CFA Level 1 - Financial Ratios

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7.1 - Introduction
INTRODUCTION
Knowing how to calculate and use financial ratios is important for not only analysts, but for investors, lenders
and more. Ratios allow analysts to compare a various aspect of a company's financial statements against others
in its industry, to determine a company's ability to pay dividends, and more.

The material presented in this section is extremely important to know for your exam. The majority of the
questions you see on your exam, within the accounting section,
will require you to have excellent knowledge on how to
calculate and manipulate ratios. You also need to recognize how
ratios are interrelated and how the results of two or more other
ratios can be used to calculate other ratios.

A. ANALYZING FINANCIAL STATEMENTS

I. Common-Size Financial Statements

Common-size balance sheets and income statements are used to compare the performance of different
companies or a company's progress over time.

• A Common-Size Balance Sheet is a balance sheet where every dollar amount has been restated to be a
percentage of total assets.
o Calculated as follows:

Formula 7.1

% value of balance sheet account = Balance sheet account

Total Assets

• A Common-Size Income Statement is an income statement where every dollar amount has been
restated to be a percentage of sales.
o Calculated as follows:

Formula 7.2

% value of income statement account = Income statement account

Total Sales (Revenues)
Example: FedEx Common Size Balance Sheet and Income Statement
At first glance, all numbers stated within FedEx's income statement in figure 7.1, and balance sheet in figure
7.2, can seem daunting. It requires close examination to determine whether operating expenses are increasing or
decreasing, or which particular expense comprises the highest percentage total operating expenses.

Figure 7.1: FedEx Consolidated Income Statements

However, if we consider the common-size statements in figures 7.2 and 7.4 below, you can tell at first glance
how a company is performing in many areas.

The common-size income statement informs us that salaries and other comprise the largest percentage of total
operating expenses and their most recent net income comprises 3.39% of total 2004 revenues. Alternately, the
common-size balance sheet in figure 7.4 quickly shows that receivables comprise a large percentage of current
assets and are decreasing, and more.

Figure 7.2: FedEx Common-sized Income Statements

Figure 7.3: FedEx Consolidated Balance Sheets
Figure 7.4: FedEx Common-sized Consolidated Balance Sheets
II.Financial Ratios
Classification of Financial Ratios
Ratios were developed to standardize a company’s results. They allow analysts to quickly look through a
company’s financial statements and identify trends and anomalies. Ratios can be classified in terms of the
information they provide to the reader.

There are four classifications of financial ratios:

1. Internal liquidity – The ratios used in this classification were developed to analyze and determine a
company’s financial ability to meet short-term liabilities.
2. Operating performance - The ratios used in this classification were developed to analyze and
determine how well management operates a company. The ratios found in this classification can be
divided into ‘operating profitability’ and ‘operating efficiency’. Operating profitability relates the
company’s overall profitability, and operating efficiency reveals if the company’s assets were utilized
efficiently.
3. Risk profile - The ratios found in this classification can be divided into ‘business risk’ and ‘financial
risk’. Business risk relates the company’s income variance, i.e. the risk of not generating consistent cash
flows over time. Financial risk is the risk that relates to the company’s financial structure, i.e. use of
debt.
4. Growth potential - The ratios used in this classification are useful to stockholders and creditors as it
allows the stockholders to determine what the company is worth, and allows creditors to estimate the
company’s ability to pay its existing debt and evaluate their additional debt applications, if any.

7.2 - Internal Liquidity Ratios

1. Current Ratio
This ratio is a measure of the ability of a firm to meet its short-
term obligations. In general, a ratio of 2 to 3 is usually
considered good. Too small a ratio indicates that there is some
potential difficulty in covering obligations. A high ratio may
indicate that the firm has too many assets tied up in current assets
and is not making efficient use to them.

Formula 7.3
Current ratio = current assets / current liabilities

2. Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of
liquidity. Only liquid assets are taken into account. Inventory and
other assets are excluded, as they may be difficult to dispose of.

Formula 7.4
Quick ratio = (cash+ marketable securities + accounts receivables)
current liabilities

3. Cash Ratio
The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current
obligations.

Formula 7.5
Cash ratio = (cash + marketable securities)/current liabilities

4. Cash Flow from Operations Ratio

Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick
ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash
it produces from current operations.

