Profitability Analysis

I. Profitability Ratios
Gross Profit Margin %

(Net Sales – Cost of Goods Sold) / Net Sales

Gross profit is revenues less cost of goods sold. The gross profit margin is a
percentage, or ratio, of gross profit to sales.

The gross profit margin measures the percentage of the sales price available to
cover nonmanufacturing expenses, usually called selling, general, and
administrative expenses, or SG&A.

“Net Sales” is sales minus sales discounts and sales returns and allowances. If
information on sales discounts and sales returns and allowances is not given in a
problem and only “Sales” is given, then assume that “Sales” is “Net Sales.”

Changes in the gross profit margin are usually due to one or more of the following:

• Sales volume increases or decreases

• Unit selling price increases or decreases
• Increases or decreases in cost per unit

Operating Profit Margin Percentage

Operating Income / Net Sales

Operating income includes revenues and expenses of the company’s principal

operations. It does not include revenues and expenses that result from secondary or
auxiliary activities of the company, gains and losses from investments, or gains and
losses from discontinued operations.

Gross Profit – Selling Expenses – Administrative Expenses = Operating Income

Net Profit Margin Percentage

Net Income/ Net Sales

Net income includes revenues and expenses of the company from all sources (except
for other comprehensive income items, which are reported directly in equity). The
net profit margin percentage measures the percentage of sales revenue that
actually becomes profit.

Operating Income +(-) Financial Income(Expense) +(-) non-operating gains(losses) –

income tax expense = Net Income

Example: The net profit margin below is 9%, calculated as net income of $1,080,000
divided by $12,000,000 in net sales.

% of Sales

Net sales 12,000,000

Cost of goods sold 8,000,000

Gross profit 4,000,000 33.3% = Gross Profit Margin

Selling, gen., admin. expense 2,500,000

Operating income 1,500,000 12.5% = Operating Profit Margin

Interest and dividend income 25,000

Interest expense 40,000

Non-operating gains 57,857

Income before tax 1,542,857

Provision for income tax at 30% 462,857

Net income 1,080,000 9.0% = Net Profit Margin

EBITDA Margin Percentage

EBITDA / Net Sales

EBITDA is used to analyze a company's earnings before interest and taxes as well
as before the non-cash charges of depreciation and amortization.

EBITDA stands for earnings before interest, taxes, depreciation and amortization.

EBIT + Depreciation/Amortization Expense = EBITDA

Each ratio is determined by the expense component used to calculate it. The
following chart identifies each cost category and its impact on each ratio.

Ratio Cost of Sales Operating Interest Expense

Expenses Non-operating
including Selling Gains/ (Losses)
and Income Taxes
Administrative
Expenses
Gross Margin Yes No No
Operating Margin Yes Yes No
Profit Margin Yes Yes Yes

II. ROA and ROE

Return on Assets

Income / Average Assets

Return on assets measures how much return the company earns on the capital it
has invested in its assets and thus it measures the company’s success in using
financing to generate profits. The higher the ROA, the better, or more effectively,
the company is using its assets.

Return on assets is also used in:

1. Determining the effectiveness of managers. Return on assets can be

calculated for an individual division, department, or other segment of a
business as well as for the consolidated firm. The level of the return on assets
for a segment or for the whole company is a function of the skill,
resourcefulness, ingenuity, and motivation of the company’s managers,
because they make the financing, investing and operating decisions and
make and execute plans.
2. Measuring profitability. Return on assets provides a measure that relates the
income statement to the balance sheet. Therefore, return on assets is an
important indicator of the company’s ability to utilize its assets to earn
profits and is thus an indicator of the long-term financial strength of the
company.
3. Measuring forecasted earnings. ROA for past, current, and forecasted
financial statements can be compared. Thus, it can identify overly optimistic
or overly pessimistic forecasts.
 4. Planning, budgeting, and control. Because ROA consists of the returns
achieved and the losses suffered by the company’s various segments, ROA
helps senior management to assess how well the managers of individual
profit centers or business units have done at meeting their goals. Current
ROA can be used in setting goals for the coming period.

Return on Equity

Income / Average Equity

Return on equity measures the return the business receives on the stockholders’
equity invested in the business.

Average equity in the denominator of return on equity includes preferred stock.

