Earnings Basis - Explained
What is a Earnings Basis?
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Table of ContentsWhat is an Earnings Basis?How Does an Earnings Basis Work?Earnings Basis in the Context of a CompanyEarnings Basis in the Context of an Individual Employee
What is an Earnings Basis?
The term Earnings Basis can have vastly differing denotations, depending on whether it is used in the context of an employee or an organization. In the context of an individual employee, earnings basis refers to the basis of an employees earnings that is used to calculate his/her pension contributions. On the other hand, when used in the context of company valuation, earnings basis refers to the procedure of calculating the value of a company on the sole basis of its total profits.
Back to:BUSINESS & PERSONAL FINANCE
How Does an Earnings Basis Work?
Earnings constitute a significant part of a company as well as of individual employees, and therefore, it is a vital concept of finance. As such, the concept of earnings basis plays a major role in (a) determining the business value of a company as well as (b) calculating the part of an employees earnings that his/her pension contributions will be based on.
Earnings Basis in the Context of a Company
A company generates a finite amount of earnings over a specified reporting period. This period can be quarterly, semi-annual or annual. These earnings provide a basis for calculating the financial performance of the company and as such, it is a vital statistic employed by analysts in order to forecast the company's future profitability on the basis of its past earnings. A company that is able to achieve better earnings figures than its estimated profits is said to be outperforming. Such a company is most likely to enjoy an increase in the prices of its shares. On the other hand, a company that achieves earnings figures that are below its estimated profits is said to be underperforming. Such companies are very likely to witness a decrease in their share prices. A company's earnings are directly tied to its earnings per share (EPS) figure, which is calculated by dividing the company's total earnings by the total number of its outstanding shares. The EPS is often used to calculate the company's earning yield, which is obtained by dividing its EPS by the market price of each share. Similarly, the company's earnings can also be used in the calculation of its Price to Earnings (P/E ratio), which is used to evaluate and compare the earnings of different companies competing within the same industry. Income and market valuation procedures employ certain business valuation methodologies that use an estimate of the earning power of a company in order to determine its business value. There are several methods that can be used to estimate business earnings depending on the earnings basis. These measurement methods are broadly classified into two discrete categories - accounting methodologies and economic methodologies.
Accounting Methodologies consist of the following procedures that are used to measure a company's earnings:
- Gross revenue or Net Sales
- Net after-tax income
- Earnings before tax (or, EBT)
- Earnings before interest and taxes (or, EBIT)
- Earnings before interest, tax, depreciation and amortization (or, EBITDA)
Economic Methodologies employ the following procedures in order to estimate the earnings of a company:
- Net cash flow, which is a measure of earnings used as the basis in the Discounted Cash Flow (DCF) method of business valuation.
- Sellers discretionary cash flow (SDCF), which is a common cash flow-based measure of earnings for owner-operator-managed businesses.
Earnings Basis in the Context of an Individual Employee
On an individual employee level, there are two discrete settings that help an employer evaluate how much the company as well as the employees will be contributing towards their pensions on a regular basis. These are - earnings basis and contribution level. It is the earnings basis of every individual employee that helps determine his/her contributions during each pay period. Employers usually choose from three distinct earnings bases for evaluation of the pensionable earnings of their employees in order to calculate their pension contributions. They are:
- Qualifying Earnings
- Pensionable Earnings
- Total Earnings
Qualifying Earnings are calculated on a band of earnings that lies within the lower earnings limit and the upper earnings limit. Qualifying Earnings typically consists of the following types of earnings:
- Bonuses and commission
- Statutory sick pay
- Statutory pay received during paternity leave, maternity leave any various other forms of family leave.
Pensionable Earnings is the basic foundation for calculating pension contributions. Pensionable earnings typically consist of at least the basic pay component of the employees income.
TotalEarnings typically consists of
- Statutory sick pay
- Statutory maternity pay
- Ordinary or additional statutory paternity pay
- Statutory adoption pay
This list may also include other pay components depending on the employer and terms of employment. Moreover, the employer is usually at liberty to choose the type of earnings basis that best suits his/her requirements.