Formula 7.6

Cash flow from operations ratio = cash flow from operations

current liability

5. Receivable Turnover Ratio

This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover
will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to
the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a
result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having
difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.

Formula 7.7

Receivable turnover = net annual sales / average receivables

Where:
Average receivables = (previously reported account receivable + current account receivables)/2

6. Average Number of Days Receivables Outstanding (Average Collection Period)

This ratio provides the same information as receivable turnover except that it indicates it as number of days.

Formula 7.8

Average number of days receivables outstanding = 365 days_

receivables turnover

7. Inventory Turnover Ratio

This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high
inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not
languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio
could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the
potential of losing customers. It could also indicate inadequate production levels for meeting customer demand.

Formula 7.9

Inventory turnover = cost of goods sold / average inventory

Where:
Average inventory = (previously reported inventory + current inventory)/2

8. Average Number of Days in Stock

This ratio provides the same information as inventory turnover except that it indicates it as number of days.

Formula 7.10
 Average number of days in stock = 365 / inventory turnover

9. Payable Turnover Ratio

This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful
in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a
company's credit rating.

Formula 7.11
Payable turnover = Annual purchases / average payables

Where:
Annual purchases = cost of goods sold + ending inventory – beginning inventory
Average payables = (previously reported accounts payable + current accounts payable) / 2

10. Average Number of Days Payables Outstanding (Average Age of Payables)

This ratio provides the same information as payable turnover except that it indicates it by number of days.

Formula 7.12
Average number of days payables outstanding = 365_____
payable turnover

II. Other Internal-Liquidity Ratios

11.Cash Conversion Cycle

This ratio will indicate how much time it takes for the company to convert collection or their investment into
cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in
process.

Formula 7.13
Cash conversion cycle = average collection period + average number of days in stock - average
age of payables

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

12.Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its
current operations without any additional sales.

Formula 7.14

Defensive interval = 365 * (cash + marketable securities + accounts receivable)

projected expenditures
Where:
Projected expenditures = projected outflow needed to operate the company

7.3 - Operating Profitability Ratios

Operating Profitability can be divided into measurements
of return on sales and return on investment.

Return on Sales
1. Gross Profit Margin
This shows the average amount of profit considering only sales and the cost of the items sold. This tells how
much profit the product or service is making without overhead considerations. As such, it indicates the
efficiency of operations as well as how products are priced. Wide variations occur from industry to industry.

Formula 7.15
Gross profit margin = gross profit / net sales

Gross profit = net sales – cost of goods sold

2. Operating Profit Margin

This ratio indicates the profitability of current operations. This ratio does not take into account the company's
capital and tax structure.

Formula 7.16
Operating profit margin = operating income/net sales

Where:
Operating income = earnings before tax and interest from continuing
operations

3. EBITDA Margin
This ratio indicates the profitability of current operations. This ratio does not take into account the company's
capital, non-cash expenses or tax structure.

Formula 7.17
EBITDA margin = earnings before tax, depreciation and amortization
net sales

4. Per-Tax Margin (EBT margin)

This ratio indicates the profitability of Company's operations. This ratio does not take into account the
company's tax structure.

Formula 7.18
Pre-tax margin = Earning before tax/sales

5. Net Margin (Profit Margin)

This ratio indicates the profitability of a company's operations.

Formula 7.19
Net margin = net income/sales

6. Contribution Margin
This ratio indicates how much each sale contributes to fixed expenditures.

Formula 7.20
Contribution margin = contribution / sales

Where: Contributions = sales - variable cost

7.4 - Return on Investment Ratios
1. Return on Assets (ROA)
This ratio measures the operating efficacy of a company without
regards to financial structure

Formula 7.21

Return on assets = (net income + after-tax cost of interest)

average total assets
OR

Return on assets = earnings before interest and taxes

average total assets

Where:
Average total assets = (previously reported total assets + current total assets)
2

2. Return on Common Equity (ROCE)

This ratio measures the return accruing to common stockholders and excludes preferred stockholders.

