What is earnings per share

Publicly owned companies must report earnings per share (EPS) below the net income line in their income statements. This is mandated by generally accepted accounting practices (GAAP). The EPS gives investors a means of determining the amount the business earned on its stock share investments. In other words, EPS tells investors how much net income the business earned for each stock share they own. It's calculated by dividing net income by the total number of capital stock share. It's important to the stockholders who want the net income of the business to be communicated to them on a per share basis so they can compare it with the market price of their shares.

Private businesses don't have to report EPS because stockholders focus more on the business's total net income. Publicly-held companies actually report two EPS figures, unless they have what's known as a simple capital structure. Most publicly-held companies though, have complex capital structures and have to report two EPS figures. One is called the basic EPS; the other is called the diluted EPS. Basic EPS is based on the number of stock shares that are outstanding. Diluted earnings are based on shares that are outstanding and shares that may be issued in the future in the form of stock options.

Obviously this is a complicated process. An accountant has to adjust the EPS formula for any number of occurrences or changes in the business. A business might issue additional stock shares during the year and buy back some of its own shares. Or it might issue several classes of stock, which will cause net income to be divided into two or more pools - one pool for each class of stock. A merger, acquisition or divestiture will also impact the formula for EPS.

How to analyze a financial statement

It's obvious financial statement have a lot of numbers in them and at first glance it can seem unwieldy to read and understand. One way to interpret a financial report is to compute ratios, which means, divide a particular number in the financial report by another. Financial statement ratios are also useful because they enable the reader to compare a business's current performance with its past performance or with another business's performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In order words, using ratios can cancel out difference in company sizes.

There aren't many ratios in financial reports. Publicly owned businesses are required to report just one ratio (earnings per share, or EPS) and privately-owned businesses generally don't report any ratios. Generally accepted accounting principles (GAAP) don't require that any ratios be reported, except EPS for publicly owned companies.

Ratios don't provide definitive answers, however. They're useful indicators, but aren't the only factor in gauging the profitability and effectiveness of a company.

One ratio that's a useful indicator of a company's profitability is the gross margin ratio. This is the gross margin divided by the sales revenue. Businesses don't discose margin information in their external financial reports. This information is considered to be proprietary in nature and is kept confidential to shield it from competitors.

The profit ratio is very important in analyzing the bottom-line of a company. It indicates how much net income was earned on each $100 of sales revenue. A profit ratio of 5 to 10 percent is common in most industries, although some highly price-competitive industries, such as retailers or grocery stores will show profit ratios of only 1 to 2 percent.

Parts of an Income Statement, Part 3

While some lines of an income statement depend on estimates or forecasts, the interest expense line is a basic equation. When accounting for income tax expense, however, a business can use different accounting methods for some of its expenses than it uses for calculating its taxable income. The hypothetical amount of taxable income, if the accounting methods used were used in the tax return is calculated. Then the income tax based on this hypothetical taxable income is fitured. This is the income tax expense reported in the income statement. This amount is reconciled with the actual amount of income tax owed based on the accounting methods used for income tax purposes. A reconciliation of the two different income tax amounts is then provided in a footnote on the income statement.

Net income is like earnings before interest and tax (EBIT) and can vary considerably depending on which accounting methods are used to report sales revenue and expenses. This is where profit smoothing can come into play to manipulate earnings. Profit smoothing crosses the line from choosing acceptable accounting methods from the list of GAAP and implementing these methods in a reasonable manner, into the gray area of earnings management that involves accounting manipulation.

It's incumbent on managers and business owners to be involved in the decisions about which accounting methods are used to measure profit and how those methods are actually implemented. A manager can be requires to answer questions about the company's financial reports on many occasions. It's therefore critical that any officer or manager in a company be thoroughly familiar with how the company's financial statements are prepared. Accounting methods and how they're implemented vary from business to business. A company's methods can fall anywhere on a continuum that's either left or right of center of GAAP.

