Professional Documents
Culture Documents
If competitors match terms, and sales remain constant A/R would Cash would If competitors dont match, and sales double Short-run: Inventory and fixed assets to meet increased sales. A/R , Cash . Company may have to seek additional financing. Long-run: Collections increase and the companys cash position would improve.
What happens if a company depreciates fixed assets over 7 years (as opposed to the current 10 years)?
No effect on physical assets. Fixed assets on the balance sheet would decline. Net income would decline. Tax payments would decline. Cash position would improve.
Purpose of an enterprise
Business as an economic entity exists to make profits: Trading activity
Selling price > Cost of purchase
Buying
Selling
Manufacturing activity:
Buying Processing
Services
Servicing
Stakeholders
We need various entities to come together to run an enterprise and generate returns. Who are the stakeholders in a business?
Investors
Equity holders majority holders, minority shareholders Debt holders including banks and financial institutions
Proprietary
Partnership
Company
Private Ltd.
Public Ltd.
Closely held
Publicly held
No difference between the obligations of the business and the obligations of the individual.
No difference between the obligations of the business and the obligations of the individual partners except when it is Limited Liability Partnership (Registered)
Company is an artificial person, created by law and has perpetual existence. Obligations of the company are separate from those of promoters and management.
Not more than 50 members Shares are not freely transferable. No invitation to public for subscription.
Closely held public limited company (Deemed) Publicly held public limited company (Listed)
Real Account :
Debit(Dr.) what comes in, Credit(Cr.)what goes out Nominal Account : Debit(Dr.) all expenses and losses Credit(Cr.) all incomes and gains Personal Account : Debit(Dr.) the receiver Credit(Cr.) the giver
Assets (Dr.)
Increases(Dr) and Decreases (Cr)
Liabilities(Cr)
Increase (Cr) and Decrease (Dr)
Capital (Cr)
Increase (Cr) and Decrease(Dr)
Accounting Concepts:
Money measurement- Accounting records only those facts that can be expressed in monetary terms. Entity : Accounts are kept for entities as distinguished from the persons associated with those entities. Going concern: Accounting assumes that an entity will continue to exist indefinitely and that it is not about to be liquidated. Cost: Nonmonetary and monetary assets are ordinarily entered in the accounts at the amount paid to acquire them. Dual aspect: Every transaction affects at least two items and preserves the fundamental equations: Assets = Liabilities + Owners equity
Cont.
Accounting Period : Accounting measures activities for a specified interval time( say from 1st April2011 to 31st March 2012) Conservatism: Revenues are recognised only when they are reasonably certain, whereas expenses are recognised as soon as they are reasonably possible. Realization: The amount recognized as revenue is the amount that customers are reasonably certain to pay. Matching: When a given event affects both revenues and expenses, the effect on each should be recognized in the same accounting period. Consistency: Once an entity has decided on a certain accounting method, it will use the same method for all subsequent events of the same character unless it has a sound reason to change methods. Materiality: Insignificant events may be disregarded, but there must be full disclosure of all important information.
Financial statements
Financial statements report the state of financial affairs of an enterprise These are made publicly available for widely held companies, usually free of cost (www.bseindia.com and www.nseindia.com ) For closely held public companies and private companies, the financial statements are reported to the Ministry of Company Affairs
Some of these are available for public viewing (both online as well as physically) for a small fee. (http://www.mca.gov.in )
Balance Sheet Profit & Loss Account and Cash flow statement
Liabilities
Owners capital
Assets
Fixed Assets Land and building Plant and Machinery
Investments
Borrowed funds
Working capital
Working Capital Raw Material Work in progress Finished goods Debtors Cash
The Liability side represent the various sources of funds for an enterprise
These are the liability of the enterprise to the providers of these funds
These are the assets held by the enterprise, that are needed to operate the business (e.g. Office space, factory, raw material, etc.)
The Assets and Liabilities should ALWAYS match. In the Liability side, the portfolio mix of the own funds and borrowed funds is called the Capital Structure of the company Balance sheet is always presented as on a given day, say as at March 31, 2008. It presents a static picture of the assets and liabilities of the enterprise as on that date.
Another way to look at the balance sheet is to match the sources and uses of funds, based on their tenure.
Equity capital Reserves and Surplus Long term borrowings Fixed Assets Investments
The rest are short term on both sides viz. Current assets, current liability and short term debt
Ideally, long term uses must always be funded with long term funds. Financing long term assets with the short term funds creates risks (mainly refinancing risk). Short term investments may be financed by a combination of long term and short term funds, based on business managers preference.
Earning before interest and taxes (EBIT) Profit before taxes (PBT) Profit after tax (PAT)
Less
Retained earnings
Scrap sales, Duty drawback Dividends and interest Rent received Profit on sale of assets / investments Prior-period items
Non-operating income
Extra-ordinary income
Cost of goods sold Direct material Direct labor Direct manufacturing overheads Administrative costs Office rent Salaries Communication costs Other costs Selling and distribution costs Salaries of sales staff Commissions, promotional expenses Advertisement expenses etc.
Depreciation Straight line method Written Down Value method Deferred revenue expenditure R&D expenses Advertisement expenses Product promotion expenses (expenses are charged as capital expenses and amortized over the period of time)
P&L Account presents a snapshot of the performance of an enterprise over a given period (a year, half-year, quarter, etc.)
P&L Account can provide great insights into the functioning of an enterprise. Let us look at a few:
Break even point is the point where there is no profit, no loss Raw material, salary and other administrative expenses are cash expenses
A statement that links the P&L generated based on accrual principle and the Balance Sheet which represents the snapshot on a given date A statement that segregates cash generated and cash used based on the source/end use of the cash Three key components of Cash flow Statement are Cash flow from Operating Activities
Represents the cash generated from the operations of the enterprise a measure of cash profit from the operations Represents the deployment of cash in various assets such as fixed assets, investments, etc. Represents the net cash raised in the form of capital such as equity capital, borrowed funds, etc.