However, if a company has preferred stock outstanding, return on common equity is
more meaningful because it focuses on the return to common shareholders only, as
follows:

(Net Income – Preferred Dividends) / Average Common Equity

Example: ROA and ROE

Selected financial data for TVX Corporation for the year is shown below.

Sales $ 22,000,000
Earnings before interest and taxes 1,700,000

Interest expense 500,000

Tax rate 40 %

Beginning of the End of Year

Year
Assets 9,600,000 10,000,000
Liabilities 6,200,000 6,800,000
Shares outstanding 1,400,000 1,500,000
Market Price per share $ 2.40 $ 2.50

Return on Asset

Return on Equity
Analyzing ROA

Net Income / Average Total Assets

Return on assets is a function of two basic elements: how much sales the company is
able to generate from the use of its assets, and the proportion of the company’s sales
revenue that it keeps in profits. Thus, return on assets can be disaggregated into
these two elements to analyze the causes of changes in ROA.

ROA = Total Asset Turnover x Net Profit Margin

ROA= Sales x Net Income

Average Total Assets Net Sales

The total asset turnover ratio is an indicator of how much sales the company is
generating from its total assets. The total asset turnover ratio measures the overall
efficiency of the company’s use of its investments, including both current assets and
noncurrent assets.

The net profit margin measures the percentage of sales revenue that actually
becomes profit for a company.

Thus, return on assets is a function of two things:

1. The amount of sales a business is getting from its assets (its total asset
turnover); and
2. The profitability of those sales (its net profit margin).
Analyzing Return on Equity

Net Income / Average Total Equity

Return on equity measures the amount of earnings produced by the business on its
equity. Therefore, it is a gauge of management performance, as it measures
management’s ability to make good use of shareholders’ funds.

The financial leverage ratio/equity multiplier expresses the company’s amount of

financial leverage. It relates total assets to assets financed by shareholders. The
larger the equity multiplier is, the smaller is the proportion of assets financed by
shareholders, and the greater is the company’s financial leverage.

Return on equity is also the product of multiplying return on assets by the financial
leverage ratio/equity multiplier, as follows:

ROE = ROA x Financial Leverage Ratio

Total Asset Turnover x Net Profit Margin x Financial Leverage Ratio

Sales x Net Income x Assets

Average Assets Sales Equity

Thus, a company’s return on equity is affected by three things, which are:

1. Efficiency of asset usage (measured by the total asset turnover),

2. Efficiency of operations (measured by the net profit margin), and
3. Financial leverage (measured by the equity multiplier).

Sustainable Growth Rate

(1 – Dividend Payout Ratio) x Return on Common Equity

The sustainable growth rate is the rate at which the company’s sales can grow each
year without the company’s needing to increase its current level of financing. In
other words, it is the growth rate that the company can fund internally through
retention of its profits.

Payment of dividends decreases the amount of a company’s retained earnings. In

assessing equity growth, the assumption is made that a portion of earnings is
retained and a portion is paid out in dividends, and that the dividend payout is
constant.
NOTE: if the company has preferred stock outstanding, “ROE” in the calculation of
the sustainable growth rate is understood to mean Return on Common Equity
because the dividend payout ratio is based on earnings available to common
shareholders.

Dividend Payout Ratio = Total Common Dividends / Income Available to Common

Shareholders

The dividend payout ratio represents the percentage of distributable earnings that
is distributed in dividends to common shareholders.

Return on Com. Eqty = (Net Income – Preferred Dividends) / Average Common

Equity

If the company has preferred stock, common equity is total equity minus preferred
stock. Averages of balance sheet items are usually calculated by averaging the
beginning and ending balances. Therefore, average common equity is the average of
(beginning total equity minus beginning preferred stock) and (ending total equity
minus ending preferred stock).