Formula 7.22

Return on common equity = (net income – preferred dividends)

average common equity

Where:
Average common equity = (previously reported common equity + current common equity) / 2

3. Return on Total Equity (ROE)

This is a more general form of ROCE and includes preferred stockholders.

Formula 7.23
Return on total equity = net income/average total equity

Where:
Average common equity = (previously reported total stockholders' equity + current total
stockholders' equity) / 2

4. Return on Total Capital (ROTC)

Total capital is defined as total stockholder liability and equity. Interest expense is defined as the total interest
expense excluding any interest income. This ratio measures the total return the company generates from all
sources of financing.

Formula 7.24
Return on total capital = (net income + interest expense) / average total capital

7.5 - Operating Efficiency Ratios

OPERATING EFFICIENCY RATIOS

1. Total Asset Turnover

This ratio measures a company's ability to generate sales given
its investment in total assets. A ratio of 3 will mean that for
every dollar invested in total assets, the company will generate 3
dollars in revenues. Capital-intensive businesses will have a lower total asset turnover than non-capital-
intensive businesses.

Formula 7.25
Total asset turnover = net sales / average total assets

2. Fixed-Asset Turnover
This ratio is similar to total asset turnover; the difference is that only fixed assets are taken into account.

Formula 7.26

Fixed-asset turnover = net sales / average net fixed assets

3.Equity Turnover
This ratio measures a company's ability to generate sales given its investment in total equity (common
shareholders and preferred stockholders). A ratio of 3 will mean that for every dollar invested in total equity, the
company will generate 3 dollars in revenues.

Formula 7.27
Equity turnover = net sales / average total equity

7.6 - Business Risk Ratios

Business Risk – This is risk related a company's
income variance. There is a simple method and more
complex method:

Simple Method
The following four ratios represent the simple method
of business risk calculations. Business risk is the risk
of a company making less money, or worse, losing
money if sales decrease. In the declining-sales
environment, a company would lose money mainly
because of its fixed costs. If a company only incurred
variable costs, it would never have negative earnings.
Unfortunately, all businesses have a component of
fixed costs. Understanding a company's fixed-cost
structure is crucial in the determination of its business
risk. One of the main ratios used to evaluate business
risk is the contribution margin ratio.

1.Contribution Margin Ratio

This ratio indicates the incremental profit resulting
from a given dollar change of sales. If a company's
contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits.

Formula 7.28

Contribution margin ratio = contribution / sales

= 1-(variable cost / sales)

2.Operation Leverage Effect (OLE)

The operating leverage ratio is used to estimate the percentage change in income and return on assets for a
given percentage change in sales volume. Return on sales is the same as return on assets.

If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are
variable, so a 10% increase in sales will increase the company's ROA by 10%.

Formula 7.29

Operation leverage effect = contribution margin ratio

return on sales (ROS)

ROS = Percentage change in income (ROA) = OLE * % change in sales

3.Financial Leverage Effect (FLE)

Companies that use debt to finance their operations, thus creating a financial leverage effect and increasing the
return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is
used to quantify the effect of leverage within a company.

It is defined as:
Formula 7.30

Financial leverage effect = operating income / net income

If a company has an FLE of 1.33, an increase of 50% in operating income would result in a 67% shift in net
income.

4.Total Leverage Effect (TLE)

By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as:

Formula 7.31

Total leverage effect = OLE * FLE

In our previous example, sales increased by $50,000, the OLE was 20% and FLE was 1.33. The total leverage
effect would be $13,333, i.e. net income would increase by $13,333 for every $50,000 in increased sales.

Complex Method
Business risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time.
A more structured approach is to use some statistics. One common method is to gather a date set that's large
enough (five to 10 years) to calculate the coefficient of variation.

With this approach:

- Business risk = standard deviation of operating income / mean of operating income
- Sales variability = standard deviation of sales / sales mean
- Another source of variability of operating income is the difference between fixed and variable cost. This is
referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if
revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1.

Look Out!
Note that it is unlikely that the exam will ask you to calculate any ratios
relating to business risk that utilize statistics.

