Earnings Per Share (EPS) and Financial Statement Analysis

Earnings Per Share (EPS)

Introduction to Accounting for Earnings Per Share

  • AASB 133 Earnings per Share is the relevant accounting standard.

  • Requires disclosure of basic earnings per share and diluted earnings per share on the face of the statement of profit or loss and other comprehensive income (per AASB 133, par. 66).

  • Applies to:

    • All companies listed on the Australian Securities Exchange.

    • Other entities that are listed or have on issue ordinary shares or partly paid ordinary shares.

    • Entities in the process of listing.

    • Entities that voluntarily disclose earnings per share.

  • An entity must disclose earnings per share on the face of the statement of profit or loss and other comprehensive income and must be presented even if the amounts are negative (loss per share) under AASB 133, par. 69.

  • Comparatives must also be shown.

  • The standard need only apply to the consolidated financial statements.

Computation of Basic Earnings Per Share

  • Earnings are determined after deducting any preference share dividends appropriated for the financial year to the extent that they have not been treated as expenses of the entity.

  • Preference share dividends are deducted to provide earnings on the basis that EPS is calculated from the perspective of the ordinary shareholders—EPS relates to earnings per ordinary share.

  • In periods where preference dividend not paid, need to consider whether or not preference shares are cumulative.

    • If cumulative, dividends not paid in one year must be paid in later years before ordinary shareholders are entitled to dividends.

    • If not cumulative and no preference dividend paid, it is ignored for purposes of calculating earnings per share.

  • Earnings must be calculated to exclude the following:

    • Any portion attributable to non-controlling interests.

    • Any costs of servicing equity, paid or provided for, other than dividends on ordinary shares and partly paid shares.

  • When calculating weighted-average number of ordinary shares need to consider:

    • Definition of ordinary shares.

    • Number of shares.

    • Weighting to consider both fully and partly paid shares.

  • Definition of ordinary shares:

    • An equity instrument that is subordinate to all other classes of equity instruments.

    • For the purposes of the standard, it does not matter what the shares are called.

    • If they have the above characteristics, they are treated as ordinary shares—standard applies a substance-over-form test.

  • Determining the number of shares:

    • The number of ordinary shares outstanding at the beginning of the financial year is adjusted as follows:

      • Increased by ordinary shares issued during the year from unissued capital, weighted by reference to the number of days from the date of issue of those shares to the reporting date as a proportion of the total number of days in the reporting period, and

      • Decreased by ordinary shares bought back during the financial year, weighted by reference to the number of days from the date of reduction to the reporting date as a proportion of the total number of days in the reporting period.

  • The weighted average number of ordinary shares (denominator when calculating EPS) also needs to take into account partly paid shares.

  • Partly paid shares will be included only to the extent that they carry rights to participate in dividends relative to an ordinary share.

  • Where the partly paid ordinary shares carry no rights to participate in earnings, they would not be included in the weighted-average number of ordinary shares.

  • Entities might also have on issue mandatory convertible securities (securities that must ultimately be converted to ordinary shares).

  • Ordinary shares that will be issued upon the conversion of a mandatory convertible instrument are included in the calculation of basic earnings per share from the date the contract is entered into.

  • Bonus issues have an impact on the weighted-average number of ordinary shares.

  • The bonus issue does not change total shareholders’ funds—it involves a transfer from retained earnings to share capital (assuming funded from retained earnings).

  • The number of shares outstanding before the bonus issue should be increased as if the bonus has been in place for the entire reporting period.

  • Weighted-average number of ordinary shares prior to rights or other issue is divided by an adjustment factor.

  • If one-for-one bonus issue, number of shares would double.

  • Given no effect on earnings, doubling shares would halve EPS.

  • Prior period comparatives for EPS are also adjusted for the bonus issue so that comparisons can be made as if the bonus shares had been issued in the previous period.

  • If shares issued at the prevailing market price, there is no bonus element, and no adjustment is necessary.

  • Calculation of adjustment factor Adjustmentfactor=PxPoAdjustment factor = \frac{Px}{Po}, where:

    • PxPx = theoretical ex-rights price = [(Po×No)+Pr]/(No+1)[(Po \times No) + Pr] / (No + 1)

      • PoPo = last sales price or, if higher, last bid price cum rights

      • NoNo = no. of shares required for one right

      • PrPr = subscription price of right + present value of dividends forgone in respect of ordinary shares required for one right not presently participating in dividends

Diluted Earnings Per Share

  • AASB 133 requires that diluted EPS be disclosed together with basic EPS on the face of the statement of comprehensive income.

