If sales manager decided to offer 60-day credit terms to customers, rather than 30-day credit terms?

If competitors match terms, and sales remain constant … A/R would é Cash would ê

If competitors don’t match, and sales double … Short-run: Inventory and fixed assets é to

meet increased sales. A/R é, Cash ê. Company may have to seek additional financing.

Long-run: Collections increase and the company’s cash position would improve.

What happens if a company depreciates fixed assets over 7 years (as opposed to the current 10 years)?

No effect on physical assets.

Fixed assets on the balance sheet would decline.

Net income would decline.

Tax payments would decline.

Cash position would improve.

Purpose of an enterprise

Business as an economic entity exists to make profits: Trading activitySelling price > Cost of purchase

Manufacturing activity: Selling price > Cost of purchase + conversion costs

ServicesPrice for service > Cost of providing the service

Buying Selling

SellingProcessingBuying

Servicing

Stakeholders

We need various entities to come together to run an enterprise and generate returns. Who are the stakeholders in a business? Investors

Equity holders – majority holders, minority shareholders

Debt holders including banks and financial institutions

Management Employees Suppliers Customers Community, Taxman

Various forms of enterprise

Partnership

Enterprise

Closely held

CompanyProprietary

Public Ltd.Private Ltd.

Publicly held

Various forms of enterprise

Proprietary business – owned by single owner No difference between the obligations of the business and the obligations of the individual.

Partnership firm – owned by two or more owners No difference between the obligations of the business and the obligations of the individual

partners except when it is Limited Liability Partnership (Registered)

Company is an artificial person, created by law and has perpetual existence. Obligations of the company are separate from those of promoters and management.

Private limited company Not more than 50 members Shares are not freely transferable. No invitation to public for subscription.

Public limited company Closely held public limited company (Deemed) Publicly held public limited company (Listed)

Golden Rules of Accounting(British Accounting)

Three types of Accounts:Real Account : All assets (like land, building, furniture, fixtures,

patent, goodwill, copy rights, cash and bank balances, etc)Nominal Account : All expenses/losses and

incomes/gains( Expenses and losses like purchases,rent, salary, wages, commission paid, discount allowed, loss on sale of assets, bad debts and income and gains like sales, commission received, rent received, interest received, discount received and profit on sale of assets)

Personal Account :Individuals : Ravi, Smita, Ratan, Anil, Indira, etc

Artificial Person : SBI, PNB, KIIT University, Reliance Ind, Tata SteelRepresentative Person : Debtors, Creditors, capital and drawings, etc

Golden Rules of Accounting(British Accounting)

Real Account : Debit(Dr.) what comes in, Credit(Cr.)what goes out

Nominal Account :Debit(Dr.) all expenses and lossesCredit(Cr.) all incomes and gains

Personal Account :Debit(Dr.) the receiver Credit(Cr.) the giver

American way of Accounting Incomes and gains(Cr.) Increases - Cr. And Decreases- Dr. Expenses and losses(Dr.)

Increases- Dr. and Decreases – Cr. Assets (Dr.)

Increases(Dr) and Decreases (Cr) Liabilities(Cr)

Increase (Cr) and Decrease (Dr) Capital (Cr)

Increase (Cr) and Decrease(Dr)

Accounting Concepts:

Money measurement- Accounting records only those facts that can be expressed in monetary terms.

Entity : Accounts are kept for entities as distinguished from the persons associated with those entities.

Going concern: Accounting assumes that an entity will continue to exist indefinitely and that it is not about to be liquidated.

Cost: Nonmonetary and monetary assets are ordinarily entered in the accounts at the amount paid to acquire them.

Dual aspect: Every transaction affects at least two items and preserves the fundamental equations:

Assets = Liabilities + Owners’ equity

Cont….

Accounting Period : Accounting measures activities for a specified interval time( say from 1st April’2011 to 31st March’ 2012)

Conservatism: Revenues are recognised only when they are reasonably certain, whereas expenses are recognised as soon as they are reasonably possible.

Realization: The amount recognized as revenue is the amount that customers are reasonably certain to pay.

Matching: When a given event affects both revenues and expenses, the effect on each should be recognized in the same accounting period.

Consistency: Once an entity has decided on a certain accounting method, it will use the same method for all subsequent events of the same character unless it has a sound reason to change methods.

Materiality: Insignificant events may be disregarded, but there must be full disclosure of all important information.

