A2 - 1

Foundation of Ratio and Financial
Analysis
4
Chapter
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Chapter Objectives
• Examine the purpose and use of ratios and provide some
cautionary notes.
• Explain the use of common-size statement.
• Discuss the construction and use of:
 Short term and long term activity (turnover) ratios
that measure the efficiency with which the firm uses its
resources.
 Liquidity ratios, including working capital ratios, the
cash cycle and the defensive interval that assess the firm’s
ability to meet its near term obligations.
 Solvency ratios that examine capital structure and the
firm’s ability to meet long term obligations and capital
needs.

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 Profitability ratios that measure income relative to revenues
and invested capital.
• Define and compute measures of operating and financial leverage.
• Show how the integrated analysis of ratios can be used to evaluate
corporate performance.
• Relate ratios to corporate strategy and the product life cycle.
• Examine the computation and usefulness of earnings per share
and other ratios used for valuation purposes


Chapter Objectives, cont.
A2 - 4
Financial ratios are used to compare the risk and return of different
firms in order to help equity investors and creditors make intelligent
investment and credit decisions.

Ratios can also provide a profile of a firm, its economic
characteristics and competitive strategies and its unique operating ,
financial and investment characteristic.

Purpose and Use of Ratio Analysis

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Four ratio categories measure the risk and return relationships:
1. Activity Analysis: Evaluates revenue and output generated by the
firm’s assets.
2. Liquidity Analysis: Measures the ability to meet the near-term
obligations. Ability to convert into cash.
3. Long-Term Debt and Solvency Analysis: Examine the capital
structure, including the mix of its financing sources and the
ability of the firm to satisfy its long-term debt and investment
obligations.
4. Profitability Ratios: Measures the income of the firm relative to
its revenues and invested capital.


Purpose and Use of Ratio Analysis, cont.

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Ratio Analysis : Cautionary Notes
Ratio computation and comparisons are further compounded by
the lack or inappropriate use of benchmarks, the timing of
transactions, negative numbers, and differences in reporting
methods.

Economic Assumptions:
Ratio analysis is designed to facilitate comparisons by eliminating
size differences across firms and over time. Implicit assumptions
in this process is the proportionality assumption that the
relationship between numerator and denominator doesn't depend
on size. This assumption ignores the existence of fixed costs.

A2 - 7
Benchmarks:
Ratio analysis often lacks appropriate benchmarks to indicate
optimal levels. The evaluation of a ratio depends on the point of view
of the analyst. For example, for a short-term lender, a high liquidity
ratio may be a positive indicator. However, from the perspective of
an equity investor, it may indicate poor cash or working capital
management.
One relevant bench marks is the industry norms. Using an industry
average as the benchmark may be useful for comparisons within an
industry, but not for comparisons between companies in different
industries.
Ratio Analysis : Cautionary Notes, cont.
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Timing and Window Dressing:
Data used to compute ratios are available only at specific points in
time when financial statements are issued. As a result, especially in
the case of seasonal business ratios may not reflect normal
operating relationships. For example, inventories and accounts
payable may be understated.

The timing issue leads to another problem. Transactions at year end
can lead to manipulation of the ratios to show the firm in a more
favorable light, often called window dressing.
Ratio Analysis : Cautionary Notes, cont.
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Negative Numbers:
Ratio analysis without reference to the underlying data can lead to
wrong conclusions as it appears that both companies earn identical
returns on their investment. Because much financial and ratio
analysis today is computer generated, the existence of negative
numbers will be overlooked unless the program is well written.

Accounting Method:
Reported financial statement amounts can be affected by the choice
of accounting methods. Thus, ratios are not comparable between
firms with different accounting methods or for the same firm over
time when it changes its accounting methods. For eliminating such
problem it is necessary to convert all companies report into one
method.
Ratio Analysis : Cautionary Notes, cont.
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Common-Size Statements:
Common-size statements are used to standardize financial statement
components by expressing them as a percentage of a relevant base.

Balance sheet components can be shown as a percentage of total
assets. Income statement components (revenues, and expenses) can
be computed as a percentage of total sales, and in the direct method
cash flow statement, the component of cash flow from operations
can be related to cash collection.