  • Diluted EPS must be calculated where an entity has on issue ‘potential ordinary shares’ that are, in fact, dilutive.

  • Potential ordinary shares are:

    • A financial instrument or other contract that may entitle its holder to ordinary shares.

  • Examples of potential ordinary shares:

    • Convertible preference shares.

    • Share options.

    • Convertible bonds.

    • Convertible notes.

  • Potential ordinary shares are considered dilutive when and only when the conversion to, calling of, or subscription for ordinary shares would decrease (or increase) net profit (or loss) from continuing ordinary operations per share.

  • If securities currently on issue might be converted to ordinary shares, this will increase the number of ordinary shares on issue, leading to a decrease in EPS.

  • Users of financial statements need to know about this potential reduction (dilution) in EPS.

  • Diluted earnings per share will show how EPS would fall if the potential ordinary shares were actually converted to ordinary shares—aim is to inform investors about how EPS could be affected in the future.

  • To determine diluted EPS:

    • Weighted-average number of shares calculated as per basic EPS.

    • Adjusted by a factor based on weighted-average number of potential ordinary shares that the company had on issue throughout all or part of the financial year.

  • General rule applies that if a potential ordinary share issue would increase EPS, it is not considered to be dilutive.

    • Excluded from calculation of diluted EPS.

  • Each type of potential ordinary share needs to be considered separately.

  • If the conversion is at the option of the entity, and the conversion is probable, the potential ordinary shares must be included in the diluted EPS calculation—even if their inclusion does not dilute EPS.

  • If conversion of potential ordinary shares to ordinary shares is mandatory, they would have already been included in basic EPS calculation.

  • Calculating earnings for diluted EPS:

    • Start with earnings used to calculate basic EPS and make adjustments for the after-tax effect of:

      • any dividends or other items related to dilutive potential ordinary shares deducted in arriving at profit or loss attributable to ordinary equity holders of the parent entity as calculated in accordance with paragraph 12

      • any interest recognised in the period related to dilutive potential ordinary shares

      • any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares

  • Calculating the weighted-average number of shares for diluted EPS:

    • Start with number used to calculate basic EPS and add the following:

      • weighted-average number of shares deemed to be issued for no consideration

      • weighted-average number of shares that are contingently issued

  • Dilutive potential ordinary shares are weighted by the number of days they were outstanding.

  • Shares issued for no consideration:

    • If the price paid for the shares is less than the market price:

      • Refer to AASB 133, paragraphs 46 and 47

      • In the case of options, for example, there is a need to calculate the number of shares issued for no consideration—this number is added to the number of ordinary shares (to the denominator) in the computation of EPS.

  • Contingently issuable shares:

    • Ordinary shares issued for little or no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement (AASB 133, par. 5)

    • Refer to AASB 133, paragraph 52

Analysis and Interpretation of Group Financial Statements

Comparative Analysis

  • Types of useful comparative information:

    • Intra-entity basis:

      • Comparisons within a single entity (detects changes in financial relationships and trends).

    • Industry averages:

      • Between entities in the same industry (determines position relative to others).

    • Inter-entity basis:

      • Between other entities (indicates competitive position).

Comparative Analysis Techniques

  • Horizontal analysis:

    • Evaluates a series of financial data over time.

  • Vertical analysis:

    • Evaluates financial items in relation to a base amount.

  • Ratio analysis:

    • Evaluates a comprehensive range of financial relationships representing different aspects of an entity’s activities.

Horizontal Analysis

  • Used to evaluate a series of financial statement data over a period of time.

  • Analyses increases or decreases that have occurred from a particular base year.

  • Figures are stated as both dollar amounts and as percentages.

  • Percentages remove the effect of size, so relative magnitude of change is revealed

  • One year is selected as the base year and then increases or decreases are based on the formula.

Vertical Analysis

  • Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude.

  • Useful for comparing companies of different sizes.

  • Calculated percentages can also be tracked over time to determine patterns of change.

Ratio Analysis

  • Ratio analysis can be used to make both:

    • intra-company comparisons

    • inter-entity comparisons.

