Impact of Corporate Actions on Financial ratios

Here in this unit, we will discuss the impact of different corporate actions on the financial ratios of the companies. If you are unaware of the concept of financial ratios, you can read our ELM school module on 'Ratio Analysis.' Click here.

Now, let us continue one by one. 

1)Buyback of Shares

When the company purchases its own shares, then the outstanding shares in the market get reduced and hence the investors stake increases as the number of shares have reduced in the market.

Buybacks can be performed either through a tender offer route or through the open market.

Now let us understand  how the Buyback of shares affects the financial ratios of the company.

Impact on Earnings Per Share (EPS):

EPS is calculated by dividing the net income by the total outstanding number of shares during the year. Since the company extinguishes the shares bought back, the EPS tends to increase. 

Let us understand this with the help of an example:

Company – XYZ Ltd

Outstanding Shares – 100 crore shares at the beginning of the year.

Net Income – ₹500 crores,

EPS = ₹5 (500/100).

Buyback Shares = 10 crore shares

Hence the outstanding number of shares post buyback is 90 crores (100-10).

Now the Revised EPS is ₹5.55 (500/90).

Several valuation metrics incorporate EPS in their calculation & hence the stock is positively re-rated. 

Impact on debt-to-equity ratio:

Debt to equity ratio measures the financial leverage of the company.

It is calculated by dividing the Total debt by the Total Equity during the year

It represents the proportion of debt a company takes to finance its operation.

Buyback of shares reduces the equity of the company.

Since, the equity of the company is reduced it increases the debt-to-equity ratio of the company.

For example, a company has debt amounting to ₹50 crores.

The company’s equity is ₹100 crores before the buyback.

The company has undertaken buyback worth ₹10 crores during the year which reduces the equity of the company to ₹90 crores (100-10).

Hence the debt-to-equity ratio deteriorates from 0.5 (50/100) before buyback to 0.55 (50/90) post buyback

Impact on book value per share:

Book value per share is derived by dividing shareholder’s equity by the total outstanding shares.

A company’s book value per share will decrease after a share repurchase if the market price per share was greater than the book value per share prior to the repurchase and vice versa.

This is explained in two situations below-

For example,

Case 1:

XYZ is a company with 1,00,000 shares outstanding.

The shareholder equity value of the company is 15,00,000 and hence the book value computed is ₹15 (15,00,000/1,00,000).

Now let us assume that the company buybacks 10,000 shares @₹10 per share amounting to ₹1,00,000.

Post the buyback of shares, the shareholders equity value of the company has reduced to ₹14,00,000 (₹15,00,000-₹1,00,000) and the book value per share has increased to ₹15.56 (₹14,00,000/₹90,000).

Thus, this impacts a company positively as it’s worth has increased.

Case 2:

XYZ is a company with 1,00,000 shares outstanding.

The shareholder equity value of the company is ₹8,00,000 and hence the book value computed is:

(₹8,00,000/₹1,00,000) = ₹8

Now let us assume the company buybacks 10,000 shares @₹10 per share amounting to ₹ 1,00,000.

Post the buyback of shares, the shareholders equity value of the company has been reduced to ₹7,00,000 (₹8,00,000-₹1,00,000) and the book value per share has decreased to ₹7.77 (₹7,00,000/₹90,000).

In this case, the book value per share was higher before the buyback. 

The effect of a corporate action should always be measured before making any investment decision.

2)Rights Issue

The rights issue is an offering to the existing shareholders of the company which makes them eligible to buy additional shares in the company at a discounted price to the prevailing market price of the shares.

The rights issue on shares can be subscribed by the existing shareholders as proportionately to the number of shares being held by them on the record date. Other market participants can also take part in rights issues by purchasing Rights Entitlements from the open market.

Impact on Debt-to-Equity Ratio:

Rights issue of shares improves the debt-to-equity ratio of the company.

Debt-to-equity ratio is computed by dividing the debt value of the company by total equity of the company.

When the company issues right shares, the company’s equity value increases.

Therefore, the debt-to-equity ratio improves since the company has raised money through the issue of shares (equity).

For example, XYZ Ltd has 100 outstanding shares & ₹200 in long-term debt.

The company plans to issue right shares in a ratio of 1:5 to its existing shareholders to finance a new project.

Post issue, The debt-to-equity ratio will improve from 2(200/100) to 1.66 (200/120).

Impact on EPS:

EPS is computed by dividing the net income by the total outstanding shares of the company.

In case of rights issues, the number of shares increases and hence the earnings per share is reduced.

Moreover, to keep the EPS constant post right issue, the company’s profit should increase to a greater extent in the future to compensate for the additional shares.

For Example, XYZ Ltd has a net income of ₹10 crores during the year. The company has 1 crore shares outstanding during the year. The company has issued rights shares in a ratio of 1:10 to the existing shareholders. As a result, the total number of outstanding shares increases to 1.1 crores.

Therefore, the EPS of the company has reduced from ₹10 (10/1) to ₹9.09 (10/1.10) post rights issue

Hence, The EPS gets negatively impacted due to rise in the number of outstanding shares. 

3)Bonus Shares

Bonus shares are fully-paid up shares issued free of cost to existing shareholders in a certain ratio.

Bonus shares are issued by companies to capitalize on their free reserves. Companies share their retained earnings with their shareholders in the wake of absence of any capex or expansion in the near future.

Impact on EPS:

EPS is computed by dividing the net income of the company by the total outstanding number of shares.

In case of bonus issue, the company issues additional shares to its existing shareholders on a proportionate basis.

Therefore, bonus issue of shares reduces the EPS of the company.

For example, XYZ Ltd has reported a net income of 10 crores for the year and has 1 crore shares outstanding during the year.

The company issues bonus shares in a ratio of 1:1 during the year.

The bonus shares are shares that are offered free of cost to the existing shareholders and hence it only increases the number of shares outstanding.

Hence, the EPS of the company during the year falls from ₹10 (10/1) to ₹5 (10/2) post issue of bonus shares. 

Summarizing what we just learnt:

• Buyback of shares improves the earnings per share of the company.
• Buyback of shares adversely impacts the debt-to-equity ratio of the company.
• Buyback of shares impacts book value per share both positively as well as negatively
• Rights issue of shares positively impacts the debt-to-equity ratio of the company.
• Rights issue of shares negatively impacts the earnings per share of the company.
• Bonus issue of shares adversely impacts the earnings per share of the company.