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Finance Reading Material
Monetrix – The Finance and Economics Club of MDI
5/30/2016
Preface
Greetings! While you pack your bags and spend the last few days of your pre MBA life,
Monetrix has compiled the below document to make your life easier once on campus. The
below document has been prepared keeping in mind that this would be the first brush with the
world of finance for many of you. We hope you make full use of this document and use this as a
guiding document to further expand your horizons.
One of the key elements of decision making is to analyze the current situation of the business
completely. This analysis includes both qualitative and quantitative analysis. Qualitative analysis
is a good starting point to analyze any company. Qualitative analysis generally includes strategy
analysis of the company where one needs to identify the sustainable competitive advantage
(SCA) of the company.
Then one moves to the financial or quantitative analysis. Financial analysis helps in utilizing
information about the past performance of the company. This further helps to identify
potential problem areas and troubleshoot those. This reading material presents an introduction
to principles of accounting and financial analysis. One needs to understand financial statements
well to perform the financial analysis of a business. The material begins with types of business
entities in India, basics of accounting, accounting principles which are required for the
understanding of the financial statements. Then we dive deeper in the three basic financial
statements. Finally we will cover the most important part – financial ratio analysis.
Good Luck!
Team Monetrix
1|Monetrix – The Finance and Economics Club of MDI

The Different Types of Business Entities in India
Sole Proprietorship
This is the most easy business entity to establish in India. It doesn’t need its own Permanent
Account Number (PAN) and the PAN of the owner (Proprietor) acts as the PAN for the Sole
Proprietorship firm. Registrations with various government departments are required only on a
need basis. For example, if the business provides services and service tax is applicable, then
registration with the service tax department is required. It is not possible to transfer the
ownership of a Sole Proprietorship from one person to another.
Partnership
Two or more people can form a Partnership subject to maximum of 20 partners. A partnership
deed is prepared that details the amount of capital each partner will contribute to the
partnership. It also details how much profit/loss each partner will share. Working partners of
the partnership are also allowed to draw a salary. A partnership is also allowed to purchase
assets in its name. However the owners of such assets are the partners of the firm. A
partnership may/may not be dissolved in case of death of a partner. Partners of the firm have
unlimited business liabilities which means their personal assets can be attached to meet
business liability claims of the partnership firm. Also losses incurred due to act of one partner
are liable for payment from every partner of the partnership firm.
Limited Liability Partnership
LLP allows members to retain flexibility of ownership (similar to Partnership Firm) but provides
a liability protection. The maximum liability of each partner in an LLP is limited to the extent of
his/her investment in the firm.
Private Limited Company
Private Limited Company allows owners to subscribe to its shares by paying a share capital fees.
On subscribing to shares, the owners/members become shareholders on the company. A
Private Limited Company is a separate legal entity both in terms of taxation as well as liability.
The personal liability of the shareholders is limited to their share capital. Private Limited
Company can have between 2 to 50 members with minimum share capital of Rs 1,00,000 (one
lac). To look after the day to day activities of the company, Directors are appointed by the
Shareholders. Minimum two Directors must be appointed to look after the daily affairs of the
company. A Private Limited Company has more compliance burden when compared to a
Partnership and LLP. One the positive side, Shareholders of a Private Limited Company can
change without affecting the operational or legal standing of the company. Generally Venture

Capital investors prefer to invest in businesses that are Private Limited Company since it allows
great degree of separation between ownership and operations. It also allows investors to exit
the company by selling shares without being liable for company affairs.
Public Limited Company
Public Limited Company is similar to Private Limited Company with the difference being that
number of shareholders of a Public Limited Company can be unlimited with a minimum seven
members. It is generally very difficult to establish a public limited company. A Public Limited
Company can be either listed in a stock exchange or remain unlisted.A Listed Public Limited
Company allows shareholders of the company to trade its shares freely on the stock exchange.
A Public Limited Company requires more public disclosures and compliance from the
government as well as market regular SEBI (Securities and Exchange Board of India) including
appointment of independent directors on the board, public disclosure of books of accounts, cap
of salaries of Directors and CEO. Like a Private Limited Company, a Public Limited Company is
also an independent legal person; its existence is not affected by the death, retirement or
insolvency of any of its shareholders.

Basics of Financial Statements
Imagine that a business is like an apple tree. Like an apple tree, your business produces an
annual yield. Now to analyze the performance of the apple tree, you would look at the annual
yield and current condition of the apple tree. In a business, we generally use three basic
financial statements income statement, balance sheet and cash flow statement to analyze the
performance of the company.
With time, the business grows

and performance is measured
through financial statements
The Income Statement measures the fruits of your business efforts.
Like an apple tree, the yield gets reset every year.

The Income Statement starts at zero at the beginningof every year and measures the annual
yield.
The Balance Sheet is a picture in time. While the income statement helps one to identify the
annual yield or profit of the business, the balance sheet tells about the current situation of the
business. It basically tells about what a firm owns and what it owes.It measures the cumulative
result of your business efforts.
At the end of each year, net earnings (or Net Income) is added to Retained Earnings on the
Balance Sheet.
Previous year balance sheet
Current Year Retained earnings

The Balance Sheet measures what you own and what you owe. What you own is called your
Assets. What you owe is called your Liabilities.
Before we go into details of various financial statements, we will first try to understand the
accounting principles which form the basis of these financial statements.

