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Liquidity Measurement Ratios

2014-12-31 16:12:18.0

Liquidity Measurement Ratios


The first ratios we’ll take a look at are the liquidity 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) and its shortterm
liabilities.




In general, the greater the coverage of liquid assets to short-term liabilities, the better it is,
since it is a clear signal that a company can pay debts that are going to become due in the
near future and it can still fund its on-going operations. On the other hand, a company with a
low coverage rate should raise a red flag for the investors as it may be a sign that the company
will have difficulty meeting running its operations, as well as meeting its debt obligations.


The biggest difference between each ratio is the type of assets used in the calculation. While
each ratio includes current assets, the more conservative ratios will exclude some current
assets as they aren’t as easily converted to cash. The ratios that we’ll look at are the current,
quick and cash ratios and we will also go over the cash conversion cycle, which goes into how
the company turns its inventory into cash.

Current Ratio


The current ratio is a popular financial ratio used to test a company’s liquidity (also referred
to as its current or working capital position) by deriving the proportion of current assets
available to cover current liabilities. 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. In theory, the higher the
current ratio, the better.

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S current assets amounted
to 13,041 (balance sheet), which is the numerator; while current liabilities amounted to 4030
(balance sheet), which is the denominator. By dividing, the equation gives us a current ratio
of 3.24 which can be considered very healthy.


The current ratio is used extensively in financial reporting. However, while easy to understand,
it can be misleading in both a positive and negative sense - i.e., a high current ratio is not
necessarily good, and a low current ratio is not necessarily bad (see chart below).


Here’s why: contrary to popular perception, the ubiquitous current ratio, as an indicator of
liquidity, is flawed because it is conceptually based on the liquidation of all of a company’s
current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors
have to look at a company as a going concern. It’s the time it takes to convert a company’s
working capital assets into cash to pay its current obligations that is the key to its liquidity. In
a word, the current ratio can be “misleading.”


A simplistic, but accurate, comparison of two companies’ current position will illustrate the
weakness of relying on the current ratio or a working capital number (current assets minus
current liabilities) as a sole indicator of liquidity (amounts in Rs. crs.) :

 

 

 




Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of
current assets over current liabilities, a seemingly good current ratio and working capital of
Rs. 300. Company has no current asset/liability margin of safety, a weak current ratio, and
no working capital.


However, to prove the point, what if: (1) both companies’ current liabilities have an average
payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its
account receivables and its inventory turns over just once a year (365 days); and (3) Company
is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).
In this contrived example, company ABC is very illiquid and would not be able to operate
under the conditions described. Its bills are coming due faster than its generation of cash.
You can’t pay bills with working capital; you pay bills with cash! Company’s ‘s seemingly
tight current position is, in effect, much more liquid because of its quicker cash conversion.
When looking at the current ratio, it is important that a company’s current assets can cover
its current liabilities; however, investors should be aware that this is not the whole story on
company liquidity. Try to understand the types of current assets the company has and how
quickly these can be converted into cash to meet current liabilities. This important perspective
can be seen through the cash conversion cycle. By digging deeper into the current assets, you
will gain a greater understanding of a company’s true liquidity.


Quick Ratio


The quick ratio - aka the quick assets ratio or the acid-test ratio - 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.

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S quick assets amounted
to 13,041 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). By
dividing, the equation gives us a quick ratio of 3.24. XYZ being in the services sector does not
have any inventory on its balance sheet and this quick ratio and current ratio come out to be
the same.

Some presentations of the quick ratio calculate quick assets (the formula’s numerator) by
simply subtracting the inventory figure from the total current assets figure. The assumption
is that by excluding relatively less-liquid (harder to turn into cash) inventory, the remaining
current assets are all of the more-liquid variety. Generally, this is close to the truth, but not
always. In some companies, restricted cash, prepaid expenses and deferred income taxes do
not pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstates
more liquid assets and inflates its quick ratio.


The quick ratio is a more conservative measure of liquidity than the current ratio as it removes
inventory from the current assets used in the ratio’s formula. By excluding inventory, the
quick ratio focuses on the more-liquid assets of a company. 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.


While considered more stringent than the current ratio, the quick ratio, because of its
accounts receivable component, suffers from the same deficiencies as the current ratio -
albeit somewhat less. Both the quick and the current ratios assume a liquidation of accounts
receivable and inventory as the basis for measuring liquidity. While theoretically feasible, as a
going concern a company must focus on the time it takes to convert its working capital assets
to cash - that is the true measure of liquidity. Thus, if accounts receivable, as a component of
the quick ratio, have, let’s say, a conversion time of several months rather than several days,
the “quickness” attribute of this ratio is questionable.


Investors need to be aware that the conventional wisdom regarding both the current and
quick ratios as indicators of a company’s liquidity can be misleading.


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.

 

 

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S cash assets amounted
to 9,797 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). By
dividing, the equation gives us a cash ratio of 2.43.


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. It also ignores
inventory and receivables, as there are no assurances that these two accounts can be converted
to cash in a timely matter to meet current liabilities. Very few companies will have enough
cash and cash equivalents to fully cover current liabilities, which isn’t necessarily a bad thing,
so don’t focus on this ratio being above 1:1.


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. While providing an
interesting liquidity perspective, the usefulness of this ratio is limited.


Profitability Indicator Ratios


These ratios, much like the operational performance ratios, give users a good understanding
of how well the company utilized its resources in generating profit and shareholder value. 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 allimportant
“profit”.


We look at four important profit margins, which display the amount of profit a company
generates on its sales at the different stages of an income statement. We’ll also show you how
to calculate the effective tax rate of a company. The last three ratios covered in this section
- Return on Assets, Return on Equity and Return on Capital Employed - detail how effective a
company is at generating income from its resources.


Profit Margin Analysis


In the income statement, there are four levels of profit or profit margins – gross profit,
operating profit, pre-tax 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.
Profit margin analysis uses the percentage calculation to provide a comprehensive measure of
a company’s profitability on a historical basis (3-5 years) and in comparison to peer companies
and industry benchmarks. Basically, it is the amount of profit (at the gross, operating, pre-tax
or net income level) generated by the company as a percentage of the sales generated. The
objective of margin analysis is to detect consistency or positive/negative trends in a company’s
earnings. Positive profit margin analysis translates into positive investment quality. To a large
degree, it is the quality, and growth, of a company’s earnings that drive its stock price.

 

 

 

 

 

 



All the amounts in these ratios are found in the income statement. As of March 31, 2010,
with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of 21,140, which is
the denominator in all of the profit margin ratios. The equations give us the percentage profit
margins as indicated.

 

 

 



Second, income statements in the multi-step format clearly identify the four profit levels.
However, with the single-step format the investor must calculate the gross profit and operating
profit margin numbers. To obtain the gross profit amount, simply subtract the cost of sales
(cost of goods sold) from net sales/revenues. The operating profit amount is obtained by
subtracting the sum of the company’s operating expenses from the gross profit amount.
Generally, operating expenses would include such account captions as ‘selling’, ‘marketing and
administrative’, ‘research and development’, ‘depreciation and amortization’, ‘rental properties’
etc.


Third, 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. The success, or lack thereof, of this
important management function is what determines a company’s profitability. A large growth
in sales will do little for a company’s earnings if costs and expenses grow disproportionately.
Lastly, the profit margin percentage for all the levels of income can easily be translated into a
handy metric used frequently by analysts and often mentioned in investment literature. The
ratio’s percentage represents the number of paises there are in each rupee worth of sales. For
example, using XYZ’S numbers, in every sales rupee for the company in 2010, there’s roughly
35, 31, and 23 paisa of operating, pre-tax, and net income, respectively.
Let’s look at each of the profit margin ratios individually:


Gross Profit Margin


A company’s cost of sales, or cost of goods sold, represents the expense related to labour,
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 analyse how efficiently a company
is using its raw materials, labour and manufacturing-related fixed assets to generate profits.
A higher margin percentage is a favourable profit indicator. Industry characteristics of raw
material costs, particularly as these relate to the stability or lack thereof, have a major effect
on a company’s gross margin. Generally, management cannot exercise complete control over
such costs. Companies without a production process (ex., retailers and service businesses)
don’t have a cost of sales exactly. In these instances, the expense is recorded as a “cost of
merchandise” and a “cost of services”, respectively. With this type of company, the gross
profit margin does not carry the same weight as a producer type company.


Operating Profit Margin


By subtracting selling, general and administrative, 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. A company’s operating income figure is
often the preferred metric (deemed to be more reliable) of investment analysts, versus its net
income figure, for making inter-company comparisons and financial projections.


Pre-tax Profit Margin


Again, many investment analysts prefer to use a pre-tax 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. It behoves investors to take a comprehensive look at a company’s profit margins on
a systematic basis.


Effective Tax Rate


This ratio is a measurement of a company’s tax rate, which is calculated by comparing its income
tax expense to its pre-tax income. This amount will often differ from the company’s stated
jurisdictional rate due to many accounting factors, including foreign exchange provisions. This
effective tax rate gives a good understanding of the tax rate the company faces.






As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had a provision for income
taxes in its income statement of 1,717 (income statement) and pre-tax income of 7,520
(income statement). By dividing, the equation gives us an effective tax rate of 23% for FY
2010.


The variances in this percentage can have a material effect on the net-income figure. Peer
company comparisons of net profit margins can be problematic as a result of the impact of the
effective tax rate on net profit margins. The same can be said of year-over-year comparisons
for the same company. This circumstance is one of the reasons some financial analysts prefer
to use the operating or pre-tax profit figures instead of the net profit number for profitability
ratio calculation purposes.


One could argue that any event that improves a company’s net profit margin is a good one.
However, from a quality of earnings perspective, tax management manoeuvrings (though
may be legitimate) are less desirable than straight-forward positive operational results.
Tax provision volatility of a company’s finances makes an objective judgment of its true or
operational net profit performance difficult to determine. Techniques to lessen the tax burden
are practiced, to one degree or another, by many companies. Nevertheless, a relatively stable
effective tax rate percentage and resulting net profit margin, would seem to indicate that the
company’s operational managers are more responsible for a company’s profitability than the
company’s tax accountants.


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.

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803
(income statement), and average total assets of 19,922 (balance sheet). By dividing, the
equation gives us an ROA of 29% for FY 2010. The need for investment in current and noncurrent
assets varies greatly among companies. Capital-intensive businesses (with a large
investment in fixed assets) are going to be more asset heavy than technology or service
businesses. In the case of capital-intensive businesses, which have to carry a relatively large
asset base, will calculate their ROA based on a large number in the denominator of this ratio.
Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be
generally favoured with a relatively high ROA because of a low denominator number.


It is precisely because 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 analysed. If peer company comparisons are made,
it is imperative that the companies being reviewed are similar in product line and business
type. Simply being categorised in the same industry will not automatically make a company
comparable. As a rule of thumb, investment professionals like to see a company’s ROA come
in at no less than 5%. Of course, there are exceptions to this rule. An important one would
apply to banks, which typically have a lower ROA.


