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Accounting Fundamentals

INDEX

Accountancy Accounting Function of accounting Objective of accounting Fields of accounting Types of accounting Branches of accounting Costing budgeting Types of accounts Personal Real Nominal Rules of accounting Accounting transaction Financial management Activities of firm Areas of finance Finance function Types of investment decision Reconciliation types Physical Financial Receivables Account receivables Bills receivables Payables Account payable Discounted account payable Debtor Creditor Types of debts Book value Financial statements Profit and loss Balance sheet Cash flow statement GAP Analysis EBITDA Consolidated financial results Accounting principles Concepts Conventions

Why double entry system in accounting Working capital Capital budgeting Investment evaluation methods Discounted cash flow NPV IRR PI Non discounted cash flow Payback Discounted payback Accounting rate of return Cost of capital Weighted average cost of capital Capital asset pricing model (CAPM) Depreciation methods Straight line method Written down value method Inventory valuation method FIFO LIFO Weighted average cost Lease Types of lease Leverage Types of leverage Tools of financial analysis Ratio analysis

AccountancyAccountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in selecting the information that is relevant to the user and is reliable. The principles of accountancy are applied to business entities in three divisions of practical art, named accounting, bookkeeping, and auditing. AccountingThe systematic recording, reporting, and analysis of financial transactions of a business is called accounting. Accounting allows a company to analyze the financial performance of the business, and look at statistics such as net profit. Accounting as a system for providing quantitative information primarily financial in nature, about economic entities that is intended to be useful in making economic decisions. Objective has to be that the accounts fairly reflect the true "substance" of the business and the results of its operation. Accounting is a practice of recording, classifying, summarizing, analyzing and interpreting the financial transactions and communicating the results thereof to the persons interested in such information. Accounting is more than adding & subtracting. Core of accounting is made up of system of balanced debits & credits Sales, operations, manufacturing & management all generate raw financial data accounting turn that data into useful information Functions of Accounting Recording the business transactions of financial character in the books. (preparation of first book called 'Journal') Classifying the recorded data of similar nature in one place (preparation of second book called 'Ledger') Summarizing the classified data to know the result of business operation and its financial position (preparation of Trial balance, Income statement and Balance sheet) Analysis and interprets the summarized data in such a way to get a meaningful judgment about the operational result and financial position of the business) Communicating the interpreted data to the various users such as Owners, Investors, Bank, etc Objective of Accounting To maintain record of the business To calculate profit or loss To know financial position To provide financial information to various users Anonymous Field of accounting Cost accounting Financial accounting Fund accounting Forensic accounting management accounting tax accounting Types of accounting- Financial accounting, managerial accounting, cost accounting. Financial accounting - Financial accounting is a different representation of costs and financial performance that includes a company's assets and liabilities Cost accounting - Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost control programs, which can improve net margins for the company in the future. Managerial accounting - The key difference between managerial and financial accounting is that managerial accounting information is aimed at helping managers within the organization to make decisions. In contrast, financial accounting is aimed at providing information to parties outside the organization.

Accounting software- TALLY Branches of accounting Financial accounting area of accounting that is concerned with reporting financial information to interested external parties. Management accounting involves development and interpretation of accounting information especially as an aid to management in running the business. Management focus on information needed for planning, implementing plans and controlling costs. Cost accounting provides information about costs, which the management accountant uses to plan, control and make decisions. Cost value attributed to a resources Elements of cost material, labor, services (expenses) Classification of costs depends on the purpose for which it is required Target costing estimated price of the product in market is called target price, desired profit margin is called target profit, and the cost at which target must be produced called target cost. Kaizen costing process of cost reduction during the manufacturing phase of an existing product. (Kaizen continual & gradual improvement through small betterment activities, rather than large or radical improvement made through innovation or large investments in technology) Activity based costing allows a company to match activities with their appropriate level so as to understand better the relationship between activities and the resources used. SG&ASG&A (alternately SGA or SAG) is an acronym used in accounting to refer to Selling, General and Administrative Expenses, which is a major non-production cost presented in an Income statement. Selling: Cost of Sales, which includes salaries, advertising expenses, cost of manufacturing, rent, and all expenses and taxes directly related to producing and selling product General: General operating expenses and taxes that are directly related to the general operation of the company, but don't relate to the other two categories. Administration: Executive salaries and general support and all associated taxes related to the overall administration of the company Budget Financial plan showing how the company will acquire resources and use them in operations during a specified time period usually one year. Budget takes the form of a proforma set of financial statements & supporting schedules Budgeting is a planning process, budgeting is a cost benefit proposition. Zero based budgeting ( pioneered by TEXAS instrument company- US) Basic feature of this is while preparing their budgets departments should not take anything for granted and starts as it were, on a clean slate. Concept implies all activities of organization should be reviewed afresh. Budgetary slack means for dealing with uncertain situation, budget review process itself. GIGO garbage in garbage out Responsibility centers cost centre, marketing centre, profit centre, investment centre and revenue centre. Benchmarking continual search for most effective method for accomplishing a task by comparing existing methods and performance levels with those of other organization. Sources of capital investors, lenders, business itself by retaining earnings Debt Equity (Common Shares)

Hybrid product (Preferred shares)

Types of accounts - Personal accounts, Real accounts, Nominal accounts Personal account (Related to person or institute) Example-Sandip or IACM o Natural persons account: These are accounts of real persons who transact with the business in various capacities. The proprietors account and the accounts of customers are some examples of natural persons accounts o Artificial persons accounts: These are accounts of firms and entities that transact with the business. The accounts of a limited companies or banks that are not real persons are the examples of artificial persons accounts. o Representative personal account: These are accounts that represent certain person or persons. If a business has not paid the rent of a number of shops for the past two months then all landlords are creditors of the business and the amount due to them is recorded under a common head called Rent Outstanding Account. This is a representative personal account. Other examples of representative personal accounts are Interest Outstanding and Interest Paid in Advance accounts. Real account (related to assets or fixed assets) Example furniture, land, building etc o Tangible Real accounts: These are accounts of things that can be touched, measured, sold or purchase. Examples of tangible real accounts are land account, furniture account and cash account. o Intangible Real accounts: These are accounts of things that cannot be touched in the physical sense but can be measured in terms of money value. Trademark or patent rights are examples of intangible real accounts. Nominal account (related to profit and loss) Example paid salary, electricity bill, received commission o Nominal accounts are the accounts of each head of expense or income of a business. They are used to define the nature of the transactions; hence, they are also called fictitious accounts. Without nominal accounts, it is very difficult for the management to find out where the money was spent. As these accounts are used to define the nature of the transaction they are nominal accounts.

Rules of accounting Personal account debit the receiver, credit the giver Real account debit what comes in, credit what goes out Nominal account debit the expenses & loss, credit the profit & gains According to Global Accepted Accounting Policies (GAAR) In Indian (English) system 3 accounting types - Real, Personal, Nominal In American system 5 accounting types -Assets, Liabilities, Income, Expenses, Capital o Assets & Liabilities - main accounts o Income, expense, capital sub accounts Assets & expenses are debit accounts ( debit a debit will increase & vice-a versa) Liabilities, income & capital are credit accounts (credit a credit account will increase & vice-a-versa) Types of accounts (English system) Assets Accounts: debit increases in assets and credit decreases in assets Liabilities Accounts: credit increases in liabilities and debit decreases in liabilities Capital Account: credit increases in capital and debit decreases in capital Revenues or Incomes Accounts: credit increases in incomes and gains and debit decreases in incomes and gains

Expenses or Losses Accounts: debit increases in expenses and losses and credit decreases in expenses and losses

Accounting transaction An external event or internal event which gives rise to a change affecting the operations or finances of an organization. Financial management It is a managerial activity which is concerned with planning and controlling of the firms financial resources 4 main activities of firm Production Marketing Finance Servicing (new emerging trend) Areas of finance Corporate finance personal finance public finance Finance function Investment decision finance decision dividend decision liquidity decision Finance managers role Fund raising fund allocation profit planning understanding capital markets Types of investment decision Expansion of existing business expansion of new business replacement & modernization mutually exclusive independent & contingent Capital rationing in capital shortage raising funds from govt. for the profitable project Annuity fixed payment or receipt of each period for a specific number of periods. Sinking fund fund which is created out of fixed payments each year for a specified period of time. Capital always comes with cost. (CCC) Inventory generally have low liquidity Inventory = work in process + raw material + finished goods

Seed capital The initial capital used to start a business. Seed capital often comes from the company founders' personal assets or from friends and family. The amount of money is usually relatively small because the business is still in the idea or conceptual stage. Such a venture is generally at a pre-revenue stage and seed capital is needed for research & development, to cover initial operating expenses until a product or service can start generating revenue, and to attract the attention of venture capitalists.

Venture capital Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns. Floating capital Floating capital denotes currency in circulation and assets which are movable and storable. It represents working capital; assets which are in circulation or transportable; rather than those that are fixed, such as buildings, installations, etc. It comprises the materials and components, constantly supplied in the effecting of all manufactures; currency used for the purpose of transactions, wages and salaries; products in transportation, or in the process of being stored in the prospect of being eventually utilized for this purpose; and the working, circulating capital; rather than that which is fixed as permanently stationary value. Reconciliation- it is process of comparing two sets of records to find out discrepancy. Types of reconciliation Physical reconciliation inventory management (we compare end day stock with actual stock) Financial reconciliation bank reconciliation The basic accounting equation is assets = liabilities + equities. This is the balance sheet. The foundation for the balance sheet begins with the income statement, which is revenues - expenses = net income or net loss. This is followed by the retained earnings statement, which is beginning retained earnings + net income + additional capital (capital contribution) - dividends/drawings = ending retained earnings. Account receivableIf a company has receivables, this means it has made a sale but has yet to collect the money from the purchaser. Most companies operate by allowing some portion of their sales to be on credit. Accounts receivable are not limited to businesses - individuals have them as well. People get receivables from their employers in the form of a monthly or bi-weekly paycheck. They are legally owed this money for services (work) already provided Money owed by customers (individuals or corporations) to another entity in exchange for goods or services that have been delivered or used, but not yet paid for. Receivables usually come in the form of operating lines of credit and are usually due within a relatively short time period, ranging from a few days to a year. On a public company's balance sheet, accounts receivable is often recorded as an asset because this represents a legal obligation for the customer to remit cash for its short-term debts. Bills receivable Example Mr. A has purchased some goods from Mr. B worth 500 $ and Mr. A has written a legal document (Called bill of exchange) on Mr. B that he will pay to him 500 $ on a particular date and Mr. B has accepted it. This document (i.e. Bill) is a Bill receivable for Mr. A and Bill Payable for Mr. B.

Trade debtors

All the credit sales are not made only on behalf of bills of exchange; some amount of sales is without bills which are called Trade Debtors. Accounts Receivables is the total sum of Bills Receivables and Trade Debtors Discounted account receivableOutstanding invoices representing money owed to a creditor which the firm/creditor sells to a buyer for less than face value, typically to quickly raise capital and improve cash flow. The buying firm - also referred to as a factor purchases the financial obligation at a discounted rate providing the selling firm with immediate cash. However, the sale is undertaken without recourse, meaning that the factor assumes full responsibility for collecting the money owed in order to recoup its financial layout for the account. Accounts receivables are often sold at a discount in order to mitigate the risk that the debtor will not satisfy the obligation. The discount arises because the factor assumes the underlying risk of the receivables and must be compensated for the delayed inflow of funds Account payableAn accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable entry is found on a balance sheet under the heading current liabilities. Accounts payable are often referred to as "payables". Accounts payable are debts that must be paid off within a given period of time in order to avoid default. For example, at the corporate level, AP refers to short-term debt payments to suppliers and banks. If people or companies don't pay their bills, they are considered to be in default

creditor An entity (person or institution) that extends credit by giving another entity permission to borrow money if it is paid back at a later date. Creditors can be classified as either "personal" or "real". Those people who loan money to friends or family are personal creditors. Real creditors (i.e. a bank or finance company) have legal contracts with the borrower granting the lender the right to claim any of the debtor's real assets (e.g. real estate or car) if he or she fails to pay back the loan Unsecured creditor An individual or institution that lends money without obtaining specified assets as collateral. This poses a higher risk to the creditor because it will have nothing to fall back on should the borrower default on the loan. A debenture holder is an unsecured creditor. Commercial paper is unsecured. Debtor (Accounts receivable) (Customers to whom the goods are sold on credit) A company or individual who owes money. If the debt is in the form of a loan from a financial institution, the debtor is referred to as a borrower. If the debt is in the form of securities, such as bonds, the debtor is referred to as an issuer Sundry (Sundry = Various) Miscellaneous small or infrequent customers that are not assigned individual ledger accounts but are classified as a group. Sundry debtors (Debtors for various reasons and not merely for Credit Sales.)

