ccounts Receivable Turnover Ratio

Accounts receivable turnover is the number of times per year that a business
collects its average accounts receivable. The ratio is intended to evaluate the
ability of a company to efficiently issue credit to its customers and collect funds
from them in a timely manner. A high turnover ratio indicates a combination of a
conservative credit policy and an aggressive collections department, as well as a
number of high-quality customers. A low turnover ratio represents an opportunity
to collect excessively old accounts receivable that are unnecessarily tying up
working capital. Low receivable turnover may be caused by a loose or
nonexistent credit policy, an inadequate collections function, and/or a large
proportion of customers having financial difficulties. It is also quite likely that a
low turnover level indicates an excessive amount of bad debt.

It is useful to track accounts receivable turnover on a trend line in order to see if

turnover is slowing down; if so, an increase in funding for the collections staff
may be required, or at least a review of why turnover is worsening.

To calculate receivables turnover, add together beginning and ending accounts

receivable to arrive at the average accounts receivable for the measurement
period, and divide into the net credit sales for the year. The formula is as
follows:

Net Annual Credit Sales

(Beginning Accounts Receivable + Ending Accounts Receivable) / 2

For example, the controller of ABC Company wants to determine the company's
accounts receivable turnover for the past year. In the beginning of this period,
the beginning accounts receivable balance was $316,000, and the ending
balance was $384,000. Net credit sales for the last 12 months were $3,500,000.
Based on this information, the controller calculates the accounts receivable
turnover as:

$3,500,000 Net credit sales

($316,000 Beginning receivables + $384,000 Ending receivables) / 2

$3,500,000 Net credit sales

$350,000 Average accounts receivable
 = 10.0 Accounts receivable turnover

Thus, ABC's accounts receivable turned over 10 times during the past year,
which means that the average account receivable was collected in 36.5 days.

Here are a few cautionary items to consider when using the receivables turnover
measurement:

Some companies may use total sales in the numerator, rather than net
credit sales. This can result in a misleading measurement if the proportion of
cash sales is high, since the amount of turnover will appear to be higher than
is really the case.
A very high accounts receivable turnover number can indicate an
excessively restrictive credit policy, where the credit manager is only allowing
credit sales to the most credit-worthy customers, and letting competitors with
looser credit policies take away other sales.
The beginning and ending accounts receivable balances are for just two
specific points in time during the measurement year, and the balances on
those two dates may vary considerably from the average amount during the
entire year. Therefore, it is acceptable to use a different method to arrive at
the average accounts receivable balance, such as the average ending balance
for all 12 months of the year.
A low receivable turnover figure may not be the fault of the credit and
collections staff at all. Instead, it is possible that errors made in other parts of
the company are preventing payment. For example, if goods are faulty or the
wrong goods are shipped, customers may refuse to pay the company. Thus,
the blame for a poor measurement result may be spread through many parts
of a business.

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What is the 'Receivables Turnover Ratio'

An accounting measure used to quantify a firm's effectiveness in extending credit
and in collecting debts on that credit. The receivables turnover ratio is an activity
ratio measuring how efficiently a firm uses its assets.
Receivables turnover ratio can be calculated by dividing the net value of credit
sales during a given period by the average accounts receivable during the same
period. Average accounts receivable can be calculated by adding the value of
accounts receivable at the beginning of the desired period to their value at the
end of the period and dividing the sum by two.

The method for calculating receivables turnover ratio can be represented with
the following formula:

The
receivables turnover ratio is most often calculated on an annual basis, though this
can be broken down to find quarterly or monthly accounts receivable turnover as
well.

Next Up

Turnover

Asset Turnover Ratio

Turnover Ratio

Efficiency Ratio

BREAKING DOWN 'Receivables Turnover Ratio'

Receivable turnover ratio is also often called accounts receivable turnover, the
accounts receivable turnover ratio or the debtors turnover ratio.

In essence, the receivables turnover ratio indicates the efficiency with which a
firm manages the credit it issues to customers and collects on that credit.
Because accounts receivable are moneys owed on a credit agreement without
interest, by maintaining accounts receivable firms are indirectly extending
interest-free loans to their clients. As such, because of the time value of money
principle, a firm loses more money the longer it takes to collect on its credit
sales.