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.

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 4,845
(income statement), and average shareholders’ equity of 19,922 (balance sheet). By dividing,
the equation gives us an ROE of 24.3% for FY 2010. XYZ on account of being a debt free
company has its ROE equal to ROA. If a company has issued preferred stock, investors
wishing to see the return on just common equity may modify the formula by subtracting
the preferred dividends, which are not paid to common shareholders, from net income and
reducing shareholders’ equity by the outstanding amount of preferred equity.


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. Company peers and industry and overall market comparisons are appropriate;
however, it should be recognized that there are variations in ROEs among some types of
businesses. In general, financial analysts consider return on equity ratios in the 15-20%
range as representing attractive levels of investment quality.


While highly regarded as a profitability indicator, the ROE metric does have a recognized
weakness. Investors need to be aware that a disproportionate amount of debt in a company’s
capital structure would translate into a smaller equity base. Thus, a small amount of net income
(the numerator) could still produce a high ROE off a modest equity base (the denominator).

For example, let’s reconfigure XYZ’S debt and equity numbers to illustrate this circumstance.
If we reduce the company’s equity amount by Rs. 9,922 crores and increase its long-term
debt by a corresponding amount, the reconfigured debt-equity relationship will be (figures
in Rs. crores) 9,922 and 10,000, respectively. XYZ’S financial position is obviously much
more highly leveraged, i.e., carrying a lot more debt. However, its ROE would now register a
whopping 58% (5,803 ÷ 10,000), which is quite an improvement over the 29% ROE of the
almost debt-free FY 2010 position of XYZ indicated above. Of course, that improvement in
XYZ’S profitability, as measured by its ROE, comes with a price...a lot more debt and thus a
lot more risk.


The lesson here for investors is that they cannot look at a company’s return on equity in
isolation. A high or low ROE needs to be interpreted in the context of a company’s debt-equity
relationship. The answer to this analytical dilemma can be found by using the return on capital
employed (ROCE) ratio.


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. By comparing net income to the sum of a company’s debt and equity capital, investors
can get a clear picture of how the use of leverage impacts a company’s profitability. Financial
analysts consider the ROCE measurement to be a more comprehensive profitability indicator
because it gauges management’s ability to generate earnings from a company’s total pool of
capital.

As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803
(income statement). The company’s average short-term and long-term borrowings were 0
and the average shareholders’ equity was 19,922 (all the necessary figures are in the 2009
and 2010 balance sheets), the sum of which, 19,922, is the capital employed. By dividing, the
equation gives us an ROCE of 29% for FY 2010.


Often, financial analysts will use operating income (earnings before interest and taxes or
EBIT) as the numerator. There are various takes on what should constitute the debt element
in the ROCE equation, which can be quite confusing.


Our suggestion is to stick with debt liabilities that represent interest-bearing, documented
credit obligations (short-term borrowings, current portion of long-term debt, and long-term
debt) as the debt capital in the formula.

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. The ratios covered in this section
include the debt ratio, which is gives a general idea of a company’s financial leverage as does
the debt-to-equity ratio. The capitalization ratio details the mix of debt and equity while the
interest coverage ratio and the cash flow to debt ratio show how well a company can meet its
obligations.


Overview Of Debt


Before discussing the various financial debt ratios, we need to clear up the terminology used
with “debt” as this concept relates to financial statement presentations. In addition, the debtrelated
topics of “funded debt” and credit ratings are discussed below.


There are two types of liabilities - operational and debt. The former includes balance sheet
accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations,
etc. The latter includes notes payable and other short-term borrowings, the current portion of
long-term borrowings, and long-term borrowings. Often times, in investment literature, “debt”
is used synonymously with total liabilities. In other instances, it only refers to a company’s
indebtedness.


The debt ratios that are explained herein are those that are most commonly used. However,
what companies, financial analysts and investment research services use as components to
calculate these ratios is far from standardized.


In general, debt analysis can be broken down into three categories, or interpretations: liberal,
moderate and conservative.


• Liberal - This approach tends to minimize the amount of debt. It includes only long-term
debt as it is recorded in the balance sheet under noncurrent liabilities.


• Moderate - This approach includes current borrowings (notes payable) and the current
portion of long-term debt, which appear in the balance sheet’s current liabilities; and of
course, the long-term debt. In addition, redeemable preferred stock, because of its debt-like
quality is considered to be debt. Lastly, as a general rule, two-thirds (roughly one-third goes
to interest expense) of the outstanding balance of operating leases, which do not appear in
the balance sheet, are considered debt principal. The relevant figure will be found in the notes
to financial statements and identified as “future minimum lease payments required under
operating leases that have initial or remaining non-cancelable lease terms in excess of one
year.”

• Conservative - This approach includes all the items used in the moderate interpretation
of debt, as well as such non-current operational liabilities such as deferred taxes, pension
liabilities and other post-retirement employee benefits.


Investors may want to look to the middle ground when deciding what to include in a company’s
debt position. With the exception of unfunded pension liabilities, a company’s non-current
operational liabilities represent obligations that will be around, at one level or another, forever
- at least until the company ceases to be a going concern and is liquidated. Also, unlike debt,
there are no fixed payments or interest expenses associated with non-current operational
liabilities. In other words, it is more meaningful for investors to view a company’s indebtedness
and obligations through the company as a going concern, and therefore, to use the moderate
approach to defining debt in their leverage calculations. Funded debt is a term that is seldom
used in financial reporting. Technically, funded debt refers to that portion of a company’s debt
comprised, generally, of long-term, fixed maturity, contractual borrowings. No matter how
problematic a company’s financial condition, holders of these obligations, typically bonds,
cannot demand payment as long as the company pays the interest on its funded debt. In
contrast, long-term bank debt is usually subject to acceleration clauses and/or restrictive
covenants that allow a lender to call its loan, i.e., demand its immediate payment. From an
investor’s perspective, the greater the percentage of funded debt in the company’s total debt,
the better.


Lastly, credit ratings are formal risk evaluations by credit agencies such as CRISIL, ICRA,
CARE, and Fitch - of a company’s ability to repay principal and interest on its debt obligations,
principally bonds and commercial paper. Obviously, investors in both bonds and stocks follow
these ratings rather closely as indicators of a company’s investment quality. If the company’s
credit ratings are not mentioned in their financial reporting, it’s easy to obtain them from the
company’s investor relations department.


The 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.

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995
(balance sheet) and total assets of 22,036 (balance sheet). By dividing, the equation provides
the company with a low leverage as measured by the debt ratio of 9%. 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
signalled 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. However, one thing to
note with this ratio: it isn’t a pure measure of a company’s debt (or indebtedness), as it
also includes operational liabilities, such as accounts payable and taxes payable. Companies
use these operational liabilities as going concerns to fund the day-to-day operations of the
business and aren’t really “debts” in the leverage sense of this ratio. Basically, even if you
took the same company and had one version with zero financial debt and another version
with substantial financial debt, these operational liabilities would still be there, which in some
sense can muddle this ratio. The use of leverage, as displayed by the debt ratio, can be a
double-edged sword for companies. If the company manages to generate returns above their
cost of capital, investors will benefit. However, with the added risk of the debt on its books, a
company can be easily hurt by this leverage if it is unable to generate returns above the cost
of capital. Basically, any gains or losses are magnified by the use of leverage in the company’s
capital structure.


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.
To a large degree, the debt-equity ratio provides another vantage point on a company’s
leverage position, in this case, comparing total liabilities to shareholders’ equity, as opposed
to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that
a company is using less leverage and has a stronger equity position.

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995
(balance sheet) and total shareholders’ equity of 22,306 (balance sheet). By dividing, the
equation provides the company with a relatively low percentage of leverage as measured
by the debt-equity ratio at 9%. A conservative variation of this ratio, which is seldom seen,
involves reducing a company’s equity position by its intangible assets to arrive at a tangible
equity, or tangible net worth, figure. Companies with a large amount of purchased goodwill
form heavy acquisition activity can end up with a negative equity position. The debt-equity
ratio appears frequently in investment literature. However, like the debt ratio, this ratio is not
a pure measurement of a company’s debt because it includes operational liabilities in total
liabilities. Nevertheless, 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. Generally, large, well-established companies can push the liability component of
their balance sheet structure to higher percentages without getting into trouble.


Capitalization Ratio


The capitalization ratio measures the debt component of a company’s capital structure, or
capitalization (i.e., the sum of long-term debt liabilities and shareholders’ equity) to support
a company’s operations and growth. Long-term debt is divided by the sum of long-term debt
and shareholders’ equity. This ratio is considered to be one of the more meaningful of the
“debt” ratios – it delivers the key insight into a company’s use of leverage. There is no right
amount of debt. Leverage varies according to industries, a company’s line of business and its
stage of development. Nevertheless, common sense tells us that low debt and high equity
levels in the capitalization ratio indicate investment quality.

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total long-term debt of
0 (balance sheet), and total long-term debt and shareholders’ equity (i.e., its capitalization) of
22,036 (balance sheet). By dividing, the equation provides the company with a zero leverage
as measured by the capitalization ratio. A company’s capitalization (not to be confused with its
market capitalization) is the term used to describe the makeup of a company’s permanent or
long-term capital, which consists of both long-term debt and shareholders’ equity. A low level
of debt and a healthy proportion of equity in a company’s capital structure is an indication of
financial fitness.


Prudent use of leverage (debt) increases the financial resources available to a company for
growth and expansion. It assumes that management can earn more on borrowed funds than
it pays in interest expense and fees on these funds. However, successful this formula may
seem, it does require a company to maintain a solid record of complying with its various
borrowing commitments.


A company considered too highly leveraged (too much debt) may find its freedom of action
restricted by its creditors and/or have its profitability hurt by high interest costs. Of course,
the worst of all scenarios is having trouble meeting operating and debt liabilities on time and
surviving adverse economic conditions. Lastly, a company in a highly competitive business, if
hobbled by high debt, will find its competitors taking advantage of its problems to grab more
market share. As mentioned previously, the capitalization ratio is one of the more meaningful
debt ratios because it focuses on the relationship of debt liabilities as a component of a
company’s total capital base, which is the capital mobilized by shareholders and lenders.

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.

 

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had earnings before interest
and taxes (operating income) of 7,520 (income statement), and total interest expense of 0
(income statement). This equation provides the company with an Infinite margin of safety due
to lack of leverage. 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. In a
more positive sense, prudent borrowing makes sense for most companies, but the operative
word here is “prudent.” Interest expenses affect a company’s profitability, so the cost-benefit
analysis dictates that borrowing money to fund a company’s assets has to have a positive
effect. An ample interest coverage ratio would be an indicator of this circumstance, as well
as indicating substantial additional debt capacity. Obviously, in this category of investment
quality, XYZ would go to the head of the class.