It is an entity from who amounts are due for goods sold or services rendered or in respect of contractual obligations. Sundry debtor shows debit balance. Sundry creditors It refers to companies or individuals to which money is owed. Sundry creditor shows credit balance Debt fatigue When a debtor stops making payments on his or her debts and starts spending again after being overwhelmed by the amount of debt incurred and the seeming futility of the debt repayment process (the overall amount of debt owed does not appear to dramatically lessen as payments are made). Experiencing debt fatigue may eventually cause the debtor to declare bankruptcy as a last-ditch effort to resolve the situation One of the worst and most immediate effects of debt fatigue is that the debtor may start to overspend and incur more debt again. Increasing the debt load will not help the debtor's financial situation and is likely to drive the debtor to insolvency. Senior debt Borrowed money that a company must repay first if it goes out of business. Companies have a number of options for obtaining financing, including bank loans and the issuance of bonds and stocks. Each type of financing has a different priority level in being repaid if the company decides to liquidate.

If the company goes under, the holders of each type of financing have different levels of rights to the company's assets. If a company goes bankrupt, senior debt holders who are often bondholders or banks that have issued revolving credit lines are most likely to be repaid, followed by junior debt holders, preferred stock holders and common stock holders. Senior debt is secured by collateral, and that collateral can be sold to repay the senior debt holders. As such, senior debt is considered lower risk and carries a relatively low interest rate. Even though senior debt holders are the first in line to be repaid, they will not necessarily receive the full amount they are owed in a worst-case scenario.

Subordinated debt A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings. Also known as a "junior security" or "subordinated loan". In the case of default, creditors with subordinated debt wouldn't get paid out until after the senior debt holders were paid in full. Therefore, subordinated debt is more risky than unsubordinated debt. Recourse debt Recourse debt is a debt that is not backed by collateral from the borrower. Also known as a recourse loan, this type of debt allows the lender to collect from the debtor and the debtor's assets in the case of default as opposed to foreclosing on a particular property or asset as with a home loan or auto loan. Nonpayment of recourse debt allows the lender the right to collect assets or pursue legal action Recourse debt can either be full or limited recourse debt. A full recourse debt gives the granter the right to take any and all assets of the debtor, up to the full amount of the debts. The lender will sell the seized assets, including the asset acquired through the original loan. Limited, or partial recourse debt, relies on the original loan contract, where named assets are the extent to which a lender may take action Recourse Debt Borrower is Personally liable with its assets (not backed by collateral) Nonrecourse Debt Not personally liable (limited to assets) (Backed by collateral)

Non recourse debt

Non-recourse debt or a non-recourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral. Thus, non-recourse debt is typically limited to 50% or 60% loan-to-value ratios, so that the property itself provides "overcollateralization" of the loan. Non-recourse debt is typically used to finance commercial real estate and similar projects with high capital expenditures, long loan periods, and uncertain revenue streams. It is also commonly used for stock loans and other securities-collateralized lending structures. Because most commercial real estate is owned in a partnership structure (or similar tax pass-through), non-recourse borrowing gives the real estate owner the tax benefits of a tax-passthrough partnership structure (that is, loss pass-through and no double taxation), and simultaneously limits personal liability to the value of the investment. Gross profit equals sales revenue minus cost of goods sold (COGS), thus removing only the part of expenses that can be traced directly to the production or purchase of the goods. Gross profit still includes general (overhead) expenses like R&D, S&M, G&A, also interest expense, taxes and extraordinary items. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) equals sales revenue minus cost of goods sold and all expenses except for interest, amortization, depreciation and taxes. It measures the cash earnings that can be used to pay interest and repay the principal. Since interest is paid before income tax is calculated, the debt holder can ignore taxes. Earnings Before Interest and Taxes (EBIT) / (OPBIT) / (PBIT) or operating profit equals sales revenue minus cost of goods sold and all expenses except for interest and taxes. This is the surplus generated by operations. It is also known as Operating Profit before Interest and Taxes or simply Profit before Interest and Taxes. Expressed as a % of sales. Earnings Before Tax (EBT) / (PTBI) or Net Profit before Tax equals sales revenue minus cost of goods sold and all expenses except for taxes. It is also known as pre-tax book income net operating income before taxes or simply pre-tax Income. Earnings after Tax or Net Profit after Tax equals sales revenue after deducting all expenses, including taxes (unless some distinction about the treatment of extraordinary expenses is made). In the US, the term Net Income is commonly used. Income before extraordinary expenses represents the same but before adjusting for extraordinary items. Earnings after Tax (or Net Profit after Tax) minus payable dividends becomes Retained Earnings. Return on net worth net earning divided by (paid-up capital + reserves) Top line Top line is corporate net sales, that is, total revenue/income generated by a business. Bottom line is the profit/loss number, after all expenditures/liabilities have been discounted from net sales. Both of these terms come from the accounting document known as the income statement, or Profit/Loss account. Top line is the first line of that document, and bottom line is the last line in that document. When companies talk about the need to increase their top line, they are talking about the need to focus on generating / increasing sales. Bottom Line efforts are usually aimed toward cost reduction to increase the margin and therefore increase the result Bottom line "Bottom line" is the net income that is calculated after subtracting the expenses from revenue. Since this forms the last line of the income statement, it is informally called "bottom line." It is important to investors as it represents the profit for the year attributable to the shareholders. After revision to IAS 1 in 2003, the Standard is now using profit or loss for the year rather than net profit or loss or net income as the descriptive term for the bottom line of the income statement Book value Sum total of issued equity capital & reserves (excluding revaluation reserves) Book value per share = total of issued equity capital & reserves (excluding revaluation reserves)/ no. of equity shares Traditionally book value was total assets-intangible assets & liabilities.

In accounting it is value of an asset as carried in its balance sheet and is based on the original cost of the asset minus any depreciation or amortization Company It is a non living entity formed by group of people coming together having similar kind of interest. Motive of a company (why in business) To earn a profit or to create a value Financial statements Financial statements record only those facts, which are possible to be expressed in financial terms. Non-monetary events, howsoever important they may be, are not recorded. Therefore, financial statements do not provide all the information about the firm. 1. Statement of Financial Position: also referred to as a balance sheet, reports on a company's assets, liabilities, and ownership equity at a given point in time. 2. Statement of Comprehensive Income: also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. A Profit & Loss statement provides information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state. 3. Statement of Changes in Equity: (statement of retained earnings) - explains the changes of the company's equity throughout the reporting period Equity Shares capital + Securities premium 4. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities. Consolidated financial results It represents the combined financial statements of a parent company and its subsidiaries. Because consolidated financial statements present an aggregated look at the financial position of a parent and its subsidiaries, they enable you to gauge the overall health of an entire group of companies as opposed to one company's stand alone position Consolidated net Consolidated net profit forms part of consolidated financial statement to report the sum total of the net profits of all controlled subsidiaries. This statement presents net profit as financial information about a parent and its subsidiary/subsidiaries as a single economic entity to show the economic resources controlled by the group, the obligations of the group and results the group Profit & loss or Income statement The income statement is basically the first financial statement you will come across in an annual report or quarterly. Shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain time period. The best revenue is those that continue year in and year out. Temporary increases, such as those that might result from a short-term promotion, are less valuable and should garner a lower price-to-earnings multiple for a company. Profit and Loss Account of Royal Industries for June, Current Year Expenses Amount (Rs) Revenues Cost of goods sold (equivalent to cost of goods purchased and sold) 6,00,000 Sales revenue Gross Profit 1,60,000 7,60,000 Salaries 30,000 Gross profit Rent of the shop 10,000 Electricity 2,000 Stationary 2,000 Refreshments 3,000 Telephone, postage and courier charges 1,000 Miscellaneous expenses 2,000

Amount (Rs) 7,60,000 7,60,000 1,60,000

Net profit

1,10,000 1,60,000

1,60,000

Income statement discloses different versions of profit gross profit. EBITDA, EBIT, EBT, EAT Each form of profit is important as it is useful for different classes of investors for analyzing financial performance. Revenues -direct variable expenses Contribution Indirect fixed expenses Gross Profit SG & A Expenses (Consistently rising gross profit implies cost efficiency) EBITD [measures of cash generated from business operations] [EBITDA margin (EBITDA/Revenues) is an indicator of operating efficiency of business] EBITDA Eliminate difficulties associated with varying depreciation policies & capital structures EBITD - Depreciation EBIT (Operating profit) ignores the effect of financing At EBIT stage profits are available to all providers of finance (debt & equity) Post this Capital structure (leverage or D:E Ratio) will drive net profit to shareholders EBIT (Operating profit) - Interest Expenses + Other Income EBT (Determine how well a company is using its borrowing or debt to enhance its return on equity) - Tax PAT (Net Profit) - residual profit that belongs to equity shareholders Till EBIT all the expenses are operating expenses (Cost of goods sold + SG&A) After EBIT all the expenses are non operating expenses (Interest + Tax+ Depreciation) D & A - Capital Expenses (for capital goods depreciation) P &L tell about performance of the company over a period of time Revenues- financial compensation for the products or services offered. Revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. Revenue is income received by an organization in the form of cash or cash equivalents. Revenues are recorded when they are earned, not when the company receives the money. Recording revenues when they are earned is the result of one of the basic accounting principles known as the revenue recognition principle For exampleIf Joe delivers 1,000 parcels in December for $4 per delivery, he has technically earned fees totaling $4,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 10. Even though his clients won't be paying Direct Delivery until January 10, the accrual basis of accounting requires that the $4,000 be recorded as December revenues, since that is when the delivery work actually took place. After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December.

When Joe receives the $4,000 worth of payment checks from his customers on January 10, he will make an accounting entry to show the money was received. This $4,000 of receipts will not be considered to be January revenues, since the revenues were already reported as revenues in December when they were earned. This $4,000 of receipts will be recorded in January as a reduction in Accounts Receivable. (In December Joe had made an entry to Accounts Receivable and to Sales.) Expense Expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. Expense is an event in which an asset is used up or a liability is incurred. In terms of the accounting equation, expenses reduce owners' equity. The International Accounting Standards Board defines expenses as...decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence's of liabilities that result in decreases in equity, other than those relating to distributions to equity participants An expense report is a form of document that contains all the expenses that an individual has incurred as a result of the business operation. For example, if the owner of a business travels to another location for a meeting, the cost of travel, the meals, and all other expenses that he/she has incurred may be added to the expense report. Consequently, these expenses will be considered business expenses and are tax deductible. There are many kinds of expenses, but the two most common are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. Costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. SG&A also includes depreciation and amortization Profits = Revenue Expenses Gross profit is calculated as revenue minus cost of goods sold. Directly impact profit margin & is a indicator of profitability Operating profit is equal to revenues minus the cost of good sold and SG&A S G &A if revenue grows faster than the SG&A then it appears like below, Revenue grows from 100 Cr to 200 Cr SG&A - Grows from 50 Cr to 75 Cr then profit growth will be SG&A rises by 50% and Revenue rises by 100% means profit grows by 50% EBITDA tells us cash generated (all cost is removed), for asset heavy companies like manufacturing EBITDA stands as Operating profit. It ignores asset size & then compares two companies cash generated EBIT Compares companies at their capital structure (Debt & Equity). Useful for comparing non asset heavy companies like IT firms. Bottom line is generally the figure people refer to when they use the word "profit" or "earnings Depreciation reduction on value of fixed / tangible asset. Amortization reduction in value of intangible asset like goodwill. Check for impairment check if there is reduction in goodwill Appropriation Take some part of profit out & keep it in reserves Tangible assets can be depreciated, but intangible asset cant, it can be amortized. Example If Joe hires someone to help him with December deliveries and Joe agrees to pay him $500 on January 3 that $500 expense needs to be shown on the December income statement. The actual date that the $500 is paid out doesn't matterwhat matters is when the work was donewhen the expense was incurredand in this case, the work was done in December. The $500 expense is counted as a December expense even though the money will not be paid out until January 3. The recording of expenses with the related revenues is associated with another basic accounting principle known as the matching principle. This matching principle is very important in measuring just how profitable a company was during a given time period.