Financial statements

Financial statements report the state of financial affairs of an enterprise

These are made publicly available for widely held companies, usually free of cost (www.bseindia.com and www.nseindia.com )

For closely held public companies and private companies, the financial statements are reported to the Ministry of Company Affairs Some of these are available for public viewing (both online as well

as physically) for a small fee. (http://www.mca.gov.in )

Three key financial statements are Balance Sheet Profit & Loss Account and Cash flow statement

Construct of a Balance Sheet

Liabilities

Owners’ capital Equity Capital Reserves and Surplus

Borrowed funds Long term debt Short term debt

Working capital Creditors Current liabilities and

Provisions

Assets Fixed Assets

Land and building Plant and Machinery

Investments Investment made in shares,

bonds, government securities, etc.

Working Capital Raw Material Work in progress Finished goods Debtors Cash

Some observations on Balance Sheet

The Liability side represent the various sources of funds for an enterprise These are the liability of the enterprise to the providers of these

funds The Asset side represent the various uses of funds by an

enterprise These are the assets held by the enterprise, that are needed to

operate the business (e.g. Office space, factory, raw material, etc.)

The Assets and Liabilities should ALWAYS match. In the Liability side, the portfolio mix of the own funds and

borrowed funds is called the Capital Structure of the company

Balance sheet is always presented as on a given day, say as at March 31, 2008. It presents a static picture of the assets and liabilities of the enterprise as on that date.

Some observations on Balance Sheet

Another way to look at the balance sheet is to match the sources and uses of funds, based on their tenure. In Liability side, long term sources are

Equity capital Reserves and Surplus Long term borrowings

In Asset side, long term uses are Fixed Assets Investments

The rest are short term on both sides viz. Current assets, current liability and short term debt

Ideally, long term uses must always be funded with long term funds. Financing long term assets with the short term funds creates risks (mainly refinancing risk).

Short term investments may be financed by a combination of long term and short term funds, based on business managers’ preference.

Construct of a Profit & Loss account

Revenues from the businessLess Raw material consumed

Employee expenses

Other manufacturing expenses

Administrative expenses

Selling expenses

Sub total: Cost of Sales

Earning before interest, taxes, Depreciation & Amortization(EBITDA)Less Depreciation

Earning before interest and taxes (EBIT)Less Interest payment

Profit before taxes (PBT)Less Taxes

Profit after tax (PAT)Less Dividend

Retained earnings

Inside the P&L Account

Typical items under ‘Revenue from business’ Sales revenue Other related income

Scrap sales, Duty drawback Non-operating income

Dividends and interest Rent received

Extra-ordinary income Profit on sale of assets / investments Prior-period items

Typical items under ‘Cost of Sales’ Cost of goods sold

Direct material Direct labor Direct manufacturing overheads

Administrative costs Office rent Salaries Communication costs Other costs

Selling and distribution costs Salaries of sales staff Commissions, promotional expenses Advertisement expenses etc.

Inside the P&L Account

Depreciation Straight line method Written Down Value method

Deferred revenue expenditure R&D expenses Advertisement expenses Product promotion expenses(expenses are charged as capital expenses and

amortized over the period of time)

Inside the P&L Account

Some observations on P&L Account

P&L Account presents a snapshot of the performance of an enterprise over a given period (a year, half-year, quarter, etc.) Unlike Balance Sheet, which presents a static picture on a

given date P&L Account can provide great insights into the

functioning of an enterprise. Let us look at a few: Variable costs Vs. Fixed costs

Break even point is the point where there is ‘no profit, no loss’ Cash expenses Vs. Non-cash expenses

Raw material, salary and other administrative expenses are cash expenses

Depreciation is typically the only non-cash expense Recurring income Vs. one-time income

Income from ordinary activities are typically recurring in nature Extraordinary income / expenses are typically one-time in nature Few examples: Sale of office space, disposal of a factory unit, VRS

Cash flow Statement

What is a Cash flow Statement? A statement that links the P&L generated based on ‘accrual’

principle and the Balance Sheet which represents the snapshot on a given date

A statement that segregates cash generated and cash used based on the source/end use of the cash

What are its components? Three key components of Cash flow Statement are

Cash flow from Operating Activities Represents the cash generated from the operations of the

enterprise – a measure of ‘cash profit’ from the operations Cash flow in Investing Activities Represents the deployment of cash in various assets such as fixed

assets, investments, etc. Cash flow from Financing Activities Represents the net cash raised in the form of capital such as

equity capital, borrowed funds, etc.

