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also cause dilution of EPS.
To alert investors to the potential effects of management
stock options and convertible securities, a second EPS is cal-
culated by public corporations, which is called the diluted
EPS. This lower EPS takes into account the effects on EPS that

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would be caused by the issue of additional common stock
shares under terms of management stock option plans and
convertible securities (plus any other commitments a business
has entered into that requires it to issue additional stock
shares in the future). Both basic EPS and diluted EPS (if appli-
cable) are reported in the income statements of publicly
owned business corporations. The diluted EPS is a more con-
servative figure on which to base market value.


MARKET VALUE RATIOS
The capital stock shares of more than 10,000 business corpo-
rations are traded on public markets”the New York Stock
Exchange, Nasdaq, and other stock exchanges. The day-to-
day market price changes of these shares receive a great deal
of attention, to say the least. More than any other factor, the
market value of capital stock shares depends on the earnings
per share performance of a business”its past performance
and its future profit potential. It™s difficult to prove whether
basic EPS or diluted EPS is the driver of market value. In
many cases the two are very close and the gap is not signifi-
cant. In some cases, however, the spread between the two
EPS figures is fairly large.

In addition to earnings per share (EPS) investors in stock
shares of publicly owned companies closely follow two other
ratios: (1) the dividend yield ratio and (2) the price/earnings
ratio (P/E). The dividend yield and P/E ratios are reported in
the stock trading tables published in the Wall Street Journal,
which demonstrates the importance of these two market value
ratios for stock shares.


Dividend Yield Ratio
The dividend yield ratio equals the amount of cash dividends
per share during the most recent, or trailing, 12 months
divided by the current market price of a stock share. The divi-
dend yield ratio is the measure of cash income from a share of
stock based on its current market price. The annual return on
an investment in stock shares includes both the cash divi-
dends received during the period and the gain or loss in mar-
ket value of the stock shares over the period. The calculation

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FINANCIAL REPORTING


of the historical rate of return for a stock investment over two
or more years and for a stock index such as the Dow Jones 30
Industrial or the Standard & Poor™s 500 assumes that cash
dividends have been reinvested in additional shares of stock.
Of course, individual investors may decide not to reinvest
their dividends. They may spend their dividend income or put
the cash flow into other investments.


Price/Earnings Ratio
The market price of stock shares of a public business is
divided by its most recent annual EPS to determine the
price/earnings ratio:
Current market price of stock share
Earnings per share (either basic or diluted EPS)
= price/earning ratio, or P/E
Y
Suppose a company™s stock shares are trading at $60.00
FL
per share and its EPS for the most recent year (called the
trailing 12 months) is $3.00. Thus, its P/E ratio is 20. By the
AM


way, the Wall Street Journal uses diluted EPS to report P/E
ratios in its stock trading tables. Like the other ratios dis-
cussed in this chapter, the P/E ratio is compared with indus-
trywide and marketwide averages to judge whether it™s too
TE




high or too low. I remember when a P/E ratio of 8 was typical.
Today P/E ratios of 20 or higher are common.

The stock shares of a privately owned business are not
actively traded, and thus the market value of its shares is diffi-
cult to ascertain. When shares do change hands occasionally,
the price is usually kept private between the seller and buyer.
Nevertheless, stockholders in these businesses are interested
in what their shares are worth. To estimate the value of their
stock shares, a P/E multiple can be used. In the example, the
company™s EPS is $3.75 for the most recent year (see Figure
4.1). Suppose you own some of the capital stock shares and
someone offers to buy your shares. You could establish an
offer price at, say, 12 times basic EPS, which is $45 per share.
The potential buyer may not be willing to pay this price, of
course. Or he or she might be willing to pay 15 or even 18
times EPS.

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DEBT-PAYING-ABILITY RATIOS
If a business cannot pay its liabilities on time, bad things can
happen. Solvency refers to the ability of a business to pay its
liabilities when they come due. Maintaining solvency (debt-
paying ability) is essential for every business. If a business
defaults on its debt obligations it becomes vulnerable to legal
proceedings by its lenders that could stop the company in its
tracks, or at least seriously interfere with its normal opera-
tions.
Therefore, investors and lenders are very interested in the
general solvency and debt-paying ability of a business.
Bankers and other lenders, when deciding whether to make
and renew loans to a business, direct their attention to certain
solvency ratios. These ratios provide a useful profile of the
business for assessing its creditworthiness and for judging the
ability of the business to pay its loans and interest on time.