Opening Balance: Cash and Cash Equivalents Add Net Cash from Operating Activities Less Net Cash used in Investing Activities Add Net Cash Generated from Financing Activities = Closing Balance: Cash and Cash Equivalents
Cash flow statement provides the reference check for the quality of profits generated by a company
For instance, if the company reports profits, most of which remain uncollected in the form of debtors, cash flow from operations will be negative, which should prompt an analyst to probe debtors further.
Cash flow statement provides a snapshot of where the cash comes and where the cash goes
Disproportionate cash going into investing activities on a continuous basis could provide a clue on unproductive assets in a company.
Opening and Closing Cash balances should tie in with the actual balance in the bank account as on the opening and closing dates. Acts as a good reference check point.
Negative cash flow from operations is not necessarily a sign of distress, especially for a growing company.
Typically, increase in working capital could be more than the cash profit generated by a growing company
Free Cash flow measures a companys ability to fund its capital expenditures for property, buildings, and equipment and its dividends from its net cash provided by operating activities Free Cash Flow =
net cash provided by operating activities Capital Expenditure Dividends
Cash Equivalents: Short-term, highly liquid investments such as Treasury bills, commercial paper, and money market funds that are made solely for the purpose of generating a return on temporarily idle funds. XBRL: Extensible Business Reporting Language It is a framework that establishes individual tags for elements in structured documents, allowing specific elements to be immediately accessed and aggregated. It dramatically improves the financial reporting process.
Ratio analysis
Some important ratios for analyzing performance of a company: Operating profit margin Net profit margin
Return on Capital Employed Current Ratio Debt: Equity ratio Interest coverage ratio
Ratio analysis
Indicates the business profitability OPM = EBITDA / Operating Income (or Net Sales) Depending on the industry, for healthy companies, OPM ranges from 15% - 50%
Indicates the returns generated by the business for its owners NPM = PAT / Operating Income (or Net Sales) For healthy companies, NPM ranges from 3% - 12%
Several other profitability measures are there (Gross margin, Contribution margin, etc.) but the above two are most commonly used. The profitability margins are very useful for peer comparison (i.e. comparing with other companies in same industry)
Ratio analysis
Return on Capital Employed
Indicates true measure of performance of an enterprise The capital employed in business is Equity capital, reserves and surplus, long term debt and short term debt. Returns generated for all these providers of capital is EBIT. ROCE = EBIT / (Net worth + Total Debt)
The ratio is independent of the industry, capital structure or asset intensity. For healthy companies, ROCE ranges from 15% - 30% If ROCE is less than Interest rate for a company consistently, the company is destroying value for its equity investors / owners
The owners are better off dissolving the company and parking their money in bank fixed deposits and earn interest!!!
The ratio of borrowed funds to owners funds D:E ratio is also known as gearing, leverage or capital structure Gearing = (Long term debt + Short Term debt) (Equity capital + Reserves & Surplus) For most manufacturing companies, D:E less than 2.0x is considered healthy. Higher the ratio, better it is for owners; but at the same time, more risky for lenders
Company has to service higher interest cost if it borrows more; in a recession, the company may be more vulnerable to default on its interest.
Interest
The
coverage
ratio indicates the cushion the company has, to service its interest Interest coverage = EBIT / Interest cost Higher the ratio, better it is for the lenders For healthy companies, Interest coverage ranges from 2.0x to 8.0x. Interest coverage < 1.0x indicates high stress, and probably default on interest payments.
This is a commonly used liquidity ratio, used by banks that lend for working capital Current ratio = Current Assets Current liabilities + Short term debt The ratio indicates the ratio of short term assets to short term liabilities.
Indirectly, the ratio also indicates the proportion of long term assets funded by long term liabilities.
For solvent companies, current ratio ranges between 1.2x to 2.0x Current ratio of < 1.0x indicates that the company may face liquidity problems, as more current liabilities / short term debt are maturing in the next one year, than the current assets that are maturing in the same period.
The Profit earned by the company for each share in the share capital of the enterprise EPS = Profit After Tax Number of Equity shares outstanding EPS is expressed in Rupees. This represents each shareholders claim in the profits of the company, for the relevant period (one year, one quarter, etc.) Two common sub-classification are Basic EPS and Fully Diluted EPS
Basic EPS is computed based on no. of shares outstanding currently Fully Diluted EPS is computed assuming all warrants, convertibles and options are exercised fully.
Ralie Co. is 2006 had net income of $7 million. It had outstanding 100000 shares of $8 preferred stock(i.e., preferred stock whose annual dividend is $8 per share) convertible into 2,00,000 shares of common stock and 1 million shares of common stock. The preferred stock dividend of $8,00,000 must be subtracted from net income in the calculation of basic earnings per share to arrive at net income applicable to common stock.
Ralies Basic EPS= $(7000000-800000)/1000000 shares = 6.20 Diluted EPS = $ 70,00,000/12,00,000 = 5.83
The ratio of current market price of the equity share to the annual earnings per share PE = Current Market Price per share Earnings Per Share (EPS) PE is expressed in ratio or times. When EPS is negative, PE is meaningless. Two common sub-classification are Forward PE and Trailing Twelve Months (TTM) PE
Forward PE is computed using EPS of the next financial year TTM PE is computed using EPS of last 4 quarters
PE ratio has no meaning for unlisted companies as there is no market price for these shares Broadly speaking, PE ratio is in the range of 5-12x during recession times and 10-25x during boom times.
The ratio is also related to the growth in earnings that the company can generate in the next few years.
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