Conversion Ratio

Conversion ratio refers to the number of common shares an investor receives for each convertible security when the conversion option is exercised. Convertible bonds and convertible preferred stocks usually have this ratio. 

The number of shares exchanged while conversion is positively correlated with the ratio. The number of shares exchanged increases with the increase in ratio. The Par value of the convertible security and market price per share of common stock are the important elements of this ratio determined at the time of the convertible security's issuance.

• The conversion ratio is the number of common shares acquired when convertible preference shares or bonds are converted.
• The formula to derive the ratio is the convertible security's par value divided by the equity's conversion price. The conversion price is usually equal to the market price of the common stock.
• Choosing the ideal interest rate and associated conversion ratio is crucial for the issuing corporation. Furthermore, it is also notable that the quality of the bond and the date of issue influences the actual interest rate and conversion ratio combination.

The conversion ratio indicates the number of common shares that an investor will get upon conversion of each convertible security, such as convertible preferred shares or convertible bonds. The issuing company determines the ratio for these convertible securities at the time and date of issuance. Then, the issuing company or the bondholder can opt for conversion. 

An organization may issue stock or bond that is convertible into common stock in the future to obtain less expensive funds. Most of these conversion correlations are defined by a ratio or the price of the securities. Therefore, it is essential to comprehend the conversion relationship to determine whether the deal is beneficial and when to convert the stocks to maximize financial benefits or break even.

The company's stock is pricey that issues the convertible bond are often less than the conversion price. As a result, the bondholder gains more from the interest payments' cash flow. However, the decision to convert the bond into common stock becomes appealing when the market price of the company's shares is higher than the conversion price.

Based on their expectations for the stock price, the bondholder decides when to execute the conversion option. For instance, the bondholder could delay converting if they believe there is considerable growth potential in the stock price. Also, the investor can keep the bond and continue to get the income stream even if the stock performs badly and its price fails to increase above the conversion price. In addition, they will get payment of the face amount if they keep the bond to maturity without using the conversion option.

The difference between the price of a convertible security and the conversion price or the market value of the common stock into which it may be converted is known as a conversion premium. When the premium is positive, investors prefer to sell the convertible bond rather than a stock conversion. Conversion becomes less likely in the presence of a considerable premium, and the convertible will act more like a bond than a share. An increase in market price reduces the conversion premium. The holder won't sell securities if the premium value is negative. 

Selecting the optimum interest rate and corresponding conversion ratio is important to the issuing company. The selection also depends on analyzing the potential combination of interest rate and corresponding conversion ratio. Analysts may utilize a linear regression model to determine what interest rate and conversion ratio combinations are available for the convertible bond under the analysis process. It is also notable that the quality of the bond and the date of issue influences the actual interest rate and conversion ratio combination. 

The convertible bond or convertible preferred stock's conversion ratio formula is:

In simple terms, if the ratio is n:1, the convertible security conversion occurs to "n" shares of stock.

Let us look at the conversion ratio example to understand the concept: 

An investor owns a convertible bond of $1000 par value. The share price of the company issuing the convertible bond is $25.Then the ratio calculation is as follows:

Given:

Par value of the convertible security is $1000

The share price is $25

The share price is the conversion price of equity

Applying these details to the formula gives the required ratio:

= $1000/$25

= 400

The conversion ratio of the convertible bond is 400. It indicates that the investor will receive 400 shares of the issuing company's common stock.

This article has been a guide to What is Conversion Ratio. We explain its formula, calculation, and example. You may also find some useful articles here -

• Convertible Debt
• Accounting for Convertible Bonds
• Convertible Arbitrage