Construct of a Cash flow Statement

Cash flow from Operating ActivitiesProfit Before Tax

Less Non-operating income (e.g. Interest income, profit on sale of assets)

Add Interest expense

Add Depreciation

Less Other cash adjustments (e.g. Unrealized foreign exchange loss)

= Operating Profit before Working Capital Changes

Less Increase in Debtors

Less Increase in Inventory

Less Increase in other current assets (e.g. Loans and Advances)

Add Increase in Creditors

Add Increase in other Current liabilities and Provisions

= Cash generated from Operations

Less Taxes

= Net Cash from Operating Activities

Construct of a Cash flow StatementCash flow from Investing Activities

Purchase of Fixed Assets (negative because it is cash outgo)

Add Purchase of Long term investments

Less Proceeds from Sale of Fixed Assets or Investments (if any)

Add Interest and Dividend Income

= Net Cash used in Investing Activities

Cash flow from Financing Activities

Proceeds from issue of share capital

Add Proceeds from raising fresh loans

Less Repayment of existing loans

Less Interest expense

Less Dividend paid

= Net Cash Generated from Financing Activities

Opening Balance: Cash and Cash Equivalents

Add Net Cash from Operating Activities

Less Net Cash used in Investing Activities

Add Net Cash Generated from Financing Activities

= Closing Balance: Cash and Cash Equivalents

Some observations on Cash flow statement

Cash flow statement provides the reference check for the quality of ‘profits’ generated by a company For instance, if the company reports profits, most of which remain uncollected

in the form of ‘debtors’, cash flow from operations will be negative, which should prompt an analyst to probe debtors further.

Cash flow statement provides a snapshot of where the cash comes and where the cash goes Disproportionate cash going into investing activities on a continuous basis

could provide a clue on ‘unproductive’ assets in a company.

Cash flow statement, like balance sheet, provides a self-check point Opening and Closing Cash balances should tie in with the actual balance in the

bank account as on the opening and closing dates. Acts as a good reference check point.

Negative cash flow from operations is not necessarily a sign of distress, especially for a growing company. Typically, increase in working capital could be more than the cash profit

generated by a growing company

Free Cash flow

Free Cash flow measures a company’s ability to fund its capital expenditures for property, buildings, and equipment and its dividends from its net cash provided by operating activities

Free Cash Flow =net cash provided by operating activities– Capital Expenditure – Dividends

Cash Equivalents: Short-term, highly liquid investments such as

Treasury bills, commercial paper, and money market funds that are made solely for the purpose of generating a return on temporarily idle funds.

XBRL: Extensible Business Reporting LanguageIt is a framework that establishes individual ‘tags’

for elements in structured documents, allowing specific elements to be immediately accessed and aggregated. It dramatically improves the financial reporting process.

Ratio analysis

Some important ratios for analyzing performance of a company:

Operating profit margin Net profit margin

Return on Capital Employed Current Ratio Debt: Equity ratio Interest coverage ratio

Earnings per share Price Earnings ratio Return on Net worth

Ratio analysis

Operating profit margin Indicates the business profitability OPM = EBITDA / Operating Income (or Net Sales) Depending on the industry, for healthy companies, OPM

ranges from 15% - 50%

Net profit margin Indicates the returns generated by the business for its

owners NPM = PAT / Operating Income (or Net Sales) For healthy companies, NPM ranges from 3% - 12%

Several other ‘profitability’ measures are there (Gross margin, Contribution margin, etc.) but the above two are most commonly used.

The profitability margins are very useful for peer comparison (i.e. comparing with other companies in same industry)

Ratio analysis

Return on Capital Employed Indicates true measure of performance of an enterprise The capital employed in business is Equity capital, reserves

and surplus, long term debt and short term debt. Returns generated for all these providers of capital is EBIT. ROCE = EBIT / (‘Net worth’ + ‘Total Debt’) The ratio is independent of the industry, capital

structure or asset intensity. For healthy companies, ROCE ranges from 15% - 30% If ROCE is less than Interest rate for a company

consistently, the company is destroying value for its equity investors / owners

The owners are better off dissolving the company and parking their money in bank fixed deposits and earn interest!!!

