Understanding Business Accounting For Dummies, 2nd Edition (107 page)

A seemingly small change in the profit ratio can have a big impact on the bottom line. Suppose that this business had earned a profit ratio of 5 per cent instead of 3.65 per cent. That increase in the profit ratio translates into a £700,000 increase in bottom-line profit (net income) on the same sales revenue.

Profit ratios vary widely from industry to industry. A 5-10 per cent profit ratio is common in most industries, although some high-volume retailers, such as supermarkets, are satisfied with profit ratios around 1 per cent or 2 per cent.

You can turn any ratio upside down and come up with a new way of looking at the same information. If you flip the profit ratio over to be sales revenue divided by net income, the result is the amount of sales revenue needed to make £1 profit. Using the same example, £52 million sales revenue ÷ £1.9 million net income = 27.37 to 1 upside-down profit ratio, which means that this business needs £27.37 in sales to make £1 profit. So you can say that net income is 3.65 per cent of sales revenue, or you can say that sales revenue is 27.37 times net income - but the standard profit ratio is expressed as net income divided by sales revenue.

Earnings per share, basic and diluted

Publicly-owned businesses, according to generally accepted accounting principles (GAAP), must report
earnings per share (EPS)
below the net income line in their profit and loss accounts - giving EPS a certain distinction among the ratios. Why is EPS considered so important? Because it gives investors a means of determining the amount the business earned on their share investments: EPS tells you how much net income the business earned for each share you own. The essential equation for EPS is as follows:

Net income ÷ total number of capital stock shares = EPS


For the example in Figures 14-1 and 14-2, the company's £1.9 million net income is divided by the 795,000 shares of stock the business has issued to compute its £2.39 EPS.

Note:
Private businesses do not have to report EPS if they don't want to. Considering the wide range of issues covered by GAAP, you find surprisingly few distinctions between private and public businesses - these authoritative accounting rules apply to all businesses. But EPS is one area where GAAP makes an exception for privately-owned businesses. EPS is extraordinarily important to the shareholders of businesses whose shares are publicly-traded. These shareholders focus on market price
per share
. They want the total net income of the business to be communicated to them on a per share basis so that they can easily compare it with the market price of their shares. The shares of privately-owned companies are not actively traded, so there is no readily available market value for their shares. The thinking behind the rule that privately-owned businesses should not have to report EPS is that their shareholders do not focus on per share values and are more interested in the business's total net income performance.

The business in the example is too small to be publicly-owned. So we turn here to a larger public company example. This publicly-owned company reports that it earned £1.32 billion net income for the year just ended. At the end of the year, this company has 400 million shares
outstanding
, which refers to the number of shares that have been issued and are owned by its shareholders. Thus, its EPS is £3.30 (£1.32 billion net income ÷ 400 million stock shares). But here's a complication: The business is committed to issuing additional capital shares in the future for share options that the company has granted to its managers, and it has borrowed money on the basis of debt instruments that give the lenders the right to convert the debt into its capital stock. Under terms of its management share options and its convertible debt, the business could have to issue 40 million additional capital shares in the future. Dividing net income by the number of shares outstanding plus the number of shares that could be issued in the future gives the following computation of EPS:

£1.32 billion net income ÷ 440 million capital stock shares = £3.00 EPS


This second computation, based on the higher number of shares, is called the
diluted
earnings per share. (
Diluted
means thinned out or spread over a larger number of shares.) The first computation, based on the number of shares actually outstanding, is called
basic
earnings per share. Publicly-owned businesses have to report two EPS figures - unless they have a
simple capital structure
that does not require the business to issue additional shares in the future. Generally, publicly-owned companies have
complex capital structures
and have to report two EPS figures. Both are reported at the bottom of the profit and loss account. So the company in this example reports £3.30 basic EPS and £3.00 diluted EPS. Sometimes it's not clear which of the two EPS figures is being used in press releases and in articles giving investment advice. Fortunately,
The Financial Times
and most other major financial publications leave a clear trail of both EPS figures.

Calculating basic and diluted EPS isn't always as simple as our examples may suggest. An accountant would have to adjust the EPS equation for the following complicating things that a business may do:

Issue additional shares during the year and buy back some of its shares (shares of its stock owned by the business itself that are not formally cancelled are called
treasury stock
)

Issue more than one class of share, causing net income to be divided into two or more pools - one pool for each class of share

Go through a merger (business combination) in which a large number of shares are issued to acquire the other business

The shareholders should draw comfort from the fact that the top management of many businesses in which they invest are probably just as anxiously reviewing EPS performance as they are. This extract from Tesco's annual accounts reveals much:

Annual bonuses based on achieving stretching EPS growth targets and specific corporate objectives.