To provide an example of how to calculate the receivables turnover ratio,

suppose that during 2014 Company A had $800,000 in net credit sales. Also
suppose that on the first of January it had $64,000 accounts receivable and that
on December 31 it had $72,000 accounts receivable. With this information, one
could calculate the receivables turnover ratio for 2014 in the following way:
$800,000 / [($64,000 + $72,000) / 2] = $800,000 / ($136,000 / 2) = $800,000 /
$68,000 = 11.76

This number also serves as an indicator of the number of accounts receivable a

company collects during a year. Because of this functionality, one can determine
the average duration of accounts receivable during a given year by dividing 365
by the receivables turnover ratio for that year. For this example, the average
accounts receivable turnover is 31.04 days (365 / 11.76).

Interpreting 'Receivables Turnover Ratio'

A high receivables turnover ratio can imply a variety of things about a company.
It may suggest that a company operates on a cash basis, for example. It may also
indicate that the companys collection of accounts receivable is efficient, and that
the company has a high proportion of quality customers that pay off their debts
quickly. A high ratio can also suggest that the company has a conservative policy
regarding its extension of credit. This can often be a good thing, as this filters
out customers who may be more likely to take a long time in paying their debts.
On the other hand, a companys policy may be too conservative if it is too tight
in extending credit, which can drive away potential customers and give business
to competitors. In this case, a company may want to loosen policies to improve
business, even though it may reduce its receivables turnover ratio.

A low ratio, in a similar way, can also suggest a few things about a company,
such as that the company may have poor collecting processes, a bad credit
policy or none at all, or bad customers or customers with financial difficulty.
Theoretically, a low ratio can also often mean that the company has a high
amount of cash receivables for collection from its various debtors, should it
improve its collection processes. Generally, however, a low ratio implies that the
company should reassess its credit policies in order to ensure the timely
collection of imparted credit that is not earning interest for the firm.

Uses of 'Receivables Turnover Ratio'

The receivables turnover ratio has several important functions other than simply
assessing whether or not a company has issues collecting on credit. Though this
offers important insight, it does not tell the whole story. For example, if one were
to track a companys receivables turnover ratio over time, it would say much
more about the companys history with issuing and collecting on credit than a
single value can. By looking at the progression, one can determine if the
companys receivables turnover ratio is trending in a certain direction or if there
are certain recurring patterns. What is more, by tracking this ratio over time
alongside earnings, one may be able to determine whether a companys credit
practices are helping or hurting the companys bottom line.
While this ratio is useful for tracking a companys accounts receivable turnover
history over time, it may also be used to compare the accounts receivable
turnover of multiple companies. If two companies are in the same industry and
one has a much lower receivables turnover ratio than the other, it may prove to
be the safer investment.

Limitations of 'Receivables Turnover Ratio'

Like any metric attempting to gauge the efficiency of a business, the receivables
turnover ratio comes with a set of limitations that are important for any investor
to consider before using it.

One important thing to consider is that companies will sometimes use total sales
instead of net sales when calculating their ratio, which generally inflates the
turnover ratio. While this is not always necessarily meant to be deliberately
misleading, one should generally try to ascertain how a company calculates their
ratio before accepting it at face value, or otherwise should calculate the ratio
independently.

Another important consideration is that accounts receivable can vary dramatically

over the course of the year. This means that if one picks a start and end point
for calculating the receivables turnover ratio arbitrarily, the ratio may not reflect
the true climate of the companys issuing of and collection on credit. As such, the
beginning and ending values selected when calculating the average accounts
receivable should be carefully picked so as to represent the year well. In order to
account for this, one could take an average of accounts receivable from each
month during a twelve-month period.

It is also important to note that comparisons of different companies receivables

turnover ratios should only be made when the companies are in same industry,
and ideally when they have similar business models and revenue numbers as well.
Companies of different sizes may often have very different capital structures,
which can greatly influence turnover calculations, and the same is often true of
companies in different industries. The receivables turnover ratio is not
particularly useful in comparing companies with significant differences in the
proportion of sales that are credit, as determining the receivables turnover ratio
of a company with a low proportion of credit sales does not indicate much about
that companys cash flow. Comparing such companies with those that have a high
proportion of credit sales also does not usually indicate much of importance.