Ratio analysis – Lenders’ perspective

Lenders, such as a bank giving loan, or a Mutual Fund investing in bonds or debentures of a company, may use the following ratios:

Debt: Equity ratio The ratio of borrowed funds to owners’ funds D:E ratio is also known as ‘gearing’, ‘leverage’ or ‘capital

structure’ Gearing = (Long term debt + Short Term debt)

(Equity capital + Reserves & Surplus) For most manufacturing companies, D:E less than 2.0x is

considered healthy. Higher the ratio, better it is for owners; but at the same

time, more risky for lenders Company has to service higher interest cost if it borrows more;

in a recession, the company may be more vulnerable to default on its interest.

Ratio analysis – Lenders’ perspective

Interest coverage The ratio indicates the cushion the company

has, to service its interest Interest coverage = EBIT / Interest cost Higher the ratio, better it is for the lenders For healthy companies, Interest coverage

ranges from 2.0x to 8.0x. Interest coverage < 1.0x indicates high stress,

and probably default on interest payments.

Ratio analysis – Lenders’ perspective

Current ratio This is a commonly used ‘liquidity ratio’, used by banks that lend

for ‘working capital’ Current ratio = Current Assets

Current liabilities + Short term debt The ratio indicates the ratio of short term assets to short term

liabilities. Indirectly, the ratio also indicates the proportion of long term assets

funded by long term liabilities. For solvent companies, current ratio ranges between 1.2x to 2.0x Current ratio of < 1.0x indicates that the company may face

liquidity problems, as more current liabilities / short term debt are maturing in the next one year, than the current assets that are maturing in the same period.

Please read the commentary: http://www.crisil.com/Ratings/Commentary/CommentaryDocs/Common-myths-about-current-ratio_Dec05.pdf

Ratio analysis – Equity investors’ perspective

Equity investors, such as a Mutual Fund investing in shares, or an individual investor, or a Private Equity investor, may use the following ratios:

Earnings Per Share (EPS) The Profit earned by the company for each share in the share

capital of the enterprise EPS = Profit After Tax

Number of Equity shares outstanding EPS is expressed in Rupees. This represents each shareholder’s claim in the profits of the

company, for the relevant period (one year, one quarter, etc.) Two common sub-classification are Basic EPS and Fully Diluted

EPS Basic EPS is computed based on no. of shares outstanding

currently Fully Diluted EPS is computed assuming all “warrants’,

‘convertibles’ and ‘options’ are exercised fully.

Warrants: The right to purchase shares of common(equity) stock(shares) at a state price within a given time period is called a warrant. For example a warrant could give its holder the right to buy 100 shares of XYZ Company stock for Rs.25 per share anytime between January1, 2007 to December 31, 2010.

Options: A stock option is essentially the same as a warrant except that it is not negotiable. Many corporations grant options to certain officers and managers to buy company’s stock within a period at a stated price.

ESOP : Some corporations have a programme of setting aside stock for the benefit of employees as a group, this is called as an Employee Stock Ownership Plan(ESOP). Contributions to the plan are tax-deductible.

Diluted Earning Per share

Ralie Co. is 2006 had net income of $7 million. It had outstanding 100000 shares of $8 preferred stock(i.e., preferred stock whose annual dividend is $8 per share) convertible into 2,00,000 shares of common stock and 1 million shares of common stock.

The preferred stock dividend of $8,00,000 must be subtracted from net income in the calculation of basic earnings per share to arrive at net income applicable to common stock.

Ralie’s Basic EPS= $(7000000-800000)/1000000 shares = 6.20 Diluted EPS = $ 70,00,000/12,00,000 = 5.83

Ratio analysis – Equity investors’ perspective

Price - Earnings Ratio (PE) The ratio of current market price of the equity share to the

annual earnings per share PE = Current Market Price per share

Earnings Per Share (EPS) PE is expressed in ratio or times. When EPS is negative, PE is meaningless. Two common sub-classification are Forward PE and Trailing

Twelve Months (TTM) PE Forward PE is computed using EPS of the next financial year TTM PE is computed using EPS of last 4 quarters

PE ratio has no meaning for unlisted companies as there is no ‘market price’ for these shares

Broadly speaking, PE ratio is in the range of 5-12x during recession times and 10-25x during boom times.

The ratio is also related to the growth in earnings that the company can generate in the next few years.

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