Assumes that on December 1 Direct Delivery borrows $20,000 from Joe's aunt and the company agrees to pay his aunt 6% per year in interest, or $1,200 per year. This interest is to be paid in a lump sum each on December 1 of each year. Now even though the interest is being paid out to his aunt only once per year as a lump sum, Joe can see that in reality, a little bit of that interest expense is incurred each and every day he's in business. If Joe is preparing monthly income statements, Joe should report one month of Interest Expense on each month's income statement. The amount that Direct Delivery will incur as Interest Expense will be $100 per month all year long ($20,000 x 6% 12). In other words, Joe needs to match $100 of interest expense with each month's revenues. The interest expense is considered a cost that is necessary to earn the revenues shown on the income statements. Balance sheet The balance sheet, also known as the statement of financial condition, offers a snapshot of a company's health. It tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets" or "shareholders equity". Balance always has life of one day only. There are two formats of balance sheet. T- Format Companies act 1956 requires the balance sheet to be represented vertically Assets Fixed assets, current assets Liabilities- Equity, Debt and Current liabilities H Format Equity Debt

Sources of Funds (Liabilities)

Equity - Share capital, Securities premium, General and other reserves, Net profit & loss a/c balance, retained profits, minority interest Debt - long term loans, Short term loans, Deferred tax liabilities Moratorial period initial period of the loan during which only interest has been repaid and no principal payments made during the period Fixed assets Working capital (current assets current liabilities) Fixed assets Application of Funds (Assets)

(Gross block-accumulated depreciation), Goodwill Investments (long term & strategic) Deferred tax assets, Non-current advances Working Capital Current assets cash & bank, short term investments, Sundry debtors, Inventory, Loans and advances Current liabilities Sundry creditors, provisions Revaluation reserves after revaluation of assets extra value created goes to equity, generally it comes after the life cycle of the asset. This salvage value goes to equity. Working capital involves two factors working capital need & working capital financing limit Sources (being payable) are liabilities and Resources (being the ownership of firm) are assets. Company owns assets & owes liabilities Accounting equation o owners equity = assets liabilities

The accounting equation serves as an error detection tool. If at any point the sum of debits for all accounts does not equal the corresponding sum of credits for all accounts, an error has occurred. It follows that the sum of debits and the sum of the credits must be equal in value. In balance sheet asset side classified from most liquid to least liquid liability side organized from short term to long term borrowings Balance Sheet has two sides, namely, Assets and Liabilities. Assets are valuable resources owned by the firm and Liabilities are obligations payable by it. Assets Long term loans mostly taken to create fixed assets Assets has market value Means used to operate the company & are balanced by financial obligations, equity investment, retained earnings. Assets are things that a company owns and are sometimes referred to as the resources of the company. There are two main types of assets: current assets and non-current assets, tangible assets, intangible assets. Liabilities & equity support the assets to operate companies business Current assets are likely to be used up or converted into cash within one business cycle - usually treated as twelve months (cash to cash conversion) current asset-These are the assets which can be converted into cash within 1 operating cycle. Operating cycle starts from cash & ends on cash at end. Items found on the balance sheet are: cash and cash equivalent, inventories and accounts receivables, prepaid expenses, depreciation, Non-current assets-are defined as anything not classified as a current asset. This includes items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is in financial distress and is liquidating assets, investors need not pay too much attention to fixed assets. They are carried on the balance sheet at cost regardless of their actual value. Hard assets property, plant & equipment, inventory / receivables Tangible assets plant & machinery, land & buildings Intangible assets - Corporate intellectual property (items such as patents, trademarks, copyrights and business methodologies), goodwill and brand recognition, computer softwares. [Goodwill cant be amortized but checked for impairment+ Contingent assets- An asset in which the possibility of an economic benefit depends solely upon future events that can't be controlled by the company. Due to the uncertainty of the future events, these assets are not placed on the balance sheet. However, they can be found in the company's financial statement notes. These assets, which are often simply rights to a future potential claim, are based on past events. An example might be a potential settlement from a lawsuit. Liabilities These are the liabilities which have to pay within 1 operating cycle generally one year. Operating cycle starts from cash & ends on cash at end. Liabilities has obligation. There are current liabilities and non-current liabilities. Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers. Non-current liabilities represent bank and bondholder debt. If the ratio is 1 or higher, it says that the company has enough cash and liquid assets to cover its short-term debt obligations. Liabilities are sources of financing assets. Liabilities are broadly classified into two categories,

External Liabilities (consisting of creditors and lenders) and Internal Liabilities (consisting of owners' contribution/equity) o Internal liability / Owners' equity consists of Initial capital provided by them and Retained earnings accumulated over the years from the firm's profitable operations. o External liability-holders have first claim on the assets of the firm and owners have a residual claim. It is for this reason owners' capital is known as Risky Capital. Profits, since payable to owners, are liabilities from the perspective of the firm and losses, since recoverable from them are its assets. This is as per Separate Entity concept. Current ratio = current assets inventories / current liabilities
Balance Sheet of Royal Industries as on June 25, Current Year Liabilities Capital Profits Reliable Suppliers (Creditors)*** 14% Loan Amount (Rs) Assets 30,00,000 Cash 1,00,000 Bank Balance* 3,00,000 Stock (Finished Goods) 10,00,000 Stock (Raw Material) Building** Machinery** 44,00,000 Amount (Rs) 9,00,000 12,00,000 2,00,000 3,00,000 8,00,000 10,00,000 44,00,000

Note: * Is higher by the sum received from State Financial Corporation ** Ownership continues with Royal Industries. ***As the sum is payable, Reliable Suppliers are creditors.

Off balance sheet items contingent assets & contingent liabilities

Contingent liability The possibility of an obligation to pay certain sums dependent on future events or obligations by a company that must be met, but the probability of payment is minimal. A possible obligation from past events that will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise Warranty liability Estimated amount that a company will have to spend to repair or replace a product during its warranty period. The liability amount is recorded at the time of the sale. (It is also the time when the expense is reported.) The liability

will be reduced by the actual expenditures to repair or replace the product. Warranty Payable or Warranty Liability is considered to be a contingent liability Deferred tax liability Because there are differences between what a company can deduct for tax and accounting purposes, there will be a difference between a company's taxable income and income before tax. A deferred tax liability records the fact that the company will, in the future, pay more income tax because of a transaction that took place during the current period, such as an installment sale receivable, differences between the company's accounting and tax carrying values, the anticipated and enacted income tax rate, and estimated taxes payable for the current year. This liability may or may not be realized during any given year, which makes the deferred status appropriate Deferred tax liability is good [higher corporate tax and lesser income tax (actual pay)] because, tax that you have not paid in initial years to govt. but reports to shareholders that have to pay in later years. So till the time comes we can utilize that money for our business. Deferred tax Assets We pay tax as per income tax (lower corporate tax & higher income tax). We pay more tax as per IT but report to shareholders low tax paid. This extra tax paid creates asset for tax i.e. deferred tax asset. In future we have to make only small provisions fosr tax amount. Equity - Equity = Total Assets Total Liabilities The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares Shareholders funds = Share capital + securities premium

EBITDAEBITDA is widely used in loan covenants. The theory is that it measures the cash earnings that can be used to pay interest and repay the principal There are two EBITDA metrics used. The measure of a debt's pay-back period is Debt/EBITDA. The longer the payback period, the greater the risk. The metric presumes that the business has stopped making interest payments (because interest is added back). But it is argued that once that happens the debt holder is unlikely to wait around (say) three years to recover their principal while the business continues to operate in default. So does the metric measure anything? There is also the problem of adding back taxes. This metric ignores all tax expenses even though a good portion is cash payments, and the government gets paid first. Principal repayments are not tax-deductible. One interest coverage ratio (EBITDA/Interest Expense) is used to determine a firm's ability to pay interest on outstanding debt. The greater the multiple of cash available for interest payments, the less risk to the lender. The greater the year-to-year variance in EBITDA, the greater the risk. Interest is tax-deductible. EBITDAREBITDAR = revenue expenses (excluding tax, interest, depreciation, amortization and restructuring or rent costs) EBITDAR, when evaluating the impact of rent expense is often used by retail businesses and airlines. Typically, in such an analysis the rent expense will be capitalized and added to the net debt of the company in order to better understand the leverage levels in the company's capital structure.

4 things to look into quarterly results 1) Operational performance operational level reflects core business of a company. Total income = operational & non operational income Operational income = money a firm generates from selling its products Non operational income = rate, interest, dividend, foreign exchange gains

2) Margins helps to determine marginal safety of a company after accounting for cost and expenses Operating margin = determine how well a company has controlled its cost not related to production (SG &A) Net profit margin = Shows how much money is left after deducting all the expenses 3) Profits Revenues direct variable expenses Contribution Indirect fixed expenses Gross Profit SG & A Expenses (Consistently rising gross profit implies cost efficiency) EBITD [measures of cash generated from business operations] [EBITDA margin (EBITDA/Revenues) is an indicator of operating efficiency of business] EBITDA Eliminate difficulties associated with varying depreciation policies & capital structures EBITD - Depreciation EBIT (Operating profit) ignores the effect of financing At EBIT stage profits are available to all providers of finance (debt & equity) Post this Capital structure (leverage or D:E Ratio) will drive net profit to shareholders EBIT EBIT (Operating profit) - Interest Expenses + Other Income EBT (Determine how well a company is using its borrowing or debt to enhance its return on equity) - Tax PAT (Net Profit) - residual profit that belongs to equity shareholders 4) share holding pattern It includes ownership information across group of investors (institutional & non- institutional) like FII, Banks, mutual funds & promoters. Rising promoters stake is considered positive as it indicates owners confidence in the firms future prospectus Book value Traditionally book value = total assets intangible assets & liabilities In accounting, book value = value of an asset as carries on its balance sheet and is based on the original cost of the asset minus any depreciation or amortization. Consolidated versus standalone results of a company? Standalone results = results of the parent company alone consolidated results = results of the parent company + its subsidiaries

What are the differences between affiliate, associate and subsidiary companies? For example, the Walt Disney Corporation owns about a 40% stake in the History Channel, an 80% stake in ESPN and a 100% interest in the Disney Channel. In this case, the History Channel is an affiliate company, ESPN is a subsidiary and the Disney Channel is a wholly owned subsidiary company." That is; "In most cases, the terms affiliate and associate are used synonymously to describe a company whose parent only possesses a minority stake in the ownership of the company. A subsidiary, on the other hand, is a company whose parent is a majority shareholder."

ExampleConsolidated net profits for Tata motors FY11 (9274 Crores) %Change - 261% increase from previous year. Standalone net profits for Tata motors FY11 (1812) %Change - 19% decrease from previous year. How does an investor interpret these statements - "that Tata motors is depending a lot on its subsidiaries for its profits? (Especially on Jaguar-Land rover)" Collateralized debt obligationsCollateralized Debt Obligations are sophisticated financial tools that banks use to repackage individual loans into a product that can be sold to investors on the secondary market. These packages consist of auto loans, credit card debt, mortgages or corporate debt. They are called collateralized because the promised repayment of the loans is the collateral that gives the CDOs value. CDOs are a special type of derivative. Like its name implies, derivatives are any kind of financial product that derives its value from another underlying asset Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying asset. CDO securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk. Similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first Collateralized lending & borrowing obligation CBLOs were developed by the Clearing Corporation of India (CCIL) and Reserve Bank of India (RBI). The details of the CBLO include an obligation for the borrower to repay the debt at a specified future date and an expectation of the lender to receive the money on that future date, and they have a charge on the security that is held by the CCIL. It is a variant of liquidity adjustment facility, permitted by RBI. It is a mechanism to borrow and lend funds against securities for maturities of 1 day to 1 year. It is a tripartite repo transaction involving CCIL as 3rd party, which functions as intermediary or common counter party to borrower as well as lender. Borrower will be able to repay back even before maturity, compared to payment on due date under the existing Repo system. CBLO is expected to meet the needs of banks, FIs, PDs, MFs, NBFCs and companies for deploying their surplus funds, which have been phased out of the call money market operations. CBLO is issued at a discount to face value. Under CBLO, securities of borrower will be held in their constituent SGL account opened with CCIL and will not be transferred to lender. It is used most often in India, that represents an obligation between a borrower and lender, which can be traded in the secondary market Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation. Debt consolidation Debt consolidation entails taking out one loan to pay off many others. This is often done to secure a lower interest rate, secure a fixed interest rate or for the convenience of servicing only one loan. Debt consolidation can simply be from a number of unsecured loans into another unsecured loan, but more often it involves a secured loan against an asset that serves as collateral, most commonly a house. In this case, a mortgage is secured against the house. The collateralization of the loan allows a lower interest rate than

without it, because by collateralizing, the asset owner agrees to allow the forced sale (foreclosure) of the asset to pay back the loan. The risk to the lender is reduced so the interest rate offered is lower. Sometimes, debt consolidation companies can discount the amount of the loan. When the debtor is in danger of bankruptcy, the debt consolidator will buy the loan at a discount. A prudent debtor can shop around for consolidators who will pass along some of the savings. Consolidation can affect the ability of the debtor to discharge debts in bankruptcy, so the decision to consolidate must be weighed carefully. Debt consolidation is often advisable in theory when someone is paying credit card debt. Credit cards can carry a much larger interest rate than even an unsecured loan from a bank. Debtors with property such as a home or car may get a lower rate through a secured loan using their property as collateral. Then the total interest and the total cash flow paid towards the debt is lower allowing the debt to be paid off sooner, incurring less interest Example If you have 10 different debts that total $1000.00 and borrow $1000.00 to pay them all off, you have consolidated all those small debts into one big debt. You save 9 stamps per month. Answer: Taking multiple debt or credit lines and consolidating them into one new payoff plan. Frequently, this is a consolidation loan, provided to consolidate debts into one loan with one payment, typically shifting credit card debts to secured debt by refinancing a mortgage. It could also refer to a credit counseling or debt settlement program. Net worth Net worth (sometimes called net assets) is the total assets minus total outside liabilities of an individual or a company. For a company, this is called shareholders' preference and may be referred to as book value. Net worth is stated as at a particular year in time. In personal finance, net worth (or wealth) refers to an individual's net economic position; similarly, it uses the value of all assets (long term assets) minus the value of all liabilities. Net worth in business is generally based on the value of all assets and liabilities at the carrying value which is the value as expressed on the financial statements . To the extent items on the balance sheet do not express their true (market) value; the net worth will also be inaccurate. In balance sheet, if the accumulated losses exceed the shareholder's equity, it is a negative value for net worth. CASH FLOW STATEMENTThe cash flow statement provides information on how the organization is allocating the resources that were generated by the organization during preceding year. This shows how cash has been generated and used over the relevant time period. Most cash flow statement styles will present the flows of cash using 3 main categories:

