Principles of Financial Accounting: Financial Statement Analysis - Market Ratios, EPS P/E Ratio Dividend Yield Dividend Payout

What It Is

Market ratios are financial metrics used to evaluate a company's performance and value. They help investors, analysts, and managers assess a company's profitability, efficiency, and growth prospects. For example, if a company generates $100,000 in net income and has 100,000 outstanding shares, its earnings per share (EPS) would be $1.

Key Concepts & Formulas

• Earnings Per Share (EPS): Net income divided by the number of outstanding shares. EPS = Net Income / Outstanding Shares Example: If a company has $100,000 in net income and 100,000 outstanding shares, its EPS would be $1.
• Price-to-Earnings (P/E) Ratio: Market price per share divided by EPS. P/E Ratio = Market Price per Share / EPS Example: If a company's stock price is $50 and its EPS is $1, its P/E ratio would be 50.
• Dividend Yield: Annual dividend per share divided by market price per share. Dividend Yield = Annual Dividend per Share / Market Price per Share Example: If a company pays an annual dividend of $2 per share and its stock price is $50, its dividend yield would be 4%.
• Dividend Payout Ratio: Dividends per share divided by net income per share. Dividend Payout Ratio = Dividends per Share / Net Income per Share Example: If a company pays $2 in dividends per share and has a net income of $10 per share, its dividend payout ratio would be 20%.
• Gross Profit Margin: Gross profit divided by sales. Gross Profit Margin = Gross Profit / Sales Example: If a company has $100,000 in sales and $60,000 in gross profit, its gross profit margin would be 60%.
• Operating Profit Margin: Operating income divided by sales. Operating Profit Margin = Operating Income / Sales Example: If a company has $100,000 in sales and $40,000 in operating income, its operating profit margin would be 40%.
• Return on Equity (ROE): Net income divided by total equity. ROE = Net Income / Total Equity Example: If a company has $100,000 in net income and $500,000 in total equity, its ROE would be 20%.

Journal Entry Examples

1. Dividend Payment: Dr. Cash $10,000 Cr. Dividends Payable $10,000 Explanation: The company pays $10,000 in dividends to its shareholders, increasing cash and decreasing dividends payable.

2. Stock Dividend: Dr. Retained Earnings $10,000 Cr. Common Stock $10,000 Cr. Dividends Payable $10,000 Explanation: The company declares a stock dividend, increasing retained earnings, common stock, and dividends payable.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Forgetting to record dividends payable. Correction: Always record dividends payable when paying dividends to shareholders.
3. Mistake: Confusing dividend yield with dividend payout ratio. Correction: Dividend yield is the annual dividend per share divided by market price per share, while dividend payout ratio is the dividends per share divided by net income per share.

Exam Tips

1. Tip: Be careful with reversing normal balances. Trap: Remember that assets, expenses, and dividends payable have normal balances, while liabilities, equity, and revenues have reversing normal balances.
2. Tip: Use the "ADE" rule to remember debits for assets, drawings, and expenses. Trap: Remember that debits increase assets, drawings, and expenses, while credits increase liabilities, equity, and revenues.
3. Tip: Be careful with stock dividends. Trap: Remember that stock dividends increase retained earnings, common stock, and dividends payable.

Quick Practice

1. Problem: A company has $100,000 in net income and 100,000 outstanding shares. What is its EPS? Answer: $1 Explanation: EPS = Net Income / Outstanding Shares = $100,000 / 100,000 = $1
2. Problem: A company pays an annual dividend of $2 per share and its stock price is $50. What is its dividend yield? Answer: 4% Explanation: Dividend Yield = Annual Dividend per Share / Market Price per Share = $2 / $50 = 4%
3. Problem: A company has $100,000 in sales and $60,000 in gross profit. What is its gross profit margin? Answer: 60% Explanation: Gross Profit Margin = Gross Profit / Sales = $60,000 / $100,000 = 60%

Last-Minute Cram Sheet

1. Earnings Per Share (EPS): Net income divided by outstanding shares.
2. Price-to-Earnings (P/E) Ratio: Market price per share divided by EPS.
3. Dividend Yield: Annual dividend per share divided by market price per share.
4. Dividend Payout Ratio: Dividends per share divided by net income per share.
5. Gross Profit Margin: Gross profit divided by sales.
6. Operating Profit Margin: Operating income divided by sales.
7. Return on Equity (ROE): Net income divided by total equity.
8. Assets: Have normal balances (debit).
9. Liabilities: Have reversing normal balances (credit).
10. Dividends are NOT an expense – they go directly to retained earnings.