 

Cash Flow To Debt Ratio


This coverage ratio compares a company’s operating cash flow to its total debt, which, for
purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of
long-term debt and long-term debt. This ratio provides an indication of a company’s ability to
cover total debt with its yearly cash flow from operations. The higher the ratio, the better is
the company’s ability to carry its total debt.

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net cash provided by
operating activities (operating cash flow as recorded in the statement of cash flows) of 5,876
(cash flow statement), and total debt of 0 (balance sheet). By dividing, the equation provides
the company with infinite margin of debt coverage. A more conservative cash flow figure
calculation in the numerator would use a company’s free cash flow (operating cash flow minus
the amount of cash used for capital expenditures).

A more conservative total debt figure would include, in addition to short-term borrowings,
current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirds
of the principal of non-cancel-able operating leases. In the case of XYZ, their debt load is
nil so the resulting cash flow to debt ratio percentage is off the chart. In this instance, this
circumstance would indicate that the company has ample capacity to borrow a significant
amount of money, if it chose to do so, as opposed to indicating its debt coverage capacity.
Under more typical circumstances, a high double-digit percentage ratio would be a sign of
financial strength, while a low percentage ratio could be a negative sign that indicates too
much debt or weak cash flow generation. It is important to investigate the larger factor behind
a low ratio. To do this, compare the company’s current cash flow to debt ratio to its historic
level in order to parse out trends or warning signs.


Operating Performance Ratios


The next series of ratios we’ll look at are the operating performance ratios. Each of these
ratios have differing inputs and measure different segments of a company’s overall operational
performance, but the ratios do give users insight into the company’s performance and
management during the period being measured. 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.


In this section, we’ll look at the fixed-asset turnover ratio and the sales/revenue per employee
ratio, which look at how well the company uses its fixed assets and employees to generate
sales.


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.

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of
(income statement) and average fixed assets, or PP&E, of 2,342 (balance sheet - the average
of yearend 2009 and 2010 PP&E). By dividing, the equation gives us a fixed-asset turnover rate
for FY 2010 of 5.6. Instead of using fixed assets, some asset-turnover ratios would use total
assets. We prefer to focus on the former because, as a significant component in the balance
sheet, it represents a multiplicity of management decisions on capital expenditures. Thus, this
capital investment, and more importantly, its results, is a better performance indicator than
that evidenced in total asset turnover. 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. Before putting too much faith
into this ratio, it’s important to determine the type of company that you are using the ratio on
because a company’s investment in fixed assets is very much linked to the requirements of
the industry in which it conducts its business. Fixed assets vary greatly among companies. For
example, an IT company, like XYZ, has less of a fixed-asset base than a heavy manufacturer
like BHEL. Obviously, the fixed-asset ratio for XYZ will have less relevance than that for BHEL.


Sales/Revenue per Employee


As a gauge of personnel productivity, this indicator simply measures the amount of rupee
sales, or revenue, generated per employee. The higher the figure the better. Here again,
labour-intensive businesses (ex. mass market retailers) will be less productive in this metric
than a high-tech, high product-value manufacturer.

 

 


As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had generated 22,098 in net
sales with an average personnel component for the year of approximately 85,000 employees.
The sales, or revenue, figure is the numerator (income statement), and the average number
of employees for the year is the denominator (annual report) and Sales Per Employee come
out to be Rs. 2,500,000.


An ‘Earnings per Employee’ ratio could also be calculated using net income (as opposed to net
sales) in the numerator.


Industry and product-line characteristics will influence this indicator of employee productivity.
Tracking this figure historically and comparing it to peer-group companies will make this
quantitative amount more meaningful in an analytical sense.


Du-Pont Analysis


The DuPont ratio can be used as a compass in the process of assessing financial performance
of the company by directing the analyst toward significant areas of strength and weakness
evident in the financial statements.

The DuPont ratio is calculated as follows:

 

 


The ratio provides measures in three of the four key areas of analysis, each representing a
compass bearing, pointing the way to the next stage of the investigation.


The DuPont Ratio Decomposition


The DuPont ratio is a good place to begin a financial statement analysis because it measures
the return on equity (ROE). A for-profit business exists to create wealth for its owner(s). ROE
is, therefore, arguably the most important of the key ratios, since it indicates the rate at which
owner wealth is increasing.


The three components of the DuPont ratio, as represented in equation, cover the areas of
profitability, operating efficiency and leverage.


Profitability: Net Profit Margin

Profitability ratios measure the rate at which either sales or capital is converted into profits
at different levels of the operation. As we have seen, the most common are gross, operating
and net profitability, which describe performance at different activity levels. Of the three,
net profitability is the most comprehensive since it uses the bottom line net income in its
measure.


The net profitability for XYZ Technologies in 2010 is:

 

 



A proper analysis of this ratio would include at least three to five years of trend and crosssectional
comparison data. The cross sectional comparison can be drawn from a variety of
sources.


Asset Utilization: Total Asset Turnover


Turnover or efficiency ratios are important because they indicate how well the assets of a
firm are used to generate sales and/or cash. While profitability is important, it doesn’t always
provide the complete picture of how well a company provides a product or service. A company
can be very profitable, but not too efficient. Profitability is based upon accounting measures
of sales revenue and costs. Such measures are generated using the matching principle of
accounting, which records revenue when earned and expenses when incurred. Hence, the
gross profit margin measures the difference between sales revenue and the cost of goods
actually sold during the accounting period. The goods sold may be entirely different from
the goods produced during that same period. Goods produced but not sold will show up as
inventory assets at the end of the year. A firm with abnormally large inventory balances is not
performing effectively, and the purpose of efficiency ratios is to reveal that fact.


The total asset turnover (TAT) ratio measures the degree to which a firm generates sales with
its total asset base. It is important to use average assets in the denominator to eliminate bias
in the ratio calculation. Financial ratio bias is commonly present when combining items from
both the balance sheet and income statement. For example, TAT uses income statement sales
in its numerator and balance sheet assets in the denominator. Income statement items are
flow variables measured over a time interval, while balance sheet items are measured at a
fixed point in time. In cases where the firm has been involved in major change, such as an
expansion project, balance sheet measures taken at the end of the year may misrepresent
the amount of assets available and/or in use over the course of the year. Taking a simple
average for balance sheet items (i.e., ((beginning + ending)/2)) will control for at least some
of this bias and provide a more accurate and meaningful ratio. The limiting assumption is that
the change in the balance sheet occurred evenly over the course of the year, which may not
always be the case.


The measure of total asset turnover for XYZ is:

 

 


Leverage: The Leverage Multiplier


Leverage ratios measure the extent to which a company relies on debt financing in its capital
structure. Debt is both beneficial and costly to a firm. The cost of debt is lower than the cost
of equity, an effect which is enhanced by the tax deductibility of interest payments in contrast
to taxable dividend payments and stock repurchases. If debt proceeds are invested in projects
which return more than the cost of debt, owners keep the residual, and hence, the return
on equity is “leveraged up.” The debt sword, however, cuts both ways. Adding debt creates
a fixed payment required of the firm whether or not it is earning an operating profit, and
therefore, payments may cut into the equity base. Further, the risk of the equity position is
increased by the presence of debt holders having a superior claim to the assets of the firm.
The leverage multiplier employed in the DuPont ratio is directly related to the proportion of
debt in the firm’s capital structure. The measure, which divides average assets by average
equity, can be restated in two ways, as follows:

 

 

 

 

 

 

 


Once again, averages are used to control for potential bias caused by the end-of-year values.
The leverage multiplier for XYZ is:

 

 

 

.

Understanding Financial Statements


As mentioned in Chapter 1, the most important part of fundamental analysis involves delving
into the financial statements or financial reports of companies. Financial information, which
accounting helps to standardize, is presented in the companies’ financial reports. Indian listed
companies must periodically report their financial statements to the investors and regulators.
Why is this so? The laws and rules that govern the securities industry in the India derive
from a simple and straightforward concept: all investors, whether large institutions or private
individuals, should have access to certain basic facts about an investment prior to buying it.
To achieve this, the Securities and Exchange Board of India (SEBI), the market regulator in
India, requires public companies to disclose meaningful financial and other information to
the public. This provides a common pool of knowledge for all investors to use to judge for
themselves if a company’s securities are a good investment. Only through the steady flow of timely,
comprehensive and accurate information can people make sound investment decisions.


Where can one find financial statements?


Listed companies have to send all their shareholders annual reports. In addition, the quarterly
financials of the company can be found on the stock exchanges’ websites and on the website
of the company. Here are the financial statements of a major IT services company, XYZ
Technologies Ltd. (XYZ)


XYZ Technologies Limited


Comparative Balance Sheets


(All figures in Rs. Crs.)











Comparative Income Statements

 

 

 

 

 

 




Statement of Cash Flows

 

 

 

 



The primary and most important source of information about a company are its Annual
Reports, prepared and distributed to the shareholders by law each year. Annual Reports are
usually well presented. A tremendous amount of data is given about the performance of a
company over a period of time. If an Annual Report is impressive about the operations and
future direction, if the company has made a profit and if a reasonable dividend has been
paid, the average investor is typically content in the belief that the company is in good hands.
However, for a fundamental analyst or for that matter any investor, this alone must not be the
criterion by which to judge a company. The intelligent investor must read the annual report in
depth; he must read between and beyond the lines; he must peep behind the figures and find
the truth and only then should he decide whether the company is doing well or not.


The Annual Report is usually broken down into the following specific parts:
1. The Director’s Report
2. The Auditor’s Report
3. The Financial Statements and
4. The Schedules and Notes to the Accounts.


Each of these parts has a purpose and a story to tell.

The Director’s Report


The Director’s Report is a report submitted by the directors of a company to shareholders,
informing them about the performance of the company, under their stewardship:


1. It enunciates the opinion of the directors on the state of the economy and the political
situation vis-à-vis the company.


2. Explains the performance and the financial results of the company in the period under
review. This is an extremely important part. The results and operations of the various
separate divisions are usually detailed and investors can determine the reasons for their
good or bad performance.


3. The Director’s Report details the company’s plans for modernization, expansion and
diversification. Without these, a company will remain static and eventually decline.


4. Discusses the profits earned in the period under review and the dividend recommended
by the directors. This paragraph should normally be read with sane scepticism as the
directors will always argue that the performance was satisfactory. If profits have improved
the reasons stated would invariably be superior technology adopted, intense marketing
and hard work in the face of severe competition etc. If profits are low, adverse economic
conditions are usually blamed for the same.


5. Elaborates on the directors’ views of the company’s prospects for the future.


6. Discusses plans for new acquisitions and investments.


An investor must intelligently evaluate the issues raised in a Director’s Report. If the report
talks about diversification, one must the question that though diversification is a good strategy,
does it make sense for the company? Industry conditions, the management’s knowledge of
the new business must be considered. Although companies must diversify in order to spread
the risks of economic slumps, every diversification may not suit a company. Similarly, all other
issues raised in the Director’s Report should be analysed. Did the company perform as well
as others in the same industry? Is the finance being raised the most logical and beneficial
to the company? It is imperative that the investor read between the lines of the Director’s
Report and find the answers to these and many other questions. In short, a Director’s Report
is valuable and if read intelligently can give the investor a good grasp of the workings of a
company, the problems it faces, the direction it intends taking and its future prospects.