• Cross-Sectional Comparisons
• Industry Comparisons
• Comparisons Over Time
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Discussion of Ratios by Category:
Ratio Analysis:
The financial statement analysis in which the numerical relationship
between two financial figures of a financial statement is determined
is called ratio analysis. In financial statement analysis, a number of
ratios are commonly used in assessing the financial position and
operating performance of the firm.
The analyst’s primary focus should be the relationships indicated by
the ratios, not the details of their calculation.
• Activity Analysis
• Liquidity Analysis
• Long-Term Debt and Solvency Analysis
• Profitability Analysis
• Operating and Financial Leverage




A2 - 12
Discussion of Ratios by Category, cont.
Activity Analysis:
A firms operation activities require investments in both short-term
(inventory and AR) and long-term (property, plant, equipment) asset.

Activity ratios describe the relationship between the firm’s level of
operations (usually defined as sales) and the assets needed to sustain
operating activities.

The higher the ratio, the more efficient the firm’s operations. Fewer
assets are needed to support a given level of operations (sales).

Activity ratios can also be used to forecast a firm’s capital
requirements (both operating and long-term)
A2 - 13
Activity Analysis
Short-Term (Operating) Activity Ratios:

1. Inventory Turnover Ratio:
Measures the efficiency of the firm’s inventory management. A
higher ratio indicates that inventory does not remain in ware house
but turns over rapidly from the time of acquisition to sale.




This ratio is affected by the choice of accounting method.

inventory Average
Sold goods of Cost
ratio turnover Inventory =
A2 - 14
Activity Analysis, cont.
2. Average No, of Days Inventory in Stock:
This ratio can be used to calculate the average number of days
inventory is held until it is sold. As low as better it is.


turnover Inventory
stock in inventory days of no Average
365
. =
A2 - 15
Activity Analysis, cont.
3. Receivables Turnover Ratios:
Measures the effectiveness of the firm’s credit policy and also
indicate the level of investments in receivables needed to maintain
the firm’s sales level. Receivable turnover should be computed
using only trade receivables in the numerator in order to evaluate
operating performance.
ceivable Average
Sales
Tuerover ceivables
Re
Re =
A2 - 16
Activity Analysis, cont.
4. Average No, of Days Receivables Outstanding:
This ratio is used to evaluate the firm’s ability to collect its credit
sales in a timely manner.
It also called Days Sales Outstanding (DSO). DSO represents the
average length of time that the firm must wait after making a credit
sale before receiving cash – that is, its average collection period.
Turnover ceivables
ding Outs ceivables Days of no Average
Re
365
tan Re . =
A2 - 17
Activity Analysis, cont.
5. Accounts Payable Turnover:
The accounts payable turnover ratio shows the number of times that
accounts payable are paid throughout the year.

A falling turnover ratio is a sign that the company is taking longer
to pay off its suppliers, which could be a bad sign. A rising turnover
ratio means that the company is paying off suppliers at a faster rate,
which is good.

Payable Acconts
Purchase
Turnover Payable =
A2 - 18
Turnover Payables
ding Outs Payables Days of No Average
365
tan . =
6. Average No, of Days Payables Outstanding:
The average amount of time it takes a company to pay its accounts
payable. A company's accounts payable are short-term liabilities
resulting from purchases the company has made on credit.
Activity Analysis, cont.
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Activity Analysis, cont.
7. Working Capital Turnover:
Working capital turnover is a summery ratio that reflects the
amount of operating capital needed to maintain a given level of
sales. Only operating assets and liabilities should be used to
compute this measure. Short-term debt, marketable securities, and
excess cash should be excluded as they are not required for
operating activities.