Operating cash flows Investing cash flows Financing cash flows As liabilities goes up cash comes in As assets goes out cash comes in As liabilities goes down cash goes out As assets comes in cash goes out

Operating cash flows Net profit + Depreciation (non cash expenses considered 4 net profit r added back as they dont affect cash movement) +Non cash expenses (Depreciation) - Non cash income +Interest expenses (non operating expenses r added back as they not related to operations) + Non operating losses

- Incomes + Decrease in working capital (affects cash added/reduced as related 2 operations but not considered in P&L) - Increase in working capital Investing cash flows deal - Capital expenditure - New LT investments + Proceeds from sale of fixed assets, LT investments + Income from investments + New loans drawn - Repayment of loans - Interest on loans + Net proceeds from issue of shares - Dividends

Operating cash flows will include the flows from the core operations of the business and is driven by trading. Investing cash flows deal with any investments in the future of the business. Any new plant and equipment would be included in this section. Financing cash flows deals with any investments made by shareholders and any dividends paid to them. Any new borrowings or any repayments of existing loans would also be shown in this section.

Free cash flow = total cash flow working capital money for future growth = Total cash flow capex Unlevered free cash flow = cash flow before any payment towards debt & equity holders Free cash flow to firm = net income + interest (after tax) + depreciation (non cash expense) capex working capital = EBITDA adjusted taxes capex working capital + non cash expense = net income + non cash expense capex working capital principal & interest paid. Free cash flow to firm = Unlevered free cash flow FUND FLOW STATEMENTIt is the statement in financial position prepared to determine only the sources and uses of working capital between dates of two balance sheets GAP Analysis 1) The process through which a company compares its actual performance to its expected performance to determine whether it is meeting expectations and using its resources effectively. Gap analysis seeks to answer the questions "where are we?" (Current state) and "where do we want to be?" (target state). 2) A method of asset-liability management that can be used to assess interest rate risk or liquidity risk excluding credit risk. Gap analysis is a simple IRR measurement method that conveys the difference between rate sensitive assets and rate sensitive liabilities over a given period of time. This type of analysis works well if assets and liabilities are compromised of fixed cash flows. Because of this a significant shortcoming of gap analysis is that it cannot handle options, as options have uncertain cash flows. Accounting principles These are the rules and guidelines that companies must follow when reporting financial data. The common set of accounting principles is the generally accepted accounting principles (GAAP). To remain listed on many major stock exchanges in the U.S., companies must file regular financial statements reported according to GAAP. Accounting principles differ around the world, and countries usually have their own, slightly different, versions of GAAP.

Accounting conceptsThese concepts provide foundation for accounting process. No enterprise can prepare its financial statements without considering these concepts An accounting concept is a basic assumption concerning the economic environment in which accounting exists. Characteristics of Accounting Concepts: Accounting concepts are continuously changing and evolving: In the event of rapidly changing economic activities, accounting concepts also undergo frequent changes. This is a healthy sign for the accounting fields. This is because of the following two main reasons. 1. It is relatively a new field and hence it is developing with time. 2. Some aspects tend to change with the changes in social, economic and commercial conditions. Another important feature of accounting concepts is the interrelationship among the different concepts. Most of the concepts do not stand by themselves; they depend on the other concepts to a large extent

Accounting concepts: 1) Business entity concept The entity concepts form the basic for recognition of the accounting concepts i. Business is treated distinct and separate from its members ii. Separate set of books are prepared iii. Proprietor is treated as creditor of business iv. For other business of proprietor different books are prepared 2) Money measure concept The money measurement a concept is an assumption that any accounting transaction is to be measured in money or moneys worth. The operational implication of the Money Measurement Concept is that financial statements do not provide all information about the business. i. Transactions of monetary nature are recorded. Accounting records state only those facts about a business firm, which can be expressed in monetary terms. In other words, business events and facts that cannot be expressed in monetary terms, howsoever important they may be, are excluded ii. Transactions of qualitative nature, even though of great importance to business are not considered 3) The Going Concern Concept:According to this concepts an enterprise has an unlimited existence Unless & until there is evidence to the contrary, an enterprise must be considered as continuing largely in its present form and with its present purpose There are some undertakings (business) which are primarily for limited period. Such entities are exceptions. The Going Concern Concept implies that the firm will continue to operate in the foreseeable future. The operational implication of this assumption is that assets are not shown in Balance Sheet at their realizable market value, which implies liquidation value. Assets are shown at their cost in balance sheet. Instead, evaluation of assets is with reference to the value of goods and services they are likely to produce in future years to come. 4) Cost Assets/resources owned by the firm are shown at their acquisition cost and not at current market value/current worth. The rationale for this assumption is that it provides objective and verifiable basis for accounting records. Market valuation of assets in use is not only difficult to be made but also is related to subjectivity. Besides, market values may be constantly subject to change. Evidently, individual assets (except cash and bank balances) shown in Balance Sheet do not reflect

their current market value. Some assets such as land and buildings in major cities may have higher valuation than shown in books and some other assets, like plant and machinery may have lower valuation than shown in records. The cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less than their cost According to Historical cost concept, all the transactions are recorded in the books at cost and not at its market value. Thus the underlying ideas of this concept are two forms a. An asset is recorded at the price paid to acquire it i.e. at cost b. This cost is the basis of all the subsequent treatment of the assets. E.g. - depreciation, stock valuation.

5) Dual aspect Value of assets owned by the concern is equal to the claims on these assets. Assets = liabilities + owners equity Every transaction that an organization has a dual impact on the accounting records that is it will have impact on two or more accounts simultaneously. That is why accounting is called double entry system. 6) Accounting periodIt requires that Income Statement should be prepared at periodic intervals for purposes such as performance evaluation and determination of taxes. Conventionally, the time span covered is one year. Corporate firms, as per Companies Act, are required to produce interim accounts and many business firms produce monthly or quarterly accounts for internal purposes. Very often, the accounting period chosen is 1st April to 31st March to conform to the financial year of Government. Other accounting peri The economic activities of the business must be recorded periodically. These periods is called as Accounting period & these Accounting period is normally called as Accounting Year or Financial Year or Fiscal Year. It is, within this Accounting Year, that the income &expenses (i.e.) costs & revenues are matched with reasonable accuracy to provide significant results.

7) Conservatism As the name suggests, Conservative Concept warrants use of conservatism in business records. In relation to Income Statement, the principle is, "anticipate no profits unless realized but provide for all probable future losses". Stock of finished goods is valued at the cost of the market price whichever is lower. Likewise, it is normal for the firms to provide for likely irrecoverable sum from debtors by creating provisions for bad and doubtful debts at the end of accounting year. This assumption safeguards over-estimation of profits. The Conservative principle is based on the premise of playing safe. Its' basic tenet is "provide for all possible losses but anticipate no profits till they are realized" The profit should not be taken into account unless it is actually realized in cash, while all possible losses must be fully provided for. 8) Accrual ConceptAccrual Concept is a fall-out of Accounting Period concept. This concept requires that expenses incurred for a particular accounting period should be reckoned in the same period, irrespective of the fact whether these expenses have been paid in cash or not in that year. The same holds true for

revenues, i.e., revenues earned in a specific accounting period are construed as incomes of the same period, irrespective of their receipts. As losses, do not have potentials to contribute to further revenues, they are normally written off in the same accounting year in which they occur. Cash basis of expenses recognition has an inherent drawback of maneuvering and distorting income results of the accounting periods. In the absence of Accrual accounting, the Income Statement may indicate more profit in one year at the cost of the profits of some other year. Cash basis of expense recognition will hamper comparison of profit figures over the years. In operational terms, cash surplus and deficiency are not indicative of profit and loss situations respectively. According to the Accrual concept, revenues are recognized at the time of sales / earned and not when they are received / not at the time of receipts from debtors. Likewise, expenses are recognized when they are incurred and not when they are paid.

9) Realization Sale is considered to have taken place only when either the cash is received or some third party becomes legally liable to pay the amount. Realization concept indicates the amount and revenue that should be recognized from a given sale This convention is most effectively employed in valuation of current assets, like stock, debtors, bills receivables, etc. As seen above, the principle of valuating stock at cost or market value whichever is lower is the result of this convention Accounting conventions 1. Matching cost and revenues This concept follows the accounting period concept i.e. once an accounting period is determined, within that period; the revenues and its related costs are matched. Accrual concept - For matching of costs and revenue under accrual concept, all revenues related to current year, whenever received, and all costs of the current year, whenever paid, must be taken into account In simple words, this principle requires matching of expenses/costs incurred to revenues realized in an accounting period. The more perfect this matching is, more correct is the income determination. Revenues are equivalent to value of goods and services sold during the specified accounting period, irrespective of actual receipt of cash. There is much expenditure, which benefit several accounting years. Therefore, these expenses cannot be charged to Income Statement of a single year. For this purpose, it is useful to classify expenses into capital and revenue categories.

Capital expenditures (for instance purchase of plant and machinery) involve relatively large investment sum and often have some sales value. Expenses--the purchase cost of plant and machinery (say of 500 lakhs) cannot be considered as an expense of a single accounting year in which it is purchased; its cost needs to be spread-over (technically known as depreciation) among all the years in which this machine is used. Capital expenditure is amortized during several accounting years on the basis of some logical, objective and scientific criterion. Revenue expenses, such as rent, salaries, stationary, repairs, etc., benefit one accounting year only and, hence fully charged/written off against the revenues of the same year. They require relatively small sums and do not have sales value Revenue expenses can be apportioned between two or more accounting periods (on the basis of time) to conform to accrual principle. Matching principle has underlined the importance of treatment of capital expenditure items in income determination process. It focuses on the equitable methods, which must be used to write off the

cost of plant and machinery (and in that way of other long-term assets) so that its cost is fairly allocated as expense, in form of depreciation, to each accounting period throughout its estimated useful life Depreciation is required by the basic accounting principle known as the matching principle. Depreciation is used for assets whose life is not indefiniteequipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset to Depreciation Expense on the income statement over its useful life. 2. Consistency The Consistency Principle requires that there should be a consistency of accounting treatment of items (say depreciation method used in respect of plant and machinery) in all the accounting periods. For instance, if Straight Line method of depreciation is used for plant and machinery, the same should be used year after year. Switching over to Diminishing Balance method in any of the subsequent years will obviously affect depreciation charges and, hence, their profits. Procedure selected from among several acceptable alternatives must be followed consistently during the successive accounting periods. Changes in accounting methods if any, must be fully disclosed by way of explanatory notes to the financial statements 3. Objectivity An evidence of happening of transaction should support every transaction. Objectivity principle means that financial information is supported by independent and unbiased evidence. 4. Materiality Effect of all significant or material transactions must be reported in conformity with the general accepted accounting principles. This convention puts a check on the unnecessary disclosure in the financial statements. The financial statements should not be bulky with unnecessary details which are not material. A separate disclosure would be necessary, if an item is material in nature. The Companies Act, 1956 also says that a separate disclosure of items of income and expenses should be made if it exceeds 1% of total revenue of the company. Difference between concepts and conventions Concepts tend to be written in the accounting standards whereas conventions are not and are assumed. Examples of concepts would be: Accruals concept, Prudence concept. Examples of conventions would be: double entry, accounting equation (assets - liabilities = capital)