The Auditor’s Report


The auditor represents the shareholders and it is the auditor’s duty to report to the shareholders
and the general public on the stewardship of the company by its directors. Auditors are required
to report whether the financial statements presented do in fact present a true and fair view
of the state of the company. Investors must remember that the auditors are required by law
to point out if the financial statements are true and fair. They are also required to report any
change, such as a change in accounting principles or the non-provision of charges that result
in an increase or decrease in profits. It is really the only impartial report that a shareholder
or investor receives and this alone should spur one to scrutinize the auditor’s report minutely.
Unfortunately, more often than not it is not read. There can be interesting contradictions. It
was stated in the Auditor’s Report of ABC Co. Ltd. for the year 1999-2000 that, “As at the
year-end 31st March 2000 the accumulated losses exceed the net worth of the Company and
the Company has suffered cash losses in the financial year ended 31st March 2000 as well as
in the immediately preceding financial year. In our opinion, therefore, the Company is a sick
industrial company within the meaning of clause (O) of Section 3(1) of the Sick Industrial
Companies (Special Provisions) Act 1985”. The Director’s report however stated, “The financial
year under review has not been a favourable year for the Company as the computer industry
in general continued to be in the grip of recession. High input costs as well as resource
constraints hampered operations. The performance of your Company must be assessed in the
light of these factors. During the year manufacturing operations were curtailed to achieve cost
effectiveness. Your directors are confident that the efforts for increased business volumes and
cost control will yield better results in the current year”. The auditors were of the opinion that
the company was sick whereas the directors spoke optimistically of their hope that the future
would be better! They could not, being directors, state otherwise.


At times, accounting principles are changed or creative and innovative accounting practices
resorted to by some companies in order to show a better result. The effect of these changes
is at times not detailed in the notes to the accounts. The Auditor’s Report will always draw
the attention of the reader to these changes and the effect that these have on the financial
statements. It is for this reason that a careful reading of the Auditor’s Report is not only
necessary but mandatory for an investor.


Financial Statements


The published financial statements of a company in an Annual Report consist of its Balance
Sheet as at the end of the accounting period detailing the financing condition of the company
at that date and the Profit and Loss Account or Income Statement summarizing the
activities of the company for the accounting period and the Statement of Cash Flows for
the accounting period.


Balance Sheet


The Balance Sheet details the financial position of a company on a particular date; the
company’s assets (that which the company owns), and liabilities (that which the company
owes), grouped logically under specific heads. It must however, be noted that the Balance
Sheet details the financial position on a particular day and that the position can be materially
different on the next day or the day after.


Sources of funds


A company has to source funds to purchase fixed assets, to procure working capital and to
fund its business. For the company to make a profit, the funds have to cost less than the
return the company earns on their deployment.


Where does a company raise funds? What are the sources?


Companies raise funds from its shareholders and by borrowing.


a) Shareholders’ Funds (Total Share Capital in XYZ’s Balance Sheet)


A company sources funds from shareholders by the issue of shares. Shareholders’ funds is the
balance sheet value of shareholders’ interest in a company. For the accounts of a company
with no subsidiaries it is total assets minus total liabilities. For consolidated group accounts the
value of minority interests is excluded. Minority interest refers to the portion of a subsidiary
corporation’s stock that is not owned by the parent corporation.


Shareholders’ funds represent the stake shareholders have in the company, the investment
they have made.


Share Capital
Share capital represents the shares issued to the public. This is issued in following ways:

Private Placement - This is done by offering shares to selected individuals or
institutions.

Public Issue - Shares are offered to public. The details of the offer, including the
reasons for raising the money are detailed in a prospectus and it is important that
investors read this.

Rights issues - Companies may also issue shares to their shareholders as a matter of
right in proportion to their holding. So, if an investor has 100 shares and a company
announces a 2:1 rights, the investor stands to gain an additional 200 shares. Rights
issues come at a price which the investors must pay by subscribing to the rights offer.
The rights issues were often offered at a price lower than the company’s market value
and shareholders stood to gain. With the freedom in respect of pricing of shares now
available, companies have begun pricing their offerings nearer their intrinsic value.
Consequently, many of these issues have not been particularly attractive to investors and
several have failed to be fully subscribed. However, strong companies find subscribers to
thier rights issues as investors are of the view that their long term performance would
lead to increase in share prices.

Bonus shares - When a company has accumulated a large reserves out of profits, the
directors may decide to distribute a part of it amongst the shareholders in the form of
bonus. Bonus can be paid either in cash or in the form of shares. Cash bonus is paid
in the form of dividend by the company when it has large accumulated profits as well
as cash. Many a times, a company is not in a position to pay bonus in cash (dividend)
in spite of sufficient profits because of unsatisfactory cash position or because of its
adverse effects on the working capital of the company. In such a case, the company pays
a bonus to its shareholders in the form of shares. Bonus shares are shares issued free to
shareholders by capitalizing reserves. No monies are actually raised from shareholders.
Nothing stops a company from declaring a bonus and dividend together if it has large
accumulated profits as well as cash.


Reserves - Reserves are profits or gains which are retained and not distributed. Companies
have two kinds of reserves - capital reserves and revenue reserves:


• Capital Reserves – Capital reserves are gains that have resulted from an increase
in the value of assets and they are not freely distributable to the shareholders. The
most common capital reserves one comes across are the share premium account
arising from the issue of shares at a premium and the capital revaluation reserve, i.e.
unrealized gain on the value of assets.


• Revenue Reserves - These represent profits from operations ploughed back into the
company and not distributed as dividends to shareholders. It is important that all the
profits are not distributed as funds are required by companies to purchase new assets
to replace existing ones, for expansion and for working capital.


b) Loan Funds
The other source of funds a company has access to is borrowings. Borrowing is often preferred
by companies as it is quicker, relatively easier and the rules that need to be complied with are
much less. The loans taken by companies are either :

Secured loans - These loans are taken by a company by pledging some of its assets
or by a floating charge on some or all of its assets. The usual secured loans a company
has are debentures and term loans.

Unsecured loans - Companies do not pledge any assets when they take unsecured
loans. The comfort a lender has is usually only the good name and credit worthiness of
the company. The more common unsecured loans of a company are fixed deposits and
short term loans. In case a company is dissolved, unsecured lenders are usually paid
after the secured lenders have been paid. Borrowings or credits for working capital
which fluctuate such as bank overdrafts and trade creditors are not normally classified
as loan funds but as current liabilities.


Fixed Assets (Net Block in XYZ’s Balance Sheet) - Fixed assets are assets that a company
owns for use in its business and to produce goods. Typically it could be machinery. They are
not for resale and comprises of land, buildings i.e. offices, warehouses and factories, vehicles,
machinery, furniture, equipment and the like. Every company has some fixed assets though
the nature or kind of fixed assets vary from company to company. A manufacturing company’s
major fixed assets would be its factory and machinery, whereas that of a shipping company
would be its ships. Fixed assets are shown in the Balance Sheet at cost less the accumulated
depreciation. Depreciation is based on the very sound concept that an asset has a useful life
and that after years of toil it wears down. Consequently, it attempts to measure that wear and
tear and to reduce the value of the asset accordingly so that at the end of its useful life, the
asset will have no value.


As depreciation is a charge on profits, at the end of its useful life, the company would have set
aside from profits an amount equal to the original cost of the asset and this could be utilized
to purchase another asset. However, in the inflationary times, this is inadequate and some
companies create an additional reserve to ensure that there are sufficient funds to replace the
worn out asset. The common methods of depreciation are:

Straight line method - The cost of the asset is written off equally over its life.
Consequently, at the end of its useful life, the cost will equal the accumulated
depreciation.

Reducing balance method - Under this method, depreciation is calculated on the
written down value, i.e. cost less depreciation. Consequently, depreciation is higher in
the beginning and lower as the years progress. An asset is never fully written off as
the depreciation is always calculated on a reducing balance.


Land is the only fixed asset that is never depreciated as it normally appreciates in value.
Capital work in progress - factories being constructed, etc. - are not depreciated until it is a
fully functional asset.

Investments


Many companies purchase investments in the form of shares or debentures to earn income or
to utilize cash surpluses profitably. The normal investments a company has are:

Trade investments - Trade investments are normally shares or debentures of
competitors that a company holds to have access to information on their growth,
profitability and other details.

Subsidiary and associate companies - These are shares held in subsidiary or
associate companies. The large business houses hold controlling interest in several
companies through cross holdings in subsidiary and associate companies.

Others - Companies also often hold shares or debentures of other companies for
investment or to park surplus funds.


Investments are also classified as quoted and unquoted investments. Quoted investments
are shares and debentures that are quoted in a recognized stock exchange and can be freely
traded. Unquoted investments are not listed or quoted in a stock exchange. Consequently,
they are not liquid and are difficult to dispose of.

Investments are valued and stated in the balance sheet at either the acquisition cost or
market value, whichever is lower. This is in order to be conservative and to ensure that losses
are adequately accounted for.


Current assets - Current assets are assets owned by a company which are used in the
normal course of business or are generated by the company in the course of business such as
debtors or finished stock or cash.


The rule of thumb is that any asset that is turned into cash within twelve months is a current
asset. Current assets can be divided essentially into three categories :

Converting assets - Assets that are produced or generated in the normal course of
business, such as finished goods and debtors.

Constant assets - Constant assets are those that are purchased and sold without
any add-ons or conversions, such as liquor bought by a liquor store from a liquor
manufacturer.

Cash equivalents - They can be used to repay dues or purchase other assets. The
most common cash equivalent assets are cash in hand and at the bank and loans
given.


The current assets a company has are:


• Inventories - These are arguably the most important current assets that a company
has as it is by the sale of its stocks that a company makes its profits. Stocks, in turn,
consist of:

Raw materials - The primary purchase which is utilized to manufacture the
products a company makes.

Work in progress - Goods that are in the process of manufacture but are yet to
be completed.

Finished goods - The finished products manufactured by the company that are
ready for sale.


Valuation of stocks


Stocks are valued at the lower of cost or net realizable value. This is to ensure that there will
be no loss at the time of sale as that would have been accounted for. The common methods
of valuing stocks are:


FIFO or first in first out - It is assumed under this method that stocks that come in
first would be sold first and those that come in last would be sold last.


LIFO or last in last out - The premise on which this method is based is the opposite
of FIFO. It is assumed that the goods that arrive last will be sold first. The reasoning
is that customers prefer newer materials or products. It is important to ascertain the
method of valuation and the accounting principles involved as stock values can easily
be manipulated by changing the method of valuation.

