Value relevance of Financial or Accounting Numbers

Book value = Net Worth/No of shares

 Investors
o Equity
 Accounting Returns : ROI, ROE, ROCE, ROTA
 Market Return: Change in price / Old price
 Return = f(fundamentals of the business)
o Debt
 Ability of the entity to pay interest
 Ability of the entity to pay back the principal
 Managers / Banker
 Credit Rating Agencies

Regression for Price is function of Fundamentals of the business .Understanding the past to calculate the future

Financial Statements

 Balance Sheets (assets = Equity + Liability)

 Income Statement (Income -Expenses = Profit)
 CFS (Change in Cash =
o Receipts – Payments (CIH = CFO + CFI + CFF)
o Opening + Receipts – Payments (CIH = CFO + CFI + CFF)
 Relevant Questions for Discussion relating to CFs
o Why is CIH not same as profit?
o Why is CFO not same as profit?
o How different is CFO from OCF and FCF
 CFO vs OCF vs FCF
 CFF : Cash from Financing Decision
o Issue of Shares (Pubic or Rights)
o Issue of Debt ( Bonds/Debentures) Raised
o Less
o Interest
o Dividend(Distribution of Dividend)
o BB of Shares
o Redemption/Repayment of Loans
o Even a negative CFF, the reason for it is not the same always
 CFI: Cash from Investment Decisions
o Sale of FA/Investments
o Dividend/Interest Received
o Less
o Purchased of FA/Investments for Cash
o If negative, we are ideally creating future cash flows
 CFO: Cash from Operations
o Direct Method – Receipts and Payments from Operations
 Cash sales + collections + advances
 Less
 Payments/advances to creditor
 Purchase of goods for cash
 Payment of operating expenses
o Indirect Method – Answers question why CFO is not equal to Profit
 CFO = Profit After Tax +/- Noncash items, Non operating items, credit items
 Depreciation, Amortization, Provision, Bad debt, Discount
 Interest paid and received, Dividend received
 Credit sales, credit purchases, credit expenses
 Cash is not governed by accrual and matching principle but profit is governed by accrual and matching
principle.

 Capital
o Opening capital
o Add
o Issue of shares (public issue) – Increase in Cash
o Issue of shares (rights issue) – Increase in Cash
o Issue of shares (bonus issue) – No effect on cash
o Issue of Shares (Conversion of CDs) – No effect on cash
o Less
o Buy back of Shares
o Redemption of Share (In case of preference)
 Reserves
o Opening
o Add
 Profit
o Less
 Losses
 Dividend
 Stock
 Cash
o Closing
 Fixed Assets
o Opening
o Add
 Purchase on Cash
 Purchase on Credit
  Revaluation
o Less
 Depreciation
 Sale
 Impairment
o Closing

Financial Statements Analysis

1. What
a. Comparison of the following
i. Liquidity: Ability of the firm to meet the short term obligations.
ii. Solvency: Ability to meet long term obligations
iii. Efficiency: Ability to use the asset
iv. Profitability: Ability to generate or ability to distribute profit
1. Performance of a company = f(L,S,E,P) >> Surrogate the performance with
Share price
b. Comparison of the following Decisions
i. Financing
ii. Investment
iii. Operating
1. Performance = f(FD,ID,OD)
2. Why
3. How

Liquidity, FD and Financial Statement Analysis

How to analyze?

1. Comparative Statements
a. Inter firm comparison – Company analysis
b. Intra firm comparison – Industry analysis
2. Common Size Statements
3. Ratio Analysis

Why DTL and DTA is treated as an Equity and not an asset or liability?

Focus of Day2:

Liquidity Position and Financing Decision:

Questions for Discussions:

 How is the company financing its assets

a. Is the company using Short term sources or Long Term sources to finance its business?
 Liquidity: Is the company liquid? What is the ability of the company to meet its short term obligations?
Focus: CA and CS (Current Assets and Current Sources)

Financing Decision:
  How is the company financing its assets
Is the company using Short term sources or Long Term sources to finance its business?
 To find Working Capital is defined as
o CA – CL
o Positive WC
 CA > CL
 Part of the Current assets are financed by NCS
o Negative WC
 CA < CL
 Part of NCA are financed by CS
 What are the components of Current Sources
o Creditors
 Converted into Long term loans
o Outstanding Expenses
o Short Term Loans
o Advances from customers
o Cash Credits
o Borrowings from Sister concerns
 IBCL (Interest Bearing) vs NIBCL (Non interest Bearing)
 Negative is not bad..But depends on whether its IBCL or NIBCL?
o Zero WC
 CA = CL
 All CA are financed by CS
 All NCA are financed by NCS

For Financing Decisions, pick up Debt-Equity Ratio as well as working capital management.