Accounting Principles
To understand the accounting principles better, we will consider an example and apply various
accounting principles onto it. So, consider the following example:
Jhamji who works at a textile mill in Tezpur likes cooking and cooks delicious “sattu paranthas”.
Now he is not educated but he wants his children to get the best education. But he is highly
underpaid and therefore it is not possible for him to provide best education to his children in the
salary that he gets. One day his wife Sati advices him to start a business of his own so that all
their dreams can be fulfilled. He then decides to move to Haryana and starts a cafeteria named
“Jhamji Paranthas” at MDI, Gurgaon. Soon his “sattu paranthas” are famous all over the
campus; students now have to wait in queues just to get a taste of his paranthas. He starts
making big profits and his savings now would be able to pay for all his dreams.
Double Entry and the Accrual Basis of Accounting
At the heart of financial accounting is the system known as double entry bookkeeping (or
"double entry accounting"). Each financial transaction that a company makes is recorded by
using this system.
The term "double entry" means that every transaction affects at least two accounts. For
example, if Jhamji Paranthas decides to borrow INR 50000 from a bank, then its liabilities
increase. But it now has INR 50000 cash also so its asset side also increases. So any financial
transaction will impact at least two accounts. (Don’t worry about asset and liabilities, you will
learn about them in the next section.)
The advantage of double entry accounting is this: at any given time, the balance of a company's
asset accounts will equal the balance of its liability and stockholders' (or owner's) equity
accounts.
Financial accounting is required to follow the accrual basis of accounting (as opposed to the
"cash basis" of accounting). Under the accrual basis, revenues are reported when they are
earned, not when the money is received. Similarly, expenses are reported when they are
incurred, not when they are paid. For example, a first year student Ayan goes to Jhamji
Paranthas and orders 2 “sattu paranthas”. After eating the sattu paranthas, he realizes that he
does not have money to pay for those paranthas. So he promises to pay Jhamji for those
paranthas the next day. Now the revenue from paranthas purchased by Ayan will be counted in
the revenues of Jhamjiparanthas for that particular day only even when Ayan has not paid for

them. This is called accrual basis of accounting. (You will learn more about this when we will
discuss income statement in detail.)
Basic Principles of Accounting
There are some general rules and concepts that govern the field of accounting. These general
rules–referred to as basic accounting principles and guidelines–form the base on which more
detailed accounting rules are based. The following is a list of the ten main accounting principles
and guidelines together with a highly condensed explanation of each.
Economic Entity Assumption
Business and business owner are considered to be separate entity in accounting. Therefore the
business transactions of a business are kept separate from the business owner's personal
transactions.Say, one day Jhamji buys a toy worth INR 100 for his children and sends it by post
to Tezpur. Now this transaction would not be recorded in the financial statements of
“Jhamjiparanthas” even when it is carried out by Jhamji himself as business and business owner
are considered to be different entities in accounting.
Monetary Unit Assumption
Economic activity is measured in Indian rupees, and only transactions that can be expressed in
Indian rupees are recorded. Only those transactions which have a monetary value will be
recorded in the financial statements of JhamjiParanthas.
Cost Principle
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the
cash equivalent) when an item was originally obtained, whether that purchase happened last
year or thirty years ago. For this reason, the amounts shown on financial statements are
referred to as historical cost amounts.Say JhamjiParanthas is doing great and Jhamji decides to
expand his business. So, JhamjiParanthas buys a piece of land in Rewari, Haryana for INR 10
lakhs to open up a new restaurant there. After one year, the land price rises to INR 12 lakhs
even then land would be mentioned worth INR 10 lakhs only because of the cost principle.
Because of this accounting principle asset amounts are not adjusted upward for inflation. In
fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value.
Hence, an asset amount does not reflect the amount of money a company would receive if it
were to sell the asset at today's market value. (An exception is certain investments in stocks
and bonds that are actively traded on a stock exchange.)

Full Disclosure Principle
If certain information is important to an investor or lender using the financial statements, that
information should be disclosed within the statement or in the notes to the statement. It is
because of this basic accounting principle that numerous pages of "footnotes" are often
attached to financial statements.
Say JhamjiParanthas decides to raise a certain amount of money, so Jhamji goes to a lender to
raise the money required. Now he must disclose all the relevant information honestly to the
lender. If he refuses to do so, the business will be in legal trouble.
Going Concern Principle
This accounting principle assumes that a company will continue to exist long enough to carry
out its objectives and commitments and will not liquidate in the foreseeable future. If the
company's financial situation is such that the accountant believes the company will not be able
to continue on, the accountant is required to disclose this assessment. This assumption is very
important for accrual accounting.
Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The
matching principle requires that expenses be matched with revenues. For example, say
Jhamjiparanthas purchased its raw material from Sharmaji on the condition that it will pay
Sharmji after one month. Now the cost of the raw material will be noted in the income
statement of this month only if paranthas made from that raw material are sold this month and
not in the next month’s income statement. Expenses are matched with revenues. As revenues
are earned in this month, expenses will be noted this month only even if they are paid on a
later date.
Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to

violate another accounting principle if an amount is insignificant. Professional judgement is
needed to decide whether an amount is insignificant or immaterial.Because of materiality,
financial statements usually show amounts rounded to the nearest dollar, to the nearest
thousand, or to the nearest million dollars depending on the size of the company.
Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item,
conservatism directs the accountant to choose the alternative that will result in less net income

and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased and objective.
The basic accounting principle of conservatism leads accountants to anticipate or disclose