Debtors - Most companies do not sell their products for cash but on credit and purchasers are
expected to pay for the goods they have bought within an agreed period of time - 30 days or
60 days. The period of credit would vary from customer to customer and from the company
to company and depends on the credit worthiness of the customer, market conditions and
competition. Often customers may not pay within the agreed credit period. This may be due
to laxity in credit administration or the inability of the customers to pay. Consequently, debts
are classified as:


1. Those over six months, and
2. Others


These are further subdivided into;


1. Debts considered good, and
2. Debts considered bad and doubtful


If debts are likely to be bad, they must be provided for or written off. If this is not done,
assets will be overstated to the extent of the bad debt. A write off is made only when there is
no hope of recovery. Otherwise, a provision is made. Provisions may be specific or they may
be general. When amounts are provided on certain identified debts, the provision is termed
specific whereas if a provision amounting to a certain percentage of all debts is made, the
provision is termed general.


Prepaid Expenses - All payments are not made when due. Many payments, such as insurance
premia, rent and service costs, are made in advance for a period of time which may be 3
months, 6 months, or even a year. The portion of such expenses that relates to the next
accounting period are shown as prepaid expenses in the Balance Sheet.


Cash & Bank Balances - Cash in hand in petty cash boxes, safes and balances in bank
accounts are shown under this heading in the Balance Sheet.


Loans & Advances - These are loans that have been given to other corporations, individuals
and employees and are repayable within a certain period of time. This also includes amounts
paid in advance for the supply of goods, materials and services.


Other Current Assets - Other current assets are all amounts due that are recoverable
within the next twelve months. These include claims receivable, interest due on investments
and the like.


Current Liabilities - Current liabilities are amounts due that are payable within the next
twelve months. These also include provisions which are amounts set aside for an expense
incurred for which the bill has not been received as yet or whose cost has not been fully
estimated.

Creditors - Trade creditors are those to whom the company owes money for raw materials
and other articles used in the manufacture of its products. Companies usually purchase these
on credit - the credit period depending on the demand for the item, the standing of the
company and market practice.


Accrued Expenses - Certain expenses such as interest on bank overdrafts, telephone costs,
electricity and overtime are paid after they have been incurred. This is because they fluctuate
and it is not possible to either prepay or accurately anticipate these expenses. However, the
expense has been incurred. To recognize this the expense incurred is estimated based on past
trends and known expenses incurred and accrued on the date of the Balance Sheet.


Provisions - Provisions are amounts set aside from profits for an estimated expense or
loss. Certain provisions such as depreciation and provisions for bad debts are deducted from
the concerned asset itself. There are others, such as claims that may be payable, for which
provisions are made. Other provisions normally seen on balance sheets are those for dividends
and taxation.


Sundry Creditors - Any other amounts due are usually clubbed under the all-embracing title
of sundry creditors. These include unclaimed dividends and dues payable to third parties.


Income Statement


The Profit and Loss account summarizes the activities of a company during an accounting
period which may be a month, a quarter, six months, a year or longer, and the result achieved
by the company. It details the income earned by the company, its cost and the resulting profit
or loss. It is, in effect, the performance appraisal not only of the company but also of its
management - its competence, foresight and ability to lead.


Sales - Sales include the amount received or receivable from customers arising from the sales
of goods and the provision of services by a company. A sale occurs when the ownership of
goods and the consequent risk relating to these goods are passed to the customer in return
for consideration, usually cash. In normal circumstances the physical possession of the goods
is also transferred at the same time. A sale does not occur when a company places goods at
the shop of a dealer with the clear understanding that payment need be made only after the
goods are sold failing which they may be returned. In such a case, the ownership and risks
are not transferred to the dealer nor any consideration paid.


Companies do give trade discounts and other incentive discounts to customers to entice
them to buy their products. Sales should be accounted for after deducting these discounts.
However, cash discounts given for early payment are a finance expense and should be shown
as an expense and not deducted from sales.


There are many companies which deduct excise duty and other levies from sales. There
are others who show this as an expense. It is preferable to deduct these from sales since
the sales figures would then reflect the actual mark-up made by the company on its cost of
production.


Other Income - Companies may also receive income from sources other than from the sale
of their products or the provision of services. These are usually clubbed together under the
heading, other income. The more common items that appear under this title are:

Profit from the sale of assets - Profit from the sale of investments or assets.


Dividends - Dividends earned from investments made by the company in the shares
of other companies.

Rent - Rent received from commercial buildings and apartments leased from the
company.

Interest - Interest received on deposits made and loans given to corporate and other
bodies.


Raw Materials - The raw materials and other items used in the manufacture of a company’s
products. It is also sometimes called the cost of goods sold.


Employee Costs - The costs of employment are accounted for under this head and would
include wages, salaries, bonus, gratuity, contributions made to provident and other funds,
welfare expenses, and other employee related expenditure.


Operating & Other Expenses - All other costs incurred in running a company are called
operating and other expenses, and include.

Selling expenses - The cost of advertising, sales commissions, sales promotion
expenses and other sales related expenses.

Administration expenses - Rent of offices and factories, municipal taxes, stationery,
telephone and telex costs, electricity charges, insurance, repairs, motor maintenance,
and all other expenses incurred to run a company.

Others - These include costs that are not strictly administration or selling expenses,
such as donations made, losses on the sale of fixed assets or investments, miscellaneous
expenditure and the like.


Interest & Finance Charges - A company has to pay interest on money it borrows. This is
normally shown separately as it is a cost distinct from the normal costs incurred in running a
business and would vary from company to company.


The normal borrowings that a company pays interest on are:
1. Bank overdrafts
2. Term loans taken for the purchase of machinery or construction of a factory
3. Fixed deposits from the public
4. Debentures
5. Inter-corporate loans

Depreciation - Depreciation represents the wear and tear incurred by the fixed assets of a
company, i.e. the reduction in the value of fixed assets on account of usage. This is also shown
separately as the depreciation charge of similar companies in the same industry will differ,
depending on the age of the fixed assets and the cost at which they have been bought.


Tax - Most companies are taxed on the profits that they make. It must be remembered
however that taxes are payable on the taxable income or profit and this can differ from the
accounting income or profit. Taxable income is what income is according to tax law, which is
different to what accounting standards consider income to be. Some income and expenditure
items are excluded for tax purposes (i.e. they are not assessable or not deductible) but are
considered legitimate income or expenditure for accounting purposes.


Dividends - Dividends are profits distributed to shareholders. The total profits after tax are
not always distributed – a portion is often ploughed back into the company for its future
growth and expansion. Companies generally pay an interim and / or final dividend. Interim
dividend usually accompanies the company’s interim financial statements. The final dividend
is usually declared after the results for the period have been determined. The final dividend
is proposed at the annual general meeting of the company and paid after the approval of the
shareholders.


Transfer to Reserves - The transfer to reserves is the profit ploughed back into the company.
This may be done to finance working capital, expansion, fixed assets or for some other purpose.
These are revenue reserves and can be distributed to shareholders as dividends.


Contingent Liabilities - Contingent liabilities are liabilities that may arise up on the happening
of an event. It is uncertain however whether the event itself may happen. This is why these
are not provided for and shown as an actual liability in the balance sheet. Contingent liabilities
are detailed in the Financial Statements as a note to inform the readers of possible future
liabilities while arriving at an opinion about the company. The contingent liabilities one normally
encounters are:

Bills discounted with banks - These may crystallize into active liabilities if the bills are
dishonoured.

Gratuity to employees not provided for

Claims against a company not acknowledged or accepted

Excise claims against the company etc.


Schedules and Notes to the Accounts


The schedules and notes to the accounts are an integral part of the financial statements of a
company and it is important that they be read along with the financial statements.


Schedules - The schedules detail pertinent information about the items of Balance Sheet
and Profit & Loss Account. It also details information about sales, manufacturing costs,
administration costs, interest, and other income and expenses. This information is vital for
the analysis of financial statements.


The schedules enable an investor to determine which expenses increased and seek the reasons
for this. Similarly, investors would be able to find out the reasons for the increase or decrease
in sales and the products that are sales leaders. The schedules even give details of stocks and
sales, particulars of capacity and productions, and much other useful information.


Notes - The notes to the accounts are even more important than the schedules because it is
here that very important information relating to the company is stated. Notes can effectively
be divided into:


• Accounting policies - All companies follow certain accounting principles and these
may differ from those of other entities. As a consequence, the profit earned might
differ. Companies have also been known to change (normally increase) their profit by
changing the accounting policies. For instance, ABC Co. Ltd.’s Annual Report stated
among other things, “There has been a change in the method of accounting relating
to interest on borrowings used for capital expenditure. While such interest was fully
written off in the previous years, interest charges incurred during the year have been
capitalized for the period upto the date from which the assets have been put to use.
Accordingly, expenditure transferred to capital account includes an amount of Rs.
46.63 crores towards interest capitalized. The profit before taxes for the year after
the consequential adjustments of depreciation of Rs. 0.12 crore is therefore higher by
Rs. 46.51 crores than what it would have been had the previous basis been followed”.
This means that by changing an accounting policy ABC Co. Ltd. was able to increase
its income by Rs. 46 crore. There could be similar notes on other items in the financial
statements.


The accounting policies normally detailed in the notes relate to:
o How sales are accounted for?
o What the research and development costs are?
o How the gratuity liability is expensed?
o How fixed assets are valued?
o How depreciation is calculated?
o How stock, including finished goods, work in progress, raw materials and
consumable goods are valued?
o How investments are stated in the balance sheet?
o How has the foreign exchange translated?


• Contingent liabilities - As noted earlier, contingent liabilities that might crystallize
upon the happening of an uncertain event. All contingent liabilities are detailed in
the notes to the accounts and it would be wise to read these as they give valuable
insights. The more common contingent liabilities that one comes across in the financial
statements of companies are:


o Outstanding guarantees.
o Outstanding letters of credit.
o Outstanding bills discounted.
o Claims against the company not acknowledged as debts.
o Claim for taxes.
o Cheques discounted.
o Uncalled liability on partly paid shares and debentures.


• Others - It must be appreciated that the purpose of notes to the accounts is to inform
the reader more fully. Consequently, they detail all pertinent factors which affect, or
will affect, the company and its results. Often as a consequence, adjustments may
need to be made to the accounts to unearth the true results. The more common notes
one comes across are:


o Whether provisions for known or likely losses have been made.
o Estimated value of contracts outstanding.
o Interest not provided for.
o Arrangements agreed by the company with third parties.
o Agreement with labour.


The importance of these notes cannot be overstressed. It is imperative that investors read
these carefully.


Cash Flow Statement


Complementing the balance sheet and income statement, the cash flow statement (CFS)
allows investors to understand how a company’s operations are running, where its money is
coming from and how it is being spent.