Short-Term Solvency Test: The Current Ratio
The current ratio is used to test the short-term liability-paying
ability of a business. The current ratio is calculated by divid-
ing total current assets by total current liabilities. From the
data in the company™s balance sheet (Figure 4.2), its current
ratio is computed as follows:
$12,742,329 current assets
= 2.08 current ratio
$6,126,096 current liabilities
The current ratio is hardly ever expressed as a percent
(which would be 208 percent in this case). The current ratio is
stated as 2.08 to 1.00 for this company, or more simply just as
2.08. The general expectation is that the current ratio for a
business should be 2 to 1 or higher. Most businesses find that
their creditors expect them to maintain this minimum current
ratio. In other words, short-term creditors generally prefer
that a business limit its current liabilities to one-half or less of
its current assets.
Why do short-term creditors put this limit on a business?
The main reason is to provide a safety cushion for payment of
its short-term liabilities. A current ratio of 2 to 1 means there
is $2 of cash and assets that should be converted into cash
during the near future to pay each $1 of current liabilities that

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FINANCIAL REPORTING


come due in roughly the same time period. Each dollar of
short-term liabilities is backed up with two dollars of cash on
hand plus near-term cash inflows. The extra dollar of current
assets provides a margin of safety.
In summary, short-term sources of credit generally demand
that a company™s current assets be double its current liabili-
ties. After all, creditors are not owners”they don™t share in
the profit success of the business. The income on their loans is
limited to the interest they charge. As creditors, they quite
properly minimize their loan risks; they are not compensated
to take on much risk.


Acid Test Ratio, or Quick Ratio
Inventory is many weeks away from conversion into cash.
Products usually are held two, three, or four months before
being sold. If sales are made on credit, which is normal when
one business sells to another business, there™s a second wait-
ing period before accounts receivables are collected. In short,
inventory is not nearly as liquid as accounts receivable; it
takes a lot longer to convert inventory into cash. Furthermore,
there™s no guarantee that all the products in inventory will be
sold, or sold above cost.
A more severe test of the short-term liability-paying ability
of a business is the acid test ratio, which excludes inventory
(and prepaid expenses also). Only cash, marketable securities
investments (if the business has any), and accounts receivable
are counted as sources available to pay the current liabilities
of the business. This ratio is also called the quick ratio because
only cash and assets quickly convertible into cash are included
in the amount available for paying current liabilities.
The example company™s acid test ratio is calculated as
follows (the business has no investments in marketable
securities):
$2,345,675 cash + $3,813,582 accounts receivable
$6,126,096 total current liabilities
= 1.01 acid test ratio

The general expectation is that a company™s acid test ratio
should be 1:1 or better, although you find many more excep-
tions to this rule than to the 2:1 current ratio standard.

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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


Debt-to-Equity Ratio
Some debt is good, but too much is dangerous. The debt-to-
equity ratio is an indicator of whether a company is using
debt prudently or is overburdened with debt that could cause
problems. The example company™s debt-to-equity ratio is cal-
culated as follows (see Figure 4.2 for data):
$13,626,096 total liabilities
$13,188,483 total stockholders™ equity
= 1.03 debt-to-equity ratio
This ratio reveals that the company is using $1.03 of liabilities
for each $1.00 of stockholders™ equity. Notice that all liabilities
(non-interest-bearing as well as interest-bearing, and both
short-term and long-term) are included in this ratio. Most
industrial businesses stay below a 1 to 1 debt-to-equity ratio.
They don™t want to take on too much debt, or they cannot con-
vince lenders to put up more than one-half of their assets. On
the other hand, some businesses are much more aggressive
and operate with large ratios of debt to equity. Public utilities
and financial institutions have much higher debt-to-equity
ratios than 1 to 1.

Times Interest Earned
To pay interest on its debt a business needs sufficient earnings
before interest and income tax (EBIT). To test the ability to pay
interest, the times-interest-earned ratio is calculated. For the
example, annual earnings before interest and income tax is
divided by interest expense as follows (see Figure 4.1 for data):
$3,234,365 earnings before interest and income tax
$795,000 interest expense
= 4.07 times interest earned
There is no standard guideline for this particular ratio, al-
though obviously the ratio should be higher than 1 to 1. In
this example the company™s earnings before interest and
income tax is more than four times its annual interest
expense, which is comforting from the lender™s point of view.
Lenders would be very alarmed if a business barely covered
its annual interest expense. The company™s management
should be equally alarmed, of course.

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FINANCIAL REPORTING


ASSET TURNOVER RATIOS
A business has to keep its assets busy, both to remain solvent
and to be efficient in making profit. Inactive assets are an
albatross around the neck of the business. Slow-moving assets
can cause serious trouble. Investors and lenders use certain
turnover ratios as indicators of how well a business is using
its assets and to test whether some assets are sluggish and
might pose a serious problem.


Accounts Receivable Turnover Ratio
Accounts receivable should be collected on time and not
allowed to accumulate beyond the normal credit term offered
to customers. To get a sense of how well the business is con-
trolling its accounts receivable, the accounts receivable turn-
over ratio is calculated as follows (see Figures 4.1 and 4.2 for
data):
$39,661,250 annual sales revenue
= 10.4 times
$3,813,582 accounts receivable
The accounts receivable turnover ratio is one of the ratios
published by business financial information services such as
Dun & Bradstreet, Standard & Poor™s, and Moody™s. In this

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