Section 2: Ratios Measuring Financial Strength Chapter Statement Analysis: Measuring Profitability, Financial Strength, and Liquidity 24 Section 2: Ratios Measuring Financial Strength This second section of chapter 24 explains how to calculate ratios which measure financial strength. Section Objectives Compute and interpret financial ratios that measure financial strength.

Objective 2. Compute And Interpret Financial Ratios That Measure Financial Strength. A company’s financial strength can be measured using ratio analysis. In general, the higher the ratio the stronger the company.

Ratios Measuring Financial Strength Number of times bond interest earned. Ratio of stockholders’ equity to total equities. Ratio of stockholders’ equity to total liabilities. Book value per share of stock. The four common ratios which measure financial strength are: Number of times bond interest earned Ratio of stockholders’ equity to total equities Ratio of stockholders’ equity to total liabilities Book value per share of stock

Number of Times Bond Interest Earned Measures the ability of net income to cover the required bond interest payments. Formula: Income before bond interest and income taxes Bond interest cash requirement Times bond interest earned = Procedure: Step 1: Compute the income before bond interest and income taxes. Step 2: Compute the cash required to pay bond interest. Step 3: Compute the ratio. The Number of Times Bond Interest Earned is a ratio that measures the margin of safety that net income provides for required bond interest payments. The calculation of this measurement is: (income before bond interest and income taxes ÷ bond interest cash requirement). Let’s try following the steps listed here to calculate this number. . .

Number of Times Bond Interest Earned Step 1: Compute income before bond interest and income taxes. Income before tax $80,826 Add bond interest expense 9,500 Available for bond interest $90,326 In Step 1, we compute income before bond interest and income taxes. For California Products, Inc. it is $90,326.

Number of Times Bond Interest Earned Step 1: Income before bond interest and income taxes = $90,326 Step 2: Compute the cash required to pay bond interest. $100,000 x 0.10 $ 10,000 In step 2: we compute the cash required to pay annual bond interest. For California Products, Inc. that number is $10,000.

Number of Times Bond Interest Earned Step 1: Income before bond interest and income taxes = $90,326 Step 2: Cash required to pay bond interest = $10,000 Step 3: Compute the ratio. Finally, in step 3, we can compute the ratio. At 9.0, the income of California Product, Inc. easily covers the required annual bond payments. $ 90,326 $ 10,000 = 9.0 times The income of California Products, Inc. easily covers required bond payments.

Ratio of Stockholders’ Equity to Total Equities Measures the portion of total capital provided by the stockholders and indicates the protection afforded creditors against possible losses. Formula: Stockholders’ equity Total equities Ratio of stockholders’ equity to total equities = Example: Recall the basic equation Total Assets = Total Equities. The sum of a corporation’s liabilities and stockholder’s equity is referred to as its total equities. The ratio of Stockholders’ Equity to Total Equities measures the portion of total capital provided by stockholders and indicates protection afforded creditors against losses. The formula is: (stockholders’ equity ÷ Total equities). For California Products, Inc. the measure is .57 to 1. This means that in the current year, the stockholders of the company provided 57 cents of each dollar of total equities. This ratio varies widely from industry to industry. A comparison with the industry average is important in determining a desirable ratio for a particular business. $315,921 $557,016 = 0.57 to 1 A comparison with the industry average is important in determining a desirable ratio for a particular business.

Ratio of Stockholders’ Equity to Total Liabilities Also known as the ratio of owned capital to borrowed capital. Formula: Stockholders’ equity Total liabilities Ratio of stockholders’ equity to total liabilities = Example: This ratio is another way to express the stockholders’ equity to total equity ratio. The calculation is: = Stockholders equity Total liabilities Emphasize that a low ratio here can be risky. The corporation might not be able to make interest and principal payments on its debts. $315,921 $241,095 = 1.31 to 1

Book Value per Share of Stock Measures the financial strength underlying each share of stock. Formula: Common stockholders’ equity Number of common shares Book value per share of stock = Procedure: Step 1: Compute the claims of preferred shareholders. Step 2: Compute the claims of common stockholders. Step 3: Divide the total claims of common stockholders by the number of shares outstanding. Book Value per share of stock is a measure of the financial strength of a business that underlies each share of stock. To calculate this measurement: (common stockholders’ equity ÷ number of common shares). Let’s follow these steps to calculate book value per share for California Products, Inc. . .

Book Value per Share of Stock Step 1: Compute the claims of preferred stockholders. For California Products, Inc. the book value of preferred stock is the same as the par value, $100 per share. $ 100 x 500 shares outstanding $50,000 In step 1, we compute the claims of preferred stockholders. Since there are no cumulative dividends or special liquidation provisions for the preferred stock of the company, the book value is the same as the par value, $100 per share. If we multiply the $100 x the 500 shares outstanding we get total claims for preferred shareholders of $50,000.

Book Value per Share of Stock Step 1: Claims of preferred stockholders = $50,000 Step 2: Compute the claims of common stockholders. Stockholders’ equity $315,921 Less preferred stock equity 50,000 Next, we need to compute the claims of common stockholders. To do this, we deduct the claims of preferred stockholders from total stockholders’ equity. This amount is $265,921. Claims of common stockholders $265,921

Book Value per Share of Stock Step 1: Claims of preferred stockholders = $50,000 Step 2: Claims of common stockholders = $265,921 Step 3: Divide the total claims of common stockholders by the number of shares outstanding. Finally, we divide the total claims of common stockholders by the number of shares of common stock outstanding. The book value of each share of stock is $44.32. $265,921 6,000 shares = $44.32

Book Value per Share Book value and fair market value often are quite different. Book value per share does not indicate how much the stockholder would receive if the assets were sold and the corporation liquidated. Since market value of stock or current value may not be readily available to financial statement users, book value per share is used to measure the financial strength of stock. (Book value per share is based on asset cost, not market or liquidation value.)

SECTION R E V I W Complete the following sentences: The number of times bond interest earned measures the ability of __________ to cover required _____________________. net income bond interest payments The ratio of ________________________ _______ is an indication of the protection afforded creditors against possible losses. stockholders’ equity to total equities Let’s review. . . The ratio of owned capital to borrowed capital is the ________________________ _______________. ratio of stockholders’ equity to total liabilities

R E V I W book value per share of stock SECTION R E V I W Complete the following sentences: book value per share of stock The __________________________ measures the financial strength underlying each share of stock. The formula for book value per share of stock is __________________________ divided by _______________________. common stockholders’ equity number of common shares Book value per share does not indicate how much the stockholder would receive if the assets were sold and the corporation _________. liquidated

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