7.7 - Financial Risk Ratios

FINANCIAL RISK RATIOS

Financial Risk – This is risk related to the company's

financial structure.

Analysis of a Company's Use of Debt

1.Debt to Total Capital

This measures the proportion of debt used given the
total capital structure of the company. A large debt-to-
capital ratio indicates that equity holders are making
extensive use of debt, making the overall business
riskier.

Formula 7.32

Debt to capital = total debt / total capital

Where:
Total debt = current + long-term debt
Total capital = total debt + stockholders' equity

2. Debt to Equity
This ratio is similar to debt to capital.
Formula 7.33

Debt to equity = total debt / total equity

Analysis of the Interest Coverage Ratio

3. Times Interest Earned (Interest Coverage ratio)

This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings
available for interest covers required interest payments.
 Formula 7.34

Times interest earned = earnings before interest and tax

interest expense

4.Fixed-Charge Coverage
Fixed charges are defined as contractual committed periodic interest and principal payments on leases and debt.

Formula 7.35

Fixed-charge coverage = earnings before fixed charges and taxes

fixed charges

5.Times Interest Earned - Cash Basis

Adjusted operating cash flow is defined as cash flow from operations + fixed charges + tax payments.

Formula 7.36

Times interest earned - cash basis = adjusted operating cash flow

interest expense

6.Fixed-Charge Coverage Ratio – Cash Basis

Formula 7.37

Fixed charge coverage ratio – cash basis = adjusted operating cash flow/fixed charges

7.Capital Expenditure Ratio

Provides information on how much of the cash generated from operations will be left after payment of capital
expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times
what it will need to reinvest in the business to keep operations going; the excess could be allocated to service
the debt.

Formula 7.38

Capital expenditure ratio = cash flow from operations

capital expenditures

8. CFO to Debt
Provides information on how much cash the company generates from operations that could be used to pay off
the total debt. Total debt includes all interest-bearing debt, short and long term.
Formula 7.39

CFO to debt = cash flow from operations / total debt

7.8 - Growth Potential Ratios

1. Sustainable Growth Rate

Formula 7.40
 G = RR * ROE

Where:
RR = retention rate = % of total net income reinvested in the company
or, RR = 1 – (dividend declared / net income)
ROE = return on equity = net income / total equity

Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested
in the company and the remaining 20% is distributed in the form of cash dividends.

Therefore, Dividend Payout = Dividend Declared/Net Income

Look Out!
Students sometimes confuse retention rate with actual dividend declared.
Students should read questions diligently.

Let's consider an example:

7.9 - Return on Equity and the Dupont System

DuPont System
A system of analysis has been developed that focuses the attention on all three critical elements of the financial
condition of a company: the operating management, management of assets and the capital structure. This
analysis technique is called the "DuPont Formula". The DuPont
Formula shows the interrelationship between key financial
ratios. It can be presented in several ways.

The first is:

Formula 7.41

Return on equity (ROE) = net income / total equity

If we multiply ROE by sales, we get:

Return on equity = (net income / sales) * (sales / total equity)

Said differently:
ROE = net profit margin * return on equity
The second is:
Formula 7.42

Return on equity (ROE) = net income / total equity

If in a second instance we multiply ROE by assets, we get:

ROE = (net income / sales) * (sales / assets) * (assets / equity)

Said differently:
ROE = net profit margin * asset turnover * equity multiplier

Uses of the DuPont Equation

By using the DuPont equation, an analyst can easily determine what processes the company does well and what
processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of
the firm.

All firms should attempt to make ROE as high as possible over the long term. However, analysts should be
aware that ROE can be high for the wrong reasons. For example, when ROE is high because the equity
multiplier is high, this means that high returns are really coming from overuse of debt, which can spell trouble.

If two companies have the same ROE, but the first is well managed (high net-profit margin) and managed assets
efficiently (high asset turnover) but has a low equity multiplier compared to the other company, then an investor
is better off investing in the first company, because the capital structure can be changed easily (increase use of
debt), but changing management is difficult.

More Useful Dupont Formula Manipulations

The DuPont formula can be expanded even further, thus giving the analyst more information.

