UNDERSTANDING INCOME STATEMENTSPart 2 BINUS FINANCIAL ANALYST ACADEMY CFA Preparation Program Level 1 Batch 24

2013 CFA Level 1 Financial Statement Analysis 4

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

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

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

Simple v Complex Capital StructureSimpleComplexBasic EPSBasic EPSDiluted EPS*

Basic EPS = Net Income - Preferred Dividends

Weighted Average Number of Common Shares OutstandingBasic EPSAll firms with complex capital structures must report two EPS figures: basic and dilutedFirms with simple capital structure report basic EPSBasic EPS does not consider the effect of any dilutive securities EPS refers to earning available to common shareholders

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Basic EPS = (10,000 - 1,000)/11,000 = $0.82Weighted Average No of SharesIs the number of shares outstanding during the year weighted by the portion of the year they were outstanding

Example: Johnson Co has net income of $10,000, $1,000 cash dividends paid to preferred and $1,750 paid to common. At the beginning of the year there were 10,000 shares outstanding, 2,000 new shares were issued on July 1.

What is Johnsons Basic EPS?Weighted average shares: (10,000x12)+ (2,000x6) /12= 11,000*

Stock Dividends and Stock SplitsThe effect of stock dividends and splits is applied retroactively to the beginning of the year and is not weighted by the portion of the year after the stock dividend or split occurred.

Example: During 2008, ABC had net income of $100,000 and paid dividends of $50,000 to its preferred stockholders and $30,000 to its common shareholders. The common stock account showed the following:1/1/08: Shares issued & outstanding at beg of the year10,0004/1/08: Shares issued4,0007/1/08: 10% stock dividend9/1/09: Shares repurchased for the treasury3,000Stock Dividend and Stock Splits are not time sensitive. They dontaffect the ownership of shares (no changes in shareholders composition).Therefore, as they are not time sensitive, apply the effects of stock dividends and stock splits to the beginning of the period.

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Stock Dividends and Stock Splits (2)Answer:1/1/08: Initial shares adjusted for stock div11,0004/1/08: Shares issued adjusted for stock div4,4007/1/08: 10% stock dividends[Applied above]9/1/08: Shares of treasury stock repurchased-3,000

Weighted average number of post stock dividend shares:= [(11,000 x 12) + (4,400 x 9) - (3,000 x 4)] / 12= 13,300Basic EPS = (100,000 - 50,000)/13,300 = $3.76*

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

Diluted Earnings Per ShareComputation of diluted EPS is consistent with basic EPS, while giving effect to all dilutive potential ordinary shares outstanding during the periodExamples of potential ordinary shares:Debt equity instruments, including preference shares convertible into ordinary sharesShare warrants and optionsEmployee plans that allow employees to receive ordinary shares as part of their remuneration and other share purchase plansAny securities that may increase the number of common shares may be potentially dilutive securities.*

Diluted EPS = Adjusted income available for common sharesWeighted average common & potential common shares outstanding

Diluted EPS - FormulaDilutedEPS Net Income Convertible pre- ferred stock dividend-Weighted average shares+(1 - t) Convertible debt interestPreferred dividendsShares from conversion of convertible P/SShares issuable from stock options+Shares from conversion of convertible debt+++=*

Diluted EPSThe numerator of dilutive EPS:If there are dilutive securities that will cause the weightedaverage common shares to change then the numerator must beAdjusted

Preferred dividends on convertible preferred shares are addedback to numeratorInterest expense and other related adjustments (net of tax effect)on convertible debt are added back to numeratorConvertible securities are weighted for the period they would beoutstanding*

Diluted EPS (2)The denominator of dilutive EPS: basic EPS denominator adjusted for the equivalentnumber of common shares created by the conversion of alloutstanding dilutive securities

Adjusted for the weighted average number of ordinary shares which would be issued assuming conversion of all dilutive potential ordinary shares

Conversion is assumed at the beginning of the period (or attime of issuance, if later)Anti Dilutive securities are not considered!!!

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Options and WarrantsDilutive stock options increase the number of common sharesoutstanding in the denominator for diluted EPS.Options and warrants are dilutive only if the exercise price is lessthan average market price.Assume exercise of dilutive optionsExercise assumed at the beginning of the period (or at time ofissuance, if later).