Capital king AverageWor
Sales
nover CapitalTur Working =
A2 - 20
Activity Analysis, cont.
Long-Term (Investment) Activity Ratios:

1. Fixed Assets Turnover Ratio:
These ratios measure the efficiency of long term capital investment
to generate sales. It reflect the level of sales generated by
investments in productive capacity.
Assets Fixed
Sales
Turnover Asset Fixed =
A2 - 21
Activity Analysis, cont.
Long-Term (Investment) Activity Ratios:

2. Total Assets Turnover Ratio:
The total assets turnover indicates the efficiency with which the
firm uses its assets to generate sales. Generally the higher a firm’s
total assets turnover, the more efficiently its assets have been used.
assets Total
Sales
turnover asset Total =
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Some points to be Noted:
 Growing / New / Startup company: Initial turnover may be
low, as their level of operations is below their productive
capacity. As sales grow, however turnover will continually
improve until the limits of the firm’s initial capacity are
reached.
 Mature or Stable company: The mature firm’s turnover is
stable.
 Declining company: The turnover ratio is low as the sales
decreased by the time pass
 Two firms with similar capacity and efficiency may show
differing ratios. Because price was different when assets were
purchased.
Activity Analysis, cont.
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 The firm with older assets has higher turnover ratios, as
accumulated depreciation has reduced value of its assets. The firm
with new assets has lower turnover ratios.

 It is better to take gross fixed asset rather than net fixed assets.
The old machine might have high market value but after
depreciation it becomes low. Which may results in a higher
turnover ratio.

 Newer assets generally operate more efficiently due to improve
technology. However, due to inflation, newer assets may be more
expensive and thus decrease the turnover ratio.

 The method of acquisition and subsequent financial reporting
choices also affect turnover ratios for otherwise similar firms.

Activity Analysis, cont.
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Short-term lenders and creditors must assess the ability of a firm to
meet its current obligations. The ability depends on the cash resources
available as of the balance sheet date and the cash to be generated
through the operating cycle of the firm.
Length of Cash Cycle:
• Operating Cycle: No, of days inventory in stock + Days sales
outstanding.
• Cash Cycle: Operating cycle - No. of days payable outstanding
 The shorter the cycle, the more efficient the firm’s operations and
cash management.
 The longer cycles may be indicative of cash shortfalls and
increased financing costs.

Liquidity Analysis
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1. Current Ratio:
It measures the firm’s ability to meet its short term obligation.
Generally the higher the current ratio, the more liquid the firm is
considered to be. But this may be as a result of higher inventory,
which is bad for the company. The company may fail to sell its
goods.
s Liabilitie Current
Assets Current
Ratio Current =
Liquidity Analysis, cont.
A2 - 26
2. Quick Ratio:
A more conservative measure of liquidity is the quick ratio. It
actually measures the immediate short-term debt paying ability.

The included assets are called quick asset because they can be
quickly converted to cash. Inventory and prepaid expenses are
excluded.
If this ratio is much lower than current ratio, then the firm is facing
liquidity problem. It may have higher inventory that the firm can
not sell.

s Liabilitie Current
ceiables C A Sec Mar Cash
Ratio Quick
Re / . + +
=
Liquidity Analysis, cont.
A2 - 27
3. Cash Ratio:
This is the most conservative measure of liquidity. Only actual cash
and securities easily convertible to cash are used to measure cash
resources.

s Liabilitie Current
Securities Marketable Cash
Ratio Cash
+
=
Liquidity Analysis, cont.
A2 - 28
Liquidity Analysis, cont.
4. Cash Flow from Operation Ratio:
This ratio measures liquidity by comparing actual cash flows-
instead of current and potential cash resources, with current
liabilities. This ratio avoids the issues of actual convertibility of
cash turnover and the need for minimum levels of working capital
(cash) to maintain operation.
s Liabilitie Current
Operation from Flow Cash
Ratio eration FlowFromOp Cash =
A2 - 29
5. Defensive Interval:
It compares the currently available quick sources of cash with
estimated outflows needed to operate the firm’s projected
expenditure.

The defensive interval represents a worst-case scenario indicating
the number of days a firm could maintain the current level of
operations with its present cash resources but without considering
any additional revenues.

e Expenditur ojected
ceivable C A Sec Mar Cash
X
Interval Defensive
Pr
Re / .
365
+ +
=
Liquidity Analysis, cont.
A2 - 30
Long-Term Debt & Solvency Analysis
The analysis of a firm’s capital structure is essential to evaluate its
long-term risk and return prospect. Leveraged firms accrue excess
return to shareholder, when ROI is greater than the cost of debt.

The benefits of financial leverage bring additional risks, in the form
of fixed cost (interest on debt) may affect profitability if the
demand or profit margins decline.