losses, but it does not allow a similar action for gains. For example, a customer files a case
against JhamjiParanthas, now potential losses from this lawsuit must be reflected in the
financial statements while potential gains would not be reported.
10 | M o n e t r i x – T h e F i n a n c e a n d E c o n o m i c s C l u b o f M D I
Financial Statements
Balance Sheet
Before we move on to the details of a balance, we will learn about assets, liabilities and equity.
Assets
An asset is officially defined as:
A resource controlled by the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise.
To put it more simply...
An asset is a possession of a business that will bring the business benefits in the future.
What is the test of whether something is considered an asset for your business? Well, one asks,
“Is the _______ something I own, and will it bring me benefits in the future?”
Let’s take land. If you owned the land, would it be an asset for your business? Not sure? Well,
do you expect to receive benefits for your business in the future from the land? Of course. So
what are the benefits it will bring? Well, you can construct a building on it that you can use for
business. Even selling it would bring benefits, in the form of cash.
How about a computer that you own – is this an asset? Will it bring you benefits in the future?
Well, amongst other things, you can store and retrieve large amounts of information and use it
to communicate with suppliers and customers.
So yes, a computer is certainly an asset.
Now let’s take something more tricky – what about cash? Is cash an asset? Answer: cash is
certainly an asset. What are the benefits of having cash? Simple: you can pay for things! That is
certainly useful (and indeed essential) for a business.
Have you ever heard of debtors? Debtors are people that owe your business money and the
value of these debts as a whole.
Another name for debtors is accounts receivable. The word receivable simply meanscapable of
being received, or will be received.
Would debtors or accounts receivable be an asset for your business?
Answer: Even though you cannot own a debtor, you will get benefits in future from having
money owed to your business.
The benefits are simple – you will get paid! So if you have $3,000 owed to you by Mr. Smith,
you have a debtor, an asset, worth $3,000.
An additional requirement for an asset is that you have to be able to measure its value
somehow and you have to be able to measure this accurately. This is usually quite simple, as
the value is equal to how much you paid for it.
So let's take employees...Are employees assets? Well if you ask a HR, obviously they are. But
how do you value an employee? Can you put an accurate, reliable figure on how much an
employee is worth to you, bearing in mind that he or she can resign at any point by giving
notice? Tricky, right? As you can imagine, it's nearly impossible to place a value on people –
consequently employees are actually never included as assets in accounting - but only because
we can't value them.
So the full test of whether something is an asset is:
1. DOES YOUR BUSINESS OWN/CONTROL IT?
2. WILL IT BRING YOUR BUSINESS BENEFITS IN THE FUTURE?
3. CAN YOU VALUE IT ACCURATELY?
If these three criteria are met, then you have an asset according to the accounting system.
They are the resources of the company that have been acquired through transactions, and have
future economic value that can be measured and expressed in dollars. Assets also include costs
paid in advance that have not yet expired, such as prepaid advertising, prepaid insurance,
prepaid legal fees, and prepaid rent.
Examples of asset accounts that are reported on a company's balance sheet include:
 Cash
 Accounts Receivable
 Inventory
 Supplies
 Prepaid Insurance
 Land
 Land Improvements
 Buildings
 Equipment
 Goodwill
 Bond Issue Costs
Classifications of Assets on The Balance Sheet
Accountants usually prepare classified balance sheets. "Classified" means that the balance
sheet accounts are presented in distinct groupings, categories, or classifications. The asset
classifications and their order of appearance on the balance sheet are:
 Current Assets
 Investments
 Property, Plant, and Equipment
 Intangible Assets
 Other Assets
Liabilities
Liability is officially defined as:=
A present obligation of the enterprise arising from past events, the settlement of which is
expected to result in an outflow from the enterprise of resources embodying economic benefits.
In other words, a liability is simply...
A debt of the business.
The debt will result in assets (usually cash) leaving the business in the future.
The most common liability is a loan.
Another common liability is called creditors.
A creditor, also known as a payable, is any business or person that you owe (apart from a loan).
Suppliers (who you owe for products purchased on credit) would fall under creditors.
Other examples of creditors are the telephone company that you owe or a printing shop you
owe for printing fliers. Even the tax authorities could be considered a creditor if you owe them.
When you pay a loan back, or you pay off your creditors, some of your assets (most often cash)
will leave your business.
Liabilities also include amounts received in advance for future services. Since the amount
received (recorded as the asset Cash) has not yet been earned, the company defers the
reporting of revenues and instead reports a liability such as Unearned Revenues or Customer
Deposits.
Examples of liability accounts reported on a company's balance sheet include:
 Notes Payable
 Accounts Payable
 Salaries Payable
 Wages Payable
 Interest Payable
 Other Accrued Expenses Payable
 Income Taxes Payable
 Customer Deposits
 Warranty Liability
 Lawsuits Payable
 Unearned Revenues
 Bonds Payable
Owner's (Stockholders') Equity
The owner’s equity is simply the owner’s share of the assets of a business. You see, assets can
only ‘belong’ to two types of people: the first type is people outside the business you owe
money to (liabilities), and the second is the owner himself (owner's equity).
Owner’s equity, often just called equity, represents the value of the assets that the owner can
lay claim to.
In other words, it's the value of all the assets after deducting the value of assets needed to pay
liabilities.
It is the value of the assets that the owner really owns.
ASSETS = EQUITY + LIABILITIES
Thus the accounting equation indicates how much of the assets of a business belong to, or are
owned, by whom.
Now we will move on to the balance sheet
The balance sheet is also referred to as the statement of financial position.Because the balance
sheet informs the reader of a company's financial position as of one moment in time, it allows
someone—like a creditor—to see what a company owns as well as what it owes to other
parties as of the date indicated in the heading. This is valuable information to the banker who
wants to determine whether or not a company qualifies for additional credit or loans.It basically
reveals what a company “owns” and what a company “owes”.
The balance sheet thus provides a snapshot of a business at an exact point in time - it shows the
balances of the various accounts on the last day of the reporting period.
Balance Sheet Categories:
Non-Current versus Current
The balance sheet also divides the assets and liabilities into categories.
Assets and liabilities must be divided up into long-term and short-term categories. Non-current
means long-term and current means short-term.
The dividing line between current and non-current is one year from the date that the balance
sheet is issued.
In other words, an asset will be classified as current if it is expected to be sold (or used) within a
year from the date of the report.
An asset will be classified as non-current if it is expected to be used for more than one year.
A liability that is expected to be paid off within a year, such as a creditor, is classified as current.
A loan, which is expected to be paid off more than a year from the balance sheet date, is
classified as a non-current liability.
The division of assets and liabilities into these categories is done to provide more meaningful
information to the readers of this report.
One type of asset that we haven't gone over in previous lessons is investments. Investments are
also known as other financial assets.
This category of assets includes investments in other businesses as well as long-term