The Structure of the CFS


The cash flow statement is distinct from the income statement and balance sheet because it
does not include the amount of future incoming and outgoing cash that has been recorded
on credit. Therefore, cash is not the same as net income, which, on the income statement
and balance sheet, includes cash sales and sales made on credit. Cash flow is determined by
looking at three components by which cash enters and leaves a company, its core operations,
investing activities and financing activities.


Cash Flow From Operations


Measuring the cash inflows and outflows caused by core business operations, the
operations component of cash flow reflects how much cash is generated from
a company’s products or services. Generally, changes made in cash, accounts
receivable, depreciation, inventory and accounts payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net income by adding or subtracting
differences in revenue, expenses and credit transactions (appearing on the balance sheet
and income statement) resulting from transactions that occur from one period to the next.
These adjustments are made because non-cash items are calculated into net income (income
statement) and total assets and liabilities (balance sheet). So, because not all transactions
involve actual cash items, many items have to be re-evaluated when calculating cash flow
from operations.


For example, depreciation is not really a cash expense; it is an amount that is deducted from
the total value of an asset that has previously been accounted for. That is why it is added back
into net sales for calculating cash flow. The only time income from an asset is accounted for
in cash flow statement calculations is when the asset is sold.


Changes in accounts receivable on the balance sheet from one accounting period to the
next must also be reflected in cash flow. If accounts receivable decreases, this implies that
more cash has entered the company from customers paying off their credit accounts - the
amount by which accounts receivable has decreased is then added to net sales. If accounts
receivable increases from one accounting period to the next, the amount of the increase
must be deducted from net sales because, although the amounts represented in accounts
receivable are revenue, they are not cash.


An increase in inventory, on the other hand, signals that a company has spent more money to
purchase more raw materials. If the inventory was paid with cash, the increase in the value
of inventory is deducted from net sales. A decrease in inventory would be added to net sales.
If inventory was purchased on credit, an increase in accounts payable would occur on the
balance sheet, and the amount of the increase from one year to the other would be added
to net sales.


The same logic holds true for taxes payable, salaries payable and prepaid insurance. If
something has been paid off, then the difference in the value owed from one year to the
next has to be subtracted from net income. If there is an amount that is still owed, then any
differences will have to be added to net earnings.


Cash Flow From Investing


Changes in equipment, assets or investments relate to cash from investing. Usually cash
changes from investing are a “cash out” item, because cash is used to buy new equipment,
buildings or short-term assets such as marketable securities. However, when a company
divests of an asset, the transaction is considered “cash in” for calculating cash from investing.

Cash Flow From Financing


Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash
from financing are “cash in” when capital is raised, and they’re “cash out” when dividends are
paid. Thus, if a company issues a bond to the public, the company receives cash financing;
however, when interest is paid to bondholders, the company is reducing its cash.


A company can use a cash flow statement to predict future cash flow, which helps with matters
in budgeting. For investors, the cash flow reflects a company’s financial health: basically, the
more cash available for business operations, the better. However, this is not a hard and fast
rule. Sometimes a negative cash flow results from a company’s growth strategy in the form
of expanding its operations.


By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear
picture of what some people consider the most important aspect of a company: how much
cash it generates and particularly, how much of that cash stems from core operations.


Financial Statement Analysis and Forensic Accounting


A comprehensive financial statement analysis provides insights into a firm’s performance
and/or standing in the areas of liquidity, leverage, operating efficiency and profitability. A
complete analysis involves both time series and cross-sectional perspectives. Time series
analysis examines trends using the firm’s own performance as a benchmark. Cross sectional
analysis augments the process by using external performance benchmarks (Industry or peers)
for comparison purposes.


Comparative and Common-size Financial Statements


As seen in the previous NCFM module4, we often use comparative financial statements in
order to compare different financial ratios of a firm with the industry averages and other
peers in the industry whereas we use common-size financial statements in order to compare
performance of a firm or two firms over time. Financial ratios in isolation mean nothing. We
need to observe them change over time or compare financial ratios of a cross section of firms
in order to make sense of them.


Financial Ratios


To find the data used in the examples in this section, please see the XYZ Technologies Limited’s
financial statements given earlier.

 

Combination and Analysis of the Results


Once the three components have been calculated, they can be combined to form the ROE, as
follows:

 

 


While additional measures for prior years would provide the basis for a necessary trend
analysis, this result is not meaningful until it is compared to an industry or best practices
benchmark. The DuPont ratio/or the Indian IT Industry is:


20*1.01 * 1.1 = 22.2%


As can be seen, strengths in XYZ are immediately evident in the comparison of DuPont values
for XYZ and Indian IT Industry. The company appears to be significant in profitability, while
total asset turnover seems to be roughly in line with the industry. The overall industry leverage
is slightly higher than XYZ’Ss zero debt balance sheet. The analyst can now focus on the
company’s profitability. A quick analysis of profitability yields the following result:


Sound financial statement analysis is an integral part of the management process for any
organization. The DuPont ratio, while not the end in itself, is an excellent way to get a quick
snapshot view of the overall performance of a firm in three of the four critical areas of
ratio analysis, profitability, operating efficiency and leverage. By identifying strengths and/or
weaknesses in any of the three areas, the DuPont analysis enables the analyst to quickly focus
his or her detailed study on a particular spot, making the subsequent inquiry both easier and
more meaningful. Some caveats, however, are to be noted.


The DuPont ratio consists of very general measures, drawing from the broadest values on the
balance sheets and income statements (e.g., total assets is the most broad of asset measures).
A DuPont study is not a replacement for detailed, comprehensive analysis. Further, there
may be problems that the DuPont decomposition does not readily identify. For example, an
average outcome for net profitability may mask the existence of a low gross margin combined
with an abnormally high operating margin. Without looking at the two detailed measures,
understanding of the true performance of the firm would be lost.


The DuPont ratio can also be broken into more components called ‘The Extended DuPont’,
depending upon the needs of the analyst In any case, the DuPont can add value, even “on the
fly,” to understand and solving a broad variety of business problems.


Extended DuPont Formula

 

 


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 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. The CCC is also known
as the “cash” or “operating” cycle.

 

 


DIO is computed by
1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day
figure;
2. Calculating the average inventory figure by adding the year’s beginning (previous yearend
amount) and ending inventory figure (both are in the balance sheet) and dividing by 2
to obtain an average amount of inventory for any given year; and
3. Dividing the average inventory figure by the cost of sales per day figure.

For XYZ FY 2010 (in Rs. crores), its DIO would be computed with these figures:

 

 

 



DIO gives a measure of the number of days it takes for the company’s inventory to turn over,
i.e., to be converted to sales, either as cash or accounts receivable. Understandably, being an
IT company, DIO for XYZ comes out to be zero.


DSO is computed by


1. Dividing net sales (income statement) by 365 to get a net sales per day figure;
2. Calculating the average accounts receivable figure by adding the year’s beginning
(previous yearend amount) and ending accounts receivable amount (both figures are in
the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable
for any given year; and
3. Dividing the average accounts receivable figure by the net sales per day figure.


For XYZ FY 2010 (in Rs. crores), its DSO would be computed with these figures:

 

 



DSO gives a measure of the number of days it takes a company to collect on sales that go into
accounts receivables (credit purchases).


DPO is computed by
1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day
figure;
2. Calculating the average accounts payable figure by adding the year’s beginning (previous
yearend amount) and ending accounts payable amount (both figures are in the balance
sheet), and dividing by 2 to get an average accounts payable amount for any given
year; and
3. Dividing the average accounts payable figure by the cost of sales per day figure.


For XYZ FY 2010 (in Rs. crores), its DPO would be computed with these figures:

 



DPO gives a measure of how long it takes the company to pay its obligations to suppliers.
CCC computed:



XYZ’S cash conversion cycle for FY 2005 would be computed with these numbers (rounded):

 

 


Often the components of the cash conversion cycle - DIO, DSO and DPO – are expressed
in terms of turnover as a times (x) factor. For example, in the case of XYZ, its days debtors
outstanding of 57 days would be expressed as turning over 6.4x annually (365 days ÷ 57 days
= 6.4 times). However, actually counting days is more literal and easier to understand when
considering how fast assets turn into cash.


An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it’s
an indicator of the company’s efficiency in managing its important working capital assets;
second, it provides a clear view of a company’s ability to pay off its current liabilities.
It does this by looking 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. Again, while the quick
and current ratios are more often mentioned in financial reporting, investors would be well
advised to measure true liquidity by paying attention to a company’s cash conversion cycle.


The longer the duration of inventory on hand and of the collection of receivables, coupled
with a shorter duration for payments to a company’s suppliers, means that cash is being tied
up in inventory and receivables and used more quickly in paying off trade payables. If this
circumstance becomes a trend, it will reduce, or squeeze, a company’s cash availabilities.
Conversely, a positive trend in the cash conversion cycle will add to a company’s liquidity.


By tracking the individual components of the CCC (as well as the CCC as a whole), an investor
is able to discern positive and negative trends in a company’s all-important working capital
assets and liabilities. For example, an increasing trend in DIO could mean decreasing demand
for a company’s products. Decreasing DSO could indicate an increasingly competitive product,
which allows a company to tighten its buyers’ payment terms. As a whole, a shorter CCC
means greater liquidity, which translates into less of a need to borrow, more opportunity to
realize price discounts with cash purchases for raw materials, and an increased capacity to
fund the expansion of the business into new product lines and markets. Conversely, a longer
CCC increases a company’s cash needs and negates all the positive liquidity qualities just
mentioned.


Current Ratio Vs. The CCC


The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a
strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a
company’s working capital position.

Cash Conversion cycle for XYZ over five years :

 

 

 

 

 

 

 

The Satyam Case and Need for Forensic Accounting


In what became India’s biggest corporate scandal till date, Mr. Ramalinga Raju, founder and
chairman of Satyam Computers Ltd., one of India’s four premier IT companies, admitted of a
fraud through a letter addressed to the board of the company in January 2009.


The Fraud


• There was Rs. 5040 crores worth inflated cash and bank balance
• Non-existent accrued interest of Rs. 376 crores
• Understated liability of Rs. 1230 crores
• Overstated debtor position of Rs. 490 crores
• Overstated Revenues & operating profit by Rs. 588 crores


Added together, it was a discrepancy of Rs. 7724 crores in the accounts for a company having
annual revenues of Rs. 10,000 odd crores.


Satyam’s share price crashed 77% to Rs. 40.25 on the news and the great story for a seemingly
successful Indian IT company ended. Fingers were pointed, concerns were raised, complaints
were filed and dreams were shattered.


The government was quick to act, appointing a new board for Satyam which helped carry out
bidding process for the IT giant and saved the company from extinction.
The Satyam fracas is one more fraud in the long history of misappropriation of resources
given in trust to individuals and institutions. What this entire episode brings to the fore, is the
following:


• Any control system is only as good as the people administering it
• Audits are not a replacement for responsible management
• Laws and regulations cannot deter persons who wish to defeat them – at least temporarily.

