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by a major restructuring or downsizing of the organization to
recognize the cost of terminating employees who will receive
severance packages or early-retirement bonuses. A business
may lose a major lawsuit and have to pay a huge fine or dam-
age award. A business may write off most of its inventories
due to a sudden fall in demand for its products. The list goes
on and on. These nonordinary, unusual gains and losses are
reported separately from the ongoing, continuing operations
of a company.
Extraordinary gains and losses are very frustrating in ana-
DANGER!
lyzing profit performance for investors, creditors, and man-
agers alike. Making matters worse is that many businesses
record huge amounts of extraordinary losses in one fell swoop
in order to clear the decks of these costs and losses in future
years. This is called “taking a big bath.” Quite clearly, many
managers prefer this practice. In public discussions, the
investment community wrings their hands and lambastes this
practice, as you see in many articles and editorials in the
financial press. However, I think many investors would admit
in private that they prefer that a business take a big bath in
one year and thereby escape losses and expenses in future
years. The thinking is that taking a big bath allows a business
to start over by putting bad news behind it, wiping the slate
clean so that future years escape these charges.


PROFIT RATIOS
Owners take the risk of whether their business can earn a
profit and sustain its profit performance over the years. How
much would you be willing to pay for a business that reports a
loss year after year? The value of the owners™ investment
depends first and foremost on the profit performance of the
business. Making sales and controlling expenses is how a
business makes profit, of course. The profit residual from
sales revenue is measured by a return-on-sales ratio, which
equals a particular measure of profit divided by sales revenue
for the period. An income statement reports several profit
lines, beginning with gross margin down to bottom-line net
income.

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FINANCIAL REPORTING



Figure 4.5 shows four profit ratios for the business example;
each ratio equals the profit on that line divided by sales rev-
enue. These return-on-sales profit ratios are not required to
be disclosed in the income statement. Generally speaking,
businesses do not report profit ratios with their external
income statements, although many companies comment on
one or more of their profit ratios elsewhere in their financial
reports. Managers should pay very close attention to the profit
ratios of their business of course.
The company™s net income return on sales ratio is 4.0 per-
cent ($1,585,587 net income · $39,661,250 sales revenue =
4.0%). From each $100.00 of its sales revenue, the business
earned $4.00 net income and had expenses of $96.00. The
net income profit ratio varies quite markedly from one indus-
try to another. Some businesses do well with only a 1 or 2
percent return on sales; others need more than 10 percent to
justify the large amount of capital invested in their assets.

A popular misconception of many people is that most busi-
nesses rip off the public because they keep 20, 30, or more
percent of their sales revenue as bottom-line profit. In fact,
very few businesses earn more than a 10 percent bottom-line
profit on sales. If you don™t believe me, scan a sample of 50 or
100 earnings reports in the Wall Street Journal or the New
York Times. The 4.0 percent net income profit ratio in the




Profit
Income Statement Ratios
Sales revenue $39,661,250
Cost-of-goods-sold expense $24,960,750
Gross margin $14,700,500 37.1%
Selling and administrative expenses $11,466,135
Earnings before interest and income tax $ 3,234,365 8.2%
Interest expense $ 795,000
Earnings before income tax $ 2,439,365 6.2%
Income tax expense $ 853,778
Net income $ 1,585,587 4.0%
FIGURE 4.5 Return-on-sales profit ratios.



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I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S


example is not untypical, although 4.0 percent is a little low
compared with most businesses.
Serious investors watch all the profit ratios shown in Figure
4.5. The first ratio”the gross margin return-on-sales ratio”is
the starting point for the other profit ratios. Gross margin
(also called gross profit) equals sales revenue minus only cost-
of-goods-sold expense. The company™s gross margin equals
37.1 percent of sales revenue (see Figure 4.5). If its gross
margin ratio is too low, a business typically cannot compen-
sate for this serious deficiency in gross margin by cutting
other operating expenses, so its bottom line suffers. An inade-
quate gross margin cascades down to the bottom line, in other
words. Therefore investors keep a close watch for any slip-
page in a company™s gross margin profit ratio. Investors and
stock analysts keep a close eye on year-to-year trends in profit
ratios to test whether a business is able to maintain its profit
margins over time. Slippage in profit ratios is viewed with
some alarm. A business™s profit ratios are compared with its
main competitors™ profit ratios as a way to test of the compar-
ative marketing strength of the business. Higher than average
profit ratios are often evidence that a business has developed
very strong brand names for its products or has nurtured
other competitive advantages.


BOOK VALUE PER SHARE
Suppose I tell you that the market price of a stock is $60.00
per share and ask you whether this value is too high, too low,
or just about right. You could compare the $60.00 market
price with the stockholders™ equity per share reported in its
most recent balance sheet”which is called the book value per
share. The book value per share in the business example (see
Figure 4.2) equals $31.19 ($13,188,483 total owners™ equity ·
422,823 capital stock shares = $31.19). Book value per share
has a respectable history in securities analysis. The classic
book, Security Analysis, by Benjamin Graham and David
Dodd, puts a fair amount of weight on the book value behind
a share of stock.

