Diluting Earnings And Assets
An overview on the issue of diluting earnings and assets, making provisions for liabilities and the various types of liabilities plus deducting the shareholders funds before reaching the net asset.
By issuing the convertible loan, Jones Manufacturing can offset the interest cost (the cost of servicing the loan) against tax, whereas dividends on ordinary shares or on convertible preference shares would have to be paid out of taxed income. By the time the loan can be converted, earnings should have risen significantly and the company’s asset value should also have risen. Investment analysts and journalists sometimes refer to fully diluted earnings per share and fully diluted assets per share.
This means they have calculated what the earnings per share would be on the assumption the stock was converted and current earnings (adjusted for the disappearance of the interest charge on the convertible) were spread over the larger number of shares. They have also done the same sums for the NAV. As we have seen, companies may issue convertible preference shares instead of convertible loan stocks. They convert into ordinary shares in much the same way, but the dividend on the convertible preference is not tax deductible as the convertible loan stock interest is.
There are two other unfamiliar items. The provisions for liabilities and charges of £500,000 has to be knocked off the assets figure before arriving at a net asset value. It may consist mainly of deferred tax, which is tax that might become payable in the future but is not yet a sufficiently certain liability to be provided for under current liabilities. It would also include sums the company had earmarked to meet certain known future costs, such as the cost of closing down or reorganizing one part of the business.
The second item, minority shareholders’ interest, where Jones does not own all the shares of all of its subsidiaries, this figure represents the value of the shares in these subsidiaries held by other parties. Since this value does not belong to the shareholders in Jones it has to be deducted before reaching a net asset value.
Two further items which could affect the balance sheet in the future appear in the notes to the accounts but not in the accounts themselves. One is capital commitments. This is expenditure on assets which the directors have authorized or contracted for but which has not yet taken place. It can be useful in giving an idea of the company’s investment plans and whether these would be covered by the cash flow.
The other is contingent liabilities. Jones Manufacturing might provide a guarantee for the bank borrowings of one of its associated companies. Or there might be a legal case pending against Jones, in which the other side is claiming £500,000 of damages, though Jones denies liability. In both cases Jones does not expect any liability to arise, but it might. So the liabilities are not provided for in the accounts themselves but the company notes that they might arise in the future.Keywords: earnings, tax, assets, shareholders, liability