which experience slow conversion of inventories into cash.

It is also important to note that current ratio analyses ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business has a healthy current ratio. However, most of its current assets are in inventory which can only be converted into cash in 2 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy current ratio, a business’s liquidity may be unsatisfactory to meet the short-term commitments of the business.

Lastly, as per above, one should always compare the current ratio analyses of individual firms to industry averages, to obtain a better understanding. There is a large variability of current ratio industry averages between industries. This is because different industries have different operations requirements.