Example: Sustainable Growth Rate

The following are selected items from XYZ Industries’ financial statements for the
past two years:

20x1 20x2
Stockholders’ Equity
Preferred stock, 7% cumulative, Par value $20 per 34,000 34,000
share, 1,700 shares outstanding
Common stock, par value $5/share, 15,000 shares 75,000 75,000
outstanding
Additional paid-in capital – common stock 45,000 45,000
Retained earnings 80,000 121,000
Total Stockholders’ Equity 234,000 275,000

Items from Income Statement

Net income after interest and taxes 40,000 60,000
Basic earnings per share 2.51 3.84
Dividends paid per share on common stock 0.85 1.20

Other Information
Market price per share of common stock 14 16
20x2 Dividend Payout Ratio = $1.20 / $3.84 = 0.3125

20x2 Return on Common Equity = $60,000 − ($34,000 × 0.07) = 57,620 =

26.13%

($200,000 + $241,000)/2 220,500

Sustainable Growth Rate = (1 – Dividend Payout Ratio) x Return on Common

Equity

Sustainable Growth Rate = (1 – 0.3125) x 0.2613 = 17.96%

III.. Factors that Contribute to Inconsistent Definitions in ROA and ROE

Investors and managers must be careful when using the above formulas because
there can be different meanings or definitions for assets, equity, and income. Unless
you have done the calculation yourself, you may not know exactly what numbers
have been used to calculate the return.

A. Assets can be defined as:

1. Average total assets for a two-year time period.
2. Total assets for a specific time period.
3. Operating assets, meaning property, plant and equipment. These are
the assets used to generate income.
B. Equity can be defined as:
1. Average common stockholders’ equity for a two-year time period. This
is the amount that is most commonly used. Using this definition is in
sync with the Earnings per Share (EPS) calculation, which uses only
common stock outstanding.
2. Common stockholders’ equity for a specific time period.
3. Total stockholders’ equity that includes both preferred and common
stockholders’ equity. This definition is less frequently used.
C. Income or the return can be defined as:
1. Net income.
2. Net income minus preferred stock dividends. The deduction of
preferred dividends brings the net income back to a return to common
shareholders.
3. Operating income is used to remove income taxes, other gains and
losses, and the impact of interest expense on loans outstanding.
The results of ROA and ROE calculations will be impacted by changes in the
amounts of individual components on both the income statement and the balance
sheet. The following chart lists individual components or items on a financial
statement.

IV. Factors in Measuring Income

1. Estimates—income is based on the use of estimates about future events. The

management of a publicly traded company makes estimates based on history,
current economic decisions, and other factors. The company's auditors will
verify the estimates for reasonableness. These estimates can impact the
amount of reported income significantly. Common estimates are:
A. The useful life of a depreciable asset. The longer the life, the lower the
annual depreciation expense, and therefore the higher the income.
B. The estimate of allowance for doubtful accounts. The estimated
percentage of uncollectable accounts determines the amount of bad
debt expense reported on the income statement. The higher the bad
debt expense, the lower the reported income.
2. Accounting Methods—the accounting method management chooses to use
will affect the amount of reported income. The auditors will verify that the
method is one of the generally accepted accounting methods and ensure that
the chosen method is used consistently from year to year. For example:
 A. The use of straight-line versus an accelerated depreciation method.
The accelerated method will report higher depreciation expense in the
early years of the life of the asset. This results in a lower amount of
income, as compared to the straight-line method.
B. The use of first-in, first-out (FIFO) versus last-in, last-out (LIFO) to
value inventories will determine the amount of cost of goods sold.
During periods of inflation, the FIFO method will report higher
inventory values and lower cost of goods sold compared to the use of
LIFO. The lower cost of goods sold used by FIFO will report a higher
amount of income before tax, a higher income tax expense, and higher
net income than LIFO would report.

The CMA candidate needs to understand how each method will impact
the reported income. An extension of this is to also understand the
impact the reported income and the relevant balance sheet amounts
will have on common ratios. For example, the use of FIFO increases
the amount of income, but also increases the value of the inventory.
Both the income and inventory amounts will have an effect on the
return on assets (ROA) calculation.