In this context, the relevance of forensic accounting and forensic accounts has grown
enormously in recent years. In the interest of organizations and numerous investors who
have direct stake in the financial well-being of the organizations, more and more forensic
accountants should be involved to ward off financial disasters.


The integration of accounting, auditing and investigative skills yields the speciality known as
Forensic Accounting. There is a growing need among analysts, law enforcement professionals,
small business owners, and department managers to better understand basic forensic
accounting principles, how different types of frauds occur and how to investigate a fraud that is
detected in a way that maximizes the chances of successful prosecution of the perpetrator

Brushing up the Basics

2014-12-31 14:48:04.0

Concept of “Time value of Money”


The concept of time value of money arises from the relative importance of an asset now vs.
in future. Assets provide returns and ownership of assets provides access to these returns.
For example, Rs. 100 of today’s money invested for one year and earning 5% interest will
be worth Rs. 105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100
a year from now. Therefore, any wise person would chose to own Rs. 100 now than Rs. 100
in future. In the first option he can earn interest on on Rs. 100 while in the second option he
loses interest. This explains the ‘time value’ of money. Also, Rs. 100 paid now or Rs. 105 paid
exactly one year from now both have the same value to the recipient who assumes 5% as the
rate of interest. Using time value of money terminology, Rs. 100 invested for one year at 5%
interest has a future value of Rs. 105. The method also allows the valuation of a likely stream
of income in the future, in such a way that the annual incomes are discounted and then added
together, thus providing a lump-sum “present value” of the entire income stream. For eg. If
you earn Rs. 5 each for the next two years (at 5% p.a. simple interest) on Rs. 100, you would
receive Rs. 110 after two years. The Rs. 110 you earn, can be discounted at 5% for two years
to arrive at the present value of Rs. 110, i.e. Rs. 100.


Valuing future cash flows, that may arise from an asset such as stocks, is one of the cornerstones
of fundamental analysis. Cash flows from assets make them more valuable now than in the
future and to understand the relative difference we use the concepts of interest and discount
rates. Interest rates provide the rate of return of an asset over a period of time, i.e., in future
and discount rates help us determine what a future value of asset, value that would come to
us in future, is currently worth.


The present value of an asset could be shown to be:

 

 

 


Where
PV = Present Value

FV = Future Value

r = Discount Rate

t = Time


Interest Rates and Discount Factors

 

So, what interest rate should we use while discounting the future cash flows? Understanding
what is called as Opportunity cost is very important here.


Opportunity Cost


Opportunity cost is the cost of any activity measured in terms of the value of the other
alternative that is not chosen (that is foregone). Put another way, it is the benefit you could
have received by taking an alternative action; the difference in return between a chosen
investment and one that is not taken. Say you invest in a stock and it returns 6% over a year.
In placing your money in the stock, you gave up the opportunity of another investment - say,
a fixed deposit yielding 8%. In this situation, your opportunity costs are 2% (8% - 6%).


But do you expect only fixed deposit returns from stocks? Certainly not. You expect to earn
more than the return from fixed deposit when you invest in stocks. Otherwise you are better
off with fixed deposits. The reason you expect higher returns from stocks is because the
stocks are much riskier as compared to fixed deposits. This extra risk that you assume when
you invest in stocks calls for additional return that you assume over other risk-free (or near
risk-free) return.


The discount rate of cost of capital to be used in case of discounting future cash flows to
come up with their present value is termed as Weighted Average Cost of Capital (WACC).

 

 


Where
D = Debt portion of the Total Capital Employed by the firm
TC = Total Capital Employed by the frim (D+E+P)
Kd = Cost of Debt of the Company.
t = Effective tax rate of the firm
E = Equity portion of the Total Capital employed by the firm
P = Preferred Equity portion of the Total Capital employed by the firm
Kp = Cost of Preferred Equity of the firm


The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital Asset
Pricing Model (CAPM)

 

 

 


Or
Where
Rf = Risk-free rate
β = Beta, the factor signifying risk of the firm
Rm = Implied required rate of return for the market


So what discount factors do we use in order to come up with the present value of the future
cash flows from a company’s stock?


Risk-free Rate

The risk-free interest rate is the theoretical rate of return of an investment with zero risk,
including default risk. Default risk is the risk that an individual or company would be unable
to pay its debt obligations. The risk-free rate represents the interest an investor would expect
from an absolutely risk-free investment over a given period of time.


Though a truly risk-free asset exists only in theory, in practice most professionals and academics
use short-dated government bonds of the currency in question. For US Dollar investments,
US Treasury bills are used, while a common choice for EURO investments are the German
government bonds or Euribor rates. The risk-free interest rate for the Indian Rupee for Indian
investors would be the yield on Indian government bonds denominated in Indian Rupee of
appropriate maturity. These securities are considered to be risk-free because the likelihood of
governments defaulting is extremely low and because the short maturity of the bills protect
investors from interest-rate risk that is present in all fixed rate bonds (if interest rates go up
soon after a bond is purchased, the investor misses out on the this amount of interest, till
the bond matures and the amount received on maturity can be reinvested at the new interest
rate).


Though Indian government bond is a riskless security per se, a foreign investor may look at
the India’s sovereign risk which would represent some risk. As India’s sovereign rating is not
the highest (please search the internet for sovereign ratings of India and other countries)
a foreign investor may consider investing in Indian government bonds as not a risk free
investment.


For valuing Indian equities, we will take 10-Yr Government Bond as risk-free interest rate.
(Roughly 7.8% - as of this writing).


Equity Risk Premium


The notion that risk matters and that riskier investments should have higher expected returns
than safer investments, to be considered good investments, is both central to modern finance.
Thus, the expected return on any investment can be written as the sum of the risk-free rate
and a risk premium to compensate for the risk. The equity risk premium reflects fundamental
judgments we make about how much risk we see in an economy/market and what price we
attach to that risk. In effect, the equity risk premium is the premium that investors demand for
the average risk investment and by extension, the discount that they apply to expected cash
flows with average risk. When equity risk premia rises, investors are charging a higher price
for risk and will therefore pay lower prices for the same set of risky expected cash flows.


Equity risk premia are a central component of every risk and return model in finance and is a
key input into estimating costs of equity and capital in both corporate finance and valuation.


The Beta


The Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification. Therefore, Beta measures non-diversifiable risk. It is a relative measure of risk:
the risk of an individual stock relative to the market portfolio of all stocks. Beta is a statistical
measurement indicating the volatility of a stock’s price relative to the price movement of the
overall market. Higher-beta stocks mean greater volatility and are therefore considered to be
riskier but are in turn supposed to provide a potential for higher returns; low-beta stocks pose
less risk but also lower returns.


The market itself has a beta value of 1; in other words, its movement is exactly equal to itself
(a 1:1 ratio). Stocks may have a beta value of less than, equal to, or greater than one. An
asset with a beta of 0 means that its price is not at all correlated with the market; that asset
is independent. A positive beta means that the asset generally tracks the market. A negative
beta shows that the asset inversely follows the market; the asset generally decreases in value
if the market goes up.

 

 

 

where = Beta of security with market

 

 

 


= Covariance between security and market
= Variance of market returns
OR
Where = Coefficient of Correlation between security and market returns


Consider the stock of ABC Technologies Ltd. which has a beta of 0.8. This essentially points to
the fact that based on past trading data, ABC Technologies Ltd. as a whole has been relatively
less volatile as compared to the market as a whole. Its price moves less than the market
movement. Suppose Nifty index moves by 1% (up or down), ABC Technologies Ltd.’s price
would move 0.80% (up or down). If ABC Technologies Ltd. has a Beta of 1.2, it is theoretically
20% more volatile than the market.



Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential
for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. This
idea has been challenged by some, claiming that data shows little relation between beta and
potential returns, or even that lower-beta stocks are both less risky and more profitable.


Beta is an extremely useful tool to consider when building a portfolio. For example, if you are
concerned about the markets and want a more conservative portfolio of stocks to ride out the
expected market decline, you’ll want to focus on stocks with low betas. On the other hand, if
you are extremely bullish on the overall market, you’ll want to focus on high beta stocks in
order to leverage the expected strong market conditions. Beta can also considered to be an
indicator of expected return on investment. Given a risk-free rate of 2%, for example, if the
market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should
return 11% (= 2% + 1.5(8% - 2%)).


Problems with Beta


The Beta is just a tool and as is the case with any tool, is not infallible. While it may seem
to be a good measure of risk, there are some problems with relying on beta scores alone for
determining the risk of an investment.


• Beta is not a sure thing. For example, the view that a stock with a beta of less than 1 will
do better than the market during down periods may not always be true in reality. Beta
scores merely suggest how a stock, based on its historical price movements will behave
relative to the market. Beta looks backward and history is not always an accurate
predictor of the future.


• Beta also doesn’t account for changes that are in the works, such as new lines of
business or industry shifts. Indeed, a stock’s beta may change over time though usually
this happens gradually.


As a fundamental analyst, you should never rely exclusively on beta when picking stocks.
Rather, beta is best used in conjunction with other stock-picking tools.


Risk Adjusted Return (Sharpe Ratio)


The Sharpe ratio / Sharpe index / Sharpe measure / reward-to-variability ratio, is a measure
of the excess return (or risk premium) per unit of risk in an investment asset or a trading
strategy. It is defined as:

 

 


Where, R is the asset return, Rf is the return on a benchmark asset such as the risk free rate of
return, [R − Rf] is the expected value of the excess of the asset return over the benchmark
return and σ is the standard deviation of the asset.


The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the
performance of an asset or a portfolio. The ratio helps to make the performance of one
portfolio comparable to that of another portfolio by making an adjustment for risk. It is excess
return generated for an asset or a portfolio for every one unit of risk. For example, if stock
A generates a return of 15% while stock B generates a return of 12%, it would appear that
stock A is a better performer. However, if stock A, which produced the 15% return but has
much larger risks than stock B (as reflected by standard deviation of stock returns or beta),
it may actually be the case that stock B has a better risk-adjusted return. To continue with
the example, say that the risk free-rate is 5%, and stock A has a standard deviation (risk) of
8%, while stock B has a standard deviation of 5%. The Sharpe ratio for stock A would be 1.25
while stock B’s ratio would be 1.4, which is better than stock A. Based on these calculations,
stock B was able to generate a higher return on a risk-adjusted basis. A ratio of 1 or better is
considered good, 2 and better is very good, and 3 and better is considered excellent.

There are numerous ways of taking investment decisions in the market such as fundamental
and technical analysis as seen in the previous NCFM module2.


Let’s take a look at some reasons why fundamental analysis is used for stock-picking in the
markets?

