BU121 Lecture Notes - Capital Structure, Retained Earnings, Preferred Stock

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31 Jan 2013
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Stability, profitability, and marketability ratios
Marketability:
o Earnings per Share (EPS)= earnings available for common stockholders/# shares of
common stock = net income preferred stock dividends/ # shares of common stock
o Calculate fully diluted if P/S convertible
Profitability:
o Gross Profit Margin (GPM) = gross profit/ sales
o Net Profit Margin (NPM) = net profits/ sales, check components of income statement
o ROI = net income/ shareholder’s equity (net worth), most important profitability ratio
for investor
Stability:
o Measures a company’s ability to meet its long-term obligations by measuring the
relationship between components of a firm’s capital structure. This is long term viability.
o Shows results of financing decisions. Capital structure = long term liabilities + owners’
equity. Finance through equity or debt.
o Debt to Equity OR Debt to Net Worth = total debt / shareholders’ equity (net worth) =
current liabilities + long-term liabilities/common stock + pref. stock + retained earnings.
The ‘rule of thumb’ for industrial firm <1:1. Don’t want a lot of debt, want more money.
Investors and shareholders fine with debt, and wouldn’t you rather have company make
money for you off of someone else’s money.
o Leverage= long-term debt / sh. equity (net worth). Measures the degree to which a
company has locked itself into fixed financial costs. Implies that a given change in sales
will result in a greater change in profit. Maximizing returns by buying on margin by using
someone else’s money to make more money. Idea is measuring how much we locked
into something that is fixed. Have to pay interest and have to make principal payments,
big deal.
The ‘rule of thumb’ is <.5:1 low, .5:1 1:1 average, and >1:1 high.
Advantage: long-term debt is the cheapest source of capital because interest is
tax deductible, dividends are not, therefore higher RETURN.
Disadvantage: higher long-term debt means higher interest payments which are
a legal obligation whereas dividends are not, therefore a greater RISK of
insolvency.
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