2 Study Session 8 2. "Dilutive Securities and Earnings per Share" Learning Outcomes Your learning objectives for this lesson are to be able to: a) Differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS); b) Describe the components of EPS and calculate a company s EPS in a simple capital structure; c) Define and calculate a company s weighted average number of shares outstanding; d) Describe and determine the effect of stock dividends and stock splits on a company s weighted average number of shares outstanding; e) Define and distinguish between dilutive and antidilutive securities; f) Describe the components of and calculate a company s basic and diluted EPS in a complex capital structure; g) Describe and determine the effects of convertible securities, options, and warrantees on a company s EPS; h) Compare and contrast the requirements for EPS reporting in simple versus complex capital structures. Introduction Earnings per share indicates the income earned by each share of common stock. Thus, earnings per share is reported only for common stock. a) Differentiate between simple and complex capital structures for purposes of calculating earnings per share (EPS) e) Define and distinguish between dilutive and antidilutive securities Before we start with how to calculate earnings per share you must be familiar with the following terms: Simple capital structure A corporation s capital structure is simple if it consists only of common stock or includes no potential common stock that upon conversion could dilute earnings per common share.
3 Complex capital structure A capital structure is complex if it includes securities that could have a dilutive effect on earnings per common share. Dilutive securities These are securities such as stock options, convertible debt, or convertible preferred stock that decrease earnings per share if they are exercised or converted to common stock. Antidilutive securities These are securities that upon conversion or exercise increase earnings per share (or reduce the loss per share). b) Describe the components of EPS and calculate a company s EPS in a simple capital structure; Earnings per share simple capital structure The computation of earnings per share for a simple capital structure involves three items: Net income Preferred stock dividends Weighted number of shares outstanding Preferred stock dividends As we mentioned earlier, earnings per share relates to earnings per common share. When a company has both common and preferred stock outstanding, the current year preferred stock dividend is subtracted from net income to arrive at income available to common shareholders. The earnings per share is as follows: EPS = Net income - Preferred dividends Weighted average number of shares outstanding If the preferred stock is cumulative and the dividend is not declared in the current year, an amount equal to the dividend that should have been declared for the current year only should be subtracted from net income or added to the net loss. Dividends in arrears for previous years should have been included in the previous years computations.
4 c) Define and calculate a company s weighted average number of shares outstanding; Weighed average number of shares outstanding The weighted average number of shares outstanding during the year is made up of the shares outstanding, with any shares issued or purchased during the period weighted by the fraction of the period they are outstanding. The reason for this is to determine the equivalent number of whole shares outstanding for the year. Illustrative example Date Changes Shares outstanding 1 January Opening balance 100 000 1 March Shares issued 10 000 110 000 1 July Share repurchased (20 000) 90 000 1 September Shares issued 30 000 31 December Closing balance 120 000 To compute the weighted average number of shares outstanding the following computation is made: Date Shares outstanding Fraction of year Weighted shares 1 Jan to 28 Feb 100 000 2/12 16 667 1 Mar to 30 Jun 110 000 4/12 36 667 1 July to 31 Aug 90 000 2/12 15 000 1 Sep to 31 Dec 120 000 4/12 40 000 Total 108 334 Thus the weighted number of shares to be used in the earnings per share calculation is 108 334.
5 d) Describe and determine the effect of stock dividends and stock splits on a company s weighted average number of shares outstanding; Stock dividends and stock splits When stock dividends or stock splits occur, computation of the weighted average number of shares requires restatement of the shares outstanding before the stock dividend or split. For example, assume that a corporation had 50,000 shares outstanding on January 1 and issued a 25% stock dividend on June 30. For purposes of computing a weighted average for the current year, the additional 12,500 shares outstanding as a result of the stock dividend are assumed to have been outstanding since the beginning of the year. Thus the weighted average for the year would be 62,500 shares. Illustrative example: Date Changes Shares outstanding 1 January Opening balance 100 000 1 March Shares issued 10 000 110 000 1 July 55 000 additional shares (50% stock dividend) 55 000 165 000 1 September Shares issued 30 000 31 December Closing balance 195 000 To compute the weighted average number of shares outstanding the following computation is made: Date Shares outstanding Restatement Fraction of year Weighted shares 1 Jan to 28 Feb 100 000 1.50 2/12 25 000 1 Mar to 30 Jun 110 000 1.50 4/12 55 000 1 July to 31 Aug 165 000 2/12 27 500 1 Sep to 31 Dec 195 000 4/12 65 000 Total 172 500 As you can see we have restated all of the shares prior to the share dividend for the stock dividend.
6 If a stock dividend or stock split occurs after the end of the year, but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in comparative form) must be restated. Illustrative example A company computes its weighted average number of shares to be 200 000 for the year ended 31 December 20x1. On January 10 20x2, before the financial statements are issued, the company splits its stock 2 for 1. In this case the weighted average number of shares used in the computing earnings per share for 20x1 would be 400 000 (200 000 x 2) shares. If earnings per share information for 20x0 is provided as comparative information, it also must be adjusted for the stock split.
7 Typical Exam Questions Please note that the sample questions relate to session 8 and not necessarily to the sample notes above. 1. Analysis of Financial Statements 1. Internal liquidity or solvency ratios indicate the ability of the firm to: A. meet future short term financial obligations B. meet future long-term financial obligations C. settle current debt with fixed assets D. settle future short-term debt with fixed assets Answer A. Internal liquidity and solvency ratios Internal liquidity or solvency ratios indicate the ability of the firm to meet future shortterm financial obligations. Reference Study Session 8 2003, Analysis of Financial Statements, LOS 1b 2. The return on owner s equity ratio indicates: A. the rate of return that management has earned on the capital provided by the owner after accounting for payments to all other capital suppliers B. how management uses its assets and capital, measured in terms of the sales generated by various assets or capital categories C. the rate of return that management has earned on the capital provided by the owner after accounting for payments to all other capital suppliers D. the rate of return that management has earned on the capital provided by the owner before accounting for payments to all other capital suppliers Answer B.
8 The return on owner s equity ratio The return on owner s equity ratio indicates how management uses its assets and capital, measured in terms of the sales generated by various assets or capital categories. Reference Study Session 8 2003, Analysis of Financial Statements, LOS 1c 3. Three companies had the following results during the recent period. A B C Net profit margin 0.03 0.05 0.08 Total asset turnover 2.4 2.2 1.8 Total assets/equity 2.6 2.4 2.0 The ROE for company B is equal to: A. 5.280 B. 0.264 C. 0.110 D. 0.120 Answer B. Calculating ROE The ROE for company B is equal to 0.264 ROE = Total asset turnover x Total assets/equity x Net profit margin ROE = 2.2 x 2.4 x 0.05 = 0.264 Reference Study Session 8 2003, Analysis of Financial Statements, LOS 1c