Understanding Business Accounting For Dummies, 2nd Edition (128 page)

Did Earnings Per Share Keep Up with Profit?

Chapter 14 explains that a publicly-owned business with a simple capital structure - meaning that the business is not required to issue additional shares in the future - reports just one earnings per share (EPS) for the period, which is called
basic
EPS. You calculate basic EPS by using the actual number of shares owned by shareholders. However, many publicly-owned businesses have complex capital structures that require them to issue additional shares in the future. These businesses report
two
EPS numbers - basic EPS and
diluted
EPS. The diluted EPS figure is based on a larger number of shares that includes the additional number of shares that will be issued under terms of management share options, convertible debt, and other contractual obligations that require the business to issue shares in the future.

In analysing earnings per share, therefore, you may have to put on your bifocals, as it were. For many businesses, you have to look at both basic EPS and diluted EPS. We suppose you could invest only in companies that report only basic EPS, but this investment strategy would eliminate a large number of businesses from your stock investment portfolio. Odds are, your stock investments include companies that report both basic and diluted EPS. The two EPS figures may not be too far apart, but then again, diluted EPS may be substantially less than basic EPS for some businesses.

Suppose you own stock in a public corporation that reports bottom-line net income that is 10 per cent higher than last year's. So far, so good. But you know that the market price of your shares depends on earnings per share (EPS). Ask what happened to basic and diluted EPS. Did both EPS figures go up 10 per cent? Not necessarily - the answer is often ‘no', in fact. You have to check.

Public companies whose shares are traded on one of the national stock exchanges (London Stock Exchange, New York Stock Exchange, NASDAQ, American Stock Exchange, and so on) are required to report EPS in their profit and loss accounts, so you don't have to do any computations. (Private businesses whose shares are not traded do not have to report EPS.)

EPS increases exactly the same percentage that net income increases only if the total number of shares remains constant. Usually, this is not the case. Many public corporations have a fair amount of activity in their shares during the year. So they include a schedule of changes in shareholders' equity during the year. (Chapter 8 discusses this financial summary of changes in shareholders' equity.) Look at this schedule to find out how many shares were issued during the year. Also, companies may purchase some of their own shares during the year, which is reported in this schedule.

Suppose net income increased, say, 10 per cent, but basic EPS increased only 6.8 per cent because the number of shares issued by the business increased 3 per cent during the year. (You can check the computation if you like.) You should definitely look into why additional shares were issued. And if diluted EPS does not keep pace with the company's earnings increase, you should pinpoint why the number of shares included in the calculation of diluted EPS increased during the period. (Maybe more management share options were awarded during the year.) The number of shares may increase again next year and the year after. Businesses do not comment on why the percentage change in their EPS is not the same as the percentage change in their net income. We wish that companies were required to leave a clear explanation of any difference in the percentage of change in EPS compared with the percentage of change in net income. However, this is just wishful thinking on our part. You have to ferret out this information yourself, which we advise you to do.

An increase in EPS may not be due entirely to an increase in net income, but rather to a
decrease
in the number of shares. Cash-rich companies often buy their shares to reduce the total number of shares that is divided into net income, thereby increasing basic and diluted EPS. You should pay close attention to increases in EPS that result from decreases in the number of shares. The long-run basis of EPS growth is profit growth, although a decrease in the number of shares helps EPS and, hopefully, the market price of the shares.

Did the Profit Increase Generate a Cash Flow Increase?

Increasing profit is all well and good, but you also should ask: Did
cash flow from profit
increase? Cash flow from profit is found in the first section of the cash flow statement, which is one of the three primary financial statements included in a financial report. The cash flow statement begins with an explanation of cash flow from profit.

Accountants use the term
cash flow from operating activities
- which, in our opinion, is not nearly as descriptive as
cash flow from profit
. The term
profit
is avoided like the plague in external financial reports; it's not a politically correct word. So you may think that accountants would use the phrase
cash flow from net income
. But no, the official pronouncement on the cash flow statement mandated the term
cash flow from operating activities
.
Operating activities
refers simply to sales revenue and expenses, which are the profit-making operations of a business. We'll stick with
cash flow from profit
- please don't report us to the accounting authorities.

Almost all expenses are bad for cash flow, except one: depreciation. Depreciation expense is actually good for cash flow. Each year, a business converts part of the cost of its fixed assets back into cash through the cash collections from sales made during the year. Over time, fixed assets are gradually used up, so each year is charged with part of the fixed assets' cost by recording depreciation expense. And each year, a business retrieves cash for part of the cost of its fixed assets. Thus depreciation expense decreases profit but increases cash flow. But net income plus depreciation does not equal cash flow from profit - except in the imaginary scenario in which all the company's other operating assets (mainly debtors and stock) and all its operating liabilities (mainly creditors and accrued expenses payable) don't increase or decrease during the year.

The key question is: Should cash flow from profit change about the same amount as net income changed, or is it normal for the change in cash flow to be higher or lower than the change in net income?

As a general rule, sales growth penalises cash flow from profit in the short run. A business has to build up its debtors and stock, and these increases hurt cash flow - although, during growth periods, a business also increases its creditors and accrued expenses payable, which helps cash flow. The asset increases, in most cases, dominate the liability increases, and cash flow from profit suffers.

We strongly advise you to compare cash flow from operating activities (see, we use the officially correct term here) with net income for each of the past two or three years. Is cash flow from profit about the same percentage of net income each year? What does the trend look like? For example, last year, cash flow from profit may have been 90 per cent of net income, but this year it may have dropped to 50 per cent. Don't hit the panic button just yet.

A dip in cash flow from profit in one year actually may be good from the long-run point of view - the business may be laying a good foundation for supporting a higher level of sales. But then again, the slowdown in cash flow from profit could present a short-term cash problem that the business has to deal with.

A company's cash flow from profit may be a trickle instead of a stream. In fact, cash flow from profit could be
negative
; in making a profit, the company could be draining its cash reserves. Cash flow from profit is low, in most cases, because debtors from sales haven't been collected and because the business has made large increases in its inventories. These large increases raise questions about whether all the receivables will be collected and whether all the stock will be sold at regular prices. Only time can tell. But generally speaking, you should be cautious and take the net income number that the business reports with a grain of salt.