Conversion Ratio: Definition, How It's Calculated, and Examples

What Is the Conversion Ratio?

The conversion ratio is the number of common shares received at the time of conversion for each convertible security. The higher the ratio, the higher the number of common shares exchanged per convertible security. The conversion ratio is determined at the time the convertible security is issued and has an impact on the relative price of the security. The ratio is calculated by dividing the convertible security's par value by the conversion price of equity.

Understanding the Conversion Ratio

There are two main types of capital fundraising tools: debt and equity. Debt must be paid back, but it is often cheaper to raise capital by issuing debt than by acquiring equity due to tax considerations. Equity does not need to be paid back, which is helpful in difficult times or when earnings growth is negative.

Raising capital with equity relinquishes ownership, and ownership brings voting rights. Even though equity takes a back seat to debt in terms of credit, shareholders benefit from share price appreciation when earnings growth is strong. The interest rate paid to debt holders stays the same regardless of earnings performance.

Each fundraising method has its advantages and disadvantages. One way investors and companies take advantage of both worlds is through hybrid securites called convertibles. The conversion ratio tells investors how many common shares they get in exchange for a convertible bond or stock. The company sets the conversion ratio and date at the time of issue.

The Formula for the Conversion Ratio Is

 $\begin{aligned} &\text{Conversion Ratio} = \frac{ \text{Par Value of Convertible Bond} }{ \text{Conversion Price of Equity} } \\ \end{aligned}$​Conversion Ratio=Conversion Price of EquityPar Value of Convertible Bond​​

Examples of the Conversion Ratio

The following examples show the conversation ratio in the case of convertible bonds and convertible preferreds.

Convertible Bonds

Convertible debt is a debt hybrid product with an embedded option that allows the holder to convert the debt into equity in the future. The registration statement tells investors the number of shares to be granted.

For example, one bond that can be converted to 20 shares of common stock has a 20-to-1 conversion ratio. The conversion ratio can also be found by taking the bond's par value, which is generally $1,000, and dividing it by the share price. A stock trading for $40 has a conversion ratio equal to $1,000 divided by $40, or 25.

Convertible Preferreds

Convertible stock is a hybrid equity product. Preferred stockholders receive a dividend like a bond, which ranks higher than equity in case of liquidation, but they have no voting rights. Converting to stock gives the preferred shareholder voting rights and allows them to benefit from share price appreciation.

For example, if a company issues convertible preferred with a 5% dividend and a conversion ratio of five, the investor receives five common shares for each share of preferred shares. If the preferred stock is trading at $100, the conversion break-even price on common shares can be determined by dividing the price by the conversion ratio, which is $20.

In both instances, the conversion ratio drives the price of the convertible.