Definition
The conversion ratio is a term used in finance that refers to the number of common shares an investor can obtain from converting a convertible security. It’s stated in the contract at the time a convertible security is issued. A higher conversion ratio means more common shares per convertible security, increasing a holder’s potential return.
Key Takeaways
- The Conversion Ratio is a key financial term that refers to the number of common shares that holders of a convertible security can obtain upon conversion. Convertible securities can include bonds or preferred shares. The ratio reveals the potential for dilution of earnings per share if convertible securities are converted to common stock.
- The Conversion Ratio is important in valuing convertible securities. It provides investors with a way to estimate the value of their convertible securities in terms of the underlying common stock. If the price of the common stock increases significantly, the convertible securities may be converted, providing a profit for the investor.
- It’s calculated by dividing the convertible security’s par value by the conversion price of shares. For investors, a higher Conversion Ratio may be preferable because it means they would receive more shares upon conversion. However, a higher Conversion Ratio also implies a higher potential for stock dilution for the company.
Importance
The finance term “Conversion Ratio” is important as it quantifies the number of shares an investor will receive from a convertible security if the investor decides to convert.
Convertible securities, such as convertible bonds or convertible preferred shares, offer the potential for capital appreciation through this conversion mechanism.
The conversion ratio, therefore, plays a significant role in determining the security’s value.
This conversion feature can make the convertible security more attractive to investors and potentially allow the issuing company to pay a lower interest rate.
Hence, understanding the conversion ratio is crucial in evaluating the potential return and risk of convertible securities.
Explanation
The purpose of the conversion ratio in finance is critical as it determines the number of shares investors could receive in exchange for a convertible security. It uniquely plays a role in convertible bonds and preferred stocks where investors have the option to convert these into common shares of the company. This gives an investor a leeway to benefit from the appreciating stock price, while still enjoying the stable income from bond interest or preferred dividends.
The conversion ratio thus allows measurement of the potential value of convertible securities compared to that of ordinary shares. Furthermore, the conversion ratio also directly impacts the conversion price, another critical factor for investors. This price is simply the market price of convertible security divided by its conversion ratio.
By considering the conversion price, investors can determine whether it’s profitable to convert their holdings into common shares at any given moment. If the current market price of the company’s common shares is above the conversion price, the conversion would be profitable. In essence, the conversion ratio is a determining tool for making strategic decisions and thus plays a significant role in shaping investment decisions in convertible securities.
Examples of Conversion Ratio
The conversion ratio is a financial term used to determine the number of shares an investor will get for converting a convertible security. Here are three real world examples:**TESLA Inc. Convertible Bonds:** In 2014, TESLA Inc. issued convertible bonds to finance its new factory. These were issued with a conversion ratio of7788, meaning for each $1,000 in face value of the bond, it can be converted into
7788 shares of the company. So, if an investor holds bonds with an aggregate face value of $10,000, they could choose to convert their bonds into788 shares of Tesla.**Bank of America Corp. Convertible Preferred Stock:** Bank of America offers a series of convertible preferred stock. For instance, one of these series has a conversion ratio of
This means that for each preferred share, if the holder decides to convert it, they would receive 20 shares of Bank of America’s common stock.**Awilco Drilling PLC Convertible Loan Note:** In 2019, Awilco Drilling PLC issued a convertible loan note with a conversion ratio of122, which indicates that for every $1,000 in loan notes, the investor could convert it into
122 shares of Awilco Drilling. Therefore, if an investor had a loan note worth $5,000, they could exchange it into61 shares.
FAQs on Conversion Ratio
What is a Conversion Ratio?
The Conversion Ratio is a key parameter in convertible securities (like convertible bonds and preferred stocks). It determines the number of common shares that can be obtained in exchange for the convertible security. It’s defined at the time the security is issued.
How is the Conversion Ratio calculated?
The Conversion Ratio is generally calculated by dividing the bond’s par value by the conversion price, which is the pre-determined price per share at which the bond can be converted into shares.
What does a high Conversion Ratio mean?
A high Conversion Ratio implies that the bondholder can convert their bond into more shares. This usually happens when the issuer wants to make the bond more attractive by giving the bondholder the opportunity to profit more if the issuer’s stock price increases.
How does the Conversion Ratio affect an investor?
The Conversion Ratio can significantly affect an investor’s return. If the stock price rises significantly, a bond with a high Conversion Ratio can provide a higher return than a traditional bond. However, if the stock price falls, the bondholder may choose not to convert and instead receive the bond’s stated interest payment.
Related Entrepreneurship Terms
- Convertible Securities
- Equity Dilution
- Par Value
- Conversion Price
- Convertible Bond
Sources for More Information
- Investopedia: A trusted website featuring articles and definitions on a wealth of financial terms. They often break down complex terms into an easily understandable format.
- NASDAQ: Provides a glossary of financial and investment terms. Being a major stock exchange, they provide reliable and accurate financial information.
- The Balance: Also offers a wide range of financial information, including explanations of various financial metrics and ratios.
- Moneycontrol: An India-based finance website which provides news, advice, and definitions for a wide range of financial terms and concepts.