investments with the bank. Note that investments are usually non-current assets (unless you
intend to sell off the investment within a year, in which case it is classified as a current asset).
The "10% loan" means that we have a loan that has a 10% interest charge on it per year.
Income Statement
We will first try to understand profit, income and expense and then we will move on to income
statement.
Profit is the positive amount you are left with when your total income exceeds your total
expenses.
A person starts a business, and invests his assets in the business, so that the business will
produce a profit for him.
This reason or motivation of starting and running an organization with the objective of making a
profit is called the profit motive. Other organizations, such as welfare and educational
organizations, are non-profit organizations – i.e. they do not exist so the owner makes a profit,
but for other reasons such as benefiting the community or a group of people. Thus, when we
are looking at income, expenses and profit, we are really looking at your for-profit business.
Profit Formula
REVENUE – EXPENSES = PROFIT
In order to calculate if the business has made an overall profit (or loss), we take our income and
deduct our expenses.
The amount of profit that a business makes indicates how well a business is performing.If the
business makes a profit, this will belong to the owner.
Thus more profit means more owner’s equity (the owner’s share).
But now, what are these things called income and expenses?
Income is simply the event that results in money flowing into the business.
Examples of income:
 Sales
 Services rendered (such as an accountant’s services, doctor’s services, a plumber’s
services, etc.)
 Interest received
 Rent received
Each one of these things above represent some sort of event that occurs (like a sale being
made), which results in money flowing into a business.
More income means more profit, which means more for the owner. Income thus comes into
being (and increases) on the same side as equity – namely the right side.
Remember Accrual Basis of accounting?
Accrued means ‘is/are owed’ or ‘payable’ or ‘owing’.
Accrued income is thus income that is owing.
"Owing to who?" you ask.
Well, who earned the income?
You did. Or rather, your business.
Accrued income is thus income your business has earned, that is still owed to your business.
Now, how does income differ from the cash you get? Is there any difference between the sale
itself (the income) and the cash received from a sale? Are they always the same amounts?
As mentioned before, debtors are people that owe your business money. It also refers to the
value of these debts as a whole.
Debtors are assets, as you expect to receive benefits from them in the future – you expect to be
paid. What happens if someone owes you money but you don’t expect them to pay you in
future? Well, there are no benefits then, so this is not an asset.
Another name for debtors is accounts receivable. The word receivable simply means capable of
being received, or will be received.
Accrual describes amounts that have been accumulated and are still owed.
The accrual basis of accounting means that if a sale is made in October, but cash is received in
January, the income is recorded in October (not when the cash is received in January). Between
October and January we record that cash is owed (a debtor is recognized).
The accrual basis means that income and expenses are recorded in the periods to which they
relate, and not necessarily when cash is received or paid.
Expenses
If we define income as the event that results in money flowing into the business, then how do
you think we define expenses?
Expenses are simply the events that result in money flowing out of the business.
Examples of expenses:
 Salaries and wages

