Financial Leverage, Eps and Profit Margin Essay

Profits might be compared with sales, assets, or stockholders’ equity. Why might all three bases be used? Will trends in these ratios always move in the same direction? All the three bases are used to find the return earned with respective to sales as well as investment made. When the profit is compared with sales, it is called as the net profit margin. When the profit is compared with assets, it is called as return earned on total investment and when profit is compared with stockholders’ equity, it is called as return on equity. All these are profitability ratios and help to analyze the profitability at a particular period with respect to various bases. The trend in these ratios may not always move in the same direction. For example, return on assets may increase from one period to another, but not necessarily the return on equity. A cause for this may be due to change in capital structure and mix of debt and equity. Would you expect the profit margin in a quality jewelry store to differ from that of a grocery store? Comment. Yes. The profit margin in a quality jewelry store may differ from that of a grocery store. A jewelry store’s profit margin would be much higher than of a grocery store. A grocery store will have a lower profit margin with respect to sales and earns its profits by selling more volume. But in the case of a jewelry store, the profit margin earned on each unit would be higher. Give a simple definition of earnings per share. Earnings per share can be defined as the earnings available to equity shareholders after the payment of preferred dividends, if any, with respect to one share. It is calculated as net income available to equity shareholders divided by the number of outstanding equity shares. Define financial leverage. What is its effect on earnings? When is the use of financial leverage advantageous and disadvantageous? The extent to which a firm uses fixed income securities can be termed as a financial leverage. The fixed income securities include bonds and debentures. The effect on earnings includes reduction of profits due to payment of fixed interest on these securities. The use of financial leverage is advantageous especially when the leverage is at the optimum level. At this level, the existence of leverage maximizes the earnings per share of the equity holders. This is because all the excess profits after the payment of interest go to the equity holders. The use of financial leverage is disadvantageous when it exceeds the optimal level. When the leverage is too high, it increases the risk of the company as well as the cost of capital. This also reduces the long term solvency of the business.