Efficient Market Hypothesis (EMH)


Market efficiency refers to a condition in which current prices reflect all the publicly available
information about a security. The basic idea underlying market efficiency is that competition
will drive all information into the stock price quickly. Thus EMH states that it is impossible
to ‘beat the market’ because stock market efficiency causes existing share prices to always
incorporate and reflect all relevant information. According to the EMH, stocks always tend
to trade at their fair value on stock exchanges, making it impossible for investors to either
consistently purchase undervalued stocks or sell stocks at inflated prices. As such, it should
be impossible to outperform the overall market through expert stock selection or market timing
and that the only way an investor can possibly obtain higher returns is by purchasing riskier
investments. The EMH has three versions, depending on the level on information available:


Weak form EMH


The weak form EMH stipulates that current asset prices reflect past price and volume
information. The information contained in the past sequence of prices of a security is fully
reflected in the current market price of that security. The weak form of the EMH implies that
investors should not be able to outperform the market using something that “everybody else
knows”. Yet, many financial researchers study past stock price series and trading volume
(using a technique called technical analysis) data in an attempt to generate profits.


Semi-strong form EMH


The semi-strong form of the EMH states that all publicly available information is similarly
already incorporated into asset prices. In other words, all publicly available information is
fully reflected in a security’s current market price. Public information here includes not only
past prices but also data reported in a company’s financial statements, its announcements,
economic factors and others. It also implies that no one should be able to outperform the
market using something that “everybody else knows”. The semi-strong form of the EMH thus
indicates that a company’s financial statements are of no help in forecasting future price
movements and securing high investment returns in the long-term.


2 Please see NCFM’s Investment Analysis and Portfolio Management module for details.


Strong form EMH 


The strong form of the EMH stipulates that private information or insider information too is
quickly incorporated in market prices and therefore cannot be used to reap abnormal trading
profits. Thus, all information, whether public or private, is fully reflected in a security’s current
market price. This means no long-term gains are possible, even for the management of a
company, with access to insider information. They are not able to take the advantage to profit
from information such as a takeover decision which may have been made a few minutes
ago. The rationale to support this is that the market anticipates in an unbiased manner,
future developments and therefore information has been incorporated and evaluated into
market price in a much more objective and informative way than company insiders can take
advantage of.


Although it is a cornerstone of modern financial theory, the EMH is controversial and often
disputed by market experts. In the years immediately following the hypothesis of market
efficiency (EMH), tests of various forms of efficiency had suggested that the markets are
reasonably efficient and beating them was not possible. Over time, this led to the gradual
acceptance of the efficiency of markets. Academics later pointed out a number of instances
of long-term deviations from the EMH in various asset markets which lead to arguments
that markets are not always efficient. Behavioral economists attribute the imperfections in
financial markets to a combination of cognitive biases such as overconfidence, overreaction,
representative bias, information bias and various other predictable human errors in reasoning
and information processing. Other empirical studies have shown that picking low P/E stocks
can increase chances of beating the markets. Speculative economic bubbles are an anomaly
when it comes to market efficiency. The market often appears to be driven by buyers
operating on irrational exuberance, who take little notice of underlying value. These bubbles
are typically followed by an overreaction of frantic selling, allowing shrewd investors to buy
stocks at bargain prices and profiting later by beating the markets. Sudden market crashes
are mysterious from the perspective of efficient markets and throw market efficiency to the
winds. Other examples are of investors, who have consistently beaten the market over long
periods of time, which by definition should not be probable according to the EMH. Another
example where EMH is purported to fail are anomalies like cheap stocks outperforming the
markets in the long term.


Arguments against EMH


Alternative prescriptions about the behaviour of markets are widely discussed these days.
Most of these prescriptions are based on the irrationality of the markets in, either processing
the information related to an event or based on biased investor preferences.

The Behavioural Aspect


Behavioural Finance is a field of finance that proposes psychology-based theories to explain
stock market anomalies. Within behavioural finance, it is assumed that information structure
and the characteristics of market participants systematically influence individuals’ investment
decisions as well as market outcomes.


In a market consisting of human beings, it seems logical that explanations rooted in
human and social psychology would hold great promise in advancing our understanding of
stock market behaviour. More recent research has attempted to explain the persistence of
anomalies by adopting a psychological perspective. Evidence in the psychology literature
reveals that individuals have limited information processing capabilities, exhibit systematic
bias in processing information, are prone to making mistakes, and often tend to rely on the
opinion of others.


The literature on cognitive psychology provides a promising framework for analysing
investors’ behaviour in the stock market. By dropping the stringent assumption of rationality
in conventional models, it might be possible to explain some of the persistent anomalous
findings. For example, the observation of overreaction of the markets to news is consistent
with the finding that people, in general, tend to overreact to new information. Also, people
often allow their decision to be guided by irrelevant points of reference, a phenomenon
called “anchoring and adjustment”. Experts propose an alternate model of stock prices that
recognizes the influence of social psychology. They attribute the movements in stock prices
to social movements. Since there is no objective evidence on which to base their predictions
of stock prices, it is suggested that the final opinion of individual investors may largely reflect
the opinion of a larger group. Thus, excessive volatility in the stock market is often caused by
social “fads” which may have very little rational or logical explanation.


There have been many studies that have documented long-term historical phenomena in
securities markets that contradict the efficient market hypothesis and cannot be captured
plausibly in models based on perfect investor rationality. Behavioural finance attempts to fill
that void.

Regulatory Hindrances

In the real world, many a times there are regulatory distortions on the trading activity of the
stocks such as restrictions on short-selling or on the foreign ownership of a stock etc. causing
inefficiencies in the fair price discovery mechanism. Such restrictions hinder the process of
fair price discovery in the markets and thus represent deviation from the fair value of the
stock. Then there may be some restrictions on the price movement itself (such as price bands
and circuit filters which prevent prices of stocks moving more than a certain percentage
during the day) that may prevent or delay the efficient price discovery mechanism. Also,
many institutional investors and strategic investors hold stocks despite deviation from the fair
value due to lack of trading interest in the stock in the short term and that may cause some
inefficiencies in the price discovery mechanism of the market.


So, does fundamental analysis work?


In the EMH, investors have a long-term perspective and return on investment is determined
by a rational calculation based on changes in the long-run income flows. However, in the
markets, investors may have shorter horizons and returns also represent changes in short-run
price fluctuations. Recent years have witnessed a new wave of researchers who have provided
thought provoking, theoretical arguments and provided supporting empirical evidence to show
that security prices could deviate from their equilibrium values due to psychological factors,
fads, and noise trading. That’s where investors through fundamental analysis and a sound
investment objective can achieve excess returns and beat the market.

Steps in Fundamental Analysis


Fundamental analysis is the cornerstone of investing. In fact all types of investing comprise
studying some fundamentals. The subject of fundamental analysis is also very vast. However,
the most important part of fundamental analysis involves delving into the financial statements.
This involves looking at revenue, expenses, assets, liabilities and all the other financial
aspects of a company. Fundamental analysts look at these information to gain an insight into
a company’s future performance.


Fundamental analysis consists of a systemtatic series of steps to examine the investment
environment of a company and then identify opportunities. Some of these are:


Macroeconomic analysis - which involves analysing capital flows, interest rate cycles,
currencies, commodities, indices etc.


Industry analysis - which involves the analysis of industry and the companies that are
a part of the sector


Situational analysis of a company


• Financial analysis of the company


• Valuation


The previous NCFM module3 focused on macroeconomic and industry analysis, we would
examine company analysis (financials) and valuation in this module.


3 Please see NCFM’s Investment Analysis and Portfolio Management module for details.

What is fundamental analysis?

Fundamental analysis is a stock valuation methodology that uses financial and economic
analysis to envisage the movement of stock prices. The fundamental data that is analysed
could include a company’s financial reports and non-financial information such as estimates of
its growth, demand for products sold by the company, industry comparisons, economy-wide
changes, changes in government policies etc.


The outcome of fundamental analysis is a value (or a range of values) of the stock of the
company called its ‘intrinsic value’ (often called ‘price target’ in fundamental analysts’ parlance).
To a fundamental investor, the market price of a stock tends to revert towards its intrinsic
value. If the intrinsic value of a stock is above the current market price, the investor would
purchase the stock because he believes that the stock price would rise and move towards its
intrinsic value. If the intrinsic value of a stock is below the market price, the investor would
sell the stock because he believes that the stock price is going to fall and come closer to its
intrinsic value.


To find the intrinsic value of a company, the fundamental analyst initially takes a top-down
view of the economic environment; the current and future overall health of the economy as
a whole. After the analysis of the macro-economy, the next step is to analyse the industry
environment which the firm is operating in. One should analyse all the factors that give
the firm a competitive advantage in its sector, such as, management experience, history
of performance, growth potential, low cost of production, brand name etc. This step of the
analysis entails finding out as much as possible about the industry and the inter-relationships
of the companies operating in the industry as we have seen in the previous NCFM module1.
The next step is to study the company and its products.


Some of the questions that should be asked while taking up fundamental analysis of a company
would include:


1. What is the general economic environment in which the company is operating?
Is it conducive or obstructive to the growth of the company and the industry in
which the company is operating?


For companies operating in emerging markets like India, the economic environment
is one of growth, growing incomes, high business confidence etc. As opposed to this a
company may be operating in a developed but saturated market with stagnant incomes,
high competition and lower relative expectations of incremental growth.


1 Please see NCFM’s Investment Analysis and Portfolio Management module for details.

2. How is the political environment of the countries/markets in which the company
is operating or based?


A stable political environment, supported by law and order in society leads to companies
being able to operate without threats such as frequent changes to laws, political
disturbances, terrorism, nationalization etc. Stable political environment also means that
the government can carry on with progressive policies which would make doing business
in the country easy and profitable.


3. Does the company have any core competency that puts it ahead of all the other
competing firms?


Some companies have patented technologies or leadership position in a particular
segment of the business that puts them ahead of the industry in general. For example,
Reliance Industries’ core competency is its low-cost production model whereas Apple’s
competency is its design and engineering capabilities adaptable to music players, mobile
phones, tablets, computers etc.


4. What advantage do they have over their competing firms?


Some companies have strong brands; some have assured raw material supplies while
others get government subsidies. All of these may help firms gain a competitive advantage
over others by making their businesses more attractive in comparison to competitors.
For example, a steel company that has its own captive mines (of iron ore, coal) is
less dependent and affected by the raw material price fluctuations in the marketplace.
Similarly, a power generation company that has entered into power purchase agreements
is assured of the sale of the power that it produces and has the advantage of being
perceived as a less risky business.


5. Does the company have a strong market presence and market share? Or does it
constantly have to employ a large part of its profits and resources in marketing
and finding new customers and fighting for market share?


Competition generally makes companies spend large amounts on advertising, engage
in price wars by reducing prices to increase market shares which may in turn erode
margins and profitability in general. The Indian telecom industry is an example of cut
throat competition eating into companies’ profitability and a vigorous fight for market
share. On the other hand there are very large, established companies which have a
leadership position on account of established, large market share. Some of them have
near-monopoly power which lets them set prices leading to constant profitability


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