Why double entry system in accounting To reduce chance of error while double recording entries Double entry accounting is based on the fact that every financial transaction has equal and opposite effects in at least two different accounts. It is used to satisfy the equation Assets = Liabilities + Equity, whereby each entry is recorded so as to maintain the relationship. Transactions are recorded in terms of debits and credits. Since a debit in one account will be offset by a credit in another account, the sum of all debits must therefore be exactly equal to the sum of all credits. The double-entry system of bookkeeping or accounting makes it easier to accurately prepare financial statements directly from the books of account and detect errors. Every transaction that an organization has a dual impact on the accounting records that is it will have impact on two or more accounts simultaneously. That is why accounting is called double entry system. Working capital (current assets) Gross working capital total current assets [cash, short term securities, debtors (a/c receivables or book debts ), bills receivables and stock (inventory ) ]

Net working capital difference between current assets and current liabilities. [Creditors (a/c payables), bills payables, outstanding expenses] Operating cycle time duration required to convert sales, after the conversion of resources into inventories, into cash. It starts from cash and also ends on cash in hand. Phase of operating cycle acquisition, manufacturing and selling. Length of operating cycle is the sum of inventory conversion period (ICP) & debtors (receivables) conversion period (DCP) Inventory conversion period = raw material conversion period + work in process conversion period + finished good conversion period Debtors conversion period time required to collect outstanding amount from customers. Gross operating cycle = Inventory conversion period + Debtors conversion period. Net operating cycle (cash conversion) = difference between gross operating cycle & payables deferral period. Sources of working capital trade credit, bank borrowing and commercial paper (short term ) Management of fixed assets & working capital differ in following ways.. Time compounding & discounting techniques play important role in managing fixed assets and minor in current assets. Risk-return tradeoff large holding of current assets (cash) increases liquidity & reduces profitability. Large holding of fixed assets may lead to blockage of capital. Level of fixed and current assets depend upon expected sales. Only current assets can be managed in short run. Firm has greater degree of flexibility in managing current assets. Estimating working capital Current assets holding period on basis of average holding period of current assets and relating them to costs. Ratio of sales on the assumption that current assets change with sales. ( 30% of annual sales) Ratio of fixed investment as a percentage of fixed investment. (Generally 10 -15 %) Sources of working capital Trade credit credit that customer gets from supplier of goods, grants on open account basis ( a/c payable on buyers balance sheet) and bills payable if signs a bill. Accrued expenses (wages & salaries and taxes & interest) Deferred income represents funds received by firm for goods and services for which it has agreed to supply in future. (advance payments by customers shown as liability until goods and services has been delivered to customers) Bank finance- overdraft, cash credit, purchase or discounting of bills, letter of credit, working capital loan o Security required in bank finance o Hypothecation loan against security of movable property (inventories) Ownership and possession remains with buyer. o Pledge borrower is required to transfer physical possession of property offered as a security. Lender gets possession. o Mortgage loan against immovable property. Possession lies with borrower. o Lien- right of lender to retain property until repayment. Particular lien limited to claims on property only. General lien applicable to all remaining claims. o Commercial paper (unsecured promissory note on recommendation of vaghul working group ( RBI introduced in 1989) Buyers of commercial papers banks, insurance companies, unit trusts, firms with surplus funds for a short period.

Determinants of working capital o Nature of business o Market & demand conditions o Manufacturing cycle o Credit policy o Availability of credit from suppliers o Operating efficiency o Price level changes Working Capital Management (manage cash inflow Vs Cash outflow) CA CL Account Receivable Creditors Inventory Cash

Primary Sources of liquidity Cash, bank, Debtors Secondary sources of liquidity Asset liquidation, Negotiating debt agreements, Bankruptcy, Reorganizing company (Resorting to secondary sources indicates deterioration of financial position) Short trade cycle - + ve impact Long trade cycle - -Ve impact Who impacts liquidity Drags on liquidity Reducing cash inflows, or increasing borrowing cost Pulls on liquidity Accelerate cash outflow by paying vendors sooner than optimal

Short term sources of capital 1. Uncommitted line of borrowing (may be withdrawn/ refused)- credit limit given (most risky) 2. Committed line of credit one time loan facility 3. Revolving line of credit- (Mostly assured) 4. Bankers acceptance (Charge commission) 5. Factoring (Discounting bills receivables) Why - time value of money - risk and interest Capital structure proportionate ratio of firm's debt and equity in its sources of finance called capital structure. Capital budgeting Firm's decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. Capital budgeting decisions are based on incremental cash flows, and not on accounting accrued income. CAPITAL PROJECT Returns and investment doesnt happen at same time. Sunk cost not affected by the acceptance or rejection of project. It is already incurred at the time of evaluation of project. Sunk cost + Opportunity cost = total minimum cost must incurred Cost of capital Sources of capital

Debt Equity Preference shares Cost of capital is determined by , Individual cost of different sources Averaging according to equal weights Marginal cost of capital

Sources of capital Equity Preference Debt

Amount of return Not certain Certain Certain

Certainty of payment Not certain Not certain Certain

Ke>Kp>Kd Risk ,Risk premium , Returns expected


Discount rate used in NPV and DCF is firms WACC

Cost of debt Rate at which inflows=outflows


- Yield to maturity (IRR of current debt) - Rate at which PVCI = PVCO

Taxation effect in debt A EBIT Interest PBT Tax (30%) PAT 100 -40 60 -18 42 B 100 0 100 -30 70

28 Net impact of tax Net tax saving = 40-28=12 Kd = Interest-(interest*tax%) After tax cost of debt = Kd(1-t) Always cost of debt is given is before tax Interest payments are paid with pre tax income

Taxation effect in Preference shares Kp is also the IRR at which PVCI=PVCO A EBIT Interest 100 0 B 100 0

PBT Tax (30%) PAT Pref. Div PAT

100 -30 70 -30 40

100 -30 70 0

70 30 No tax impact Kp is always after tax, hence there is no tax impact

Cost of equity
1. Gorden growth model 2. CAPM 3. Bond yield premium o Gorden growth model Ke will be different for all these methods

Ke = (D1/P0) + g P0={(D1/(Ke-g)} Where, D1 Expected dividend at time T1 P0 market price at time T0


Flotation cost Cost incurred for raising new capital (bankers fees) - cash outflow at time T0 in capital budgeting Flotation cost should be considered as one time cash outflow on NPV calculation, as this is not an ongoing cost and happens once. Ke = (D1/P0) + g.....if there flotation cost exist, Ke = (D1/P0-FC) + g

o CAPM (From investors point of view, it focus on returns)


Return on equity = Risk free rate + Risk premium = Rf + Beta(RM-Rf) o Bond Yield Ke = Bond Yield + Risk premium (equity Vs bond average risk premium) Bond yield should be of same company Bharti 12% + 4% Not company specific, but fixed Apple 8% + 4%

Types of investment decisions Expansion of existing business Expansion of new business Replacement and modernization Mutually exclusive investments serve the same purpose and compete with each other Independent investments Contingent investments are dependent projects Cannibalization Acceptance of the new project impacts the old project directly or indirectly. +Ve Result if the new project is complementary

-Ve Result if the new project is substitute Capital rationing It refers to a situation where firm faces constraints in obtaining necessary funds to invest in all investment projects with positive NPV. Under capital rationing we need a method of selecting the portfolio of projects which yields highest possible NPV within the available funds. External capital rationing occurs on account of the imperfections in the capital markets. (hamper free flow of capital in market) Internal capital rationing caused by self imposed restriction by the management. Involves constraints like not to have too much debt, generally used as a means of financial control & if finds incapable of coping with the strains and organizational problems of a fast growth. Investment evaluation DCF criteria of investment evaluation based on the concept of time value of money Basically 2 ways for accounting for time value of money Compounding Single period compoundingF = P (1+i) n Multi period compoundingF = P (1+i/m) nm Where, m-no of compounding in a year Compounding value of an annuity F = A [(1+i) n + (1+i) n-1 + (1+i) n-2 +..+ (1+i) +1] F = A {(1+i) n 1/ i } CVAF (compound value annuity factor) = [(1+i) n 1] Reciprocal of CVAF is called sinking fund factor (SFF) to obtain amount of annuity Discounting F = P (1+i) P = F / (1+i) e.g. - F = P (1 + i) n P = F [1 / (1+i) n] Where, F Lump sum in future P Present value of lump sum in future A - Annuity Discounting value of an annuity P = A {1/(1+i) + 1/(1+i) + 1/(1+i) 3 + 1/(1+i) 4 } P = A {1 1/(1+i) n / i } PVAF (Present value annuity factor) = [1 1/(1+i)n ] Reciprocal of PVAF is called capital recovery factor (CRF) to determine income to be earned. Criteria's of investment evaluation Discounted cash flow criteria [Reasons for secondary role of discounting techniques in INDIA difficulty in understanding and using these techniques, lack of qualified professionals & unwillingness of top management to use DCF techniques] o Net present value (NPV) $ (amount) amount of growth o Internal rate of return (IRR) % (Percentage) Speed of growth o Profitability index (PI) / benefit cost ratio (B/C) Times (has no unit, just an Index)

Non discounted cash flow criteria o Payback period (PB) (Years) o Discounted payback period o Accounting payback period (ARR)1. NET PRESENT VALUE (NPV)Recognizes time value of money Postulates that cash flows arising at different time periods differ in value & are comparable only when their equivalents / present values are found out. Appropriate discount rate for discounting the forecasted cash flow should be the projects opportunity cost of capital, which is equal to the required rate of return on investments of equivalent risk. NPV calculated by subtracting present value of cash outflows from present value of cash inflows. NPV is the direct measure of the expected increase in firm value. Accept the Project if NPV is +ve. ( NPV > 0) Reject the Project if NPV is -ve. ( NPV < 0) May accept / reject the project when NPV is zero. (NPV = 0) NPV = [ c1/(1+k) + c2/(1+k) + + Cn/(1+k) n ] C0 = PVCI - PVCO Where, C1 cash inflow for year 1 C2 - cash inflow for year 2 K Opportunity cost of capital in percentage C0 present value of cash outflows NPV method is popular for following reasons Time value recognizes time value of money Measure of true profitability uses all cash flows occurring over entire life of project in calculating its worth. Value additivity NPV of projects can be added. NPV (A+B) = NPV (A) + NPV (B) Value additivity means that each project can be evaluated, independent of others, on its own merit. Shareholders value method is always consistent with the objective of shareholders value maximization. Ranking of investment projects not dependent of discount rates.

2. Internal rate of return (IRR) Takes account of magnitude and timing of cash flows. Other terms used to describe IRR method are yield on an investment, marginal efficiency of capital, rate of return over cost, time adjusted rate of internal return, Why called internal rate of return rate of return depends on projects cash flows alone, rather than any outside factor. IRR is the rate of return that equates the investment outlay with the present value of cash received after one period. Rate of return is the discount rate which makes NPV = 0. C0 = C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + ..+ Cn/(1+r)n

Y = X C0/ C0
Where, C1 cash inflow for year 1 C2 - cash inflow for year 2 r Opportunity cost of capital in percentage C0 present value of cash flow after n years Y IRR rate of return X Initial cash outflow

[In NPV method required rate of return is known & net present value is found but in IRR rate of return have to be determined at which net present value is zero, IRR = when NPV is zero. NPV of project declines as discount rate increases, & if discount rate higher than projects IRR, NPV will be -ve] IRR by trial and error method If calculated present value of expected of cash inflow is lower than the present value of current cash outflow, a lower rate should be tried. On the other hand higher value should be tried if present value of cash inflows is higher than the present value of cash outflows. This process will be repeated unless net present value becomes zero

Accept the Project if IRR is greater than k. / If IRR > WACC. Reject the Project if IRR is lower than k./ If IRR < WACC. May accept / reject the project when IRR equal with k. In mutually exclusive project, a project with maximum IRR should be selected. Where, k- Opportunity cost of capital / cutoff rate / hurdle rate / required rate of return. IRR method is popular for following reasons Time value recognizes time value of money (Time allows you the opportunity to postpone consumption & earn interest) Measure of true profitability uses all cash flows occurring over entire life of project in calculating its worth. Shareholders value method is always consistent with the objective of shareholders value maximization. Demerits Multiple rates may have multiple rates or may not have unique rate of return. Value additivity principle doesn't apply. 3. Profitability index (PI) / Benefit cost ratio (B/C)It is the ratio of present value of cash inflows at the required rate of return to the initial cash outflow of the investment PI = PV of cash inflows / initial cash outlay ={ C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 + ..+ Cn/(1+r)n } / Cx Where, Cx initial cash outlay r Required rate of return PI = PVCI/ PVCO = (PVCO + NPV)/PVCO = 1 + (NPV/PVCO) Accept the Project if PI is greater than 1. (NPV value must be +Ve for PI>1) In capital rationing PI is better than NPV Reject the Project if PI is lower than 1. May accept / reject the project when PI = 1. [Project with positive NPV will have PI greater than one, PI less than one means that projects NPV is negative] Merits Time value recognizes time value of money Relative profitability since present value of cash inflows is divided by cash outflows, its relative measure of projects profitability. Shareholders value method is always consistent with the objective of shareholders value maximization.