Warrants also like stock options; Conclusion: Warrants and options are potentially dilutive. Theinclusion of warrants and options into the diluted EPS calculationONLY influences the denominator, not the numerator*

Diluted EPS = (11,560- 10,000+2,880)/(2,000+6,000) = $0.56MAKE SURE diluted EPS < basic EPS; if no: antidilutiveEPS with convertible debtExample: In 2008, ZZZ has net income of $11,560 & 2,000 shares ofcommon stock outstanding 1,000 shares of 10%, $100 par preferredstock outstanding issued 60, $1,000 par, 8% bonds for $60,000 and eachof them is convertible to 100 shares of common stock. Tax rate is 40%.

What is ZZZ Diluted EPS?Basic EPS = (11,560- 10,000)/2,000 = $0.78Shares issuable for debt conversion: (60)(100) = 6,000 sharesIncrease in income = (60)(1,000)(0.08) (1-.04) = $2,880*

EPS with stock optionsKey word: Treasury methodUnder this method, we assume that the proceeds from the exercise of stock options are used to buy the stock (to be given to option holder) from the market at the average priceThis reduces the total number of common stock to be issued to option holdersNet increase of common stock will be the total number of shares created by the exercise of options LESS the number of shares repurchased*

Diluted EPS = (11,560- 1000) / (20,000+250) = $0.52EPS with stock optionsExample: In 2008, ZZZ has net income of $11,560 & 20,000 shares of commonStock outstanding 100 shares of 10%, $100 par preferred stock outstanding1,000 stock options (or warrants) outstanding the entire year. Each option can be exercised allowing the holder to purchase 1 shares of common stock at $15 a share. The average market price is $20. What is ZZZ Diluted EPS?

No of common shares created if options are exercised1,000Cash inflow $15,000No of shares can be purchased750Increase in common shares outstanding250*

Tips in calculating Fully Diluted EPS with several potentially dilutive securitiesKey word: Antidilutive securities are not consideredTest each of the potentially dilutive securities (options, warrant etc) individually, one by one (in isolation with other securities)For example, PT K has convertible debt, options and warrants. From testing of each of these securities, the warrants and options are dilutive securities, but the convertible debt is antidilutive.In the final calculation, combine the effect of options and warrant to compute the fully diluted securitiesSee problem 3*

Comprehensive Income is the change in a companys equity from sources other than owners during a periodIncludesNet income + changes in:Unrealized gains and losses (available-for-sale investments)Minimum pension liability adjustmentsCumulative translation adjustments arising from foreign subsidiary consolidation)Unrealized gains or losses on derivatives contracts accounted for as hedges.FASB has taken position that income for a period should be all-inclusive, comprehensive incomeMay be reported on income statement or separate statement, but usually reported on statement of stockholders equity

Problem 1: Weighted average sharesJan 04: 5 million of common sharesFeb 04: issue another 3 million for IPO purposesMay 04: stock dividend 10%August 04: rights issue, issue another 5 million of sharesNovember 04: stock split 1:2 (1 old shares will be exchanged with 2 new shares)December 04: repurchase shares 2 million

Calculate the weighted average shares outstandingAssuming net income is US$20 million, calculate EPS*

Problem 2: EPS with convertible debt and/or convertible P/SNet income is US$20 million10 million common shares10%, US$10 par, 1,000,000 non convertible preferred shares6%, convertible debt of US$25,000,000, convertible into 2.5 million of common shares, outstanding for entire yearTax rate is 40%

Calculate basic and diluted EPS*

Problem 3: EPS with convertible debt and/or convertible P/SNet income is US$20 million10 million common shares10%, US$10 par, 1,000,000 convertible preferred shares into 1million shares10%, convertible debt of US$25,000,000, convertible into 0.5million of common shares, outstanding for entire yearTax rate is 40%

Calculate basic and diluted EPS*

Problem 3b: EPS with convertible debt and/or convertible P/SNet income is US$20 million10 million common shares10%, US$10 par, 1,000,000 convertible preferred shares into 1 millionshares10%, convertible debt of US$25,000,000, convertible into 5 million of common shares, outstanding for entire yearTax rate is 40%

Calculate basic and diluted EPS*

Problem 4: EPS with Options and WarrantsIn 2005, ZZZ has net income of $100,000 & 50,000 shares of common stock outstanding. ZZZ issued 10,000 stock options outstanding the entire year. Each option can be exercised allowing the holder to purchase 1 share of common stock at $25 a share. 7,500 warrants are also outstanding. Each warrants may be converted into 1 common shares at US$15The average market price is $20

What is ZZZ basic and Diluted EPS?

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