 Telephone bill
 Water and electricity
 Insurance, or
 Repairs (for example, to machinery).
Expenses are the opposite of income.
More expenses means less profit, which means less for the owner.
The owner’s equity and expenses are therefore conversely (oppositely) related, and thus
expenses come into being (and increase) on the left side.
Now we will move on to income statement.
It is also known as the profit and loss statement.The income statement is a report showing the
profit or loss for a business during a certain period, as well as the incomes and expenses that
resulted in this overall profit or loss. The amount of the profit or loss for a business during a
certain period indicates the financial performance of the business.
The income statement is a report showing the profit or loss for a business during a certain
period, as well as the incomes and expenses that resulted in this overall profit or loss. The
amount of the profit or loss for a business during a certain period indicates the financial
performance of the business.
The Statement of Owners Equity
Its full name is the statement of changes in owner's equity.
This accounting report shows all the changes to the owners’ equity that have occurred during
the period. These changes comprise capital, drawings and the profit for the period.
The format of the statement is shown below:
As you can see, it shows the balances of the owners’ equity at the beginning and end of the
period in addition to the changes that occurred during this period.
Just like the income statement, this statement normally covers a twelve-month period.
Cash Flow Statement
Before we start, have you heard of this saying?
Cash is king.
This is a common saying in the business world. It is also true, because cash is the lifeblood of
the business. Without it, you can't pay bills; you can't expand the business by purchasing assets.
You can't pay employees. As the business owner, you couldn't even pay yourself!
The cash flow statement is a statement (report) of flows (both in and out of the business) of
cash.
The cash flow statement is a key accounting report. One could show the most fantastic
performance according to the income statement, with huge profits, and yet have nothing left in
the bank. In this situation the business would not survive. How could this occur? It could occur
if all your sales have been made on credit. And it could occur if additionally you weren't
monitoring the cash flows of your business.
In real life this extreme situation would rarely occur, but this example serves to explain that the
cash situation of a business is key. And the cash flow statement, which shows us what the
business has been doing with its cash - provides vital information. So yes, cash is king - in the
business world and even in accounting.
Cash can flow in two directions – either coming in to your business or going out. Cash coming in
to your business is shown as positive amounts, whereas cash going out from your business are
shown as negative amounts (in parentheses).
Dividends are cash payouts to people who have bought shares in a company. It is similar to
drawings in a small business in that the owner is getting a payout (drawings is the owner
withdrawing some of the cash that he first put in the business).
Proceeds means cash received.
Like the rest of the financial statements, the cash flow statement is usually drawn up annually
The statement is divided into four parts. The first is the cash flows relating to your operations –
the core activities of your business.
This includes cash receipts (cash received) from your customers, cash paid to suppliers and
employees, interest received or paid and tax paid.
The second section is the cash flow from investing activities. Investing (in the context of the
cash flow statement) means the spending of cash on non-current assets. For example, one
could be spending cash on computer equipment, on vehicles, or even on a building one
purchased.
Thus investing activities mainly involves cash outflows for a business. We also include cash
inflows in this section relating to the sale of a non-current asset that we have already invested
in. Thus, the cash received this year from selling equipment that was originally bought (invested
in) three years ago, would also be included in this section.
As investing activities mainly deal with cash outflows (buying non-current assets), the total of
this section is usually a negative.
Purchases of assets are put under two different categories: additions or replacements.
Additions means purchases of additional assets in order to expand the business.
Replacements do not involve expansion but rather refer to an asset being purchased to replace
an old or obsolete (no longer used) asset.
Cash flow from financing activities is the third section. Financing is the source of the cash that
we will be using to invest in non-current assets. It is where we get cash from. Thus financing
activities mainly involves cash inflows for a business.
Financing can come from the owner (owners’ equity) or from liabilities (loans). We also include
cash outflows in this section that relate to financing that we originally obtained. Thus the
repayment of a loan (in part or in full) falls under financing activities (as a cash outflow), as the
loan served as finance for the business originally.
Similarly, drawings (or dividends for a corporation) may also be placed under this section,
although it can also be placed under the operating activities section if the business so chooses.
As financing activities mainly deal with cash inflows (receiving cash from shareholders or
lenders), the total of this section is usually a positive for cash flow.
The final section comprises the net cash increase or decrease for the period and the cash
balance at the beginning and end of the period.
Financial Ratios
1. Liquidity Measurement Ratios

Liquidity ratios attempt to measure a company's ability to pay off its short-term debt
obligations. This is done by comparing a company's most liquid assets (or, those that can
be easily converted to cash), its short-term liabilities. In general, the greater the
coverage of liquid assets to short-term liabilities the better as it is a clear signal that a
company can pay its debts that are coming due in the near future and still fund its
ongoing operations. On the other hand, a company with a low coverage rate should
raise a red flag for investors as it may be a sign that the company will have difficulty
meeting running its operations, as well as meeting its obligations.
a) Current Ratio: The concept behind this ratio is to ascertain whether a company's
short-term assets (cash, cash equivalents, marketable securities, receivables and
inventory) are readily available to pay off its short-term liabilities (notes payable,
current portion of term debt, payables, accrued expenses and taxes). In theory,
the higher the current ratio, the better.
It can be misleading sometimes, as it is not able to liquidate all the current assets
in a short period of time.
b) Quick Ratio: It is a liquidity indicator that further refines the current ratio by
measuring the amount of the most liquid current assets there are to cover
current liabilities. The quick ratio is more conservative than the current ratio
because it excludes inventory and other current assets, which are more difficult
to turn into cash. Therefore, a higher ratio means a more liquid current position.
The basics and use of this ratio are similar to the current ratio in that it gives
users an idea of the ability of a company to meet its short-term liabilities with its
short-term assets. Another beneficial use is to compare the quick ratio with the
current ratio. If the current ratio is significantly higher, it is a clear indication that
the company's current assets are dependent on inventory.
c) Cash Ratio: The cash ratio is an indicator of a company's liquidity that further
refines both the current ratio and the quick ratio by measuring the amount of
cash, cash equivalents or invested funds there are in current assets to cover
current liabilities.
The cash ratio is the most stringent and conservative of the three short-term
liquidity ratios (current, quick and cash). It only looks at the most liquid short-
term assets of the company, which are those that can be most easily used to pay
off current obligations.
The cash ratio is seldom used in financial reporting or by analysts in the
fundamental analysis of a company. It is not realistic for a company to
purposefully maintain high levels of cash assets to cover current liabilities. The
reason being that it's often seen as poor asset utilization for a company to hold
large amounts of cash on its balance sheet, as this money could be returned to
shareholders or used elsewhere to generate higher returns.
d) Cash Conversion Cycle: This liquidity metric expresses the length of time (in
days) that a company uses to sell inventory, collect receivables and pay its
accounts payable. The cash conversion cycle (CCC) measures the number of days
a company's cash is tied up in the the production and sales process of its
operations and the benefit it gets from payment terms from its creditors. The
shorter this cycle, the more liquid the company's working capital position is.
It looks at how quickly the company turns its inventory into sales, and its sales
into cash, which is then used to pay its suppliers for goods and services.
2. Profitability Indicator Ratios
The long-term profitability of a company is vital for both the survivability of the
company as well as the benefit received by shareholders. It is these ratios that can give
insight into the all-important "profit".
a) Profit Margin Analysis: In the income statement, there are four levels of profit
or profit margins - gross profit, operating profit, pretax profit and net profit. The
term "margin" can apply to the absolute number for a given profit level and/or
the number as a percentage of net sales/revenues.Basically, it is the amount of
profit (at the gross, operating, pretax or net income level) generated by the
company as a percent of the sales generated. The objective of margin analysis is
to detect consistency or positive/negative trends in a company's earnings.
Investors need to understand that the absolute numbers in the income