4. Payback method

Payback is the number of years required to recover original cash outlay invested in a project. It emphasizes on early recovery of investment and focuses on risk. It fails to consider cash flows occurring after the payback period. Does not discount the cash inflows over a series of years Payback period number of years (time) required to recover the original cash outflow Standard payback period = 3 to 5 years. If, the project generates constant annual cash inflows payback period can be computed by dividing original cash outlay invested in a project by annual cash inflow. Payback = Initial Investment / annual cash inflow.......in case of fixed amount of cash flow Reciprocal of pay back gives rate of return (May not always) Conditions - 1) Life of projects is large or at least twice the payback period. 2) Project generates equal annual cash inflows. Payback in uneven cash flows Example Initial cash outflow - Rs. 20000/Cash inflow First year Rs. 8000/Second year - Rs. 7000/Third year - Rs. 4000/Forth year - Rs. 3000/In first 3 years Rs. 19000/- is covered. For remaining Rs.1000 assume that cash inflows occur evenly during the year. Time required to recover 1000 will be [(1000/3000) * 12 months = 4 months. Thus payback period is 3 years & 4 months. Payback = Full Year + (pending Recovery/Recovery during the year.....in case of variable cash flow 5. Discounted payback period - Fails to consider cash flows occurring after the payback period

Discounted payback is always greater than payback method.


In case of deflation, If R >1, then DPB >PB If R < 2, then DPB < PB IF R changes......R , PV , Recovery , DPB Period

6. Accounting rate return method also called return on investment It is the ratio of average after tax profit (PAT) divided by average investment. If original investment depreciated constantly average investment would be half of original investment. ARR = average income / average investment Thus, ARR is the average rate. Average income = EBIT- Tax = EBIT(1-T) = net operating profit after tax Average investment = original investment annual depreciation for particular year Varying opportunity cost creates problem for IRR but not for NPV method.

7. Modified internal rate of return is the compound average annual rate that is calculated with a reinvestment rate different than the projects IRR. NPV & IRR rules are sometimes assumed to rest on an underlying implicit assumption about reinvestment about cash flows generated during lifetime of a project. IRR method assumed to imply that the cash flows generated by the project can be reinvested at its internal rate of return, where as NPV method assume that cash flows reinvested at opportunity cost of capital. Advocates of reinvestment assumption calculate terminal values of project to prove their point. Example Project X & Y are equally attractive if IRR method is used. Terminal value of project Y is Rs. 200. X should also have terminal value of Rs. 200 to have same IRR as Y. Following the IRR terminal value of X would be 200 only if its cash flows are assumed to be reinvested at its IRR of 20 % Example Rs.100 + (1+20)2 + 56 = Rs. 200. Given the initial value 115.74 and terminal value 200, compound average annual return should be equal to IRR as shown below, Cash flows (Rs.) C2 0 0

Projects X Y
3

C0 -115.74 -115.74

C1 100 0

C3 56 200

NPV @ 10% 17.24 34.52

IRR 20% 20%

200/115.74 1 = 0.20 or 20%

Some people argue that it is more realistic to use the opportunity cost of capital as the re investment rate. If we use 10 % as the reinvestment rate X's terminal value will be 177. Now project X's compound average annual return would be,
3

177/115.74 1 = 0.15 or 15%

This is modified internal rate of return. It is compound average annual rate that is calculated with a reinvestment rate that is different than projects IRR. NPV profile and IRR NPV profile is the graph that shows a projects NPV as function of diff. Discount rates.

Net Present Value

Cross over rate, at which NPV = 0 A when cash flows are much further away... ...Impact of R is greater than on the project

B
8% 12 % 15 %

IRR Rate/Discount Rate Cross over rate

There is inverse relation between Rate (R) and NPV. In mutually exclusive, if R is smaller than cross over rate, select A If R is greater than cross over rate, select B Conventional investment One whose cash flows take pattern of an initial cash outlay followed by cash inflows. These have only one change in sign of cash flow. (E.g. - ++++) Non Conventional investment Which has cash outflows, mingled with cash inflows throughout the life of project. They have more than one change in the signs of cash flows. (E.g. - ++-+-++-+) COST OF CAPITAL (Opportunity cost of capital)Minimum required rate of return on funds committed to the project. Firms cost of capital is not the same thing as The projects cost of capital. It is the compensation for time and risk It is standard tool in financial decision making like evaluating investment decisions, designing firm's debt policy, appraising the financial performance of top management. Interest It is a compensation for using ones money. For company it is a cost & for investor it is income. o Simple interest Amount at the end = P + SI +N Future value = Po + SI o Compound interest CI = Po (1+i)^n Po Future value = Po (1+i)^n Future value = present value (1+i)^n Present value = future value / (1+r)^n Weighted average cost of capital Firm obtain capital from various sources (Debt & Equity). The cost of capital of each source of capital differs. Cost of capital of each source of capital is known as component or specific cost of capital. The component costs are combined according to the weight of each component capital. Thus overall cost is called weighted average cost of capital. Optimal capital structure of a firm may maximize share price, minimize WACC. While analyzing project WACC must be considered. In calculation of average cost of capital, after tax cost of debt must be used & not the before tax cost of debt. Component cost of a specific source of capital is equal to the investors required rate of return. Investors required rate of return should be adjusted for taxes in practice for calculating the cost of a specific source of a capital to the firm. BEFORE TAX COST OF A BOND IS THE RATE, WHICH THE INVESTMENT SHOULD YIELD TO MEET THE OUTFLOWS TO BONDHOLDERS. Example If before tax cost of a bond is 16.5% and corporate tax rate is 35% then after tax cost of bond will be, Kd(1-d) = 0.1650(1-0.35) = 0.1073 = 10.73% Example WACC = Kd(1-T)*Wd + Ke*We

= Kd(1-T)*[D/(D+E)] + Ke*[E/(D+E)] Where, Kd(1-T)- after tax cost of debt Ke after tax cost of equity Wd weight of debt We weight of equity In WACC market risk premium is already involved. Cost of equity (Ke)= Rf + (Rm Rf)B Where, Rf- risk free rate Rm Rf = market risk premium B beta of the firm Example risk free rate is 6%, market risk premium is 9% & firms beta is 1.54% Ke = 0.06+0.09*1.54 = 0.1986 = 20% To calculate WACC use market value weights instead of book value weights. Weights should be based on capital structure. WACC using book value weights will be understated if market value of share is higher than the book value & vice-a-versa. WACC = Hurdle rate = required rate of return Discounting rate depends on time value of money & riskiness of capital Discounting = cash flow / (1 + WACC)^n Discounting factor = 1 / (1 + WACC)^n As discount rate increases, discount factor decreases and as discount factor decreases Present value also decreases over the time period. CoC = CoE + CoD Cost of capital 10% 20% Weight of capital 80 20 Cost 8% 4% Weight of capital 20 80 Cost 2% 16%

Total cost = 8%+4% = 12% Total cost = 2%+16% = 18%

Cost in the investment decision is the future cost / marginal cost. Marginal cost is the new or incremental cost that firm incurs if it were to raise capital now. Historical cost helps in the predicting future cost. Cost of equity capital involves an opportunity cost, shareholders supply funds to firm in expectation of dividends and capital gain commensurate with their risk of investment. Required equity return = risk free rate + risk premium Flotation cost New issue of share involves flotation cost in the form of legal fees, administrative expenses, brokerage or underwriting commission. Capital asset pricing model (CAPM) Cost of equity (Ke)= Rf + (Rm Rf)B Where, Rf- risk free rate Rm Rf = market risk premium B beta of the firm Example risk free rate is 6%, market risk premium is 9% & firms beta is 1.54% Ke = 0.06+0.09*1.54 = 0.1986 = 20% Unlevered beta = beta before any payment towards debt Levered beta = beta after taking into consideration debt More the debt, more volatile the stock/investment LB(Company) = UB (Industry) *[1+D/E(1-t)](Company) UB (Industry) = LB(Industry) / [1+D/E(1-t)](Industry) For listed companies we will get beta value from Bloomberg, Reuters or Websites, for unlisted companies beta value derived from comparable companies having no debt or industry beta neglecting beta. (Because, companys debt to equity will be quite different from industry, therefore it is always better to remove debt effect from industries beta value and add companies debt effect into unlevered beta of industry.

Depreciation methodsCapex (capital expenditure) goes for maintenance, expansion, acquisitions. In steady state capex is slightly higher than depreciation. And most of the tome there will be only maintenance capex. Depreciation o The decrease in value of assets (fair value depreciation), and o The allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle) Rates of depreciation prescribed in Schedule XIV depreciation expense is recorded on the income statement of a business, its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated depreciation, depreciation shall be provided either(a) To the extent specified in section 350; or (b) In respect of each item of depreciable asset Companies (Amendment) Act, 1988,

amended tax return (Form 1040-X) for the year at issue IRS Form 3115 requesting permission to change accounting methods Form 4562, used to figure depreciation and amortization, Section 205 of the Companies Act, 1956, prescribes the methods of charging depreciation Capital goods may have full depreciation in 2 years, i.e. 50% per year. The limit for such a write off of depreciation was Rs. 5,000/Depredation is required to be provided with reference to the total value of the fixed assets as appearing in the accounts after revaluation. However, for certain statutory purposes e.g., dividends, managerial remuneration etc., only depreciation relatable to the historical cost of the fixed assets is to be provided out of the current profits of the company Pro rata depreciation - where, during any financial year, any addition has been made to any asset, or where any asset has been sold, discarded, demolished or destroyed, the depreciation on such assets shall be calculated on a pro rata basis from the date of such addition or, as the case may be, up to the date on which such asset has been sold, discarded, demolished or destroyed" SLM rate of 11.31 (triple shift rate for general plant and machinery) prescribed in Schedule XIV, a company can charge depreciation at the rate of 10.56%. It may be mentioned that the rate of 11.31% has been determined on the basis of 8 years and 6 months or so of specified period whereas 10.56% is arrived at if 95% of the cost of the asset is divided by 9 years When a change in the method of depreciation is made, depreciation should be recalculated in accordance In cases where depreciation has not been provided in respect of extra or multiple shift allowance, it will be necessary for the auditor to quality his report accordingly. An example of the qualification is given below:

"Depreciation in respect of extra or multiple shift allowance amounting to rupees ............. has not been provided which is contrary to the provisions of Schedule XIV to the Companies Act. This has resulted in the profit being overstated by Rs ............... and plant and machinery overstated by Rs .............." Depreciation methods Mercantile System transaction recorded when sales occurs Cash system - transaction recorded as cash comes in to business. Depreciation reduction on value of fixed / tangible asset it doesnt get depreciated, instead of that its value get appreciated. In some cases if land falls into the area of landslides, prone to earthquakes then only it can depreciated. Though land fall into category of fixed assets, it Amortization reduction in value of intangible asset like goodwill. Check for impairment check if there is reduction in goodwill Tangible assets can be depreciated, but intangible asset cant, it can be amortized. Cash flow after tax = PAT + Depreciation = 108 + 70 Cash flow after tax = PBDT (1-T) + (Dep. * Tax Rate) = 250 (1-40%) + (Dep. * 40%) = 150 + 28 = 178

Tax Saving

Straight line method (SLM)The sum of depreciation is obtained by dividing the depreciable cost of machine (Purchase price of machine - Estimated Salvage Value) by the number of estimated economic useful life (in years). Accordingly, the cost of depreciation is allocated equally to each year of the estimated useful life of plant and machinery

The assumption underlying the SLM is that depreciation is basically a function of time.