The inability to meet those obligation may lead the company to
default and possible bankruptcy.
A2 - 31
Debt Covenants:
To protect themselves creditors often impose restrictions on the
borrowing company’s ability to incur additional debt and make
dividend payments.

It is, therefore important to monitor the firm to insure that ratios
comply with the level specified in the debt agreements.

Violation of debt covenants are frequently an event of default under
loan agreements, making the debt due immediately.
Long-Term Debt & Solvency Analysis, cont.
A2 - 32
Long-Term Debt & Solvency Analysis, cont.
Long-term debt and solvency analysis evaluates the level of risk
borne by a firm, changes over time, and risk relative to comparable
investments. A higher proportion of debt relative to equity increases
the riskiness of the firm.
Capital Total
Debt Total
Capital Total to Debt =
Equity Total
Debt Total
Equity to Debt =
A2 - 33
Use book value or market value to compute debt ratio:
Market value of debt and equity are generally used in valuation
model. Because they are available or can readily be estimated.

However, Use of market values may produce contradictory result.
The debt of a firm whose credit rating declines may have a market
value well below face amount.

A debt ratio based on market values may show an acceptable level
of leverage (which is bad). There have a chance to underestimate or
overestimate the firm.

Below ratio compares debt measured at book value to equity measured
at market: Total Debt at Book Value
Equity at Market Value
Long-Term Debt & Solvency Analysis, cont.
A2 - 34
3. Times Interest Earned:
This ratio measures the firm’s ability to meet interest payments
when they become due. Higher is good. If the debt-equity ratio is
higher then this ratio will be lower.

This ratio often referred to as the interest coverage ratio measures
the protection available to creditors as the extent to which earnings
available for interest cover interest expense.

Long-Term Debt & Solvency Analysis, cont.
Expense Interest
EBIT Taxes t foerInters EarningsBe
Earned Interest Times
) ( &
=
A2 - 35
4. Fixed Charge Coverage:
It is more comprehensive measurement, it includes all fixed
charges, like - contractually committed interest and principal
payment on lease as well as funded debt.

This one is better, because the previous one may give wrong result
(can be over estimated or underestimated).


Long-Term Debt & Solvency Analysis, cont.
es Ch Fixed
Taxes es h foerFixedC EarningsBe
Coverage e Ch Fixed
arg
& arg
arg =
A2 - 36
Capital Expenditure and CFO to Debt Ratio:

A firms long term solvency is a function of its ability to:
• Finance the replacement and expansion of its investment in
productive capacity, as well as
• Generate cash for debt repayment
Long-Term Debt & Solvency Analysis, cont.
A2 - 37
Long-Term Debt & Solvency Analysis, cont.
Capital Expenditure Ratio:
This ratio measures the relationship between the firm’s cash
generating ability and its investment expenditures. To the extent the
ratio exceeds 1, it indicates the firm has cash left for debt
repayment or dividends after capital expenditures.

e Expenditur Capital
CFO eration CashFromOp
Ratio e Expenditur Capital
) (
=
A2 - 38
Long-Term Debt & Solvency Analysis, cont.
Cash From Operation (CFO)-to-Debt Ratio:
This ratio measures the coverage of principal repayment
requirements by the current CFO. A low CFO-to-Debt ratio could
signal a long-term solvency problem, as the firm does not generate
cash internally to repay its debt.


Debt Total
CFO
Debt to CFO =
A2 - 39
Profitability Analysis
Equity investors are concerned with the firm’s ability to generate,
sustain and increase profit. Profitability can be measured in several
differing but interrelated dimensions. There is a relationship of a
firm’s profits to sales and also to the investment required to
generate them.
Return on Sales:
One measure of profitability is the relationship between the firm’s
costs and its sales.
1. Gross Profit Margin:
It shows the relationship between the sales and manufacturing or
merchandising cost. Higher ratio is better.


Sales
ofit Gross
in M Gross
Pr
arg =
A2 - 40
Profitability Analysis, Cont.
2. Operating Income:
It shows the firm’s profitability form the operations of its core
business. Excluding the effect of:
• Investment (income for affiliates or assets sales),
• Financing (interest expenses),
• Tax position.