Lastly, a low receivables turnover ratio might not necessarily indicate that the
companys issuing of credit and collecting of debt is lacking. If, for example,
distribution messes up and fails to get the right goods to customers, customers
may not pay, which would also decrease the companys receivables turnover
ratio.

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Importance of Accounts Receivable

Ratio
by Helen Akers,
studioDAccounti
ng ledgers keep
track of asset
accounts such
as receivables.

Related Articles

The
Reasons for
Changes in
Accounts Receivable Turnover
How Does Accounts Receivable Turnover Ratio Affect a Company?
Why Can a Business Show a Profit & Not Have Enough Cash to Pay Its
Obligations?
What Are the Functions of Accounts Receivable?
What Does It Mean if a Company's Accounts Receivable Turnover Is Very High?

The accounts receivable ratio is one of the financial performance indicators that
businesses monitor. It is useful for companies that sell goods and services on
credit. Accounting theory considers the accounts receivable ratio to be one of the
asset turnover or efficiency ratios. Small businesses can use the ratio to
determine whether their credit policies might be too strict or lenient. In order to
use the ratio properly, a business must keep track of its annual credit sales in
addition to its cash sales.

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Definition
By definition, the accounts receivable ratio is the average amount of time it takes
a company to collect on its credit sales. If a business has an annual average of
$40,000 worth of credit sales and annual sales of $100,000, the accounts
receivable turnover ratio is four. The accounts turnover ratio is different from the
accounts receivable ratio but is used in its calculation. A company calculates the
accounts receivable ratio by taking the number of days in its fiscal year and
dividing it by the turnover ratio. A turnover ratio of four yields a receivable ratio
of 91 days.

Interpretation
The accounts receivable ratio reveals the amount of days it takes a company to
receive payment on its credit sales. A receivable ratio of 91 days means that it is
an average of 91 days from the time of sale to the time of payment. Whether the
ratio is low or high depends on the company's industry. Industry averages are
benchmarks that a small business owner might use to gauge his company's
performance. Some industries, such as retail furniture stores, might have a
higher average account receivables ratio than others.

Related Reading: How Does Accounts Receivable Turnover Ratio Affect a

Company?

High Ratio
A high accounts receivable ratio is usually the result of an inefficient credit policy.
Higher ratios mean that it takes a company longer to collect its payments. High
ratios might also mean that the majority of a company's sales volume is done on
credit. Without an adequate steady cash flow, a business owner might have
difficulty keeping up with his expenses. A company might consider revising its
credit policy to give customers more incentive to make purchases with cash. In
addition, a business owner could consider giving customers incentives for paying
invoices prior to 30 days out.

Provisions
Even though the accounts receivable ratio is often a good indicator of a
company's ability to collect payment, it could be misleading. Since the ratio is an
average, a business owner should periodically review all credit accounts.
Customers that carry high balances and pay quickly could skew the average,
concealing a problem with the majority of accounts with small balances. A close
examination of each credit account could also reveal those customers who might
need their credit privileges restricted or revoked.

Importance of Accounts Receivable

Ratio
by Helen Akers,
studioDAccounti
ng ledgers keep
track of asset
accounts such
as receivables.

Related Articles

The
Reasons for
Changes in
Accounts Receivable Turnover
How Does Accounts Receivable Turnover Ratio Affect a Company?
Why Can a Business Show a Profit & Not Have Enough Cash to Pay Its
Obligations?
What Are the Functions of Accounts Receivable?
What Does It Mean if a Company's Accounts Receivable Turnover Is Very High?

The accounts receivable ratio is one of the financial performance indicators that
businesses monitor. It is useful for companies that sell goods and services on
credit. Accounting theory considers the accounts receivable ratio to be one of the
asset turnover or efficiency ratios. Small businesses can use the ratio to
determine whether their credit policies might be too strict or lenient. In order to
use the ratio properly, a business must keep track of its annual credit sales in
addition to its cash sales.

Ads by Google

Free Sales Mgmt Software

Bitrix24 - Free Sales Management Software With 35+ Sales Tools

bitrix24.com/Sales_Management_Tools

Definition
By definition, the accounts receivable ratio is the average amount of time it takes
a company to collect on its credit sales. If a business has an annual average of
$40,000 worth of credit sales and annual sales of $100,000, the accounts
receivable turnover ratio is four. The accounts turnover ratio is different from the
accounts receivable ratio but is used in its calculation. A company calculates the
accounts receivable ratio by taking the number of days in its fiscal year and
dividing it by the turnover ratio. A turnover ratio of four yields a receivable ratio
of 91 days.

Interpretation
The accounts receivable ratio reveals the amount of days it takes a company to
receive payment on its credit sales. A receivable ratio of 91 days means that it is
an average of 91 days from the time of sale to the time of payment. Whether the
ratio is low or high depends on the company's industry. Industry averages are
benchmarks that a small business owner might use to gauge his company's
performance. Some industries, such as retail furniture stores, might have a
higher average account receivables ratio than others.

Related Reading: How Does Accounts Receivable Turnover Ratio Affect a

Company?

High Ratio
A high accounts receivable ratio is usually the result of an inefficient credit policy.
Higher ratios mean that it takes a company longer to collect its payments. High
ratios might also mean that the majority of a company's sales volume is done on
credit. Without an adequate steady cash flow, a business owner might have
difficulty keeping up with his expenses. A company might consider revising its
credit policy to give customers more incentive to make purchases with cash. In
addition, a business owner could consider giving customers incentives for paying
invoices prior to 30 days out.

Provisions
Even though the accounts receivable ratio is often a good indicator of a
company's ability to collect payment, it could be misleading. Since the ratio is an
average, a business owner should periodically review all credit accounts.
Customers that carry high balances and pay quickly could skew the average,
concealing a problem with the majority of accounts with small balances. A close
examination of each credit account could also reveal those customers who might
need their credit privileges restricted or revoked.
Significance of the Gross Profit Margin
 by Jessica
Kent,
studioDDetermi
ne gross profit
margin to
measure
profitability.

Related Articles

Why Is the
Gross Profit
Margin Important to a Company?
The Importance of Net Profit
What Does Net Profit Margin Ratio Measure?
The Significance of Inventory Turnover Ratio
The Advantages of the Gross Profit Method

Gross profit margin is calculated by subtracting cost of goods sold from total
revenue, dividing the result by total revenue and multiplying by 100. Using this
formula, gross profit margin is expressed as a percent. This makes it easier to
compare a company to industry standards and benchmarks. The greater the
gross profit margin, the more profitable the company is before consideration of
general and administrative expenses.

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Operating Expenses
Gross profit margin is used to determine how much can be spent to cover
operating costs and still leave profit for the business owner. Stated differently,
gross profit margin reflects the difference between costs of production and
product revenue. The greater the gross profit margin, the greater the revenue
left to absorb operating costs and make a profit.

Profitability
Maintaining records that keep track of a companys gross profit margin assists
the business owner in tracking profitability trends. A companys gross profit,
calculated as revenue less cost of goods sold, may increase over time. However,
due to changes in revenue and fluctuations in both variable and fixed costs,
gross profit margin is a better indicator of profitability.

Related Reading: How Does Production Affect Gross Margin?

Product Pricing
Gross profit margin can be used to assist a business owner with product pricing.
Knowing costs of production for a specific product, a business owner can
determine what profit he wants to make and determine the sale price required to
generate that profit. Consideration also needs to be given to demand,
competition and demographic factors.

Industry Benchmarks
Companies use many ratios to compare themselves to competitors and industry
standards. Gross profit margin is one of the ratios used for this type of analysis
and helps determine the financial health of a company. Companies that fall
below industry benchmarks need to either increase the sale price or lower the
costs associated with production without sacrificing product quality.

Future Planning
Gross profit margin is a useful tool to plan the future operations of a company.
Since gross profit margin considers revenue and production costs, forecasting
future revenues or costs and determining the related gross profit will help
indicate overall profitability. Using gross profit margin, a company can develop
different scenarios before implementing changes.

Why Is the Gross Profit Margin

Important to a Company?

Gross profit margin is the percentage of revenue you retain after accounting for
costs of goods sold. Using the income statement, you divide the gross profit by
revenue for a period and then multiply by 100 to get a percentage. For instance,
gross profit of $400,000 on $1 million in revenue equals 0.4 or 40 percent. Gross
margin is important because it shows whether your sales are sufficient to cover
your costs.

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Bottom Line
Gross profit margin is generally important because it is the starting point toward
achieving healthy bottom line net profit. When you have a high gross profit
margin, you are a in better position to have a strong operating profit margin and
strong net income. For a newer business, the higher your gross profit margin,
the faster you reach the break-even point and begin earning profits from basic
business activities.

Cash Flow
Your gross profit margin also impacts your cash flow. Companies typically
expend significantly on inventory costs to make or acquire products. When you
sell inventory for a significant markup percentage or profit, you convert each unit
into much greater cash than what you invested. It is also easier to invest extra
cash in business expansion when you have confidence in your ability to convert
inventory and sales into profit.

What is 'Gross Profit Margin'

Gross profit margin is a financial metric used to assess a company's financial
health and business model by revealing the proportion of money left over from
revenues after accounting for the cost of goods sold (COGS). Gross profit margin,
also known as gross margin, is calculated by dividing gross profit by revenues.
Also known as "gross margin."

Calculated as:

Where: COGS = Cost

of Goods Sold
Next Up

Gross Margin

Gross Profit

Gross Income

Adjusted Gross Margin

BREAKING DOWN 'Gross Profit Margin'

There are several layers of profitability that analysts monitor to assess the
performance of a company, including gross profit, operating profit and net
income. Each level provides information about a company's profitability. Gross
profit, the first level of profitability, tells analysts how good a company is at
creating a product or providing a service compared to its competitors. Gross
profit margin, calculated as gross profit divided by revenues, allows analysts to
compare business models with a quantifiable metric.

Gross Profit Margin

Without an adequate gross margin, a company is unable to pay for its operating
expenses. In general, a company's gross profit margin should be stable unless
there have been changes to the company's business model. For example, when
companies automate certain supply chain functions, the initial investment may be
high; however, the cost of goods sold is much lower due to lower labor costs.

Gross margin changes may also be driven by industry changes in regulation or

even changes in a company's pricing strategy. If a company sells its products at
a premium in the market, all other things equal, it has a higher gross margin.
The conundrum is if the price is too high, customers may not buy the product.

Gross Margin Example

Gross profit margin is used to compare business models with competitors. More
efficient or higher premium companies see higher profit margins. That is, if you
have two companies that both make widgets and one company can make the
widgets for a fifth of the cost and in the same amount of time, that company has
the edge on the market. The company has figured out a way to reduce the costs
of goods sold by five times its competitor. To make up for the loss in gross
margin, the competitor counters by doubling the price of its product, which
should increase sales. Unfortunately, it increased the sales price but decreased
demand, as customers did not want to pay double for the product. The
competitor lost gross margin and market share in the process.

Suppose ABC company earns $20 million in revenue from producing widgets and
incurs $10 million in COGS-related expenses. ABC's gross profit is $20 million
minus $10 million. The gross margin is calculated as gross profit divided by $20
million, which is 0.50, or 50%. This means ABC earns 50 cents on the dollar in
gross margin.

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Gross profit (gross margin) is the sales revenue less the cost of sales (or cost
of goods sold). It is also known as gross margin or gross income. Gross profit
can be expressed in the following formula:

Gross Profit = Sales Revenue Cost of Sales

Gross profit of an entity is its residual profit after selling a product or service and
subtracting the costs associated with its production and sale. The associated
costs can include manufacturing costs, raw material expense, direct labor
charges, and other directly attributable costs.

Gross profit is very important measure to consider when analyzing the

profitability and financial performance of a company. Gross profit is an important
measure because it indicates the efficiency of the management in using labor
and supplies in the production process.

Gross profit of a company is affected by many factors. A company can have a

high or low gross profit for example because:

It has differentiated its products and therefore can charge high prices
It is being managed efficiently therefore it has low cost of sales
Its accounting policies move expenses from cost of sales to overheads (or
vice versa)
It is vertically integrated and can purchase raw material at lower costs

It should be kept in mind that gross profit usually varies significantly from
industry to industry. Therefore while appraising the performance of a company,
the comparison should be made with the companies in the same industry.

Changes and trends in gross profit margin can often provide useful information
for the investors. Therefore, the gross profit of a company should be analyzed
over a number of periods.
Although gross profit provides the important information about how much mark
up a company can make on its sales, it is not the best measure of profitability of
a company as a whole because it excludes many costs such as financing costs
and overhead expenses. Therefore profitability of a company should not be
measured solely on the basis of gross profit.

Gross Profit Ratio | Gross Profit Equation

The gross profit ratio shows the proportion of profits generated by the sale of
products or services, before selling and administrative expenses. It is used to
examine the ability of a business to create sellable products in a cost-effective
manner. The ratio is of some importance, especially when tracked on a trend
line, to see if a business can continue to provide products to the marketplace for
which customers are willing to pay a reasonable price.

The gross margin ratio can be measured in two ways. One is to combine the
costs of direct material, direct labor, and overhead, subtract them from sales,
and divide the result by sales. This is the more comprehensive approach. The
formula is:

Sales (Direct materials + Direct Labor + Overhead)

Sales

However, this first method includes a number of fixed costs. A more restrictive
version of the formula is to only include direct materials, which may be the only
truly variable element of the cost of goods sold. The formula then becomes:

Sales Direct materials

Sales

The second method presents a more accurate view of the margin gained on each
individual sale, irrespective of fixed costs. It is also known as the contribution
margin ratio.

Gross Profit Ratio Example

Quest Adventure Gear has been suffering declining net profits for several years,
so a financial analyst investigates the reason for the change. She discovers that
the costs of direct materials and direct labor has not changed significantly as a
percentage of sales. However, she notes that the company opened a new
production facility three years ago to accommodate increased sales volumes, but
that sales flattened shortly thereafter. The result has been increased factory
overhead costs associated with the new facility, without a sufficient amount of
offsetting sales.

Based on this analysis, management decides to shutter the new facility, which
will result in a 10% decline in sales, but also a 30% increase in gross profit, since
so much of the cost of goods sold will be eliminated.
What is 'Earnings Per Share - EPS'
Earnings per share (EPS) is the portion of a company's profit allocated to each
outstanding share of common stock. Earnings per share serves as an indicator of a
company's profitability.

Calculated as:

When
calculating, it is more accurate to use a weighted average number of shares
outstanding over the reporting term, because the number of shares outstanding
can change over time. However, data sources sometimes simplify the calculation
by using the number of shares outstanding at the end of the period.

Diluted EPS expands on basic EPS by including the shares of convertibles or

warrants outstanding in the outstanding shares number.

Next Up

Outstanding Shares

Fully Diluted Shares

Basic Earnings Per Share

Interim Earnings Per Share

BREAKING DOWN 'Earnings Per Share - EPS'

Earnings per share is generally considered to be the single most important
variable in determining a share's price. It is also a major component used to
calculate the price-to-earnings valuation ratio.

For example, assume that a company has a net income of $25 million. If the
company pays out $1 million in preferred dividends and has 10 million shares for
half of the year and 15 million shares for the other half, the EPS would be $1.92
(24/12.5). First, the $1 million is deducted from the net income to get $24
million, then a weighted average is taken to find the number of shares
outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to
generate the earnings (net income) in the calculation. Two companies could
generate the same EPS number, but one could do so with less equity
(investment) - that company would be more efficient at using its capital to
generate income and, all other things being equal, would be a "better" company.
Investors also need to be aware of earnings manipulation that will affect the
quality of the earnings number. It is important not to rely on any one financial
measure, but to use it in conjunction with statement analysis and other
measures.

For more on EPS read The 5 Different Types Of Earnings Per Share (EPS) and How
To Evaluate The Quality Of EPS

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arning Per Share (EPS)

Explanation,Importance and
Limitation
By Prasenjit Paul | February 19, 2013 | 6 Comments

What is Earning Per Share (EPS)?

Earning per share or EPS is the portion of a companys profit that is allocated to
each outstanding stock. EPS is calculated by dividing the net profit for a
particular quarter by the total number of outstanding shares in the market.
Example: Suppose a company A has posted a net profit of Rs-1,000 for a
particular year. It has a total of 100 shares. So, its earning per share will be 10
(1,000/100). A company reports its earning per share in each quarter. So.you
can easily get this figure from the quarterly result. Normally Earning per share is
calculated based on the last 12 months.So,it refers TTM (Trailing twelve months)
EPS. You will find most of the financial websites represent the figure in the form
of EPS (TTM).

When does earning per share increase?

