Define Earnings of the Company

The income for the company is generated through operating sources and non-operating sources. The sources of operating income vary from industry to industry. For the service industry no tangible product is involved and income is generated through sales of services. Take the case of commercial bank, its income is the interest on loans and investments. Interest income is referred to operating income. But in the case of industries producing tangible goods earnings arise from the sale of goods.

The companies, in addition to the revenue from sales, may get revenue from other sources too. The non-operating income may be generated from interest from bonds, rentals from lease, dividends from securities and sale of assets. The investor should analyse the income source diligently whether it is from the sale of assets or it is from investments. Sometimes earning per share may seem to be attractive in a particular year but in actual case the revenue generated through sales may be comparatively lower than in the previous year. The earnings might have been generated through the sale of assets.

The investor should be aware that income of the company may vary due to the following reasons.

Change in sales

Change in costs

Depreciation method adopted

Depletion of resources in the case of oil, mining, forest products, gas etc.

Inventory accounting method

Replacement cost of inventories

Wages, salaries and fringe benefits

Income taxes and other taxes.

Capital Structure

The equity holders’ return can be increased manifold with the help of financial leverage, i.e., using debt financing along with equity financing. The effect of financial leverage is measured by computing leverage ratios. The debt ratio indicates the position of the long term and short term debts in the company finance. The debt may be in the form of debentures and term loans from financial institutions.

Preference Shares

In the early days the preference share capital was never a significant source of capital. At present, many companies resort to preference shares. The preference shares induct some degree of leverage in finance. The leverage effect of the preference shares is comparatively lesser than the debt because the preference share dividends are not tax deductible. If the portion of preference share in the capital is larger, it tends to create instability in the earnings of the equity shares when the earnings of the company fluctuate. Sometimes the preference share may be convertible preference share; in that case it dilutes the earnings per share. So the investor should look into the preference share component of the capital structure.

Debt

Long term debt is an important source of finance. It has the specific benefit of low cost of capital because interest is tax deductible. The leverage effect of debt is highly advantageous to the equity holders. During the boom period the positive side of the leverage effect increases the earnings of the share holders. At the same time, during recession the leverage effect inducts instability in earnings per share and can lead to bankruptcy. Hence, it is important to limit the debt component of the capital to a reasonable level. The limit depends on the firm’s earning capacity and its fixed assets.

Earnings Limit of Debt

The earnings determine whether the debt is excessive or not. The earnings indicate the probability of insolvency. The ratio used to find out the limit of the debts is the interest coverage ratio i.e., the ratio of net income after taxes to interest paid on debt. The ratio shows the firm’s ability to pay the interest charges, the number of times interest is covered by earnings.

ii)  Assets Limit to Debt

This asset limit is found out by fixed assets to debt ratio. The financing of fixed assets by the debt should be within a reasonable limit. For industrial units the recommended ratio level is below 0.5.

Management

Good and capable management generates profit to the investors. The management of the firm should efficiently plan, organize, actuate and control the activities of the company. The basic objective of management is to attain the stated objectives of company are achieved, investors will have a profit. A management that ignores profit does more harm to the investors than one that over emphasizes it.

The good management depends on the qualities of the manager. Koontz and O’Donnell suggest the following as a special trait of an able manager:

Ability to get along with people

Leadership

Analytical competence

Industry

Judgement

Ability to get things done

Since the traits are difficult to measure, managerial performance is evaluated against setting and accomplishing a verifiable objective. If the investor needs greater proof of excellence of management, he has to analyse management ability. The analysis can be carried out on the following ways:

The background of managerial personnel contributes much to the success of the management. The manager’s age, educational background, advancement within the company, levels of responsibility achieved and the activities in the social sphere can be studied.

The record of management over the past years has to be reviewed. For several companies what the top management have done during its tenure in office are given in the financial weeklies and monthlies along with critical comments. This gives an insight into the ability of the top management.

The management’s skill to have market share ahead of others is a proof of managerial success. The investor can rely on this type of management and choose the stock.

The next criterion the investor should analyse is the company’s strength to expand. A firm may expand from within and diversify products in the known lines. Sometimes it may acquire an other company to expand its market. The horizontal or vertical expansion of the production is a health sign of an efficient management.

The management’s ability to maintain efficient production by proper utilization or plant and machinery has to be analysed. Suitable inventory planning and scheduling have to be drafted and worked out by the management.

The management’s capacity to finance the company adequately has to be studied. Accomplishing the financial requirement is a direct reflection of managerial ability. The management should adopt a realistic dividend policy in relation to earnings. A realistic dividend policy boosts the image of the company’s stock in the market.

The functional ability of management to work with employees and union is another area of concern. A union poses a threat to the smooth functioning of the firm. In this context the management should be able to maintain harmonious relationship with the employees and unions.

The management’s adaptability to scientific management and quality control techniques should be analysed. The management should be able to give due weightage to maintain technical competence.

After analyzing the above mentioned factors, the investor should select companies that possess excellent management and maintain the competitive position of the company in the market. The investor should also remember that the individual traits of a single manager alone cannot make the company profitable and there should be a strong management system to do so.

Operating Efficiency

The operating efficiency of a company directly affects the earnings of a company. An expanding company that maintains high operating efficiency with a low break-even point earns more than the company with high break-even point. If a firm has stable operating ratio, the revenues also would be stable.

Efficient use of fixed assets with raw materials, labour and management would lead to more income from sales. This leads to internal fund generation for the expansion of the firm. A growing company should have low operating ratio to meet the growing demand for its product.

Operating Leverage

If the firm’s fixed cost is high in the total cost the firm is said to have a high degree of operating leverage. Leverage means the use of a lever to raise a heavy object with a small force. High degree of operating leverage implies, other factors being held constant, relatively small change in sales result in a large change in return on equity. This can be explained with the help of the following example.

Let us take firm A and B. The firm A has relatively small amount of fixed charges say, ` 40,000. Firm A would not have much automated equipment, so its depreciation and maintenance costs are low. The variable cost per cent is higher than it would be if the firm used more automated equipment, In the other case firm B has high fixed costs, ` 1,20,000.

Here the firm uses automated equipment (with which one operator can turn out many units at the same labour cost) to a much larger extent. The break-even occurs at 40,000 units in firm A and 60,000 units in firm B. The selling price (P) is ` 4; the variable cost is ` 3 for firm A and ` 2 for firm B percent.

The break-even occurs when ROE (return on equity) = 0, and hence, when earnings before interest and taxes (EBIT) = 0.

EBIT=0=PQ–VQ–F

Here P is the average sales price per unit of output, Q is units of output, V is the variable cost per unit, and F is the fixed operating costs. The break-even quantity is = F / (P-V)

To a large extent, operating leverage is determined by technology. For example, telephone companies, iron and steel companies and electric utilities have heavy investments in fixed assets leading to high fixed costs and operating leverage. On the other hand cosmetics companies, and consumer goods producing companies may need significantly lower fixed costs, and hence lower operating leverage.

The investor should understand the operating leverage of the firm because the firm with high operating leverage is affected much by the cyclical decline. The operating efficiency of the firm determines the profit expectation of the company.