statement don't tell us very much, which is why we must look to margin analysis
to discern a company's true profitability. These ratios help us to keep score, as
measured over time, of management's ability to manage costs and expenses and
generate profits.
Gross Profit Margin - A company's cost of sales, or cost of goods sold, represents
the expense related to labor, raw materials and manufacturing overhead
involved in its production process. This expense is deducted from the company's
net sales/revenue, which results in a company's first level of profit, or gross
profit. The gross profit margin is used to analyze how efficiently a company is
using its raw materials, labor and manufacturing-related fixed assets to generate
profits. A higher margin percentage is a favorable profit indicator.
Operating Profit Margin - By subtracting selling, general and administrative

(SG&A), or operating, expenses from a company's gross profit number, we get
operating income. Management has much more control over operating expenses
than its cost of sales outlays. Thus, investors need to scrutinize the operating
profit margin carefully. Positive and negative trends in this ratio are, for the most
part, directly attributable to management decisions.
Pretax Profit Margin - Again many investment analysts prefer to use a pretax
income number for reasons similar to those mentioned for operating income. In
this case a company has access to a variety of tax-management techniques,
which allow it to manipulate the timing and magnitude of its taxable income.
Net Profit Margin - Often referred to simply as a company's profit margin, the
so-called bottom line is the most often mentioned when discussing a company's
profitability. While undeniably an important number, investors can easily see
from a complete profit margin analysis that there are several income and
expense operating elements in an income statement that determine a net profit
margin.
b) Return On Assets: This ratio indicates how profitable a company is relative to its
total assets. The return on assets (ROA) ratio illustrates how well management is
employing the company's total assets to make a profit. The higher the return,
the more efficient management is in utilizing its asset base. The ROA ratio is
calculated by comparing net income to average total assets, and is expressed as
a percentage.
Businesses require different-sized asset bases that investors need to think about
how they use the ROA ratio. For the most part, the ROA measurement should be
used historically for the company being analyzed. If peer company comparisons
are made, it is imperative that the companies being reviewed are similar in
product line and business type.
c) Return On Equity:This ratio indicates how profitable a company is by comparing
its net income to its average shareholders' equity. The return on equity ratio
(ROE) measures how much the shareholders earned for their investment in the
company. The higher the ratio percentage, the more efficient management is in
utilizing its equity base and the better return is to investors.
Widely used by investors, the ROE ratio is an important measure of a company's

earnings performance. The ROE tells common shareholders how effectively their
money is being employed. Peer company, industry and overall market
comparisons are appropriate; however, it should be recognized that there are
variations in ROEs among some types of businesses.
d) Return On Capital Employed: The return on capital employed (ROCE) ratio,
expressed as a percentage, complements the return on equity (ROE) ratio by
adding a company's debt liabilities, or funded debt, to equity to reflect a
company's total "capital employed". This measure narrows the focus to gain a
better understanding of a company's ability to generate returns from its
available capital base.
The return on capital employed is an important measure of a company's

profitability. Many investment analysts think that factoring debt into a
company's total capital provides a more comprehensive evaluation of how well
management is using the debt and equity it has at its disposal.
3. Debt Ratios: These ratios give users a general idea of the company's overall debt load as
well as its mix of equity and debt. Debt ratios can be used to determine the overall level
of financial risk a company and its shareholders face. In general, the greater the amount
of debt held by a company the greater the financial risk of bankruptcy.
a) Debt Ratio: The debt ratio compares a company's total debt to its total assets,
which is used to gain a general idea as to the amount of leverage being used by a
company. A low percentage means that the company is less dependent on
leverage, i.e., money borrowed from and/or owed to others. The lower the
percentage, the less leverage a company is using and the stronger its equity
position. In general, the higher the ratio, the more risk that company is
considered to have taken on.
The easy-to-calculate debt ratio is helpful to investors looking for a quick take on
a company's leverage. The debt ratio gives users a quick measure of the amount
of debt that the company has on its balance sheets compared to its assets. The
more debt compared to assets a company has, which is signaled by a high debt
ratio, the more leveraged it is and the riskier it is considered to be. Generally,
large, well-established companies can push the liability component of their
balance sheet structure to higher percentages without getting into trouble.
b) Debt-Equity Ratio: The debt-equity ratio is another leverage ratio that compares
a company's total liabilities to its total shareholders' equity. This is a
measurement of how much suppliers, lenders, creditors and obligors have
committed to the company versus what the shareholders have committed.
This easy-to-calculate ratio provides a general indication of a company's equity-
liability relationship and is helpful to investors looking for a quick take on a
company's leverage.
c) Interest Coverage Ratio:The interest coverage ratio is used to determine how
easily a company can pay interest expenses on outstanding debt. The ratio is
calculated by dividing a company's earnings before interest and taxes (EBIT) by
the company's interest expenses for the same period. The lower the ratio, the
more the company is burdened by debt expense. When a company's interest
coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be
questionable.
The ability to stay current with interest payment obligations is absolutely critical
for a company as a going concern. While the non-payment of debt principal is a
seriously negative condition, a company finding itself in financial/operational
difficulties can stay alive for quite some time as long as it is able to service its
interest expenses.
4. Operating Performance Ratios: These ratios look at how well a company turns its assets
into revenue as well as how efficiently a company converts its sales into cash. Basically,
these ratios look at how efficiently and effectively a company is using its resources to
generate sales and increase shareholder value. In general, the better these ratios are,
the better it is for shareholders.
a) Fixed-Asset Turnover: This ratio is a rough measure of the productivity of a
company's fixed assets (property, plant and equipment or PP&E) with respect to
generating sales. For most companies, their investment in fixed assets
represents the single largest component of their total assets. This annual
turnover ratio is designed to reflect a company's efficiency in managing these
significant assets. Simply put, the higher the yearly turnover rate, the better.
There is no exact number that determines whether a company is doing a good