Just the other day I read an article in the business section
of the New York Times that was very critical of a business.
Among several cogent points discussed in the article was the

49
FINANCIAL REPORTING


fact that the current market price of its stock was 29 percent
below its book value. Generally speaking, the market value of
stocks is higher than their book values. The reason for the
comment in the article is that when a stock trades below its
book value, the investors trading in the stock are of the opin-
ion that the stock is not worth even its book value. But book
value is backed up by the assets of the business.
To illustrate this point, suppose the business in the example
were to liquate all its assets at the amounts reported in its bal-
ance sheet, then pay off all its liabilities, and finally distribute
the money left over to its stockholders. Each share of stock
would receive cash equal to the book value per share, or
$31.19 per share. So book value is a theoretical liquidation
value per share. From this point of view, the market value
of the shares should not fall below $31.19. But the profit
prospects of the business may be very dim; the stockholders
may not see much chance of improving profit performance in
the near future. They may think that the business could not
sell off its assets at their book values and that no one would
pay book value for the business as a whole.
Of course, most businesses do not plan to liquidate their
assets and go out of business in the foreseeable future. They
plan to continue as a going concern and make a profit, at least
for as far ahead as they can see. Therefore the dominant fac-
tor in determining the market value of capital stock shares is
the earnings potential of the business, not the book value of
its ownership shares. The best place to start in assessing the
earning potential of a business is its most recent earnings per-
formance.
Suppose I owned 10,000 capital stock shares of the busi-
ness in the example and you were interested in buying my
shares. What price would you offer for my shares? You™ve
studied the financial statements of the business, and you pre-
dict that the business will probably improve its profit perform-
ance in the future. So you might be willing to pay $40, $50, or
higher per share for my stock, which is based on your assess-
ment of the future earnings potential of the business. Private
corporations have no readily available market value informa-
tion for their capital stock shares. So you™re on your own
regarding what price to pay for my stock shares.
Stockholders in public corporations have market value
information at their fingertips, which is reported in the Wall

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I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S


Street Journal, the New York Times, Barron™s, Investor™s Busi-
ness Daily, and many other sources of financial market infor-
mation. They know the prices at which buyers and sellers are
trading stocks. The main factor driving the market price of a
stock is its earnings per share.


EARNINGS PER SHARE
The income statement presented in Figure 4.1 includes earn-
ings per share (EPS), which is $3.75 for the year just ended.
Privately owned businesses whose capital stock shares are not
traded in public markets do not have to report their earnings
per share, and most don™t. I include it in Figure 4.1 because
publicly owned businesses whose capital stock shares are
traded in a public marketplace (such as the New York Stock
Exchange or Nasdaq) are required to report EPS.
Earnings per share (EPS) is calculated as follows for the
business (see Figures 4.1 and 4.2 for data):
$1,585,587 net income available for stockholders
422,823 total number of outstanding capital stock shares
= $3.75 basic EPS
For greater accuracy, the weighted average number of
shares outstanding during the year should be used to calcu-
late EPS”which takes into account that some shares may
have been issued and outstanding only part of the year. Also,
a business may have reduced the number of its outstanding
shares during part of the year. I use the ending number of
shares to make it easier to follow the computation of EPS.

The numerator (top number) in the EPS ratio is net
income available for common stockholders, which
equals bottom-line net income minus dividends paid to pre-
ferred stockholders of the business. Many business corpora-
tions issue preferred stock shares that require a fixed amount
of dividends to be paid each year. The total of annual dividends
to the preferred stockholders is deducted from net income to
determine net income available for the common stockholders.
The business in the example has issued only one class of capital
stock shares. It has not issued any preferred stock, so all its net
income is available for its common stock shares.

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FINANCIAL REPORTING


Basic and Diluted EPS
Please notice the word basic in the preceding EPS calculation.
Basic means that the actual number of common stock shares
in the hands of stockholders is used as the denominator (bot-
tom number) for calculating EPS. If a business were to issue
more shares, the denominator would become larger and EPS
would decrease. The larger number of shares would dilute
EPS. In fact many business corporations have entered into
contracts that oblige them to issue additional stock shares in
the future. These shares have not yet been issued, but the
business is legally committed to issue more shares in the
future. In other words, there is the potential that the number
of capital stock shares will be inflated and net income will
have to be divided over a larger number of stock shares.
Many public businesses award their high-level managers
stock options that give them the right to buy stock shares at
fixed prices. These fixed purchase prices generally are set
equal to the market price at the time the stock options are
granted. The idea is to give the managers an incentive to
improve the profit performance of the business, which should
drive up the market price of its stock shares. When (and if)
the market value of the stock shares rises, the managers exer-
cise their rights and buy stock shares at the lower prices fixed
in their option contracts. Managers can make millions of dol-
lars by exercising their stock options. There is a wealth trans-
fer from the nonmanagement stockholders to some of the
management stockholders because the market price per share
is lower than it would have been if shares had not been issued
to the managers.
The calculation of basic EPS does not recognize the addi-
DANGER!
tional shares that may be issued when management stock
options are exercised in the future. Also, some businesses
issue convertible bonds and convertible preferred stock that at
the option of the security holders can be traded in for com-
mon stock shares based on predetermined exchange rates.
Conversions of senior securities into shares of common stock

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