Sales
ncome OperatingI
in M Operating = arg
A2 - 41
3. Profit Margin:
It shows that the firm is independent of both the financing and tax
positions.



4. Pretax Margin:
This ratio is calculated after financing cost (interest expenses) but
prior to income taxes.


Profitability Analysis, Cont.
Sales
EBIT
Tax terest inBeforeIn M = & arg
Sales
EBT oreTax EarningBef
in etaxM
) (
arg Pr =
A2 - 42
5. Net Profit Margin:
This ratio measures the percentage of each dollar remaining after all
costs and expenses, including interest, taxes, and preferred
dividends, have been deducted.





All five ratios can be computed directly from financial statement.

Profitability Analysis, Cont.
Sales
NetIncome
in ofitM Net = arg Pr
A2 - 43
Return On Investment (ROI):
Measures the income of the firm relative to its revenues (Profit) and
invested capital required to generate them.

1. Return On Assets (ROA):
ROA compares income with total assets. It can be interpreted in two
ways-
• It measures management’s ability and efficiency in using the
firm’s assets to generate (operating) profits.
• It reports the total return accruing to all providers of capital (debt
and equity) independent of the sources of capital.

Profitability Analysis, Cont.
alAssets AverageTot
terestCost AfterTexIn NetIncome
ROA
+
=
A2 - 44
2. Return on Total Capital:
Return on total capital uses the sum of external debt and equity
instead of total assets as the base against which the firm’s return is
measured.
ROTC measures profitability relative to all (non-trade) capital
providers.


Profitability Analysis, Cont.
) ' ( Equity rs Stockholde TotalDebt Average
EBIT
ROTC
+
=
A2 - 45
3. Return On Equity (ROE):
The return on total stockholders’ equity excludes debt in the
denominator and uses either pretax income or net income. ROE
measures the profitability of owners’ investment.



OR,
Profitability Analysis, Cont.
Equity ckholders AverageSto
etaxIncome
ROE
'
Pr
=
Equity ckholders AverageSto
NetIncome
ROE
'
=
A2 - 46
4. Return on Common Equity (ROCE):
Companies with preferred equity can measure the return to their
residual owners – common shareholders.




 The relationship between ROA and ROE reflects the firm’s
capital structure.
 ROA (or ROTC) measure returns to all providers of capital.
ROE measures the returns to the firm’s shareholders and is
calculated after deducting the returns paid to creditors
(interest).
Profitability Analysis, Cont.
monEquity AverageCom
idends eferredDiv NetIncome
ROCE
Pr ÷
=
A2 - 47
Operating & Financial Leverage Analysis
Profitability ratios imply that profits are proportional to sales, which
may misstate the true relationship among sales, cost and profit.
Generally a doubling of sales would be expected to double of
income only if all expenses were variable.

Conceptually expenses can be classified into -

Variable Expenses (V): Expenses tend to be operating in nature.
Fixed Expenses (F): Fixed costs are the result of operating,
investing and financing decisions.


A2 - 48
Leverage:
Leverage refers to proportion of fixed costs in the firm’s overall
cost structure. Leverage can be divided into fixed operating costs
that reflect operating leverage (the proportion of fixed operating
costs to variable cost) and fixed financing costs or financial
leverage.

Leverage trades risk for return. Increases in fixed costs are risky
because they must still be paid as demand declines, decreasing the
firm’s income. At high levels of demand, fixed costs enhance the
profitability.
Operating & Financial Leverage Analysis
A2 - 49
Operating Leverage:
The contribution margin ratio is a useful measure of the effects of
operating leverage on the firm’s profitability.





This ratio indicates the incremental profit resulting from a given
dollar changes in sales
Operating & Financial Leverage Analysis
Sales
sts VariableCo
Sales
on Contributi
inRatio onM Contributi
÷ =
=
1
arg
A2 - 50
The Operating Leverage Effect (OLE):
The OLE can be used to estimate the percentage change in income
(and ROA) resulting from a given percentage change in sales
volume.




