UNDERSTANDING INCOME

STATEMENTS
Part 2

BINUS FINANCIAL ANALYST ACADEMY

CFA Preparation Program Level 1 Batch 24

2013 CFA Level 1 Financial Statement Analysis 4

Introduction
The amount of income a company earns for
every share of common stock it has outstanding,
or Earning per Share (EPS), is the standard for
reporting company earnings
EPS is the most commonly used corporate
performance statistic for publicly traded firms.

Overview
Before calculating EPS you need to understand
the following terms:
Dilutive securities are potentially ordinary
shares (stock options, warrants, convertible
debt or convertible preferred stock) that
decreases EPS if they are exercised or
converted to common stock
Antidilutive securities would increase EPS if
exercised or converted to common stock
LOS: define and distinguish between dilutive and antidilutive securities
and discuss the implications of each of the earnings per share calculation

Simple v Complex
Capital Structure
A simple capital structure is one that contains no
potentially dilutive securities. A simple capital
structure contains only common stock and NONconvertible senior securities
A complex capital structure contains potentially
dilutive securities such as options, warrants or
convertible securities
LOS: describe the components of earnings per share and calculate a
companys earnings per share (both basic and diluted earnings per
share) for both a simple and complex capital structure.

Simple v Complex
Capital Structure

Complex

Simple

Basic EPS

Basic EPS

Diluted EPS

Basic EPS
All firms with complex capital structures must report
two EPS figures: basic and diluted
Firms with simple capital structure report basic EPS
Basic EPS does not consider the effect of any dilutive
securities
EPS refers to earning available to common shareholders
Basic EPS =
Net Income - Preferred Dividends
Weighted Average Number of Common Shares Outstanding

Weighted Average No of Shares

Is the number of shares outstanding during the year
weighted by the portion of the year they were outstanding
Example: Johnson Co has net income of $10,000, $1,000
cash dividends paid to preferred and $1,750 paid to common.
At the beginning of the year there were 10,000 shares
outstanding, 2,000 new shares were issued on July 1.
What is Johnsons Basic EPS?
Weighted average shares: (10,000x12)+ (2,000x6) /12
= 11,000
Basic EPS = (10,000 - 1,000)/11,000 = $0.82

Stock Dividends and Stock Splits

The effect of stock dividends and splits is applied retroactively
to the
beginning of the year and is not weighted by the portion of the
year
after the stock dividend or split occurred.
Example: During 2008, ABC had net income of $100,000 and
paid dividends of $50,000 to its preferred stockholders and
$30,000 to its common shareholders. The common stock
account showed the following:
1/1/08: Shares issued & outstanding at beg of the year
10,000
4/1/08:

Shares

4,000
7/1/08: 10% stock dividend
9/1/09:
Shares
repurchased

issued

for

the

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treasury

Stock Dividends and Stock Splits (2)

Answer:
1/1/08:
4/1/08:
7/1/08:
9/1/08:

Initial shares adjusted for stock div

11,000
Shares issued adjusted for stock div
4,400
10% stock dividends
[Applied above]
Shares of treasury stock repurchased -3,000

Weighted average number of post stock dividend

shares:
= [(11,000 x 12) + (4,400 x 9) - (3,000 x 4)] / 12
= 13,300
Basic EPS = (100,000 - 50,000)/13,300 = $3.76

Things to know about the weighted

average shares outstanding
The weighting system is days outstanding divided by the
number of the days in year
Shares issued enter into the computation from the date
of
issuance
Previously reported EPS data is restated to reflect stock
split and
stock dividends (remember: they are not time sensitive)
Shares sold and issued in a purchase of assets are
included from
the date of issuance (time sensitive!!!)

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Diluted Earnings Per Share

Computation of diluted EPS is consistent with basic EPS,
while giving effect to all dilutive potential ordinary
shares outstanding during the period
Examples of potential ordinary shares:
Debt equity instruments, including preference shares
convertible into ordinary shares
Share warrants and options
Employee plans that allow employees to receive
ordinary shares as part of their remuneration and other
share purchase plans
Any securities that may increase the number of
common shares may be potentially dilutive securities.

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Diluted EPS - Formula

Diluted EPS =

Adjusted income available for common shares

Weighted average common & potential common shares outstanding

Diluted =
EPS

Convertible preConvertible (1 - t)
Net
Preferred
+
+
Income
dividends ferred stock dividend debt interest
Weighted
Shares from
Shares from
Shares issuable
+
+
+
average shares
conversion of
conversion of
from stock
convertible P/S
convertible
options
debt

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Diluted EPS
The numerator of dilutive EPS:
If there are dilutive securities that will cause the
weighted
average common shares to change then the
numerator must be
Adjusted
Preferred dividends on convertible preferred shares are
added
back to numerator
Interest expense and other related adjustments (net of
tax effect)
on convertible debt are added back to numerator
Convertible securities are weighted for the period they
would be
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outstanding

Diluted EPS (2)

The denominator of dilutive EPS:
basic EPS denominator adjusted for the
equivalent
number of common shares created by the
conversion of all
outstanding dilutive securities
Adjusted for the weighted average number of
ordinary
shares which would be issued assuming conversion
of all
dilutive potential ordinary shares
Conversion is assumed at the beginning of the
period (or at
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Options and Warrants

