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Adjusted basic earnings

What Is Adjusted Basic Earnings?

Adjusted basic earnings refer to the portion of a company's net income that is available to common shareholders, after making specific adjustments required by accounting standards or for analytical purposes. This metric falls under the broader category of financial reporting and is a crucial component in calculating Earnings Per Share (EPS), particularly basic EPS. The core idea is to refine the earnings figure by excluding items that are not attributable to the common shareholders or those considered non-recurring or non-operating, providing a clearer picture of a company's ongoing operational profitability from the perspective of its common stock holders.

History and Origin

The concept of earnings per share and, by extension, the calculation of earnings attributable to common shareholders, has evolved significantly with the development of modern financial statements. Accounting bodies recognized the need for standardized metrics to allow for consistent comparison across different publicly traded companies.

In the United States, the Financial Accounting Standards Board (FASB) provides detailed guidance on earnings per share calculations within its Accounting Standards Codification (ASC) Topic 260, "Earnings Per Share." This standard outlines the components of the numerator (earnings) and the denominator (shares) for both basic and diluted EPS. For instance, ASC 260-10-45-10 specifies that basic EPS should be computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding during the period.4

Internationally, the International Accounting Standards Board (IASB) addresses EPS through International Accounting Standard (IAS) 33, "Earnings Per Share." IAS 33 similarly prescribes principles for the determination and presentation of earnings per share, ensuring comparability among entities adhering to International Financial Reporting Standards.3 These standards necessitate adjustments to a company's reported profit or loss to arrive at the earnings figure relevant for common shareholders, forming the basis for adjusted basic earnings.

Key Takeaways

  • Adjusted basic earnings represent the portion of a company's net income available to common shareholders, after specific adjustments.
  • The primary adjustments typically involve subtracting preferred stock dividends from net income.
  • This metric is the numerator in the basic earnings per share (EPS) calculation, offering insight into per-share profitability.
  • It provides a foundational view of a company's earnings power before considering the potential dilutive effects of other securities.
  • Adjusted basic earnings are crucial for investors and analysts in evaluating a company's performance and valuation.

Formula and Calculation

The calculation of adjusted basic earnings primarily involves taking a company's net income and subtracting any dividends paid or accrued to holders of preferred stock. This is because preferred dividends are a distribution of earnings that takes precedence over distributions to common shareholders.

The formula for adjusted basic earnings is:

Adjusted Basic Earnings=Net Income−Preferred Dividends\text{Adjusted Basic Earnings} = \text{Net Income} - \text{Preferred Dividends}

Where:

  • Net Income: The company's total profit after all expenses, taxes, and non-operating items have been accounted for, typically found at the bottom of the income statement.
  • Preferred Dividends: The amount of dividends declared or accumulated on a company's outstanding preferred stock for the period.

This adjusted figure then serves as the numerator for calculating basic earnings per share, which divides the adjusted basic earnings by the weighted average shares outstanding during the period.

Interpreting the Adjusted Basic Earnings

Interpreting adjusted basic earnings involves understanding what this specific earnings figure represents in the context of a company's overall financial health and its capital structure. This figure directly reflects the total earnings that theoretically belong to the ordinary owners of the company for the reporting period. When analyzing this number, investors and analysts consider it a fundamental indicator of profitability on a per-share basis, forming the basis for basic EPS.

A higher adjusted basic earnings figure, especially when consistently growing, generally indicates a stronger ability for the company to generate profits for its common shareholders. It helps in assessing a company's ability to retain earnings, pay dividends to common shareholders, or reinvest in the business. By focusing on the earnings available after accounting for preferred dividends, the metric provides a more precise view of the earnings pool directly relevant to common equity investors.

Hypothetical Example

Consider Company ABC, which reports its financial results for the fiscal year.

  • Net Income: $10,000,000
  • Preferred Stock Dividends: Company ABC has cumulative preferred stock that requires an annual dividend payment of $1,000,000.

To calculate Company ABC's adjusted basic earnings:

Adjusted Basic Earnings=Net Income−Preferred Dividends\text{Adjusted Basic Earnings} = \text{Net Income} - \text{Preferred Dividends} Adjusted Basic Earnings=$10,000,000−$1,000,000\text{Adjusted Basic Earnings} = \$10,000,000 - \$1,000,000 Adjusted Basic Earnings=$9,000,000\text{Adjusted Basic Earnings} = \$9,000,000

In this example, the $9,000,000 represents the earnings available to the common shareholders of Company ABC for that fiscal year. This figure would then be used, along with the weighted average number of common shares outstanding, to calculate the basic Earnings Per Share for the company. Understanding this adjustment is key for investors analyzing shareholders' equity and a company's true profitability for common stock.

Practical Applications

Adjusted basic earnings are a foundational figure in various aspects of financial analysis and reporting. Its primary application is in the calculation of basic earnings per share, which is a mandatory disclosure for many publicly traded entities under Generally Accepted Accounting Principles (GAAP) and IFRS. This metric provides analysts and investors with a clear, straightforward measure of a company's profitability allocated to each outstanding common share.

