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There are many ratios commonly used for the financial analysis of a company, and perhaps the best known is the Price/Earnings (PE) ratio. Ratios are powerful tools because rather than considering some number on its own, they allow us to evaluate a number in the context of another number. Let’s see how this works.

Imagine there are two companies, A and B. Both earned (i.e. made a profit of) $1 million last year - will they have the same value? Suppose A is in an industry that’s dying out and B is in a growth industry – (assuming that both companies have the same number of outstanding shares) which will have the higher stock price? B has the brighter future, the higher likelihood of providing long-term value, so it will have a higher stock price. So given the same earnings, B has the higher price and therefore the higher price/earnings ratio. Thus, the PE ratio is a measure of investors’ optimism about future growth.

Normally we wouldn’t compare companies in different industries. Since different industries have different growth prospects, we would not expect companies across those industries to necessarily have similar PE ratios. But companies within an industry are all subject to the same market forces, so we would generally expect them to have the same growth expectations, and therefore the same ratio of their current price relative to their current profits (earnings). What if we find a company that has a PE ratio that’s higher than the industry average? What might we wonder? This company’s price is higher relative to its earnings than everyone else in the industry (on average) so perhaps that price is too high and this company is overvalued. Or maybe there’s a good reason for investors to be more optimistic. And, of course, if a company has a PE ratio lower than the industry average, then maybe they’re undervalued and a good buy. Or maybe there’s a good reason why their price should be lower. Ratios such as this don’t provide a final decision; they’re just a potential flag to take a further look.

Speaking of taking a further look, next time we’ll take a different look at the PE ratio and how it might be used to determine a company’s value. Better yet, take one of our seminars to learn about many other powerful yet simple analytical ratios!

In a past article we considered the various expenses a company incurs related to financing, as well as “costs” that aren’t expenses. More recently we recognized the fact that when we talk about revenue and expenses, we’re simply talking about items that affect Retained Earnings, except for one.

Before we get there, let’s review. We’ve now recognized the fact that the whole point of having a company, from a financial perspective at least, is to pay out dividends and/or increase Retained Earnings. But wait - isn’t the point of the business to make a profit? The answer, of course, is yes – the profit that we make is EXACTLY the sum of our change in Retained Earnings and the dividends that we pay out. Which is why the Income Statement (or P&L or Statement of Earnings - it has many names) is simply an itemization of all of the changes to Retained Earnings EXCEPT dividends.

In other words, we can think of it this way: during a given period, we operate the business - we increase Retained Earnings when we have revenue and we decrease Retained Earnings when we have expenses. Then we may choose to pay a dividend. Before we account for dividends, our change in Retained Earnings is equal to our Net Income (i.e. profit). THEN we may choose to distribute some of those earnings (i.e. profits) to the owners (i.e. pay out a dividend). Paying a dividend doesn’t reduce our profit; it just reduces the profit that we’ve kept in the company (i.e. the Earnings that we’ve Retained). When it comes to tax time, we pay taxes on our profits, which is simply the difference between our revenue and our expenses. Just because we decided to distribute some of those profits (i.e. paid a dividend) rather than retain them doesn’t mean that we didn’t earn them, and so of course we don’t include dividends on the Income Statement. So if dividends don’t reduce our profit (i.e. they aren’t expenses), then by definition they are not tax-deductible.

Explore these concepts and more at one of our upcoming live and online/on-demand seminars. All of our seminars are taught by Wharton and Harvard MBAs with the rare ability to distill seemingly complex concepts in simple, understandable, and very useful terms. Sign up today!

You didn’t have to go to business school to know that profit is the difference between how much we sell something for and how much it cost, and our overall business profit is total revenue minus expenses. In recent articles we’ve discussed the nature of various expenses. Now we’ll take a look from a different perspective.

Let’s consider the way we account for sales. Though intuitively we think of a sale as an exchange of our inventory for money (or an IOU), from an accounting perspective these are two separate transactions. First we handle the sale. Because we use Double-Entry Accounting (more on that another time or in one of our seminars), every transaction will affect at least two accounts on the Balance Sheet in order to maintain a balance between the two “sides” of our business. It’s a cash sale, so cash increases and what else happens? No other assets change - all that’s really happened to assets is we’ve received cash (remember - we’ll handle the inventory change later), so it must be something on the other “side” of the Balance Sheet. We don’t owe creditors more money because we’ve sold something, and nor does it mean that owners have invested more capital. By making a sale we’ve increased Retained Earnings - which makes sense since it means that selling increases the value of our Owners’ Equity. Next let’s address our having sold some inventory. Inventory decreases on the Balance Sheet and what else? Retained Earnings goes down. We no longer have the inventory and so the value of our business is diminished.

How about paying the rent? Cash and Retained Earnings both decrease. Same when we pay utilities or other bills. When we make a loan payment, our cash asset is reduced and on the other side liabilities go down by the amount of the principal payment and Retained Earnings goes down by the amount of the interest. When we Depreciate assets, Retained Earnings and Accumulated Depreciation go down by the same amount.

So looking at things from this perspective we can see that the Income Statement (a/k/a Profit & Loss or P&L) is simply a list of all of the items that affect Retained Earnings, and by “profit” we mean the net change in Retained Earnings since the prior Balance Sheet - except for one: Dividends. Learn more about that in a future article - and, of course, at one of our many upcoming seminars - sign up today!