Parts of an Income Statement, Part 2

Of course profit and cost of goods sold expense are the two most critical components of an income statement, or at least they're what people will look at first. But an income statement is truly the sum of its parts, and they all need to be considered carefully, consistently and accurately.

In reporting depreciation expense, a business can use a short-life method and load most of the expense over the first few years, or a longer-life method and spread the expense evenly over the years. Depreciation is a big expense for some businesses and the method of reporting is especially critical for them.

One of the more complex elements of a an income statement is the line reporting employee pensions and post-retirement benefits. The GAAP rule on this expense is complex and several key estimates must be made by the business, such as the expected rate of return on the portfolio of funds set aside for these future obligations. This and other estimates affect the amount of expense recorded.

Many products are sold with expressed or implied warranties and guarantees. The business should estimate the cost of these future obligations and record this amount as an expense in the same period that the goods are sold, along with the cost of goods expense. It can't really wait until customers actually return products for repair or replacement, should be forecast as a percent of the total products sold.

Other operating expenses that are reported in an income statement may also have timing or estimating considerations. Some expenses are also discretionary in nature, which means that how much is spent during the year depends on the discretion of management.

Earnings before interest and tax (EBIT) measures the sales revenue less all the expenses above this line. It depends on all the decisions made for recording sales revenue and expenses and how the accounting methods are implemented.

Parts of an Income Statement, part 1

The first and most important part of an income statement is the line reporting sales revenue. Businesses need to be consistent from year to year regarding when they record sales. For some business, the timing of recording sales revenue is a major problem, especially when the final acceptance by the customer depends on performance tests or other conditions that have to be satisfied. For example, when does an ad agency report the sales revenue for a campaign it's prepared for its client? When the work is completed and sent to the client for approval? When the client approves it? When the ads appear in the media? Or when the billing is complete? These are issues a company must decide on for reporting sales revenue, and they must be consistent each year, and the timing of reporting should be noted on the financial statement.

The next line in an income statement is the cost of goods sold expense. There are three methods of reporting cost of goods sold expense. One is called "first in-first out" (FIFO); another is the "last in-last out" (LIFO) method and the last is the average cost method. Cost of goods sold expense is a huge item in an income statement and how it's reported can make a substantial impact on the reported bottom line.

Other items in an income statement include inventory write-downs. A business should regularly inspect its inventory carefully to determine any losses due to theft, damage and deterioration, and to apply the lower of cost or market (LCM) method. Bad debts are also an important component of the income statement. Bad debts are those owed to a business by customers who bought on credit (accounts receivable) but are not going to be paid. Again the timing of when bad debts are reported is crucial. Do you report it before or after any collection efforts are exhausted?

Measuring Costs

Measuring profits or net income is the most important thing accountants do. The second most important task is measuring costs. Costs are extremely important to running a business and managing them effectively can make a substantial difference in a company's bottom line.

Any business that sells products needs to know its product costs and depending on what is being manufactured and/or sold, it can get complicated. Every step in the production process has to be tracked carefully from start to finish. Many manufacturing costs cannot be directly matched with particular products; these are called indirect costs. To calculate the full cost of each product manufactured, accountants devise methods for allocating indirect production costs to specific products. Generally accepted accounting principles (GAAP) provide few guidelines for measuring product cost.

Accountants need to determine many other costs, in addition to product costs, such as the costs of the departments and other organizational units of the business; the cost of the retirement plan for the company's employees; the cost of marketing and advertising; the cost of restructuring the business or the cost of a major recall of products sold by the company, should that ever become necessary.

Cost accounting serves two broad purposes: measuring profit and furnishing relevant information to managers. What makes it confusing is that there's no one set method for measuring and reporting costs, although accuracy is paramount. Cost accounting can fall anywhere on a continuum between conservative or expansive. The phrase actual cost depends entirely on the particular methods used to measure cost. These can often be as subjective and nebulous as some systems for judging sports. Again accuracy is extremely important. The total cost of goods or products sold is the first and usually largest expense deducted from sales revenue in measuring profit.