Formula 7.43

ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a third instance we substituted net income for EBT * (1-tax rate), we get:

ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax rate)

Formula 7.44

ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a forth instance we substituted EBT for EBIT - interest expense, we get:

ROE = [EBIT / sales * sales / total assets – interest / total assets] * total assets / equity * [1 – tax /
net before tax]

Said differently:

ROE = operating profit margin * asset turnover – interest expense rate * equity multiplier * tax
retention

7.10 - Uses and Limitations of Financial Ratios

Benchmarking Financial Ratios
Financial ratios are not very useful on a stand-alone
basis; they must be benchmarked against something.
Analysts compare ratios against the following:

1.The Industry norm – This is the most common

type of comparison. Analysts will typically look for
companies within the same industry and develop an
industry average, which they will compare to the
company they are evaluating. Ratios per industry are
also provided by Bloomberg and the S&P. These are
good sources of general industry information.
Unfortunately, there are several companies included in
an index that can distort certain ratios. If we look at
the food and beverage ratio index, it will include
companies that make prepared foods and some that are
distributors. The ratios in this case would be distorted
because one is a capital-intensive business and the
other is not. As a result, it is better to use a cross-
sectional analysis, i.e. individually select the
companies that best fit the company being analyzed.

2.Aggregate economy - It is sometimes important to

analyze a company's ratio over a full economic cycle.
This will help the analyst understand and estimate a
company's performance in changing economic
conditions, such as a recession.

3.The company's past performance – This is a very common analysis. It is similar to a time-series analysis,
which looks mostly for trends in ratios.

Limitations of Financial Ratios

There are some important limitations of financial ratios that analysts should be conscious of:

• Many large firms operate different divisions in different industries. For these companies it is difficult to
find a meaningful set of industry-average ratios.
• Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected.
Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages
must be interpreted with judgment.
• Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can
reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in
preparation for the back-to-school season. As a result, the company's accounts payable will be high and
its ROA low.
• Different accounting practices can distort comparisons even within the same company (leasing versus
buying equipment, LIFO versus FIFO, etc.).
• It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically
classified growth company may be interpreted as a good sign, but could also be seen as a sign that the
company is no longer a growth company and should command lower valuations.
• A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak
company.
In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used
intelligently, ratio analysis can provide insightful information.

7.11 - Basic Earnings Per Share

I. Introduction

Simple and Complex Capital Structures

A simple capital structure is one that contains no potential dilutive securities. A company with a simple
structure will have only common stockholders, preferred stockholders and nonconvertible debt.

Companies with simple capital structures only need to report basic EPS.

A complex structure refers to one that contains potential dilutive securities. A company with a complex
structure in addition to what is included in a company’s simple capital structure will also include warrants
and/or options and/or convertible debt instruments.

- Companies that have a complex capital structure must report

earnings per share (EPS) on a basic and fully diluted basis.

EPS is simply the net income that is attributable to common

shareholders divided by the number of shares outstanding. If a company has a complex capital structure, it
means that a portion of their dilutive securities may be converted to equity at some point in time. Since EPS
basic does not take into account these dilutive securities, EPS basic will always be greater than EPS fully
diluted.

Basic Earnings Per Share (EPS)

EPS basic does not consider potential dilutive securities. A company with a simple capital structure will
calculate only a basic EPS, which is defined as:

Formula 7.45

Basic EPS = (net income – preferred dividends)_____

weighted average number of shares outstanding

Since we are interested only in the net income that belongs to common stockholders, preferred dividends are
subtracted. Dividends, whether paid in cash or stock, or the additional dividend that is attributable to
participating preferred shares must also be deducted.

Note:

- Dividends declared to common stockholders are not subtracted from ESP as they belong to common
stockholders.
- Preferred stock dividends are the current year's dividend only.
(a) If none are declared, then calculate an amount equal to what the current dividend would have been.
(b) Don't include dividends in arrears.
(c) If a net loss occurs, add the preferred dividend.
- EPS is calculated for each component of income: income from continuing operations, income before
extraordinary items or changes in accounting principle, and net income.

