Financial Ratios - Dilutive Securities

Dilutive Securities are securities that are not common stock in form, but allow the owner to obtain common stock upon exercise of an option or a conversion privilege. The most common examples of dilutive securities are: stock options, warrants, convertible debt and convertible preferred stock. These securities would decrease EPS if exercised or if they were converted common stock. In other words, a dilutive security is any securities that could increase the weighted number of shares outstanding.

If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-dilutive security, and it should be excluded from the computation of the dilutive EPS.

For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common stock. The tax rate is 30%. XYZ's weighted average number of shares, used to compute basic EPS, is 10,000. XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.

What is the basic EPS? What is the diluted EPS?

1) Compute basic EPS:
i. Basic EPS = (12,000 - 2,000) / (10,000) = $1.00

2) Compute diluted EPS:
i. Find the adjustment to the denominator: 100 * 50 = 5,000
ii. Find the adjustment to the numerator: 100 * $1000 * 0.1 * (1 - 0.3) = $7,000

3) Find diluted EPS:
i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 = $1.13

If the fully dilused EPS > basic EPS, then the security is antidilutive. In this case, Basic EPS = $1.00 is less than the fully diluted ESP, and the security is antidilutive.

Calculating Basic and Fully Diluted EPS in a Complex Capital Structure

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