  • Three types of ratios:

    1. liquidity

    2. solvency

    3. profitability.

Liquidity Ratios

  • Liquidity ratios measure the short-term ability of an entity to pay its debts and meet unexpected needs for cash.

    • Important to bankers, suppliers and other short-term creditors.

  • Current ratio

  • Quick ratio

    • excludes inventory and prepaid assets which are the least liquid current assets.

  • Current cash debt coverage

    • reflects the whole period not just a single point in time

    • does not just use year end balances

    • combines cash and accrual figures

  • Receivables turnover

    • indicates the effectiveness of credit collection policies

    • measures the number of times trade receivables are converted into cash during the period

  • Average collection period

    • converts receivables turnover figure into a measure of days for receivables collection

  • Inventory turnover

    • reflects the effectiveness of inventory management

  • Average days in inventory

    • Converts inventory turnover into a measure of days for inventory to be sold

Solvency Ratios

  • Solvency ratios measure the ability of an entity to survive over a long period of time

    • Important to long-term creditors and shareholders.

  • Debt to total assets ratio

    • indicates the degree of leverage (percentage of total assets funded through debt)

  • Times interest earned

    • indicates entity’s ability to sustain debt by measuring its ability meet interest payments from operating profit

  • Cash debt coverage

    • indicates entity’s ability to repay liabilities from cash generated from operating activities, without having to liquidate assets used in operations

    • reflects the whole period, not just a single point in time.

  • Free cash flow

    • indicates entity’s ability to pay dividends or expand operations

    • provides an estimation of discretionary cash

    • combines cash and accrual figures

Profitability Ratios

  • Profitability ratios measure the profit or operating success of an entity for a given period of time

  • Size of entity’s profit affects its:

    • ability to obtain debt and equity financing

    • liquidity position

    • ability to grow

  • Profitability is often regarded as the ultimate test of management’s operating effectiveness

  • Return on ordinary shareholders’ equity ratio

    • indicates earnings per dollar invested by the owners

    • affected by:

      • return on assets ratio

      • degree of leverage

  • Return on assets

    • measures overall profitability with respect to investment in assets

    • affected by:

      • degree of leverage (interest expense)

      • profit margins

      • asset base.

  • Profit margin

    • measures the percentage of each dollar of sales that results in profit

      • high volume firms (e.g., supermarkets) generally experience low profit margins

      • low volume firms (e.g., white goods) have high profit margins

  • Asset turnover

    • varies considerably between industries

  • Relationship between profitability ratios

    • Return on assets: = profit margin x asset turnover

    • net profitaverage total assets=net profitnet sales×net salesaverage total assets\frac{net\,profit}{average\,total\,assets} = \frac{net\,profit}{net\,sales} \times \frac{net\,sales}{average\,total\,assets}

  • Gross profit margin/ratio

    • indicates entity’s ability to maintain an adequate selling price above its costs

    • ratio declines as industry becomes more competitive

  • Operating expenses to sales ratio

    • measures costs incurred to support each dollar of sales

  • Cash Return on Sales Ratio

    • similar to net profit ratio

    • uses cash numerator instead of accrual profit

  • Cash Dividend Payout Rate

    • measures the percentage of profit distributed in the form of cash dividends

    • entities with high growth rates generally have low payout ratios because they reinvest most of their profit in the firm

  • Earnings per share (EPS)

    • measures profit earned on each ordinary share

    • reporting of EPS is regulated by AASB 133/IAS 33

  • Price/earnings ratio

    • measures ratio of market price of each ordinary share to earnings per share

    • reflects investors’ assessments of an entity’s future earnings.

Limitations of Financial Statement Analysis

  • Estimates

    • Financial statements contain many estimates, for example:

      • allowance for doubtful debts

      • depreciation expense

      • costs of warranties.

    • If estimates are inaccurate, the financial ratios and percentages will also be inaccurate

  • Cost

    • Many items are carried at historic cost.

    • This does not account for price-level changes.

  • Alternative accounting methods

    • Differences in accounting policies for the similar financial activities are often allowed (e.g., methods of depreciation).

  • Atypical data

    • Some end-of-period data may not represent normal business conditions

  • Diversification

    • Diversification within entities limits usefulness of financial statement analysis

    • Segment data may provide more relevant and comparable information