Dilutive stock options increase the number of common
shares
outstanding in the denominator for diluted EPS.
Options and warrants are dilutive only if the exercise
price is less
than average market price.
Assume exercise of dilutive options
Exercise assumed at the beginning of the period (or at
time of
issuance, if later).
Warrants also like stock options;
Conclusion: Warrants and options are potentially dilutive.
The
inclusion of warrants and options into the diluted EPS
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calculation

EPS with convertible debt

Example: In 2008, ZZZ has net income of $11,560 & 2,000
shares of
common stock outstanding 1,000 shares of 10%, $100 par
preferred
stock outstanding issued 60, $1,000 par, 8% bonds for $60,000
and each
of them is convertible to 100 shares of common stock. Tax rate
is 40%.
What is ZZZ Diluted EPS?
Basic
EPS
= (11,56010,000)/2,000
= $0.78
Diluted
EPS
= (11,56010,000+2,880)/(2,000+6,000)
=
Shares
$0.56 issuable for debt conversion: (60)(100) = 6,000 shares
Increase
in income
= (60)(1,000)(0.08)
(1-.04)
= $2,880
MAKE SURE
diluted
EPS < basic
EPS;
if no:
antidilutive

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EPS with stock options

Key word: Treasury method

Under this method, we assume that the proceeds from
the exercise of stock options are used to buy the stock
(to be given to option holder) from the market at the
average price
This reduces the total number of common stock to be
issued to option holders
Net increase of common stock will be the total number
of shares created by the exercise of options LESS the
number of shares repurchased

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EPS with stock options

Example: In 2008, ZZZ has net income of $11,560 & 20,000 shares
of common
Stock outstanding 100 shares of 10%, $100 par preferred stock
outstanding
1,000 stock options (or warrants) outstanding the entire year. Each
option can
be exercised allowing the holder to purchase 1 shares of common
stock at
$15 a share. The average market price is $20. What is ZZZ Diluted
EPS?
No of common shares created if options are exercised
1,000
Diluted
Cash
inflowEPS = (11,560- 1000) / (20,000+250) = $0.52
$15,000
No of shares can be purchased
750
Increase in common shares outstanding
250

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Tips in calculating Fully Diluted EPS with

several potentially dilutive securities

Key word: Antidilutive securities are not considered

Test each of the potentially dilutive securities (options,
warrant etc) individually, one by one (in isolation with
other securities)
For example, PT K has convertible debt, options and
warrants. From testing of each of these securities, the
warrants and options are dilutive securities, but the
convertible debt is antidilutive.
In the final calculation, combine the effect of options
and warrant to compute the fully diluted securities
See problem 3
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Comprehensive Income
is the change in a companys equity from
sources other than owners during a period
Includes
Net income + changes in:
Unrealized gains and losses (available-for-sale
investments)
Minimum pension liability adjustments
Cumulative translation adjustments arising from foreign
subsidiary consolidation)
Unrealized gains or losses on derivatives contracts
accounted for as hedges.

FASB has taken position that income for a period

should be all-inclusive, comprehensive income
May be reported on income statement or
separate statement, but usually reported on
statement of stockholders equity

Problem 1: Weighted average shares

Jan 04: 5 million of common shares
Feb 04: issue another 3 million for IPO purposes
May 04: stock dividend 10%
August 04: rights issue, issue another 5 million of
shares
November 04: stock split 1:2 (1 old shares will be
exchanged with 2 new shares)
December 04: repurchase shares 2 million
Calculate the weighted average shares outstanding
Assuming net income is US$20 million, calculate
EPS
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Problem 2: EPS with convertible debt

and/or convertible P/S
Net income is US$20 million
10 million common shares
10%, US$10 par, 1,000,000 non convertible
preferred shares
6%, convertible debt of US$25,000,000, convertible
into 2.5 million of common shares, outstanding for
entire year
Tax rate is 40%
Calculate basic and diluted EPS

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Problem 3: EPS with convertible debt

and/or convertible P/S
Net income is US$20 million
10 million common shares
10%, US$10 par, 1,000,000 convertible preferred
shares into 1
million shares
10%, convertible debt of US$25,000,000, convertible
into 0.5
million of common shares, outstanding for entire year
Tax rate is 40%
Calculate basic and diluted EPS

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Problem 3b: EPS with convertible debt

and/or convertible P/S
Net income is US$20 million
10 million common shares
10%, US$10 par, 1,000,000 convertible preferred shares
into 1 million
shares
10%, convertible debt of US$25,000,000, convertible into 5
million of
common shares, outstanding for entire year
Tax rate is 40%
Calculate basic and diluted EPS

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Problem 4: EPS with Options and

Warrants
In 2005, ZZZ has
net income of $100,000 & 50,000 shares of common stock
outstanding.
ZZZ issued 10,000 stock options outstanding the entire year.
Each option can be exercised allowing the holder to purchase
1 share of common stock at $25 a share.
7,500 warrants are also outstanding. Each warrants may be
converted into 1 common shares at US$15
The average market price is $20
What is ZZZ basic and Diluted EPS?

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