‘Most equity investors consider net income (or net loss) to he the most important figure in the income ,statement. This amount represents the overall increase (or decrease) in owners’ equity resulting fromall profit-directed activities during the period. Financial analysts often compute net income as.a percentage of net sales (net income divided by net sales).
This measurement provides an indication of management’s abilit)’ to,control expenses and to retain II reasonable portion of its revenue as’ profit, The, normal .ratio of net income to net sales vanes greatly by industry. In some industries. companies may be successful by earning a net income equal to only 2% or 3% of net sales.
• n other industries, net income may be much higher. In 2001, Computer Bam’s net income amounts to 8% of net sales, which is very good for .a computer retailer.
Earnings Per share
Ownership of a corporation is evidenced by shares of capital stock. What does the net income of a corporation mean to someone who owns, say, 100 shares of.a corporation’s capital stock? To assist individualstockholders In relating the corporation’s net income to their ownership shares, large corporations compute earnings per share and show these amounts at the bottom of their income statements. In the simplest case, earnings per share is net income, expressed on a per-share basis.
For example, !he balance sheet ?n ~age 61~ indicates that Computer Barn has 15,000 shares of capital stock outstanding. Assuming these shares had been outstanding all year, earnings per share amounts to $4.80: Earnings per share is perhaps the most widely used of all accounting ratios. The trend in earnings per share-and the expected earnings in future periods-c-are major factors affecting the market value of a company’s shares.
Financial analysts express the relationship between the market price of a company’s stock and the underlying earnings Per share as a prlce-earnlngs (pie) ratlo. This ratio is computed by dividing the current market price per share 0′( the company’s stock by annual
earnings per share.
(A pie ratio cannot be computed for a period in which the company ‘incurs a net loss).40nly publicly held corporations are required to report earnings on a per share basis. For small businesses such as Computer Barn” the reporting of earnings per share is optional, 5Assume that all 15,000 shares have been outstanding throughout the year. Computation of earnings per share in more complex situati~ns is addressed in Chapter 12. To illustrate, assume that at the end of 2001,
Computer Barn’s capital stock is trading among investors at a market price of $96 per share. The pIe ratio of the company’s stock is computed as follows:Technically, this ratio is 20 to 1. But it is common practice to omit the “to I” and merely to describe a pIe ratio by the first number. The ‘pIe ratios of many pablicly’ owned corporations arc quoted daily in the financial pages of many newspapers.
The pIc ratio reflects investor’s expectations concemingthe company’s future performance. The more optimistic these expectations, the higher the pIe ratio is likely to be. Traditionally, stocks of financially sound companies with stable earnings usually sell at between 12 and 15 times earnings.
If investors anticipate rapid earnings growth. pIc ratios rise into the twenties, thirties; or even higher.A pIe ratio of 10 or less often indicates that investors expect earnings to decline from the current level. It may also mean, however; that the stock is undervalued. Likewise, a stock with a pIe ratio of 30 or more usually means that investors expect earnings to increase from the current level. However, it may also signal that the stock is overvalued.
One word of caution. If earnings decline to very low levels, the price of the stock usually does not follow the earnings all the way down. Therefore, a company with very low earnings is likely to have a high pie ratio even if investors are not optimistic about future earnings. .
Single-Step Income Statements
In their annual reports, many publicly owned corporations present their financial statements in a highly condensed format. For this reason, the single-step income statement is widely used in annual reports. The single-step form of income statement takes its name from the fact that all costs and expenses are deducted from total revenue in a single step.
No subtotals are shown for gross profit or for operating income, although the statement provides investors with enough information to compute these subtotals on their own. The 2001 income statement of Computer Barn appears below in a single-step format:Evaluating the Adequacy of Net Income How much net income must a business earn to be considered successful? Obviously, the dollar amount of net income that investors consider adequate depends on the size of the business.
An annual net income of $1 million might seem impressive for an automobile dealership but would represent very poor performance for a company the s~e of General Motors, Ford, or Chrysler.
•Investors usually consider two factors in evaluating a company’s profitability: (1) the : trend in earnings and (2) the amount of current earnings in relation to the amount of the resources needed to produce the earnings.
Most investors regard the trend in earnings from year to year as more important than the ‘amount of net income in the current period. Equity investors stand to benefit from the company’s performance over the long run. Years of steadily increasing earnings may increase the value of the stockholders’ investment manyfold. In evaluating the current level of earnings, many investors use return 011 investment analysis.
Return on Investment. (ROI)
.In Chapter I we explained that a basic purpose of accounting is to assist decision makers in efficiently allocating and using economic resources. In deciding where to invest their money, equity investors want to know how efficiently companies utilize resources. The most common method of evaluating the efficiency with which financial resources are employed is to compute the rate of return earned on these resources. This rate of return is called the return on investment, or ROI.
Mathematically, computing the return on investment i./ia simple concept.the annual return (or profit) generated by the investment is stated as a percentage of the average amount invested throughout the year, The basic idea is .illustrated by the following formula:The return is earned throughout the period.
Therefore, it is logical to express this return as a percentage of the average amount invested during the period, rather than the investment at year-end. The average amount invested usually is computed by adding the amounts invested as of the beginning and end of the year, and dividing this total by 2.
The concept of ROI is applied in many different situations, such as evaluating the . profitability of a business, a branch location, or a specific investment opportunity. As. a result, a number of variations in the basic ROI ratio have been developed, each suited to a particular type of analysis. These ratios differ in the manner in which return and average amount invested are defined. We will discuss two common applications of the ROI concept: return on assets and return on equity.
Return on Assets (ROA) This ratio is used in evaluating whether management has earned a reasonable return with the assets under its control. In this computation, return usually is defined as operating income, since interest expense and income taxes are determined by factors other than the manner in which assets are used. The ‘return on assets is computed as follows:Let us now determine the return on assets earned by he management of Computer Barn in 2001. Operating income, as shown in the income statement on page 625, arnounts to $120,000. Assume that Computer Barn’s assets at the beginning 0£2001 totaled $570,000.
The illustrated balance sheet on.page 618 shows total assets of $630,000 at year-end. Therefore, the company’s average total assets during the year amounted to $600,000 [($570,000 + $630,(00) -;- 2]. The return on assets in 2001 is 20%, determined as follows: