CFA Level 1 · Module 04 Financial Statement Analysis · Chapter 2
The income statement answers the question every investor asks first: did the company make money, and how? It runs from revenue at the top, through the expenses of earning that revenue, down to net income and earnings per share at the bottom. Because earnings drive valuations and because companies emphasize earnings above all other figures, the income statement is the most scrutinized of the financial statements, and the one where accounting choices most directly change the reported result.
This reading is long because it is where the real work of income-statement analysis lives. You will learn how and when revenue and expenses are recognized, how the choice to capitalize or expense a cost ripples through the statements, how to strip out items that will not recur, how to calculate basic and diluted earnings per share, and how to read an income statement in common-size form. The middle sections are heavily quantitative. Every company, and every number, in this lesson is invented by MidhaFin to illustrate the ideas; none is taken from the source curriculum or any prep provider. Formulas and standard terminology are used freely, as they belong to everyone.
The income statement reports a company’s financial performance over a period. In its simplest form it is revenue minus expenses equals net income, but the ordering carries meaning: revenue at the top, then the cost of goods sold to give gross profit, then operating expenses to give operating profit, then financing and tax to give net income, and finally net income divided among the shares to give earnings per share (EPS). Analysts read this ladder from two directions, tracking how much of each sales dollar survives to each level, and asking whether the numbers were produced by genuine performance or by accounting choices.
Two themes run through the whole reading. The first is timing: under accrual accounting, revenue and expenses are recognized when they are earned and incurred, not when cash changes hands, so the central questions are when to record revenue and when to record an expense. The second is comparability: because standards permit choices in how and when items are recognized, two economically similar companies can report different numbers, and much of an analyst’s job is to see through those choices. Keep both in mind and the reading holds together.
Under accrual accounting, revenue is recognized when it is earned, which is generally when the risks and rewards of ownership transfer to the customer, not necessarily when cash arrives. If goods are sold on credit, revenue is recognized and a receivable is created; if cash is received before delivery, the company records a liability called unearned (deferred) revenue and recognizes the revenue later as it delivers. A subscription paid up front for a year of software access is the classic case: cash now, revenue spread over the year.
IFRS and US GAAP converged their revenue standards, and the core principle of the converged standard is that revenue should depict the transfer of promised goods or services in an amount that reflects the consideration the company expects to be entitled to. To apply that principle, the standard sets out five steps.
| Step | What the company does |
|---|---|
| 1. Identify the contract | Establish an agreement with commercial substance, enforceable rights and obligations, and probable collection |
| 2. Identify the performance obligations | Separate the distinct goods or services promised in the contract |
| 3. Determine the transaction price | The consideration the company expects in exchange for the goods or services |
| 4. Allocate the price to the obligations | Split the transaction price across the separate performance obligations |
| 5. Recognize revenue as each obligation is satisfied | Record revenue when (or as) control of the good or service transfers to the customer |
Steps three and four are about the amount of revenue; step five is about the timing. Revenue is recognized only when it is highly probable it will not be reversed. If payment is conditional on future performance, the company presents a contract asset rather than a receivable until the condition is met; if it collects before performing, it records a contract liability. One subtlety worth carrying: a contract exists only if collection is probable, and the threshold for probable differs between the systems, so economically similar contracts can occasionally be treated differently under IFRS and US GAAP.
The five steps are easy for a single product delivered at one moment and hard for the business models analysts actually meet. Four recurring cases are worth knowing.
Principal versus agent. A company that controls a good before it is transferred is a principal and records the full sale price as revenue; a company that merely arranges a sale for a third party is an agent and records only its fee or commission. This distinction does not change profit in dollars, but it transforms the common-size statement: an agent shows far lower revenue and far higher margins than a principal for the same profit, so for a marketplace that sells both ways, the mix of principal and agent sales must be understood before margins can be compared or forecast.
Licensing and software as a service. When a company sells a software license that the customer installs and uses as it exists, revenue is generally recognized at the point the license transfers; when it sells access to hosted software that it continuously updates (software as a service), revenue is recognized over the subscription term. The same company may do both, so an analyst must read the note to see how much revenue is recognized up front versus spread over time. Long-term contracts, such as multi-year construction, recognize revenue over time as the work progresses, often by comparing costs incurred to total estimated costs, because control transfers to the customer continuously. Bill-and-hold arrangements, where the customer buys but asks the seller to keep the goods, recognize revenue only when strict criteria are met that show the customer truly controls the identified goods.
Revenue recognition is where conservatism shows up first. A policy that recognizes revenue earlier, or that books gross rather than net, is less conservative and flatters current results. When the disclosures do not let you adjust two companies to the same basis, you can still characterize one policy as more or less conservative than the other and reason about how that would bias the ratios. That qualitative judgment is exactly what the exam rewards when the numbers are not comparable.
Expenses are the costs of earning revenue, and a company recognizes them in the period it consumes the associated economic benefit. There are two broad patterns. Under the matching principle (IFRS calls it the matching concept), costs that are tied directly to revenue are expensed in the same period as that revenue: the clearest case is cost of goods sold, where only the cost of the units actually sold is expensed, while the cost of unsold units stays on the balance sheet as inventory. Period costs, expenditures that do not tie neatly to specific revenue, such as most administrative salaries and general overhead, are expensed as incurred.
Setup. Meridian Traders begins the year with no inventory, buys 10,000 identical units during the year at a total cost of 250,000 (so 25 per unit), and sells 8,000 of them at 45 each for cash. Using the matching principle, what revenue, cost of goods sold, gross profit, and ending inventory does it report?
Answer: revenue 360,000, cost of goods sold 200,000, gross profit 160,000, and ending inventory 50,000. Matching means the 50,000 spent on unsold units is not an expense yet; it becomes cost of goods sold only when those units are sold in a future period. When unit costs change through the year, the cost-flow method (FIFO and others) decides which costs are expensed first, a topic developed in the inventories reading.
A related idea for exam classification: whether a cost is a product cost (capitalized into inventory and expensed as cost of goods sold when the product sells) or a period cost (expensed as incurred) changes the timing of when it hits the income statement, even though the total expense over time is the same.
The single most important expense-timing decision is whether an expenditure is capitalized as an asset and expensed gradually, or expensed immediately. A cost that is capitalized appears on the balance sheet and flows through the income statement over the asset’s useful life as depreciation or amortization; a cost that is expensed hits the income statement in full right away. The total expense over the asset’s life is identical either way; only the timing differs, and that timing changes the profile of reported profit, cash flow, assets, and equity.
Setup. Two identical companies, Corvus and Trellis, each spend 1,200 on equipment with a three-year life and no salvage value (straight-line depreciation of 400 per year). Each earns cash revenue of 2,000 a year and incurs other cash expenses of 700 a year, with a 25 percent tax rate. Corvus capitalizes the equipment; Trellis expenses it immediately. Compare Year 1 net income and cash flow from operations, and the three-year totals.
Answer: in Year 1, Corvus reports higher net income (675 versus 75) and higher cash from operations (1,075 versus 75), yet the three-year total net income is identical at 2,025. Capitalizing raises current profit and reported operating cash flow (because the outlay sits in investing, not operating), while expensing lowers current profit but produces a rising profit trend. Neither company is truly more profitable; the difference is an accounting choice, and comparing their growth without knowing that would mislead.
| Measure | Capitalize | Expense immediately |
|---|---|---|
| Current net income | Higher | Lower |
| Cash from operations | Higher (outlay is in investing) | Lower (outlay is in operating) |
| Total assets and equity | Higher | Lower |
| Future profit trend | Lower later (depreciation follows) | Higher later (no depreciation) |
| Year-of-outlay profitability ratios | Higher | Lower |
Two specific capitalization rules complete the picture. Interest costs incurred to build a long-lived asset for the company’s own use are generally capitalized into the asset and later expensed through depreciation, so a company’s interest can sit partly on the balance sheet and partly on the income statement; analysts often add capitalized interest back when computing interest coverage, to see the full burden. Internal development costs for software are expensed until technological feasibility is established and capitalized thereafter, and because judgment sets the feasibility point, two software companies can capitalize very different proportions, which an analyst must adjust for before comparing them.
Do not assume capitalizing and expensing eventually wash out to the same numbers every year. Over the full life of a single asset the total expense is the same, but in any given year they differ, and the cash flow statement differs permanently in classification: a capitalized outlay reduces investing cash flow while an expensed outlay reduces operating cash flow. A company can flatter its operating cash flow simply by capitalizing costs that a peer expenses, so watch for that when comparing cash from operations.
Beyond the capitalize-or-expense decision, many expenses depend on estimates: the useful life and salvage value of an asset, the percentage of receivables that will prove uncollectible, and the expected cost of warranties. Each estimate feeds directly into reported income, and a company that stretches an asset’s useful life or shaves its bad-debt estimate reports higher current profit. As with revenue, a policy or estimate that pushes expenses later is less conservative.
This is why an analyst studies year-to-year and company-to-company differences in estimates. A sudden change in the estimated uncollectible percentage, warranty rate, or useful life may reflect a genuine change in the business, or it may signal earnings management. When the notes give enough detail, an analyst adjusts the reported expenses to a comparable basis; when they do not, the analyst characterizes the relative conservatism of the policies and reasons about the direction of the bias. The notes and the management discussion are where these policies and estimates are disclosed, so they are the first place to look.
To forecast future earnings, an analyst must separate the parts of this year’s income that are likely to continue from the parts that are not. The reading covers two kinds of non-recurring item that are reported differently.
Unusual or infrequent items, such as restructuring charges or gains and losses on the sale of a business, are considered part of ordinary continuing activities and are shown within income from continuing operations, but presented separately so the analyst can see them. Highlighting them helps the analyst judge whether they will recur; the standard advice is that it is generally not advisable to simply ignore all unusual items, because some do repeat. Discontinued operations, by contrast, are the results of a component the company has disposed of or plans to dispose of and will have no further involvement in. Their results are reported separately, net of tax, at the bottom of the income statement, and the related assets and liabilities are grouped as held for sale on the balance sheet. Because a discontinued operation will not generate future earnings for the company, an analyst usually excludes it when forming expectations about future performance.
| Item | Where it is reported | Analyst treatment |
|---|---|---|
| Unusual or infrequent items | Within continuing operations, shown separately | Judge whether they will recur; do not ignore automatically |
| Discontinued operations | Separately, net of tax, at the bottom | Usually exclude from forecasts of future earnings |
| Change in accounting policy | Retrospective: restate prior years | Statements stay comparable across years |
| Change in accounting estimate | Prospective: current and future periods only | No restatement; note the change |
| Correction of a prior-period error | Restate the prior statements affected | Read the disclosure; it may reveal control weaknesses |
Classify the item, then place it. A fire loss or a restructuring charge is unusual or infrequent but stays within continuing operations, shown separately; only the disposal of a whole component is a discontinued operation, reported net of tax at the bottom. For forecasting, exclude discontinued operations, but do not blindly exclude every unusual item, because some recur. A loss from destruction of property is a continuing-operations item, not other comprehensive income and not discontinued.
Three kinds of accounting change are treated in three different ways, and the exam tests the distinction directly. A change in accounting policy, such as adopting a new standard or switching between acceptable methods, is applied retrospectively: the company restates the prior years shown in the report as if the new policy had always been used, so the statements remain comparable across periods (unless retrospective application is impractical). A change in accounting estimate, such as revising an asset’s useful life, is applied prospectively: only the current and future periods are affected, with no restatement of the past and no separate line on the income statement. A correction of a prior-period error requires restating the affected prior statements, and its disclosure deserves careful reading because it can reveal weaknesses in a company’s accounting systems and controls.
Setup. Classify each and state the treatment: (a) a company adopts a newly issued revenue standard; (b) it revises the estimated useful life of its machinery from 8 years to 6; (c) it discovers that depreciation was miscalculated in a prior year.
Answer: (a) policy change, retrospective; (b) estimate change, prospective; (c) error correction, restate. The reliable rule: policy changes and error corrections reach back and restate prior periods, while estimate changes only go forward.
Earnings per share is the income-statement figure equity investors watch most, and how it is calculated depends on the company’s capital structure. The shares EPS is computed for are the ordinary (common) shares, the equity that ranks last in a liquidation and benefits most when the company prospers. A company has a simple capital structure if it has issued no potentially dilutive securities, and a complex capital structure if it has issued any, such as convertible bonds, convertible preferred stock, options, or warrants. A company with a simple structure reports only basic EPS (its basic and diluted EPS are equal); a company with a complex structure reports both basic EPS and diluted EPS, and diluted EPS is never greater than basic EPS.
Basic EPS is the income available to common shareholders divided by the weighted average number of common shares outstanding over the period. Income available to common shareholders is net income minus any preferred dividends, because those dividends belong to preferred, not common, holders.
The weighted average shares outstanding weights each share count by the fraction of the period it was outstanding, so shares issued mid-year count only for the months they existed and shares repurchased stop counting when bought back. A stock dividend or stock split is applied retroactively to the start of the period, because it changes the number of shares without changing the underlying value.
Setup. Kaveri Industries reports net income of 4,200,000 and pays preferred dividends of 200,000. It began the year with 2,000,000 common shares, issued 600,000 shares on 1 April, and repurchased 200,000 shares on 1 October. Compute the weighted average shares and basic EPS.
Answer: the weighted average is 2,400,000 shares and basic EPS is 1.67. The weighting matters: using the year-end share count of 2,400,000 happens to match here only by coincidence, and in general you must time-weight issuances and buybacks rather than use a simple average.
Setup. Using the same facts as Kaveri above, suppose that on 1 December the company carried out a 2-for-1 stock split, doubling every shareholder’s shares. What is basic EPS now?
Answer: basic EPS becomes 0.83. A stock split (or stock dividend) is applied retroactively to the beginning of the period and to all prior periods presented, because it merely divides the same value into more shares; this keeps EPS comparable across years rather than creating an artificial drop.
The whole point of the weighted average is that a share should count only while it actually exists and shares the earnings. A share issued halfway through the year earned only half a year of income, so it counts as half a share. The one exception is a split or stock dividend: those give existing holders more shares without new money, so they are pushed back to the start of the period and to all prior years shown, which keeps EPS trends honest instead of showing a fake plunge in the split year.
Diluted EPS answers a what-if: what would EPS be if every dilutive security were converted into common stock? It exists to warn shareholders of the potential dilution lurking in convertibles and options. Two methods do the work, depending on the security.
The if-converted method assumes the convertible security was converted at the start of the period and traces the two effects. For convertible preferred, conversion means the preferred dividends would not have been paid (so the numerator rises back to net income) and new common shares would exist (so the denominator rises).
The preferred dividend is added back to the numerator (it would not be paid if converted), and the shares that would be issued on conversion are added to the denominator. Compare the result with basic EPS: include the conversion only if it lowers EPS.
Setup. Saraswati Textiles reports net income of 3,000,000 and has a weighted average of 400,000 common shares. It also has 50,000 convertible preferred shares, each paying a dividend of 4 (total preferred dividends 200,000) and each convertible into 4 common shares. Compute basic and diluted EPS.
Answer: basic EPS is 7.00 and diluted EPS is 5.00. Because 5.00 is below 7.00, the convertible preferred is dilutive and is included in diluted EPS. Diluted EPS shows shareholders the lower per-share figure they would face if the preferred converted.
For convertible debt, conversion means the after-tax interest on the bonds would not have been paid (so it is added back to the numerator) and new shares would exist (so the denominator rises).
After-tax interest = interest on the convertible debt × (1 − tax rate). Add it back because, if the debt had converted, the company would not have paid that interest. Include the conversion only if it lowers EPS.
Setup. Anvil Manufacturing reports net income of 2,000,000, has a weighted average of 500,000 common shares, and no preferred stock. It has 1,000,000 of 8 percent convertible bonds (interest of 80,000 a year), convertible into 40,000 common shares. The tax rate is 25 percent. Compute basic and diluted EPS.
Answer: basic EPS is 4.00 and diluted EPS is 3.81. The bonds are dilutive (3.81 is below 4.00), so they are included. Note the after-tax adjustment: only the after-tax interest is added back, because the interest saved would have been taxed.
Options and warrants are handled by the treasury stock method. It assumes the options are exercised, the company receives the exercise proceeds, and it uses those proceeds to buy back shares at the average market price during the period. Only the net new shares, the shares issued on exercise minus the shares repurchased with the proceeds, are added to the denominator; the numerator is unchanged because exercising options does not affect net income.
Exercise proceeds = number of options × exercise price. These proceeds are assumed to repurchase shares at the average market price. Options are dilutive only when the exercise price is below the average market price (otherwise the buyback offsets all the new shares, or more). The incremental shares are added to the diluted denominator; the numerator is unchanged.
Setup. Blackwater Capital reports net income of 3,600,000 with a weighted average of 800,000 common shares. It has 60,000 employee options outstanding with an exercise price of 30, and the average market price of the stock during the year was 40. Compute basic and diluted EPS.
Answer: basic EPS is 4.50 and diluted EPS is 4.42. The options add 15,000 net shares because the exercise price (30) is below the average market price (40). Had the exercise price been at or above 40, the buyback would offset all the new shares and the options would not be dilutive.
| Security | Method | Numerator effect | Denominator effect |
|---|---|---|---|
| Convertible preferred | If-converted | Add back preferred dividends | Add shares from conversion |
| Convertible debt | If-converted | Add back after-tax interest | Add shares from conversion |
| Options and warrants | Treasury stock | No change | Add net (incremental) shares |
Not every convertible security lowers EPS. A security is antidilutive if including it in the calculation would raise EPS above basic EPS, and antidilutive securities are excluded from diluted EPS under both IFRS and US GAAP. The rule follows from the purpose of diluted EPS: it must show the maximum potential dilution, so any security whose conversion would increase EPS is left out, and diluted EPS is therefore always less than or equal to basic EPS. In practice you test each security by computing what EPS would be if it were included; if that figure is higher than basic EPS, you drop it.
Setup. Doran Utilities reports net income of 3,000,000 with a weighted average of 400,000 common shares. It has 20,000 convertible preferred shares, each paying a dividend of 15 (total 300,000) and each convertible into just 1 common share. Compute basic EPS and determine reported diluted EPS.
Answer: basic EPS is 6.75, and because the conversion would raise EPS to 7.14, the preferred is antidilutive and is excluded; reported diluted EPS equals basic EPS at 6.75. The lesson: always test, never assume a convertible is dilutive, because a high dividend relative to few conversion shares can make it antidilutive.
Three EPS rules recover most questions. Basic EPS uses the weighted average share count, and stock splits or dividends are applied retroactively. For diluted EPS, use the if-converted method for convertibles (add back preferred dividends, or after-tax interest for debt, and add the conversion shares) and the treasury stock method for options (add only the net new shares, no numerator change). And diluted EPS is always less than or equal to basic EPS, because antidilutive securities are excluded.
The last tool turns the income statement into percentages. A common-size income statement states every line as a percentage of revenue, which removes the effect of size and lets an analyst compare a company with its own past (time-series analysis) and with other companies (cross-sectional analysis). Because every line is scaled to sales, a small company and a large one can be laid side by side and their cost structures compared directly.
Common-size analysis also exposes strategy. Two companies of the same sales in the same industry can have very different gross margins, and the common-size statement shows why: the one with the higher gross margin and heavier spending on research and advertising is likely pursuing a differentiated, premium strategy, while the one with the thinner gross margin is likely competing on price. The percentages do not give the answer, but they point the analyst to the right question.
Setup. Three companies in one industry report the following. Northwind: sales 20,000,000, cost of sales 8,000,000, other operating expenses 6,000,000. Southgate: sales 20,000,000, cost of sales 15,000,000, other operating expenses 2,000,000. Eastvale: sales 4,000,000, cost of sales 1,600,000, other operating expenses 1,200,000. Compare their gross and operating margins.
Answer: in common-size terms, Northwind and Eastvale both run a 60 percent gross margin and 30 percent operating margin, while Southgate runs 25 percent and 15 percent. Eastvale is far smaller in dollars than Southgate yet more profitable per dollar of sales, which only the common-size view reveals. Northwind’s much higher gross margin than Southgate points to a differentiated, higher-cost-to-produce strategy rather than a price-competition strategy.
Several profitability ratios come straight off the income statement, and all are just common-size subtotals expressed as a rate.
Gross profit = revenue − cost of goods sold. Two more common margins: the operating profit margin = operating income / revenue, and the pretax margin = pre-tax income / revenue. A higher margin generally means higher profitability, but differences across companies reflect differences in strategy (a differentiated product usually carries a higher gross margin than a commodity product), so margins are judged against peers and history, not in the abstract.
Margins are a diagnostic ladder. Gross profit margin isolates production and pricing; operating margin adds the cost of running the business; net profit margin folds in financing and tax. When profitability falls, comparing the margins tells you where: a stable gross margin with a falling operating or net margin points to rising operating costs, higher financing costs, or taxes, not to a pricing problem. Reading the ladder, rather than a single bottom-line number, is what turns the ratios into an explanation.
A common-size income statement scales each line to revenue, not to net income. Stating lines as a percentage of net income is wrong and defeats the purpose, which is to compare cost and profit structures across companies of different sizes. And common-size analysis does help identify differences in strategy, so an answer claiming it hides strategy is also wrong.
A company receives cash today for a one-year service it will deliver over the coming year. How much revenue does it recognize today, and what does it record?
It recognizes no revenue today. Because the service has not yet been performed, the company records a liability, unearned (deferred) revenue, and recognizes the revenue over the year as it delivers the service. Revenue is recognized when earned, not when cash is received.
Compared with expensing an outlay, what does capitalizing it do to current net income and to cash from operations in the year of the outlay?
Capitalizing raises current net income (only the depreciation, not the whole outlay, is expensed) and raises reported cash from operations (the outlay is classified as an investing outflow rather than an operating one). The trade-off is lower profit in future years as depreciation is recognized, so capitalizing produces a lower future profit trend.
A company revises the estimated useful life of its equipment. Is this applied retrospectively or prospectively?
Prospectively. A change in an accounting estimate affects only the current and future periods; prior statements are not restated. This differs from a change in accounting policy (applied retrospectively) and a correction of an error (the affected prior statements are restated).
A company began the year with 900,000 shares and issued 300,000 more on 1 July. Net income was 2,400,000 with no preferred stock. What is basic EPS?
Weighted average shares = 900,000 × 6/12 + 1,200,000 × 6/12 = 450,000 + 600,000 = 1,050,000. Basic EPS = 2,400,000 / 1,050,000 = 2.29. The new shares count only for the half-year they were outstanding.
Under the treasury stock method, when are options dilutive?
Only when the exercise price is below the average market price of the stock during the period. In that case the proceeds from exercise buy back fewer shares than are issued, so net new shares are added to the denominator and EPS falls. If the exercise price is at or above the average market price, the buyback offsets all the new shares and the options are not dilutive.
Why is diluted EPS always less than or equal to basic EPS?
Because diluted EPS must show the maximum potential dilution, so any security whose conversion would raise EPS (an antidilutive security) is excluded. Only securities that lower EPS are included, so diluted EPS can never exceed basic EPS; at most, for a simple capital structure, the two are equal.
An online marketplace switches from acting as a principal to acting as an agent for the same volume of sales. What happens to its reported revenue and its margins?
Reported revenue falls sharply (it now records only its commission, not the full sale price), while its profit margins rise (the same profit is measured against much smaller revenue). Profit in dollars is unchanged; only the presentation changes, which is why the principal-versus-agent mix must be understood before comparing an e-commerce company’s margins with a peer’s.
Revenue is recognized when it is earned, meaning when control of the promised good or service transfers to the customer, not necessarily when cash is received. The converged IFRS and US GAAP standard applies a five-step model: identify the contract, identify the separate performance obligations, determine the transaction price, allocate the price to the obligations, and recognize revenue as each obligation is satisfied. Cash received before delivery is recorded as a contract liability (unearned revenue) and recognized later.
A principal controls a good or service before it transfers to the customer and records the full sale price as revenue. An agent merely arranges the transaction for a third party and records only its fee or commission. The distinction does not change profit in dollars, but it changes the common-size statement: an agent reports much lower revenue and much higher margins than a principal for the same profit, so the mix of principal and agent sales must be understood before comparing an e-commerce company’s margins.
Capitalizing records the outlay as an asset and spreads the expense over the asset’s useful life as depreciation or amortization; expensing recognizes the whole cost immediately. Capitalizing produces higher current net income, higher reported cash from operations (the outlay is an investing rather than operating outflow), and higher assets and equity, but a lower profit trend in later years. The total expense over the asset’s life is identical; only the timing and the cash flow classification differ.
A change in accounting policy (such as adopting a new standard) is applied retrospectively, restating the prior years shown so the statements stay comparable. A change in accounting estimate (such as revising a useful life) is applied prospectively, affecting only current and future periods with no restatement. A correction of a prior-period error requires restating the affected prior statements, and its disclosure should be read carefully because it can reveal weaknesses in the company’s accounting controls.
Basic EPS equals income available to common shareholders divided by the weighted average number of common shares outstanding. Income available to common shareholders is net income minus preferred dividends. The share count is time-weighted, so shares issued mid-year count only for the months outstanding and repurchased shares stop counting when bought back. Stock splits and stock dividends are applied retroactively to the beginning of the period, because they change the share count without changing underlying value.
Both compute diluted EPS. The if-converted method applies to convertible securities: it assumes conversion at the start of the period, adds back preferred dividends (for convertible preferred) or after-tax interest (for convertible debt) to the numerator, and adds the conversion shares to the denominator. The treasury stock method applies to options and warrants: it assumes exercise, uses the proceeds to buy back shares at the average market price, and adds only the net new shares to the denominator, leaving the numerator unchanged.
An antidilutive security is a convertible security or option whose inclusion in the diluted EPS calculation would raise EPS above basic EPS. Because diluted EPS must reflect the maximum potential dilution, antidilutive securities are excluded under both IFRS and US GAAP. As a result, diluted EPS is always less than or equal to basic EPS. Each potentially dilutive security must be tested individually, because a high dividend or interest relative to few conversion shares can make it antidilutive.
A common-size income statement states each line item as a percentage of revenue. Scaling to revenue removes the effect of company size, so it supports both time-series analysis (a company against its own past) and cross-sectional analysis (a company against peers of different sizes). It also highlights strategy: a company with a higher gross margin and heavier research and advertising spending is likely pursuing a differentiated, premium strategy, while a thinner gross margin suggests price competition. Gross, operating, pretax, and net profit margins are read directly from it.
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