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

I. 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

Where:
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 interest, tax, depreciation and amortization
net sales

4. Pre-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
Financial Ratios - Return on Investment Ratios

II. Return on Investment

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
Financial 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
Financial Ratios - Business Risk Ratios

Business Risk - This is risk related a company's income variance. There is a

simple method and more complex method:

I. 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)

Where:
ROS = Percentage change in income (ROA) = OLE x % 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.

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 x 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.

II. 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.
Financial Ratios - Financial Risk Ratios

Financial Risk - This is risk related to the company's financial structure.

I. 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

II. 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
Financial Ratios - 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:

Segment Analysis

Segment analysis requires conducting ratio analysis on any operating segment

that accounts for more than 10% of a company's revenues or total assets, or
that is easily distinguishable from the other company business in terms of
products provided or the risk/return profile of the segment. Lines of business
are often broken down into geographical segments, when the size or type of
business differentiates them from other business lines.
Since many segments have different risk profiles, they should be analyzed and
valued separately from other parts of the business. Conducting ratio analysis,
specifically profit margins, return on assets and other profitability measures can
give analysts insight into how the segment affects overall financial performance.
Both U.S. GAAP and IFRS require companies to report specific segment data,
which is only a subset of the overall reporting requirements.

Ratio Analysis

Ratio analysis can be used to estimate future performance and allows analysts
to create pro forma financial statements. Here is one example of how to
estimate the future earnings potential of a firm. An analyst can first create a
common-size income statement by dividing all accounting items by total sales.
Using forecast assumptions the analyst then determines the amount of future
sales. By multiplying the common-size percentages by the new sales amount,
the analyst prepares a pro forma income statement that estimates the future
earnings potential based on the expectations of future sales.
By using a range of values from the common-size statement and using a range
of values for sales, the analyst can conduct a sensitivity analysis for each of the
accounting items, such as cost of goods sold (COGS), profit margin and net
income, to see how sensitive they are to changes in the amount of sales.

By understanding how each of these items correlate to the changes in sales, an

analyst can create a function that provides output for these measures for any
potential sales amount in the future. Using this function an analyst can conduct
scenario analysis by choosing assumptions for different market situations and
create for example a base case, upside and downside scenario.

Scenario analysis gives analysts an idea of the risks involved in operating a firm
under different economic situations. To create an even more detailed probability
distribution of potential values and risk, some analysts will conduct simulations
that use a computer to produce many potential scenarios

Financial Ratios - 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
Financial Ratios - 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.

Financial Ratios - 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.

Financial Ratios - 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

Financial Ratios - 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 the fully dilused EPS > basic EPS, then the security is
antidilutive. In this case, Basic EPS = $1.00 is less than the fully diluted
ESP, and the security is antidilutive.

Financial Ratios - 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.