Beyond regulatory compliance, adjusted basic earnings are used by analysts to:

  • Evaluate Company Performance: Comparing adjusted basic earnings over different periods helps in assessing a company's earnings trend and operational efficiency.
  • Valuation Models: It serves as a key input in many equity valuation models, such as the price-to-earnings (P/E) ratio, enabling comparisons between companies within the same industry.
  • Dividend Capacity Analysis: The adjusted figure indicates the maximum amount of earnings available for distribution to common shareholders as dividends or for reinvestment.
  • Credit Analysis: Lenders and credit rating agencies may look at this figure to understand the earnings cushion available to common shareholders, which indirectly affects a company's financial stability.

For example, when looking at a company like The New York Times Company (NYT), financial data providers track its reported EPS, which is derived from its adjusted basic earnings. The company's EPS figures are routinely analyzed by investors to gauge its profitability and assess its stock performance.2

Limitations and Criticisms

While adjusted basic earnings provide a crucial insight into a company's profitability for its common shareholders, the metric has certain limitations and criticisms. One significant concern relates to the potential for "earnings management." This practice involves companies intentionally manipulating financial figures to present a more favorable earnings picture, which can sometimes affect the perceived adjusted basic earnings. The U.S. Securities and Exchange Commission (SEC) has addressed concerns about materiality in financial statements, emphasizing that even small intentional misstatements made to manage reported earnings are inappropriate and could be considered material.1

Other limitations include:

  • Focus on Historical Performance: Adjusted basic earnings reflect past performance and do not inherently predict future profitability.
  • Exclusion of Dilutive Effects: By definition, adjusted basic earnings do not account for the potential impact of convertible securities, stock options, or warrants, which could significantly increase the number of shares outstanding and dilute the per-share earnings. This is why diluted earnings per share is also a required disclosure.
  • Non-Cash Items: The figure is derived from net income, which includes non-cash expenses like depreciation and amortization, meaning it doesn't directly represent cash flow.
  • Variability of Accounting Policies: While accounting standards aim for consistency, some flexibility in accounting policies can still lead to variations in reported net income, affecting the comparability of adjusted basic earnings across different companies.

Analysts must therefore consider adjusted basic earnings as part of a comprehensive analysis, incorporating other financial metrics and qualitative factors to form a complete view of a company's financial health.

Adjusted Basic Earnings vs. Diluted Earnings Per Share

Adjusted Basic Earnings and Diluted Earnings Per Share are both critical components of a company's financial reporting, yet they serve distinct purposes and reflect different aspects of a company's profitability.

Adjusted Basic Earnings refers to the portion of a company's net income that is available to common shareholders after accounting for preferred dividends. This figure serves as the numerator for calculating basic earnings per share. It provides a straightforward measure of earnings attributable to each existing common share, reflecting the company's current operating profitability from the perspective of its primary owners.

Diluted Earnings Per Share, on the other hand, is a more conservative measure of a company's profitability on a per-share basis. It calculates EPS by taking into account all potential dilutive securities, such as convertible bonds, stock options, and warrants, which, if exercised or converted, would increase the number of common shares outstanding. The purpose of diluted EPS is to show the worst-case scenario for per-share earnings, assuming all potential shares are issued.

The key distinction lies in the denominator of the EPS calculation. Adjusted basic earnings focuses solely on the current common shares, while diluted EPS considers the potential increase in the number of shares that could result from the exercise or conversion of other financial instruments, thereby "diluting" the earnings per share. Both metrics are important for a complete understanding of a company's earnings profile.

FAQs

Q1: Why are preferred dividends subtracted when calculating adjusted basic earnings?

Preferred dividends are subtracted because they represent a portion of the company's earnings that is contractually owed to preferred shareholders before any earnings can be considered available to common shareholders. This adjustment ensures that the reported "earnings available to common shareholders" accurately reflects what remains for the ordinary equity holders.

Q2: What is the main difference between basic EPS and diluted EPS?

The main difference between basic EPS and diluted EPS lies in the number of shares used in the denominator. Basic EPS uses the weighted average shares outstanding of common stock, based on the adjusted basic earnings. Diluted EPS, however, includes the effect of all potential common shares that would arise from the exercise or conversion of dilutive securities (like stock options or convertible bonds), providing a more conservative view of per-share profitability.

Q3: Do all companies report adjusted basic earnings?

Publicly traded companies are typically required to report both basic and diluted earnings per share on their income statement, from which the adjusted basic earnings figure (the numerator) can be derived. This is mandated by financial reporting standards like GAAP and IFRS for entities with publicly traded common stock or potential common stock.

Q4: Can adjusted basic earnings be a negative number?

Yes, adjusted basic earnings can be a negative number. This occurs if a company reports a net loss, or if its net income is less than the preferred dividends for the period. A negative adjusted basic earnings figure indicates that the company did not generate sufficient earnings to cover its preferred dividend obligations, let alone provide any profit to common shareholders.