3. Disclosure—The FASB ASC provides the detail of the required disclosures. In

addition, the SEC can require additional disclosures be made. The purpose of
disclosures is to provide more detailed information than what is found in the
numbers themselves on the financial statements. Seeing the amount of
inventory and cost of goods sold on the balance sheet and the income
statement, respectively, does not tell you the valuation method management
used to arrive at the numbers. The information provided in the notes is for
the external users for their decision-making usefulness.
A. It is up to the company to draft the disclosures. The level of detail
provided by companies can range from the minimum required by FASB
ASC to overwhelming amounts of detail. It is up to the individual
external user to decipher and understand the information disclosed.
B. Management is cautious to disclose any information that can be used
by its competitors against the company.
C. Management's focus is to increase shareholder value. The amount and
content of the disclosures can have an impact on the stock price, as
well as the perception of the company by investors and creditors.
4. Different Needs of Users—The users of the financial statements have
different needs.
A. The internal users, or management, use the financial statements to
make business decisions to run the company. The four financial
statements oftentimes are a starting point for them. Reports prepared
using cost and managerial accounting concepts and techniques are
often more important, especially when trying to manage the costs of
 running the business. Remember that the cost and managerial reports
are prepared for internal use only and do not always follow GAAP
guidelines.
B. The external users of the financial statements have very different
needs from the internal users, as well as from each other.
i. Investors use the information to decide whether to invest, hold,
or divest themselves of the company's stock. Investors will
analyze the data to determine historical trends of sales and
income, for example. They will also use ratio analysis to
determine the financial and operational health of the company.
These analyses help them make predictions about the future of
the company, which they use to make their decision.
ii. Creditors look for information to help them decide whether to
extend credit to the company. This decision also includes a
determination of the amount of credit to extend if they have
decided to extend the firm credit. Based on the length of time of
any credit or loans made, the use of liquidity and/or solvency
ratios will help creditors do this. All creditors look for the
principal amount to be repaid to them, as well as any interest
expense that goes with the loan. Their goal is to minimize the
risk of not being repaid.
iii. Government reviews the financial statements from a tax and
regulatory point of view.
iv. Labor unions review the financial statements from the point of
view of the firm's ability to give raises and provide benefits to its
employees.

Limitations of Ratio Analysis

Ratio analysis is a great way to compare businesses of different sizes. But, their
usefulness is limited as seen in these examples:

1. Choice of inventory valuation method. If one firm uses FIFO (first in,
first out), it will have a higher inventory value and a lower cost of sales
than a firm that uses LIFO (last in, first out), all else being equal. This
choice will also give different results when calculating days’ sales in
inventory and return on assets.
2. Composition of current assets. The reason for the different variations
on the current ratio (current assets ÷ current liabilities) is to recognize
that not all current assets are created equal when it comes to liquidity
and the ability to pay back current liabilities. Prepaid expenses are a
current asset; however, they will never be converted to cash. They are
 simply used up over time. Inventory will hopefully be sold. This does
not equate to an immediate inflow of cash.
3. Choice of depreciation method. Using the straight-line method of
depreciation will result in higher operating and net income when
compared to using an accelerated method of depreciation.
4. Earnings per share. EPS is calculated as (net income minus preferred
dividends) divided by the weighted average number of common shares
outstanding. Management can change the denominator in this
equation with the purchase of treasury stock. This reduces the
denominator, which results in higher earnings per share.
5. Return on assets. Unless you are doing the calculations yourself, you
need to know and understand what numbers were used. The “return”
can be net income, operating income, or some other definition. The
“assets” can be total assets, PP&E (property, plant, & equipment), or
some other definition.

Relationship between Revenue, Inventory, and Receivables

When inventory is sold and transferred to the customer, the sale is recorded as a
sale on account. This means that accounts receivable, and not cash, will be
increased. When the perpetual inventory method is used the journal entry to reduce
inventory and increase cost of sales will be made at the same time as the recording
of the sale. Let's assume that the selling price is higher than the cost of inventory,
so there is gross profit. The two required journal entries are:

Accounts Receivable xxx Cost of Sales xxx

Sales xxx Inventory xxx

Income Balance Sheet

Statement
Sales $1,000 = $1,000 Acc. Rec.
Cost of Sales = $600 Inventory
$600
Gross Profit = $400 Current
$400 Assets
INCREASE INCREASE

The increase in income from this transaction is higher in percentage terms than the
increase in assets

So each sale will increase return on assets, all things being equal
The amount of revenue a company has will impact the level of inventory and
receivables that it holds. Increased revenue generally requires increased inventory,
and increased revenue will also usually lead to increased receivables. While greater
levels of revenue are preferable, the company holding higher levels of inventory and
receivables also carries additional risks.

• The higher the level of inventory, the greater is the risk of inventory
obsolescence and the greater the risk of loss in the case of a fire or other
disaster.
• The higher the level of receivables, the greater is the risk of customer
default and, if the receivables are in a foreign currency, the greater is the
risk of loss due to a decline in the value of the currency.