By using SLM value of the asset becomes zero at the end of life period of asset. Rate of depreciation is constant throughout life period. Also depreciation amount remains same throughout life. Written down value method (WDV)according to the WDV method, a fixed rate (say 25%) is applied to the cost of the machine (disregarding salvage value) of the first year to determine depreciation charge. In each subsequent period, the depreciation expense is determined with reference to the same fixed rate (25 %) to the written down balance (cost of machine less depreciation in the first year). Obviously, both the methods will provide different answers towards depreciation charges. Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year Depreciable cost = original cost salvage value Book value = original cost accumulated depreciation For example, the straight-line method assumes that the asset depreciates by an equal percentage of its original value for each year that it's used. In contrast, the declining balance method assumes that the asset depreciates more in the earlier years. The following table compares the depreciation amounts that would be available under these two methods, for a $1,000 asset that's expected to be used for five years and then sold for $100 in scrap. Straight-Line Method Year Annual Depreciation Year-End Book Value 1 $900 x 20%=$180 $1,000-$180=$820 2 $900 x 20%=$180 $820-$180=$640 3 $900 x 20%=$180 $640-$180=$460 4 $900 x 20%=$180 $460-$180=$280 5 $900 x 20%=$180 $280-$180=$100 Declining-Balance Method Annual Depreciation Year-End Book Value $1,000 x 40%=$400 $1,000-$400=$600 $600 x 40%=$240 $600-$240=$360 $360 x 40%=$144 $360-144=$216 $216 x 40%=$86.40 $216-$86.40=$129.60 $129.60 x 40%=$51.84 $129.60-$51.84=$77.76

As you can see, the straight-line method results in the same deduction amount every year, while the decliningbalance method results in larger deductions in the first years and much smaller deductions in the last two years. One implication of this system is that if the equipment is expected to be sold for a higher value at some point in the middle of its life, the declining balance method can result in a greater taxable gain that year because the book value of the asset will be relatively lower. Rate of depreciation is much higher in initial years and less in residual years. It creates deferred tax assets. It never becomes zero but near to zero. Deferred tax assets If we use SLM need to pay less tax in future from shareholders point of view (COMPANY report them SLM) as they suppose normally company is paying tax regularly so in later years we have to pay only remaining tax I.e. lower tax, but in later years as recommendation of IT department we should have to pay tax from deferred tax assets or tax which we company have not paid in initial years only due to RDV Method. Generally it is done for capital goods to provide some reliefs to companies as they invest much in those fixed assets.

We pay tax as per income tax (lower corporate tax & higher income tax). We pay more tax as per IT but report to shareholders low tax paid. This extra tax paid creates asset for tax i.e. deferred tax asset. In future we have to make only small provisions for tax amount. Deferred tax liabilities If we use RDV need to pay more tax in future from shareholders point of view (COMPANY report them RDV) as they suppose normally company is not paying tax regularly so in later years we have to pay higher tax, but in later years as recommendation of IT department we should have to pay tax which we company have not paid in initial years only due to RDV Method. Company law provides the choice for choosing depreciation method up to the company. But for income tax department we have to pay tax. Because there are differences between what a company can deduct for tax and accounting purposes, there will be a difference between a company's taxable income and income before tax. A deferred tax liability records the fact that the company will, in the future, pay more income tax because of a transaction that took place during the current period, such as an installment sale receivable, differences between the company's accounting and tax carrying values, the anticipated and enacted income tax rate, and estimated taxes payable for the current year. This liability may or may not be realized during any given year, which makes the deferred status appropriate Deferred tax liability is good [higher corporate tax and lesser income tax (actual pay)] because, tax that you have not paid in initial years to govt. but reports to shareholders that have to pay in later years. So till the time comes we can utilize that money for our businesss Units-of-production depreciation methodUnder the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000 & is expected to produce 6,000 units. Depreciation per unit = ($70,00010,000) / 6,000 = $10 10 actual productions will give the depreciation cost of the current year. Inventory valuation methods Inventory work in process + raw material + finished goods An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions. Inventory accounting systems The two most widely used inventory accounting systems are the periodic and the perpetual. Perpetual: The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the subsidiary ledger for each good in stock, and the account is updated each time a quantity is added or taken out. Periodic: In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods sold.

Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year. These methods produce different results because their flow of costs is based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made. LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs o Periodic versus perpetual systems There are fundamental differences for accounting and reporting merchandise inventory transactions under the periodic and perpetual inventory systems. To record purchases, the periodic system debits the Purchases account while the perpetual system debits the Merchandise Inventory account. To record sales, the perpetual system requires an extra entry to debit the Cost of goods sold and credit Merchandise Inventory. By recording the cost of goods sold for each sale, the perpetual inventory system alleviated the need for adjusting entries and calculation of the goods sold at the end of a financial period, both of which the periodic inventory system requires. In Perpetual Inventory System there must be actual figures and facts. o Using non-cost methods to value inventory Under certain circumstances, valuation of inventory based on cost is impractical. If the market price of a good drops below the purchase price, the lower of cost or market method of valuation is recommended. This method allows declines in inventory value to be offset against income of the period. When goods are damaged or obsolete, and can only be sold for below purchase prices, they should be recorded at net realizable value. The net realizable value is the estimated selling price less any expense incurred to dispose of the good. o Methods used to estimate inventory cost In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. Two very popular methods are 1) Retail inventory method, 2) Gross profit (or gross margin) method. The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. The gross profit method uses the previous years average gross profit margin (i.e. sales minus cost of goods sold divided by sales). Current year gross profit is estimated by multiplying current year sales by that gross profit margin, the current year cost of goods sold is estimated by subtracting the gross profit from sales, and the ending inventory is estimated by adding cost of goods sold to goods available for sale.

There are three basis approaches to valuating inventory that are allowed by GAAP (periodic) (a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income. (b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of

cost of goods sold among the three approaches, and the lowest net income. (c) Weighted Average cost / average cost: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO. [Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising prices for raw materials and labor, more variable inventory growth, an absence of other tax loss carry forwards, and large size. When firms switch from FIFO to LIFO in valuing inventory, there is likely to be a drop in net income and a concurrent increase in cash flows (because of the tax savings). The reverse will apply when firms switch from LIFO to FIFO] Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose to use the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. This can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.

Lease A lease is a contractual arrangement calling for the lessee (user) to pay the lessor (owner) for use of an asset. A rental agreement is a lease in which the asset is tangible property Types of lease Operating lease Financial lease Sale & lease back 1. Operating lease- (short term & cancellable) An operating lease is a lease whose term is short compared to the useful life of the asset For example, an aircraft which has an economic life of 25 years may be leased to an airline for 5 years on an operating lease. Lessor generally responsible for maintenance & insurance Single operating lease may not fully amortize the original cost of asset, Risk of obsolescence of contract remains with Lessor Shorter lease rentals & high Risk of obsolescence lead to high lease rentals. At the end of an operating lease, the lessee has several possibilities: Pursuit of the lease Return of the equipment Renewal of equipment Restoration of equipment Purchase of equipment at their market value The main advantages of operating lease are: No incidence of the rents on the balance sheet: they are operating expenses deductible from profits. Improvement of cash-flow Economy of corporate taxes

2. Finance lease ( long term, non cancellable) Use high cost & high technology instruments for lease Amortize the cost of asset over the term of lease Maintenance & insurance remains with lessee also risk of obsolescence Finance lease or capital lease is a type of lease. It is a commercial arrangement where: the lessee (customer or borrower) will select an asset (equipment, vehicle, software); the Lessor (finance company) will purchase that asset; the lessee will have use of that asset during the lease; the lessee will pay a series of rentals or installments for the use of that asset; the Lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee; the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price); The finance company is the legal owner of the asset during duration of the lease. However the lessee has control over the asset providing them the benefits and risks of (economic) ownership. Treatment in India: Finance lease is the one in which risk and rewards incidental to the ownership of the leased asset is transferred to lessee but not the actual ownership. Thus in case of finance lease lease we can say that notional ownership is passed to the lessee.

3. Sale and lease back User sale and lease it back from leasing company. Such arrangements may provide substantial tax benefits. 4. Leveraged lease 4 parties are involved, Manufacturer Lessor Lender from whom Lessor borrows substantial part of assets purchase price Lessee To secure the loan provided by lenders lessor agrees to give them mortgage of the asset, lenders have the first claim on lease payments together with the collateral on the asset; lenders will take charge of the asset if lessee is unable to make lease payments LEVERAGE It involves higher debt or higher proportion of fixed cost of capital. Risk is not directional. It can be +Ve as well as Ve in magnitude but direction of both variables should be same. (best explained in double edged sword) It is use of fixed cost to provide amplification effect It nothing but the proportion of fixed cost to total cost that firm has. Leverage is a double edged sword A Sales Variable Cost Contribution Operating Fixed cost EBIT % Change in EBIT 1000 -700 300 -100 200 B 1200 -840 360 -100 260 30.00% % Change in EBIT C 800 -560 240 -100 140 -30.00%

% Change in sales

% Change in 20.00% sales

-20.00%

DOL 1.5 Degree of leverage will very per industry 20% Increase in sales lead 2, 30% increase in EBIT It will move in +Ve/-Ve in magnitude, but direction of both will be same.

Debt equity mix of a firm is called its capital structure, capital structure affects shareholders return & risk consequently market value of shares Cost of debt = interest cost From company perspective for debt it has to give some assets as collateral, for the same security is there for lenders due to reason risk is less, ultimately interest is less, but when it comes to equity holders they invest without any security for the reason they expect more returns. If company fails to meet share holders expectations it will affect on its share price, so from company angle cost of equity is greater than cost of equity. So questions arisesif debt is cheap then why doesnt company goes for 100% Debt. & why it goes for equity. Because if in case company defaults company doesnt want creditors to take charge over asset. For debt you have to be very systematic about payments, & for equity they hadnt promised any returns. Proper mixing of debt & Equity reduces overall cost for the reason companies go for Debt & Equity. CoC = CoD + CoE IF CoD is 10% & CoE is 20% then, CoC = CoD + CoE Cost of capital 10% 20% Total Debt (100) 80 20 Total Debt (100) 20 80

total cost = 8% for debt & 4% equity [12%] total cost = 2% for debt & 16% equity [18%]

Cost of effective debt = Cost of debt(%) tax exemption (for interest paid) Gross profit 20 20 Interest -10 -6

Gross profit Interest PBT

20 -10 10

Tax (30 %) Net profit

-3 7

if.

Gross profit Tax (30 %) PAT Interest Net profit =7%

20 -6 14 -10 4

In this there is net profit difference between two is 3 Rs. i.e. effective tax rate is 3%. Cost of effective debt = Cost of existing debt (10%)*(1-tax rate) = 10*(1-30%)

Financial leverage Affects profit after tax or earning per share, based on interest cost Small change in EBIT leads to major change in net profit.

A (2010) Operating Profit Interest ROCE ROE Equity Debt 150 0 150 30% 30% 500 0

A (2011) 150 50 100 30% 40% 250 250

Use of fixed charges sources of funds such as debt, preference capital along with the owner's equity in the capital structure is described as financial leverage or gearing, or trading on equity. (Main reason to use financial leverage is to increase shareholders return) Measures of financial leverage Debt ratio ratio of debt to total capital ( vary between 0-1) Debt ratio = D/V V= D+E Debt equity ratio = D/E ( vary between 0-any large number) Interest coverage = EBIT / Interest Degree of financial leverage It is quantification (How much of the leverages) of the leverage. It has no unit, it is expressed in times. Degree of financial leverage - % change in EPS due to given % change in EBIT

Sales (Variable cost) Contribution (Fixed operating cost) EBIT (Interest) PBT (Tax) @ 10% PAT No of shares EPS

A 100 -60 40 -10 30 -10 20 -2 18 10 1.8

A' 120 -72 48 -10 38 -10 28 -2.8 25.2 10 2.52

20% increase 20% increase

26.67% increase

10%

40% increase

DFL = % Change in EPS / % change in EBIT = EBIT / EBIT-INTEREST but, in case of Preferred dividends (Fixed financial cost). = EBIT /EBIT Interest cost (Preferred dividends/1-T) = EBIT/PBT Operating leverage affects firms operating profit, based on fixed cost (rent, interest, electricity bill). Small change in operating profit more change will be on profitability A (2010) 10 6 2 2 20% A (2011) 15 6 3 6 40%

Sales Fixed cost Variable cost EBIT Profitability

Degree of operating leverage percentage change in earning before interest & taxes relative to a given percentage change in sales. s Sales (Variable cost) Contribution (Fixed operating cost) A 100 -60 40 A' 120 -72 48 20% increase 20% increase % change in EBIT / % Change in sales Contribution / EBIT (Sales variable cost)/

DOL =

-10 -10 DOL = 26.67% = EBIT 30 38 increase EBIT = Contribution /Contribution Operating fixed cost Financial fixed cost, Bu tin case of preferred dividends, = Contribution /Contribution Operating fixed cost {Interest + (Preferred dividends/1-T)} In case of per unit DOL, DOL = (Total Contribution)/Total EBIT)

= (Quantity*Contribution per unit)/EBIT NOTE Only variable items can be expressed in terms of per unit Combined leverage it is the product of the Financial leverage and Operating leverage. Combined leverage = DOL DFL = % Change in EBIT % Change in EPS % Change in Sales % Change in EBIT = % Change in EPS % Change in Sales = (Contribution /EBIT)*(EBIT/PBT) = Contribution /Contribution Operating fixed cost Financial fixed cost IMPORTANT Leverages work irrespective of direction of change Leverage is Double edged sword (Increase in sales lead to increase in EBIT, AND vice-a-versa) Leverage cant be negative (if sales has grown, its amplification effect cant be negative) Greater the leverage, Greater would be the sales level required for breaking even. Break Even Analysis (Level of output/Sales firm must generate to cover all of its fixed and variable cost at which Net Profit/Income = 0)
Revenue

COST

Total cost

Variable Cost

Fixed Cost Break Even

OUTPUT

At break even. Total Revenue = Total cost.

