1. Course Title:
Financial Statement Analysis
Course Code:
MGT-537
Course Instructor:
Dr. Hafiz Muhammad Ishaq
Total Lectures: 32

2. Previous Lecture Summary
Analysis of Profitability
Return on Investment,
Return on Total Equity,
Return on Common Equity,
The relationship between profitability rations,
Gross Profit Margin,
Trends in Profitability,
Segment Reporting,
Gains and Losses that Bypass the Income
Statement,
Interim Reports
Practical Exercise

3. Analysis for the Investor
Today's Lecture Topics
Analysis for the Investor
Definition of Financial Leverage,
Computation of Financial Leverage,
Earnings per common share,
Practical Exercises

4. Financial Leverage
Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses.
A ratio used to measure a company's mix of operating costs, giving an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ.

5. Financial Leverage
The use of debt is referred to as financial leverage
Interest as related to debt financing
A contractual obligation
Must be paid regardless of entity’s current profits
Contrast with dividends which are discretionary
Interest is tax deductible
Reduces taxable income
Reduces income tax

6. Definition of Financial Leverage and Magnification Effects
Net income increase [A] is greater than change in EBIT [B] due to the fixed nature of interest expense

7. Computation of the Degree of Financial Leverage
A ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. 
Degree of Financial Leverage (DFL) measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT), and can be mathematically represented as follows:

8. Computation of the Degree of Financial Leverage
The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT
A more simple formula for degree of financial leverage

9. Computation of the Degree of Financial Leverage (cont’d)
Degree of financial leverage calculations should exclude
Minority share of earnings
Equity income
Nonrecurring items
The all-inclusive formula for degree of financial leverage

10. Earnings Per Share
The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.
Required disclosure for corporate income statements
Pertains only to common stock
Per-share amounts are disclosed for
Income from recurring items
Discontinued operations
Extraordinary items
Net income

11. Basic Earnings per Share
Earnings pertain to an entire fiscal period
Average common shares outstanding is used for parity of information

12. Weighted Average Common Outstanding
Stock dividends and stock splits
Retroactive recognition to all comparative data

13. Practical Exercise
A firm has earnings before interest and tax of $1,000,000, interest of $200,000 and net income of $400,000 in year 1. Tax rate 50%.
Required
Calculate the degree of financial leverage in base year 1.
If earnings before interest and tax increase by 10% in year 2 what will be the new level of earnings , assuming the same tax rate as in year 1?
3. If earnings before interest and tax decrease to $ 800,000 in year 2, what
will be the new level of earnings assuming the same tax rate as in year 1?

16. Practical Exercise
Dicker Company has the following pattern of financial data for year 1 and 2:
Year 1 Year 2
Net Income $ $ 42,000
Preferred stock (5%) $450,000 $550,000
Weighted average number of
common share outstanding 38, ,500
Required
Calculate earnings per share and comment on the trend

18. The decline in earnings per share is caused mainly by the issuance of preferred stock and partially by a rise in the common shares.

19. Practical Exercise Assume the following fact for the current year:
Common shares outstanding on January 1, 50,000 shares July 1, 2- for- 1 stock split.
October 1, a stock issue of 10,000 shares
Required
Compute the denominator of the earnings per share computation for the current year.

21. Practical Exercise
XYZ corporation reported earnings per share of $ 2.00 in 2002 in In XYZ Corporation reported earnings per share $ for 1 stock splits were declared on July 1, 2003 and December 31,2003.
Required
Present the earnings per share for a tow year comparative income statement that includes 2003 and 2002.

23. Practical Exercise
ABC Company shows the following condensed Income statement information for the current year:
Revenue from sales $3,500,000
Cost of production sold (1,700,000)
Gross profit ,800,000
Operatinexpenses:
Selling expenses $425,000
General expenses $350,000 (775,000)
Operating income $1,025,000
Other income ,000
Interest (70,000)
Operating income before taxes ,000
Taxes related to operations (335,000)
Income from operations ,000
Extraordinary loss (less applicable income
taxes of $ 40,000) (80,000)
Income before minority interest ,000
Minority share of earnings (50,000)
Net Income $ 510,000
Required:
Calculate the degree of financial leverage.

25. Analysis for the Investor
Lecture Summary
Analysis for the Investor
Definition of Financial Leverage,
Computation of Financial Leverage,
Earnings per common share,
Practical Exercise