Wednesday, March 6, 2013

Earning Per Share: 4 Ways to Dilute Earnings

Earnings per share is defined as (net income)/ (outstanding shares of common stock). When most people say “earnings per share”, they’re referring to earnings per share of common stock.

Issued, authorized and outstanding shares (and also treasury stock)
I’ll take a detour and explain an important concept related to common stock. Please note the difference between these three terms:
·            Issued shares: Issued refers to shares sold to the public.
·            Outstanding shares: Shares held (owned) by the public. Wait- why would the issued shares differ from the outstanding shares? Once they’re sold to the public, don’t they stay in the public hands? Not always the case- read on…
·            Treasury shares: Shares that were issued and repurchased by the issuing company. (Issued shares) – (Treasury shares) = Outstanding shares.
·            Authorized Shares: The maximum number of shares a company is allowed to issue. That amount is normally stated in the company’s corporate charter. In other words, authorized shares are determined when the company is formed.

Dilutive earnings per share
Take a look at the formula for earnings per share (EPS) above. You’ll note that the denominator is common shares outstanding. So, if you earned $5 and had 100 shares outstanding, your EPS would be ($5/100) = $.05 per share.

Now, consider dilution. When you mix Kool-Aid with water, the drink mix is diluted- thins out. Now, apply that concept to EPS. If total earnings stay the same ($5) and common shares outstanding increase, your EPS will go down. If you earned $5 and had 200 shares outstanding, your EPS would be ($5/100) = $.025 per share. The larger denominator (common shares) generates a smaller EPS.

Securities that can cause dilution
There are several types of securities that allow the holder to convert the security into common stock. When you consider dilution, you assume that all securities that can be converted into common stock are converted. That view allows you to see the maximum number of common shares investors could potentially own. Here are four examples:

1.     Call options on stock: An option is a contract. A call option buyer pays a fee (called a premium) to own a right. The buyer has the right to buy a certain number of shares of common stock- at a certain price, for a certain period of time. If the option buyer exercises his or her right, they purchase more shares of common stock. Stock options are often issued to employees as an incentive to stay with a company and help it grow.

2.     Warrant: A warrant also allows the owner to buy stock. A warrant is usually issued with a bond. The warrant make the bond more attractive to a potential buyer. If an investor buys the bond and the warrant, they earn interest on the bond- and also can use the warrant to buy common stock. So, they can participate in the company’s debt and equity.

3.     Convertible Preferred Stock: Preferred stock is slightly different from common stock. Stock is “preferred”, because preferred shares are paid a dividend before common shareholders. If the company liquidates, preferred shareholders are “in line” ahead of common shareholders. If there are assets left after liquidation, a preferred shareholder’s claim on those assets comes before common shareholders. Convertible preferred stock allows the owner to convert from preferred stock to common stock shares.

4.     Convertible Bond: A convertible bond allows the owner to convert from a bond to shares of common stock shares. The terms of the conversion (ie- how many shares, price paid per share) are stated on the bond certificate. In that way, it’s clear to the owner how the bond can be converted.

All four of these securities can be converted into common stock. So, all four are considered to be dilutive securities. If outstanding shares of common stock increase- and total earnings stay the same- earnings per share will decline.

Your comments are welcome! Visit my website for online classes on the toughest accounting topics.

Ken Boyd
St. Louis Test Preparation
(cell) (314) 913-6529
(you tube channel) kenboydstl             
Author/ Cost Accounting for Dummies

Tuesday, March 5, 2013

Empty Shelves and the Cash Conversion Cycle

Cash conversion cycle represents the time it takes (in days) to convert resource inputs into cash flows (Source: Investopedia). By “resource inputs”, we mean assets.

Let’s say you buy towels from a supplier and sell them in retail stores. Towels that are purchased into inventory are considered assets. Inventory is something you’ll use to make money in your business- you sell the towels for a profit. So, towels are assets.

The tricky part is planning your cash flow. You need enough cash to buy the towels into inventory. Next, you need cash to build and operate the stores. You’ll incur costs for payroll, advertising, etc. In other words, you need cash to operate until someone buys your towels.

The number of days from the time you buy the towels (cash out) until you sell the towels and collect the cash (cash in) is the cash conversion cycle.

What if a court decision prevented from stocking your shelves with your product?

I’ve provided a link to the article JC Penney Could Wind Up With Empty Shelves (3/4/13)


A New York State Supreme Court Judge told JC Penney that the firm “took a risk” by buying towels and other product from a company founded by Martha Stewart. Macy’s Inc. is claiming that they have an exclusive agreement to sell Martha Stewart merchandise. It’s not the legal issue I want to focus on. Instead, consider the cash and accounting impact.

Penney already bought the inventory
The big issue is that Penney already bought the inventory. Now, they may be prevented from selling it. In fact, the inventory was targeted to be sold in May- about 60 days from the date of the article. This brings up a whole bunch of problems. Here are a few:
1.     Assuming Penney is not allowed to sell the Martha Stewart inventory, they need to replace it with something else.
2.     Penney needs cash to buy the replacement inventory. Trouble is, they already used cash to buy the Martha Stewart inventory.

Cash to buy new inventory
One way to generate cash is to sell the Martha Stewart inventory to someone else. Unfortunately, the buyer may be the very company (Macy’s) that is in litigation with Penney! Since Macy’s has an exclusive agreement, who else would Penney sell to? Penney would certainly take a loss of the sale of inventory.

If this scenario plays out, Penney would end up with less cash to use for purchasing replacement inventory. The company might have to raise funds to have sufficient cash for new inventory purchases.

Changing other costs- new product offering
If Penney is replacing the inventory, all of the marketing/ advertising/ store displays will change. It’s likely that the firm would write off the prior spending on marketing Martha Stewart as a loss. Penney would have to decide if and how much to market the new inventory. Would the company invest heavily in marketing and advertising to get the word out? After all, the original product was going on the shelf in 60 days. They don’t have much time to get the word out.

Cash conversion cycle: Before and after the change
Originally, Penney invested in marketing and advertising to sell the Martha Stewart line. They bought inventory. The plan was to stock the store shelves and start selling product in May. So, cash collections would start in May. Those cash inflows would cover the cash outflows for purchasing inventory, marketing, etc.

If Penney loses in court, the cash flow is dramatically different. The firm may take a loss on selling the Martha Stewart inventory. Penney will be to use cash to buy replacement inventory. The company will also consider an investment in a new marketing campaign to sell a different product. Will consumers (who were expecting Martha Stewart) buy the replacement product? How will the new product’s sale compare with the original plan? These questions have a huge impact on the expected cash inflows.

Your comments are welcome! Visit my website for online classes on the toughest accounting topics.

Ken Boyd
St. Louis Test Preparation
(cell) (314) 913-6529
(you tube channel) kenboydstl
(twitter) @StLouisTestPrep                         
Author/ Cost Accounting for Dummies
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