V. Market and Earnings Ratios

Book Value per Share

(Total Stockholders’ Equity – Preferred Equity) / Number of Common Shares Out.

Book value per share represents the per share amount for the common stockholders
that would result if the company were to be liquidated at the amounts that are
reported on the company’s balance sheet.

NOTE: The number of common shares outstanding used in the denominator should
be the number of shares outstanding at the balance sheet date. It should not be a
weighted average number of common shares outstanding.

Market-to-Book Ratio

Current Stock Price per Share / Book Value per Share

The market-to-book ratio will generally be greater than 1.0 if the market expects
abnormally high earnings in the future; however, it will be lower than 1.0 if the
market expects abnormally low earnings in the future.

A market price that is lower than the adjusted book value is often a predictor of a
takeover or merger, as the firm may be considered a bargain by other firms. Of
course, that determination must be made in the context of the firm’s overall
financial condition. A company on the verge of bankruptcy may be trading at a
market price that is significantly below its book value per share (adjusted or
unadjusted), but that does not mean the stock or the company is a good buy.
Price/Earnings Ratio

Market Price per Common Share/ Basic Earnings Per Share (Annual)

The price/earnings ratio gives an indication of what shareholders are paying for
continuing earnings per share. Investors view it as an indication of what the market
considers to be the firm’s future earning power.

A company’s P/E ratio is greatly influenced by whether the company is in a high-

growth stage or a low-growth stage. A company in a high-growth stage will usually
have a high P/E ratio because of the market’s expectations of future profits (which
makes the market price higher) despite the fact that at the current time, profits
may be low. Companies in a low-growth stage generally have lower P/E ratios.

Earnings Yield

Basic Earnings per Share / Market Price per Common Share

The earnings yield measures the income-producing power of one share of common
stock at the current market price. It is the inverse of the P/E ratio.

Dividend Yield

Annual Dividends per Common Share / Current Market Price per Share

The dividend yield measures the relationship between the current annual dividend
and the current market price of the stock. It is the annual percentage return in
dividends received by a shareholder based on the stock’s current price and current
dividend.
Earnings per Share (Basic)

Income Available to Common Stockholders (IAC)

Weighted-Ave. No. of Com. Shares Outstanding (WANCS)

Income Avail. to Common Stockholders W.A. Number of Common Shares Out.

Net Income [Beginning Shares

- Noncumulative preferred dividends + New Shares outstanding x Year %

DECLARED (whether or not paid
- Shares Reacquired x Year % ]
- Cumulative preferred dividends
EARNED (whether or not declared) Multiply by: (1 + Stock Div. Rate)

Multiply by: Stock-Split Ratio

If the company has net income/expense from discontinued operations on the income
statement that are reported below the income from continuing operations line,
Basic EPS must be calculated three times:

1. Using income from continuing operations minus preferred dividends in the

numerator.
2. Using the income from discontinued operations in the numerator.
3. Using net income minus preferred dividends in the numerator.

However, exam questions will generally not have any discontinued operations, so
the numerator of the Basic EPS calculation will usually simply be net income minus
preferred dividends.

Income Available to Common Stockholders

Preferred dividends are deducted from net income to determine Income Available to
Common Stockholders (IAC).

Cumulative Dividend Non-cumulative Dividend

Preferred Dividend is required to be Preferred Dividend is only required to
paid(earned) per year. be paid when declared.

The regular dividend on cumulative Only deduct the noncumulative

preferred stock is deducted from net dividend if it’s declared in the given
income to calculate IAC as soon as it is year.
earned, whether or not it has been
declared.
 Therefore, even if a cumulative
dividend is not declared for a given
year, the amount earned and due is
subtracted from net income in
calculating IAC for that year.

NOTE: If preferred shares are not specifically identified as cumulative preferred

shares in an exam problem, they are noncumulative preferred shares.

On the exam, if a problem does not specifically say whether a preferred dividend
was declared or not, assume that it was declared. Preferred dividends are declared
and paid very reliably, unless the company is in deep financial trouble.

If a question gives the amount of income available to common stockholders, do not

subtract any preferred dividends from it. Income available to common stockholders
is net income minus preferred dividends. The preferred dividends have already been
subtracted from net income to derive the IAC given in the problem. To subtract
them again would be to subtract them twice.