Calculating the Weighted Average Number of Shares Outstanding

The weighted average number of shares outstanding (WASO) is:

Formula 7.46
The # of shares outstanding during each month, weighted by the # of months those
shares were outstanding.

Included are the impacts of all stock dividends and stock splits effective during the period and those announced
after the end of the reporting period but before the financial statements are issued. Furthermore, all prior periods
must be restated to facilitate comparative analysis.

7.12 - Dilutive Effect of Splits and Dividends

Since in the Financial Statements section we described stock dividends and splits, here we will focus on their
effects by considering an example.

Example 1: Cash Dividend

In 2004, Company ABC generated a net income of $12 million
and paid a dividend of $1 million to preferred stockholders.

Other information:

The first step is to average out the number of months the shares were outstanding:

Answer: Basic EPS = $12 million – $1 million / 3.8 million = $2.89

Example 2: Stock Splits and Dividends

Stock splits and dividends are applied to all shares issued prior to the split and to the weighted average number
of shares at the beginning of the period. In other words, if in this quarter a company declares a 2-to-1 stock split,
then double the number of outstanding shares of prior months.

Furthermore, if the company declares in Q3 a stock dividend of 10%, then increase the number of shares
outstanding by 10% of prior months. Shares that are repurchased from treasury after the stock split and
dividends should not be adjusted.

Other information:
The first step is to account for the stock dividend in Q3:

The second step is average out the number of month the shares were outstanding:

Answer: Basic EPS = $12m –$1m/ 4.28m = $2.57

7.13 - Dilutive Securities

Dilutive Securities are securities that are not common stock in form, but allow the owner to obtain common
stock upon exercise of an option or a conversion privilege. The most common examples of dilutive securities
are: stock options, warrants, convertible debt and convertible preferred stock. These securities would decrease
EPS if exercised or if they were converted common stock. In other words, a dilutive security is any securities
that could increase the weighted number of shares outstanding.

If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-
dilutive security, and it should be excluded from the computation of the dilutive EPS.

For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value,
yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common
stock. The tax rate is 30%. XYZ’s weighted average number of shares, used to compute basic EPS, is 10,000.
XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.

What is the basic EPS? What is the diluted EPS?

1) Compute basic EPS:

i. Basic EPS = (12,000 – 2,000) / (10,000) = $1.00

2) Compute diluted EPS:

i. Find the adjustment to the denominator: 100 * 50 = 5,000
ii. Find the adjustment to the numerator: 100 * $1000 * 0.1 * (1 - 0.3) = $7,000

3) Find diluted EPS:

i. Diluted EPS = (12,000 – 2,000 + 7,000) / 10,000 + 5,000 = $1.13

If Basic EPS > the fully diluted ESP, then the security is anti-dilutive. In this case, Basic EPS = $1.00 is less
than the fully diluted ESP, and the security is not anti-dilutive.
7.14 - Calculating Basic and Fully Diluted EPS in a Complex Capital Structure
There are some basic rules for calculating basic and fully diluted ESP in a complex capital structure. The basic
ESP is calculated in the same fashion as it is in a simple capital structure.

Basic and fully diluted EPS are calculated for each component of income: income from continuing operations,
income before extraordinary items or changes in accounting principle, and net income.

To calculate fully diluted EPS:

Diluted EPS = [(net income – preferred dividend) / weighted average number of shares outstanding - impact of
convertible securities - impact of options, warrants and other dilutive securities]

Other form:
(net income – preferred dividends) + convertible preferred dividend + (convertible debt interest * (1-t))

Divided by

weighted average shares + shares from conversion of convertible preferred shares + shares from conversion of
convertible debt + shares issuable from stock options.

To understand this complex calculation we will look at

each possibility:

If the company has convertible bonds, use the if-

converted method:

1.Treat conversion as occurring at the beginning of the

year or at issuance date, if it occurred during the year
(additive to denominator).
2.Eliminate related interest expense, net of tax (additive
to numerator).

If the company has convertible preferred stock, use

the if-converted method:

1. Eliminate preferred dividend from numerator (decrease numerator).

2. Treat conversion as occurring at the beginning of the year or at issuance date, if it occurred during the year
(additive to denominator). Furthermore, use the most advantageous conversion rate available to the holder of
the security.