Operating Break Even = Total cost/ Operating fixed cost = EBIT must zero at operating cost level. Operating fixed cost/contribution = [must sell to come at EBIT (Operating profit) =0] = Total cost / (operating + Interest cost) = PBT must zero Total fixed cost/contribution = [must sell to come at PBT (Total profit) =0] - Required Quantity for breakeven Total Break Even

Quantity of total break even cant be < Quantity of operating break even

To remove effect of tax, Before Tax Amount (BT) * (1-T) = After Tax (AT) i.e. BT = AT/(1-T) Tools of financial Analysis (Ratio analysis) Ratio compares two or more variables; it can be expressed in percentage, times and in multiple formats. Financial ratio will not be useful when they standalone. Liquidity ratios to check whether the firm is able to meet its short term obligations Current ratio most used short term liquidity measure Current ratio = current assets / current liabilities. (Higher the ratio higher the liquidity of the firm, traditionally 2:1, varies industry wise) If ratio is low check for provisions, s debtors, s creditors. Analyst generally looks at ST Investments, cash & bank balance. In P & L, PAT & Dividends taken into consideration. Current assets cash, debtors, inventories, loans, advances, prepaid expenses. Current liabilities advance payment received, amount credited due to suppliers of goods & services, accrued expenses (wages, salaries, rentals, interest), unclaimed dividend, provision for taxes, dividends, gratuity, pensions. Acid test ratio (quick ratio) short term liquidity measure Acid test ratio = current assets inventories / current liabilities (Higher the ratio higher the liquidity of the firm, traditionally 1:1, varies industry wise) Cash ratio close to 0.5 Cash ratio = cash / short term investments Efficiency ratiosProvide basis for assessing how effectively the firm is using its resources to generate sale Receivables/Debtor turnover indicates in days how quickly receivables are collected from its customers Receivables turnover annual credit sales / sundry debtors (Higher the turnover, higher the efficiency) Payable/Creditor turnover ratio indicates hoe frequently we pay to our suppliers (Lower the turnover, higher the efficiency) Inventory turnover period --- 30 days One Operating cycle (90 days) Debtor turnover period --- 60 days Creditor turnover period --- 30 days need cash for 60 (90-30) days

Average collection period how rapidly firms accounts are being collected from its customers Average collection period 360 / receivables turnover (Smaller the period, higher the efficiency)

Inventory turnover ratio reflects no. of times inventories are turned over during a year Inventory turnover = cost of goods sold / average inventories (Higher the turnover, higher the efficiency) Fixed assets turnover ratio used to measure the efficiency with which the firm utilizes its investments, used for companies which are asset heavy Capital WIP = assets in production, in fixed assets turnover ratio CAPITAL WIP taken into consideration Fixed assets turnover ratio = sales / net fixed assets (Higher the turnover, higher the efficiency) Total asset turnover ratio - indicates how many rupees in sales the firm generates for each dollar it has invested in assets Total assets turnover = sales / total assets (Higher the turnover, higher the efficiency) Leverage ratios Used to measure extent to which non owner supplied funds have been used to finance firm's assets. It can be categorized as being either balance sheet ratio or coverage ratio. Balance sheet leverage ratio measure the proportion of firm's assets financed with non owner funds. Debt ratio long term debt to total capital ratio measures relative importance of long term debt in the firm's capitalization. Debt ratio = total long term debt (TLTD) / Total capital (D+E) Total capital = total long term debt (TLTD) + equity resources Debt equity ratio indicates relative size of debt compared to total equity of firm Debt equity ratio = total long term debt (TLTD) / equity (Equity = reserves + surpluses) Lower is the good, because in default case creditors will have priority to claim assets [Debt & equity are only two components company uses to finance its activities] It is most used in liquidation to determine the priority powers. Higher the ratio lenders / creditors have more powers in liquidation. Equity Ratio - indicates relative size of Equity compared to total capital (D + E) of firm Equity ratio = total equity / Total capital (D+E) Net Debt = total debt cash & bank balance Coverage ratios Used to measure firms ability to cover the finance charges associated with its use of financial leverage Times interest earned ratio tells whether the operating profit is sufficient to cover the interest liabilities for that year. Times interest earned ratio = operating profit (PBDIT) / Interest = EBIT / Interest Debt service coverage ratio measures the companies ability to meet interest and debt repayment capacity from its operating profit Debt service coverage ratio (DSCR) = operating profit (PBDIT) / interest + debt payment = EBIT Income tax / (principal + interest) Fixed asset coverage ratio Solvency ratio Fixed asset coverage = Fixed asset / long term debt Profitability ratio Measures effectiveness of the firms management, & looking at operational parameters

(Profitability can be measured in relation to sales and in relation to investment) When it is compared with EBITDA it is at operational level (looking at operational parameters), and when it is compared with EBIT it is at asset level (indicate operational efficiency) For credit research analyze companies at operational level Banks / Lenders are interested in EBIT for principal and interest repayment Shareholders interested in PAT for their share in profit Profitability in relation to sales reflects ability of firm's management to control various expenses involved in generating sales. Operating profit margin measures operating efficiency of firm Operating profit margin = operating profit / sales Net profit margin - measures operating efficiency of firm Net profit margin = net profit / sales Return on investment - tells about overall profitability of company in relation to the total investment of the company Return on investment = operating profit (PBDIT) / total assets Return on investment = Operating profit / sales * sales / total assets (From this analyst can analyze determinants of firm's profitability) Earning per share ratio - indicates returns per share issued by company EPS = net profit / no. of shares Return on equity ratio measures the net return on investment of the common shareholders It is a measure of the shareholders value. Return on equity ratio = net profit available to equity shareholders / equity + reserves Capital Employed = total debt + total equity ROCE (after tax)= EBIT (1-T)/capital employed, ideally must be 20% 25%. ROCE (Pre tax)= EBIT /capital employed, ideally must be 25% 30%. Pre tax returns on capital employed must be high because later out of that we have to taxes. If in that case EBIT is falling and capital employed is increasing then it may lead to problem. If ROCE are lesser than the cost of capital shareholders will make a loss and if ROCE is greater than cost of debt it is +ve leverage, i.e. greater returns for equity holders. If ROCE is 7.2% and ROE is 12% *cost of debt is 10%+think .why this happened!!! There might be other incomes to shareholders, PAT could be inflated due to sale of asset for the reason their returns zoomed faster than ROCE. If there is no debt, ROCE = ROE If EBI = 100 Rs, interest expense 1 Rs, cost of debt 10%, cost of capital employed 30% In such case due to lower cost of debt than equity, also interest coverage ratio is 100 times, company may raise more debt & from that money can buyback its shares from market; it will minimize no. of shares into the market and ultimately returns for equity holders will get distributed with less holders, so their earnings will increase.

Market value ratio It helps to relate company financials to the market price of the company's securities. Book value - book value per share worked out by dividing sum total of issued equity capital and reserves (excluding revaluation reserves) by the number of equity shares. Book value = equity + reserves

Book value per share = equity + reserves / no. of shares (Face value 10, market price 25, book value 37 stock undervalued) Price to earning ratio tells how much market discounts earnings, how much we are paying for the earning per share. Low PE (High earning yield) is always good. When there is loss for share holders there will be no PE. Price to earnings ratio= market price per share / earnings per share As EPS increases PE decreases. Mostly PE is used for asset heavy or manufacturing companies & not for IT & service industry. For banks or financial institutions loans are their assets and deposits are the liabilities. Whatever loans issued by banks are always linked to market value & not the historical value. For the reason rather than PE ratio PB ratio is taken into consideration. (low PB is good for picking banking stocks)

PEG ratio = PE / EPS PE is directly compared to growth in EPS Dividend per share = total dividend by company / no. of shares Dividend yield return of dividend as a percentage to current market price Dividend yield = cash dividend per share / market price per share

Du-Pont Analysis Return on Equity = Net profit / Equity

Net Profit PBT PBT EBIT

EBIT SALES

SALES TOTAL ASSET

TOTAL ASSET EQUITY

Tax Burden

Interest Burden

Operating Margin

Asset Turnover ratio

Capital Structure

Modified du-point Net profit / sales = net profit margin (du point) Enterprise value = Mkt. Capitalization(Equity ignores capital structure) + Debt Cash + Minority share holders + Preference share holders = Total value of company as of today = value of all the assets. Minority share holders come into picture only when there is subsidiary of a parent company having majority stake in that company. At 51 % stake one will have controlling powers of company; at 25 49% one will have its influence & not the control. EV / sale = 2 It means we are ready to pay 2 rupees for a sale of one rupee.

Enterprise value Total assets on balance sheet Ignores capital structure = Equity value + net debt = value of net debt

Equity value Book value of todays equity on balance sheet Considers capital structure = Enterprise value net debt = mkt. capitalization for listed companies.

Net debt = LT Debt* + ST Debt* + minority interest cash & cash equivalents ( * - Market value of debt may differ for troubled companies. Multiples EV / EBITDA (X) EV / Reserves (X) EV / EBIT (X) EV / FCF(X) Multiples P/E(X) P/BV(X)

Multiples can be of two types Forward & trailing 12 months (TTM)

TTM
EPS PE Stock Price 100 10 1000

FORWARD MULTIPLE
150 6.66 1500 low PE is growth potential for future

Book value = Share holders funds (net worth) / shares outstanding Paid up capital = shares outstanding / face value of share Mkt. Capitalization = shares outstanding * price of share in market

Long term assets Fixed assets + Short term assets Current assets

Net worth/equity/ Shareholders funds Long term liabilities Current liabilities

Long term assets Fixed assets + Short term assets Current assets

Net worth/equity/ Shareholders funds Long term liabilities Current liabilities

Always near to market value If current assets are financed through equity its ok. If long term assets are financed through current liabilities, it is a bad sign

While taking equity valuation then cash & short term investments taken into consideration. LT investments such which are liquid only those are added/considered otherwise not. Book value & market value -

Book value Application Sources Book value of liability Cash Book value of debt Book value of assets Book value of assets Application Cash

Market value Sources Book value of liability Book value of debt Book value of Equity Premium over book value of equity

Book value of Equity

Off balance sheet value of assets

Book value = total assets external liabilities Out of cost of asset or market value of asset, whichever is lesser is carried out as a cost of asset. Valuation always remains sensitive to WACC and terminal value. Drawbacks of DCF at valuation - It depends heavily on terminal value. - It can be easily manipulated, reduce WACC or increase in cash flows. - It uses lots of assumptions, chances of going wrong - It cant forecast innovation. Benefits of DCF at valuation - It can be customized as per ones need. - Nothing is dependent on market. Margin of safety - Discount the fair value because we might be wrong while doing calculations.

Interview process in each Multi National Companies (MNC) HR interview (to check your profile) Aptitude test- Quantitative aptitude Logical reasoning (verbal/non verbal) General knowledge Excel knowledge/shortcuts Typing test (at least 15-25 words per min depends on company) Operational round (to test your domain( theoretical/practical ) knowledge)

These are key points to be asked in interviews of Account/ Finance domain Please clear all above basic key points to crack the interview Matter consist only theoretical knowledge & doesnt consist practical life HR questions Please pass on to the needy persons

Feel free to contact for any queries Vishal Mane Mob: +91 8055082858 Vishal_4489@rediffmail.com Mon-Fri: 9:00 am-12:00 pm IST Sat-Sun: 9:00 am-6:00 pm IST Best of Luck for future endeavor!!!