In calculating IAC, no adjustments are made for common dividends declared. If a

common dividend or dividends have been declared, those amounts are just as
available to the common shareholders as the undistributed earnings are. The
earnings have just been given to the common shareholders in the form of cash
dividends.

Weighted Average Number of Common Shares Outstanding

Share Item Included for what time period

Shares issued during the year. Only the time period they are
outstanding after being issued.
Note: It does not matter whether the
shares are previously unissued shares
or treasury shares that are being
reissued. Both are treated the same
way in calculating WANCSO because
treasury shares are not outstanding
while the company holds them.

Shares reacquired by the company Only the time period before they are
during the year. reacquired. The shares reacquired are
subtracted—weighted for the period
they were not outstanding—from the
 number of shares outstanding at
beginning of the period.

Shares issued as a part of a stock split.
The entire year and all prior periods
presented as comparative periods, as if
the split had occurred at the beginning
of the first period presented. All shares
outstanding at the beginning of the
period and all shares issued or acquired
before the stock split took place are
adjusted for the stock split.

Shares issued as a stock dividend.
The entire year and all prior periods
presented as comparative periods, as if
the stock dividend had been distributed
at the beginning of the first period
presented. All shares outstanding at
the beginning of the period and all
shares issued or acquired before the
stock dividend took place are adjusted
for the stock dividend.

Treatment of shares issued or acquired Shares issued or acquired after a stock

after a stock dividend or a stock split dividend or stock split has taken place
has taken place are not adjusted for the stock dividend
or stock split.

Note: A company can also carry out a reverse split of its shares. A reverse split
might be performed, for example, when a company is in financial trouble and its
stock price falls to a level where the stock is in danger of being de-listed from the
stock exchange(s) where it is traded. A reverse split decreases the number of shares
outstanding and increases the market price per share.

For example, a company with a weighted-average number of shares outstanding of

97,500 that carries out a 1-for-2 reverse split will have a WANCSO of 48,750 shares
after the reverse split (97,500 ÷ 2).

Example: Weighted Average Number of Common Shares Outstanding

Matthew Corp. has 100,000 common shares, par value $10, outstanding on January
1, 20X0. During 20X0, the following share transactions take place:

• On April 1, 10,000 shares are issued for $50 each.

• On August 1, Matthew repurchases 24,000 shares to be held as treasury
stock.
• On October 1, Matthew carries out a 2-for-1 stock split.
• On November 1, 15,000 shares are issued for $55 each.
• On December 15, Matthew declares a 10% stock dividend.

Example: Basic Earnings Per Share

Redford’s capital structure at December 31, 20X1 was as follows:

• 100,000 shares of common stock issued and outstanding.

• 20,000 of nonconvertible preferred shares issued and outstanding.

On July 1, 20X2, Redford paid a cash dividend of $2 per share on its preferred stock
and on the same date issued a 10% stock dividend on its common stock. Net income
for the year ending December 31, 20X2 was $780,000. Calculate Redford’s basic
EPS.
Example: Basic Earnings Per Share

Redford’s capital structure at December 31, 20X1 was as follows:

• 100,000 shares of common stock issued and outstanding.

• 20,000 of nonconvertible preferred shares issued and outstanding.

On July 1, 20X2, Redford paid a cash dividend of $2 per share on its preferred stock,
but on the same date, instead of issuing a 10% stock dividend on its common stock
as was done in Example 1, Redford issued and sold 10,000 new shares. Net income
for the year ending December 31, 20X2 was $780,000. Calculate Redford’s basic
EPS.

Since no stock split or stock dividend occurred, the final column on the worksheet is
not required. WANCSO is the total of the amounts in the Weighted Average
column, as follows:

Diluted Earnings per Share

Diluted earnings per share (DEPS) is calculated by pretending that all potentially
issuable common shares that were outstanding at the yearend had actually been
converted or exercised on January 1 (or on the date they were issued, if issued
during the year).

“Potentially issuable shares” are in the form of convertible bonds, convertible

preferred shares, and options and warrants that are outstanding at the end of the
year.

Potential common shares are included in the calculation of DEPS only if they are
dilutive. Potential common shares are dilutive if their exercise or conversion into
common stock during the period would have caused a decrease in basic earnings per
share.