job of generating revenue from its investment in fixed assets. This makes it
important to compare the most recent ratio to both the historical levels of the
company along with peer company and/or industry averages.
b) Sales/Revenue Per Employee: This indicator simply measures the amount of
dollar sales, or revenue, generated per employee. The higher the dollar figurethe
better. Here again, labor-intensive businesses (ex. mass market retailers) will be
less productive in this metric than a high-tech, high product-value manufacturer.
Industry and product-line characteristics will influence this indicator of employee

productivity. Tracking this dollar figure historically and comparing it to peer-
group companies will make this quantitative dollar amount more meaningful in
an analytical sense.
5. Investment Valuation Ratios:
a) Price/Book Value Ratio: A valuation ratio used by investors which compares a
stock's per-share price (market value) to its book value (shareholders' equity).
The price-to-book value ratio, expressed as a multiple (i.e. how many times a
company's stock is trading per share compared to the company's book value per
share), is an indication of how much shareholders are paying for the net assets of
a company. The book value of a company is the value of a company's assets
expressed on the balance sheet. It is the difference between the balance sheet
assets and balance sheet liabilities and is an estimation of the value if it were to
be liquidated.
If a company's stock price (market value) is lower than its book value, it can
indicate one of two possibilities. The first scenario is that the stock is being
unfairly or incorrectly undervalued by investors because of some transitory
circumstance and represents an attractive buying opportunity at a bargain price.
That's the way value investors think. It is assumed that the company's positive
fundamentals are still in place and will eventually lift it to a much higher price
level. On the other hand, if the market's low opinion and valuation of the
company are correct (the way growth investors think), at least over the
foreseeable future, as a stock investment, it will be perceived at its worst as a
losing proposition and at its best as being a stagnant investment.
b) Price/Earnings Ratio: The price/earnings ratio (P/E) is the best known of the
investment valuation indicators. The P/E ratio has its imperfections, but it is
nevertheless the most widely reported and used valuation by investment
professionals and the investing public. The financial reporting of both companies
and investment research services use a basic earnings per share (EPS) figure
divided into the current stock price to calculate the P/E multiple (i.e. how many
times a stock is trading (its price) per each dollar of EPS).
A stock with a high P/E ratio suggests that investors are expecting higher
earnings growth in the future compared to the overall market, as investors are
paying more for today's earnings in anticipation of future earnings growth.
Hence, as a generalization, stocks with this characteristic are considered to be
growth stocks. Conversely, a stock with a low P/E ratio suggests that investors
have more modest expectations for its future growth compared to the market as
a whole.
c) PEG Ratio: The price/earnings to growth ratio, commonly referred to as the PEG
ratio, is obviously closely related to the P/E ratio. The PEG ratio is a refinement
of the P/E ratio and factors in a stock's estimated earnings growth into its
current valuation. By comparing a stock's P/E ratio with its projected, or
estimated, earnings per share (EPS) growth, investors are given insight into the
degree of overpricing or underpricing of a stock's current valuation, as indicated
by the traditional P/E ratio.
The general consensus is that if the PEG ratio indicates a value of 1, this means
that the market is correctly valuing (the current P/E ratio) a stock in accordance
with the stock's current estimated earnings per share growth. If the PEG ratio is
less than 1, this means that EPS growth is potentially able to surpass the
market's current valuation. In other words, the stock's price is being
undervalued. On the other hand, stocks with high PEG ratios can indicate just the
opposite - that the stock is currently overvalued.
Although the PEG ratio improves upon (i.e. provides additional valuation insight)
the P/E ratio, it is still far from perfect. The problem lies with the numerator and
the denominator in the equation. Misreading of a company's and/or analysts'
predictions of future earnings are very common. Also, investor sentiment
regarding a stock's pricing and earnings prospects is usually overly optimistic
during bull markets and overly pessimistic in bear markets.
Recommended Courses
Once you have read the above material and wish to strengthen your fundamentals while
delving deeper into the material, we recommend you get started with the below Basic course
before moving on to the Advanced level course.
1. Basics of Financial Accounting
https://www.coursera.org/learn/wharton-accounting/home/welcome
2. Financial Accounting Advanced
https://www.coursera.org/learn/wharton-financial-accounting
Now some questions for practice!
1. Which of the following measures the Business risk of the firm?