From the definition of earning per share, it is very clear that EPS can
increase if the net profit of the company increases. But it may not true
always. Earning per share can increase even if the profit remains flat or even
goes down. Consider the next case.
If a company has gone through a buyback program, then also EPS can
increase. Buyback program is to buy a companys own shares by its
promoters itself. Due to share buyback program the total number of
outstanding shares decreases. As a result earning per share increase.
Suppose the company A that we have mentioned earlier saw its profit
dipping to Rs-950. But its total number of shares went down to 90 due to
buybacks. Hence the EPS would go up to 10.55.(950/90).

In case of merger or an acquisition total number of outstanding shares may

decrease that could also lead to an increase of earning per share.

When does earning per share go down?

From the definition, Earning per share can go down if the profit falls. But
again, it may not true always. Earning per share can also go down even if the
company increases its profitability. Consider the following case.
Follow-on public offer or an activity to raise fresh capital increase the
number of outstanding shares. In this case even if the net profit rise,Earning
per share can go down. Lets look at the company A again. Suppose its
profit goes up to Rs-1,100. It also raised its total number of shares to 120.
So the EPS will go down to 9.16 per share (1,100/120).

Why Earning per share becomes an important consideration?

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Earning per share is a very important figure. It reveals a lot about the financial
health of a company. Increasing EPS is a very good sign for a particular
company. Moreover, it can come handy while choosing stocks from a bunch of
stocks.

Let us consider an example. You sorted two companies- ABC and XYZ from the
same segment. Now, you find both the companies good for investment but not
able to decide which one to go for. At that time, EPS can help you in selecting
the stock. Simply, find out their individual EPS (by dividing the profit by their
share price) and go for the stock having high EPS. But make sure to analyze
other parameters also because investing in a stock

EPS gives you an analysis about the profit a company earns from a single stock
available in the market. So, as an investor, you must keep a close look at the
EPS of the company in its every quarterly result.

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Limitations of EPS:-

Although EPS is an important number to note. At the same time, it should

not be the only figure to drive your decision. EPS alone cant tell you the
entire story. You have to keep a close look on the P.E ratio (price to earning
ratio) to get more clear picture. Click here to know more about P.E ratio, its
significance and importance from an investors point of view.
A company can easily manipulate its reported profit. So,EPS can also be
easily distorted. For this reason you should always invest in a company which
has clean and clear corporate governance along with an honest and
experienced management.

Conclusion- What should you do?

As I stated earlier, dont consider Earning per share in an isolation. Look at the
P.E ratio while you are figuring EPS. If you own a stock whose EPS has fallen,
you should not be in a hurry to exit. Similarly, dont invest in a stock just because
its earning per share is increasing. Find the proper reason of falling/rising of
EPS.

Earnings per Share (EPS)

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Definition
Earnings per share (EPS) is the portion of the companys distributable profit
which is allocated to each outstanding equity share (common share). Earnings
per share is a very good indicator of the profitability of any organization, and it is
one of the most widely used measures of profitability.

The earning per share is a useful measure of profitability, and when compared
with EPS of other similar companies, it gives a view of the comparative earning
power of the companies. EPS when calculated over a number of years indicates
whether the earning power of the company has improved or deteriorated.
Investors usually look for companies with steadily increasing earnings per share.

Growth in EPS is an important measure of management performance because it

shows how much money the company is making for its shareholders, not only
due to changes in profit, but also after all the effects of issuance of new shares
(this is especially important when the growth comes as a result of acquisition).

Calculation (formula)

The EPS is calculated by dividing net profit after taxes and preference dividends
by the number of outstanding equity shares. This can be expressed in terms of
the following formula:

Earnings per share = (Net Profit after Taxes Preference Dividends) / Number of
Equity Shares

If the capital structure changes (i.e. the number of shares changes) during the
reporting period, a weighted average number of equity shares is used to for the
calculations of EPS.

The diluted earning per share (Diluted EPS) expands on basic EPS and includes
the shares of all convertible securities if they were exercised. Convertible
securities are convertible preferred shares, stock options (usually employee
based), convertible debentures and warrants.

Norms and Limits

It should be noted that two different companies could generate the same EPS
but one could do so with a lesser equity. All other things being equal, this
company is better than the other one because it is more efficient at using its
capital for generating profits.

It is important that the investors do not rely on only measure of earnings per
share for making investment decisions. Instead they should use in conjunction
with other measures and financial statement analysi