“Potential Shares” Individual Formula

Stock Warrants Warrants are only dilutive if the exercise price is less than
the average stock price.

If condition above is fulfilled, Add potential stocks to EPS

Denominator

Stock Options Options x Shares/Option = Total Potential Shares

 Total Potential Shares x Exercise Price = Total Cash Inflow

Total Cash Inflow / Market Price = Shares “Repurchased”

Total Potential Shares – Shares Repurchased = Net

Additional Shares

Add Net Additional Shares to EPS Denominator

Convertible Bonds PV of Bonds x Market Int. Rate x (1 – Tax Rate) = After-tax

Interest Expense

# of Convertible Bonds x Potential Shares/Bond = Total

Potential Shares

If: (After-tax Interest Expense/Total Potential Shares) <

Basic Earnings Per Share = DILUTIVE

Add After-tax Interest Expense in Numerator

Add: Total Potential Shares(Bonds) in Denominator

Convertible Convertible Preferred Shares x Common Share per

Preferred Stock Preferred Share = Total Potential Shares

If: Dividend Earned(Cumulative) and/or

Declared(noncumulative) / Total Potential Shares < Basic
Earnings Per Share = DILUTIVE

Steps in Calculating for Diluted Earnings Per Share:

1. Compute for Basic Earnings Per Share

2. Calculate EPS Effects of warrants and Options (if not Dilutive, EXCLUDE)
3. Calculate EPS Effects of any convertible bonds and preferred shares
4. Rank EPS effects of convertible securities from most to least dilutive

The most dilutive security has the lowest EPS Effect.

 5. In the correct order from the most dilutive to the least dilutive, add the effect
of each convertible security to both IAC and WANCSO and calculate
Intermediate DEPS for each security until reaching a security that is
antidilutive.

Calculate the numerator of the equation:

Net Income − Preferred Dividends =
$1,000,000 − ($100 × 2,000 shares × 5%) =
$1,000,000 − $10,000 = $990,000. When
adjusting for the dividends, even when the
preferred stock is cumulative, only the
current year dividends (paid or not) should
be deducted from net income.

Calculate the denominator of the equation:

Weighted-Average Common Shares
Outstanding

There are two things to recognize in this

calculation. The first is that when a stock
split occurs, regardless of when during the
year, it is assumed to have occurred at the
beginning of the year. The second is that
any new issue of stock needs to be prorated
for the amount of time during the year that
these new shares were outstanding. In this
example, 80,000 shares were issued on
October 1st. This means they were outstanding for three months during the year.
Prorated, this becomes 80,000 shares times (3/12) = 80,000 shares times 25% =
20,000 shares.

Calculate Basic EPS: $990,000 ÷ 500,000 = $1.98

To calculate the Diluted EPS consider the following:

Convertible preferred stock is convertible into 3 shares of common stock for each
share of preferred stock. This conversion is calculated as 2,000 × 3 = 6,000 shares of
common stock. Remember that the preferred dividends were subtracted from the
net income when calculating basic EPS. Now that the preferred stock is converted
into common stock, no preferred stock dividends will be paid.

A. There were 5,000 stock options outstanding that could be exercised for 10 shares
of common stock each. This mean there are 50,000 shares of common stock to
consider in the dilution. However, the exercise of these options will generate a cash
inflow to the company of 50,000 shares × $40 = $2,000,000. This cash will be used to
purchase shares on the open market. This results in 40,000 shares ($2,000,000 ÷
$50 average stock price) of CS being purchased. The company only needs to issue an
additional 10,000 shares of CS. This is calculated as 50,000 minus 40,000 = 10,000
shares.

B. The 8,000 stock warrants are convertible to 1 share of CS so the total converted
number of shares is 8,000. An important note about stock warrants is that warrants
are only dilutive if the exercise price is less than the average stock price. This is
true in this example because the exercise price is $30/share and the average stock
price is $50/share. When the exercise price is greater than the average stock price
the warrants would not be exercised because the holder could purchase the stock at
a lower price on the open market than through the warrant. This would make the
stock warrants antidilutive and would not change the diluted weighted-average
number of shares outstanding.