 % Change in Income = OLE * % Change in Sales

When OLE in greater than 1, operating leverage in present.
Operating & Financial Leverage Analysis
ncome OperatingI
on Contributi
s turnonSale
inRatio onM Contributi
OLE
=
=
Re
arg
A2 - 51
Financial Leverage:
The effects of financial leverage can also be quantified. From the
point of view common shareholders, financial leverage is a risk and
return trade-off.
The financial leverage effect (FLE) relates operating income to net
income:


If the effect of both operating and financial coincide, gives a total
leverage effect (TLE) equal to the product of the individual
leverage effects:
Operating & Financial Leverage Analysis
NetIncome
ncome OperatingI
FLE =
NetIncome
on Contributi
OLExFLE TLE = =
A2 - 52
Ratios: An Integrated Analysis
Comprehensive analysis requires a review of the following three
interrelationship among ratios.

Economic Relationships:
If activity ratio increase, profitability ratio will also increase.
Higher sales = Higher investment in working capital = Higher
Receivable and inventory.

Overlap of Components:
The components of many ratios overlap due to the measure of a
same term in the numerator or denominator, or because a term in
one ratio is a subset or component of another ratio.

A2 - 53
Ratios as Composites of other Ratios:
Some ratios are related to other ratios across categories. For
example, the ROA ratio is a combination of profitability and
turnover ratios:
ROA = NI / TA
= Net PM x TAT
= NI / S x S / A
If TAT and PM increase or decrease the ROA also increase or
decrease.
Ratios: An Integrated Analysis
A2 - 54
Analysis of Firm Performance:

Disaggregation of ROA:
The ROA can be disaggregated as follows:

ROA = Total Asset Turnover x Return On Sales

=


The firm’s overall profitability is the product of an activity ratio and
a profitability ratio. A low ROA can result from low turnover,
indicating poor asset management, low profit margins, or a
combination of both factors.
Sales
income Operating
X
Assets
Sales
Ratios: An Integrated Analysis
A2 - 55
Disaggregation of ROE and its relationship with ROA:
The relationship between ROE and ROA is a function of the
proportion of debt used for financing and the relationship of the
cost of that debt to ROA. This can be formally expressed:



Benefit of financial leverage is the product of the excess return
earned on the firm’s assets over the cost of debt and the proportion
of debt financing to equity financing.

( )
(
¸
(

¸

÷ + =
Equity
Debt
X debt of Cost ROA ROA ROE
Ratios: An Integrated Analysis
A2 - 56
ROE can be desegregated as follows:
Equity
Assets
X
Assets
Sales
X
Sales
Income
Solvency X Activity X y of itabilit ROE
=
=Pr
Ratios: An Integrated Analysis
A2 - 57
Ratio Analysis :
Earning Per Share and Other Valuation Model:

Earning Per Share (EPS):
Earning per share is probably is the most commonly used corporate
performance statistic for publicly traded firms. It is used to compare
operating performance and for valuation purposes either directly or
indirectly or together with market prices in the familiar form of
price/earnings (P/E) ratio.

A2 - 58
Earning Per Share and Other Valuation Model, cont.
Simple Capital Structure: The firm that has only common shares,
the computation of EPS is relatively straightforward as follows:





OR,
ding Outs Shares n erageCommo WeightedAv
Shares ForCommon Available Earning
BasicEPS
tan
=
ding outs shares n erageCommo Weightedav
idend eferredDiv NetIncome
BasicEPS
tan
Pr ÷
=
A2 - 59
Complex Capital Structure:
Companies whose have options and convertible securities are said
to have complex capital structures. These firms must recognize the
potential effect on EPS upon the conversion of those securities if
such a conversion will result in dilution of EPS.
ding Outs Shares Common Potential and Common
Shares Common for Income Adjusted
DEPS
tan
=
Earning Per Share and Other Valuation Model, cont.
A2 - 60
The adjustment to the numerator reflect the fact that if the
convertible securities were converted to common shares, interest
and preferred dividend payments would no longer have to be made
to those security holders, increasing the amount available to
common shareholders.

Numerator adjustment therefore include:
1. Dividends on convertible preferred shares
2. Interest (after-tax) on convertible debt
3. Effect of the change resulting from 1 and 2 on profit sharing or
other expenses.

Earning Per Share and Other Valuation Model, cont.

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