a. Return on Investment
b. Debt Equity Ratio
c. Operating leverage
d. Financial Leverage
e. Interest Coverage Ratio
2. The total debt-equity ratio of Swadeshi Mills Ltd. is 4:3. Its total assets are
Rs. 7,000 Lakh and its short term debt is Rs. 1,000 lakh. If total debt
consists of both short term & long term debts, the amount of long term
debt is
a. Rs. 1,000 Lakh
b. Rs. 1,400 Lakh
c. Rs. 2,000 Lakh
d. Rs. 3,000 Lakh
e. Rs. 3,200 Lakh
3. Which of the following ratio/s use values from both Balance Sheet as well
as income statement?
a. Liquidity Ratio
b. Profitability Ratio
c. Capital Market Ratio
d. Capital Structure Ratio
e. Activity/Turnover Ratio
4. According to Du – Pont Equation of Return on Equity (ROE), other things

remaining constant, which of the following will statement is/are false?
a. An increase in net profit margin will increase the ROE
b. A decrease in debt to assets ratio will increase the ROE
c. A decrease in return on assets will decrease the ROE
d. An increase in the average asset turnover will increase the ROE
e. An increase in equity multiplier will increase ROE
5. AIB Ltd., raised money from the debt market at a rate of 10 percent per
annum to achieve a total debt-equity ratio of 0.6. In the last year, if its
return on investment (ROI) is 15 percent, what will be its return on
equity? (Assume the applicable tax rate to be 40 percent)
a. 9.20 percent
b. 10.80 percent
c. 11.50 percent
d. 12.40 percent
e. 15.00 percent
6. A ratio that compares investors' and creditors' stake in a company?

a. Investor creditor ratio
b. Creditor turnover ratio
c. Debt to Equity Ratio
d. Interest coverage Ratio
7. The best ratio to evaluate short term liquidity is?

a. Current Ratio
b. Working capital
c. Cash Ratio
d. Debt to asset Ratio
8. Firm A has a Return on Equity (ROE) equal to 24%, while firm B has an
ROE of 15% during the same year. Both firms have a total debt ratio (D/V)
equal to 0.8. Firm A has an asset turnover ratio of 0.9, while firm B has an
asset turnover ratio equal to 0.4. From this we know that
a. Firm A has a higher profit margin than firm B
b. Firm B has a higher profit margin than firm A
c. Both firms have same profit margin
d. Firm A has higher equity multiplier than firm B
e. Data insufficient
9. Assume that net sales are increasing faster than the rate of inflation, and
that the company's gross profit rate is falling. The most likely explanation
is:
a. The company's cost of purchasing merchandise is falling
b. Operating expenses are rising
c. Demand for the company's products is very strong
d. The company has achieved an increase in sales volume by reducing its
sales prices
10. Monetrix Corporation earns a rate of return on common stockholders'
equity of 14%. Which of the following will cause the rate of return to
increase?
a. Issuing 9% bonds and investing the proceeds to earn 12%
b. Increasing the size of the cash dividend paid on common stock
c. An increase in company’s P/E Ratio
d. An increase in the market price of the company's stock

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Finance Reading Material

Monetrix – The Finance and Economics Club of MDI

1|Monetrix – The Finance and Economics Club of MDI

Limited Liability Partnership

Private Limited Company

2|Monetrix – The Finance and Economics Club of MDI

Public Limited Company

3|Monetrix – The Finance and Economics Club of MDI

With time, the business grows

The Income Statement measures the fruits of your business efforts.

Like an apple tree, the yield gets reset every year.

4|Monetrix – The Finance and Economics Club of MDI

Previous year balance sheet

Current Year Retained earnings

5|Monetrix – The Finance and Economics Club of MDI

6|Monetrix – The Finance and Economics Club of MDI

Double Entry and the Accrual Basis of Accounting

7|Monetrix – The Finance and Economics Club of MDI

Basic Principles of Accounting

Economic Entity Assumption

Monetary Unit Assumption

8|Monetrix – The Finance and Economics Club of MDI

Going Concern Principle

Because of this basic accounting principle or guideline, an accountant might be allowed to

9|Monetrix – The Finance and Economics Club of MDI

The basic accounting principle of conservatism leads accountants to anticipate or disclose

An asset is officially defined as:

To put it more simply...

So yes, a computer is certainly an asset.

Would debtors or accounts receivable be an asset for your business?

So the full test of whether something is an asset is:

1. DOES YOUR BUSINESS OWN/CONTROL IT?

2. WILL IT BRING YOUR BUSINESS BENEFITS IN THE FUTURE?

3. CAN YOU VALUE IT ACCURATELY?

Liability is officially defined as:=

In other words, a liability is simply...

A debt of the business.

The most common liability is a loan.

Another common liability is called creditors.

Examples of liability accounts reported on a company's balance sheet include:

Owner's (Stockholders') Equity

It is the value of the assets that the owner really owns.

ASSETS = EQUITY + LIABILITIES

Now we will move on to the balance sheet

Non-Current versus Current

This category of assets includes investments in other businesses as well as long-term

REVENUE – EXPENSES = PROFIT

Remember Accrual Basis of accounting?

Accrued means ‘is/are owed’ or ‘payable’ or ‘owing’.

Accrued income is thus income that is owing.

"Owing to who?" you ask.

Well, who earned the income?

You did. Or rather, your business.

 Salaries and wages

Expenses are the opposite of income.

Now we will move on to income statement.

Its full name is the statement of changes in owner's equity.

The format of the statement is shown below:

Before we start, have you heard of this saying?

Proceeds means cash received.

Additions means purchases of additional assets in order to expand the business.

1. Liquidity Measurement Ratios

Investors need to understand that the absolute numbers in the income