C. The bonds would be converted into 3,000 shares of CS. This is calculated as 150
bonds multiplied by 20 shares per bond. If the bonds are converted, then no interest
would be paid to the bondholders. An adjustment is needed to net income for this.
Start by calculating the interest expense per year. This is $1,000 × 150 bonds × 5%
= $7,500 in interest. Next convert the interest expense to an after tax interest
expense amount by taking $7,500 and multiplying it by 1 minus the tax rate. This
results in $7,500 × (1 − 0.30) = $5,250 of after tax interest expense that is added
back to net income.
Now we can calculate the diluted weighted-average number of shares outstanding:

Calculate the diluted EPS: ($1,000,000 + $5,250) ÷ 527,000 = $1.91

Example: Comprehensive Earnings Per Share Computation

Kelly Corp. had a net income of $1,000,000 for the year just past and the company
had 500,000 common shares outstanding throughout the period.

Kelly also had outstanding all year 7,500 shares of $100 par value convertible
noncumulative preferred stock paying a 4% dividend, for a par value outstanding of
$750,000 ($100 × 7,500). Preferred dividends in the amount of $30,000 ($750,000 ×
0.04) were declared and paid during the year.

During the previous year, Kelly granted options to its president to purchase 30,000
common shares at a price of $10 per share. Since they were issued during the
previous year, the stock options were outstanding during the full year for which
DEPS is being calculated. During the year, Kelly’s common stock sold at the
following prices:

January 1 $22 December 31 $30 Average Price $27

In addition to the options, Kelly had outstanding all year 1,000 convertible bonds of
$1,000 face value each, with a total face value of $1,000,000 that incurred interest
of 5% per annum. Each $1,000 bond was convertible into 10 common shares. Kelly’s
tax rate is 30%.

The 7,500 shares of $100 par value preferred stock that Kelly had outstanding all
year and that paid a 4% dividend were convertible preferred shares
(noncumulative). The par value outstanding was $750,000 ($100 × 7,500). Preferred
dividends in the amount of $30,000 ($750,000 × 0.04) were declared and paid during
the year. Each preferred share was convertible into 10 common shares at the option
of the owner.

Basic Earnings per Share Computation:

The company’s BEPS was $1.94, calculated as follows:

IAC = $1,000,000 − $30,000 preferred dividend = $970,000. WANCSO is given as

500,000 common shares.

Therefore, Basic EPS = $ 970,000 / $500,000 = $1.94

Options Computation:

Convertible Bonds Computation:

Convertible Preferred Stock Computation:

Rank the EPS Effects:

#1 Stock Options

#2 Convertible Preferred Stock 0.4

#2 Convertible Bonds 3.5

Determine the Final DEPS

Once an Intermediate DEPS is higher than the last IDEPS figure, the process stops
because the security that causes IDEPS to increase is antidilutive. Antidilutive
securities are excluded, and the next-to-last IDEPS number becomes the final
DEPS. Any remaining convertible securities will also be antidilutive since their
inclusion would also increase DEPS.
Example: DEPS Computation

Wally Corp.’s Basic EPS is $3.50 ($35,000 IAC ÷ 10,000 WANCSO). The company
has convertible bonds and convertible preferred shares that have the following EPS
Effects. (Note: Income and share numbers have been created for purposes of the
following example. They cannot be recalculated from the information given.)

Convertible Bond A $1,340 / 1,000 = $1.34

Convertible Bond B $1,365 / 500 = $2.73

Convertible Preferred Shares A $1,485 / 750 = $1.98

Convertible Preferred Shares B $3,410 / 1,000 = $3.41

The four securities are ranked as follows from the lowest EPS Effect to the highest
EPS Effect:

#1: Convertible Bond A $1.34

#2: Convertible Preferred Shares A $1.98

#3: Convertible Bond B $2.73

#4: Convertible Preferred Shares B $3.41

The calculation of the Intermediate DEPS for each security and the final DEPS is:

Upon reaching this point the calculation of IDEPS stops because the next security
to be added, the Convertible Preferred Shares B, has an EPS Effect ($3.41) that is
higher than the last calculated IDEPS ($3.20). If the Convertible Preferred Shares
B were added to the calculation, the IDEPS would increase. Therefore, the
Convertible Preferred Shares B are antidilutive and are omitted.

Therefore, DEPS in this example is $3.20.