Options and warrants use the treasury-stock method:

1.Assume that exercise occurred at the beginning of the year or issue date, if it occurs during the year.
2.Assume that proceeds are used to purchase common stock for treasury stock.
3.If exercise price < market price of stock, dilution occurs.
4.If exercise price > market price, securities are anti-dilative and can be ignored in the diluted EPS calculation.

Example:

Company ABC has:

- Net income of $2m and 2m weighted average number of shares outstanding for the accounting period.
- Bonds convertible to common stock worth $50,000: 50 at $1,000, with an interest of 12%. They are
convertible to 1,000 shares of common stock.
- A total of 1,000 convertible preferred stock paying a dividend of 10% and convertible to 2,000 shares of
common stock, with a par of $100 per preferred stock.
- A total of 2,000 stock options outstanding, 1,000 of which were issued with an exercise price of $10 and the
other 1,000 of which have an exercise price of $50. Each stock option is convertible to
10 common stocks.
- A tax rate of 40%.
- Stock whose average trading price is $20 per share.

Calculate the fully diluted EPS

1.Convertible debt

Assume conversion:

If the debt is converted, the company would have to issue an additional 50,000 (50*1,000) common stock. As a
result the WASO would increase to 2,050,000.

Since the debt would be converted, no interest would have to be paid. Interest was $6,000 per annum. The
interest expense would flow through to common stockholders but not before the IRS get a portion of it. So net
of taxes the company would have generated an additional $3,600 [(6,000*(1-40%)] in net income.

Adjusted WASO: 2,050,000

Adjusted net income: $2,003,600

2.Convertible preferred stock

Assume conversion:

If the stock is converted the company would have to issue an additional 2,000 shares of common stock. As a
result the WASO would increase to 2,052,000.

Since the preferred dividend would no longer be issued the company would not have to pay $1,000 dividends
(100*1,000*10%). Since dividends are not tax deductible, there are no tax implications. So the company would
have generated an additional $1,000 in net income attributable to common stockholders.

Adjusted WASO: 2,050,000

Adjusted net income: $2,003,600
Preferred dividend is reduced to zero

3.Stock options

If-converted method:

Say there are 1,000 stock options in the money (exercise price < market price of stock). The holders of the stock
option can convert their options into stock for a profit at any point and time.

Say 1,000 stock options are out of the money (exercise price > market price of stock). The holders of the stock
option would not convert their options, because it would be cheaper to purchase the stock on the open market.

The out-of-the-money option can be ignored. The in-the-money options need to be accounted for.
Here is how in-the-money options are accounted for:

1)Calculate the amount raised through the exercise of options:

1000 * 10 *$10 = $100,000

2)Calculate the number of the common shares that can be repurchased using the amount raised through the
exercise of options (found in step #1):

$100,000 / 20 = 5,000

3)Calculate number of common shares created by the exercise of the stock options:

1000 * 10 = 10,000

4)Find the net number by which the number of new common shares, created as result of the stock options
exercised (found in step #3), exceed the number of common shares repurchased at the market price with
proceeds received from the exercise of the options (found in step #2):

10,000 – 5,000 = 5,000

5) Find the total number of shares if the stock options are exercised: add weighted average number of shares to
what you found in step #4:

2,052,000 + 5,000 = 2,057,000

Fully diluted EPS= 2,000,000 + 3,600 - 6,000 + 6,000 = 2,003,600 = 0.974

2,000,000 +50,000 + 2,000 +5,000 2,057,000

Presentation and disclosure

Simple capital structure

a. Basic EPS is presented for income from continuing operations, income before extraordinary items or change
in accounting principle, and net income.
b. Reported for all accounting periods presented
c. Prior-period EPS is restated for any prior-period adjustments.
d. Footnotes are required for stock splits and stock dividends.

Complex capital structure

a. Basic and fully diluted EPS are presented for income from continuing operations, income before
extraordinary items or change in accounting principle, and net income.
b. Reported for all accounting periods presented
c. Prior-period EPS is restated for any prior-period adjustments.
d. Footnotes are required for diluted EPS.