CFA Level 1

AAA

Financial Ratios - Basic Earnings Per Share

I. Introduction

Simple and Complex Capital Structures
A simple capital structure is one that contains no potential dilutive securities. A company with a simple structure will have only common stockholders, preferred stockholders and nonconvertible debt.

Companies with simple capital structures only need to report basic EPS.

A complex structure refers to one that contains potential dilutive securities. A company with a complex structure in addition to what is included in a company's simple capital structure will also include warrants and/or options and/or convertible debt instruments.

- Companies that have a complex capital structure must report earnings per share (EPS) on a basic and fully diluted basis.

EPS is simply the net income that is attributable to common shareholders divided by the number of shares outstanding. If a company has a complex capital structure, it means that a portion of their dilutive securities may be converted to equity at some point in time. Since EPS basic does not take into account these dilutive securities, EPS basic will always be greater than EPS fully diluted.

Basic Earnings Per Share (EPS)
EPS basic does not consider potential dilutive securities. A company with a simple capital structure will calculate only a basic EPS, which is defined as:

Formula 7.45

Basic EPS = (net income - preferred dividends)_____
weighted average number of shares outstanding

Since we are interested only in the net income that belongs to common stockholders, preferred dividends are subtracted. Dividends, whether paid in cash or stock, or the additional dividend that is attributable to participating preferred shares must also be deducted.

Note:

- Dividends declared to common stockholders are not subtracted from ESP as they belong to common stockholders.
- Preferred stock dividends are the current year's dividend only.
(a) If none are declared, then calculate an amount equal to what the current dividend would have been.
(b) Don't include dividends in arrears.
(c) If a net loss occurs, add the preferred dividend.
- EPS is calculated for each component of income: income from continuing operations, income before extraordinary items or changes in accounting principle, and net income.

Calculating the Weighted Average Number of Shares Outstanding
The weighted average number of shares outstanding (WASO) is:

Formula 7.46

The # of shares outstanding during each month, weighted by the # of months those shares were outstanding.

Included are the impacts of all stock dividends and stock splits effective during the period and those announced after the end of the reporting period but before the financial statements are issued. Furthermore, all prior periods must be restated to facilitate comparative analysis.

Dilutive Effect of Splits and Dividends
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