 Liquidity: Is the company liquid? What is the ability of the company to meet its short term obligations?
 Focus: CA and CL
 Ratio: Liquidity Ratio:
o Current Ratio : CA/CL
 CA
o Cash
o Debtors
o Inventory
o Others
 CL
o Creditors
 Converted into Long term loans
o Outstanding Expenses
o Short Term Loans
o Advances from customers
o Cash Credits
o Borrowings from Sister concerns
  CR = 1 (WC is Zero)
 CR > 1 (WC is Positive)
 CR < 1 (WC is Negative)
 Show the ability to meet the short term liabilities
 Higher the CR, better is the liquidity (General Principal)
 CR = 10 (90% is Stock)
 CR = 4
 CR = 1 (90% is Cash)
 Highly liquid is low profitability
o Liquidity is inversely proportional to Profitability
 However before interpreting the Current Ratio, one should be aware of the limitations of
Current Ratio
 It is subject to window dressing (Making it look better)
o Above limitation can be addressed by removing some assets from
current assets
 Liquid Ratio: (Current Assets – Inventory) / CL
 Absolute Cash Ratio: (CA-Inventory-Debtors) / CL
 These two add on to the interpretation of the limitations of the
current ratios.
 ABCR= (cash + near cash items) / CL
 Excess Focus on the quantity and ignores the quality of the assets
o This limitation can be addressed by examining the quality of individual
CA and CL
o Turnover Ratios
 Debtor Days
 No of days of sales remaining as debtors
o Annual Sales = 3650
o Debtors = 500
o DD = 500/(3650/365) = 50
o DD = Debtors / Sales per day
o On average this gives 50 days to recover the
debtors.
o Debtor days should not be seen in isolation,
but should be seen with creditor days
o It is better to have lesser debtor days than
creditor days
 Inventory Days
 Inventory / (COGS per day)
o COGS = Sales – Gross Margin
o COGS = Opening stock + Purchase -
Closing
 Inventory / (Sales per day)
 Creditor Days
 CD = creditor / (purchases per day)
 DD + ID – CD = Working Capital Days = Operating Cycle
 Check the behavior of the debtor days.
Liquidity Ratio

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Solvency and Financing decisions : Focus is capital employed

 Is the company financing its assets with LTS?

o Composition
o LTS= Equity + Long Term Debt = Capital Employed
o CE = TA – CL
o CE = NCA + WC
o Relevant ratio: CE / TA >> When drilled down
 D/TA
 E/TA
 Capital / Total Assets ( Financed by contributed)
 Reserves / Total Assets ( Financed by Generated profit)
 Ke > Kd
o Why do companies have High Equity Finance?
 What % of the assets is financed by LTS?

 Is the company has the ability to meet the LT obligations

o DER : Debt/Equity
 Debt
 Fixed Interest
 Repayable
 No voting right
 Fixed duration
 Tax benefit – No tax on interest
 Kd = Interest(1-Tax Rate) = Int(1-tax)
 Equity
 Dividend: not compulsory
 Irredeemable
o Exception: BB
 Voting Rights
o Exception: Non Voting Shares
o Differential Voting rights
 Ke > Kd
  Ke: Expectations of the Shareholder
o Country : Risk Free Return (Rf)
o Industry : Market Return (Rm)
o Company: Beta
o Ke = Rf + Beta*(Rm-Rf)
o Ke = Risk free return + Risk Premium
o Why do companies have High Equity Finance?
o Why do companies have low DER?
 Interpretation of DER
o DER = 1
o DER > 1
o DER < 1
 To interpret DER, one should examine the impact of DER on the following
o Cost of Capital ( WACC)
o EPS (Profit distributing ability) (DER will not affect Profit generating ability)
o Interest paying ability
 Interest coverage ratio
 Against the Guards – The Remarkable story of Risk – Peter Bernstein

Day 3

 Interest is a function of financing charges

 Distributing ability is given by PAT

 Increase in EPS
o DER
o EBIT
 Interest Coverage Ratio = PBIT/Interest

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Capital Employed = 500000

ROCE = PBIT/CE = 20%
Tax Rate = 30%
Interest = 8%
FV of shares = 5
Ke = 20%

Find EPS, ICR and WACC in the following cases of DER

 1
 3:2
  4:1
Recap

 Reduce the WaCC to maximize the value of the firm.

 Managing WaCC by managing the DER

Profitability

 Profit Generating Ability (PBIT)

 Profit Distributing Ability (PAT)

Tool:
 ROI to understand PGA and PDA
 ROI = Return/Investment
o Depends on the denominator
o Total Assets: TA
 Fixed
 Current
 Investments
o Capital Employed: TA - CL
o Owner’s Fund: TA – CL – LTD
o Capital: TA – CL- LTD – RS
 Or It can be written as
o Capital
o Capital + RS
o Capital + RS + LTD
o Capital + RS + LTD + CL = TS

ROI
 First two are PGA ( Profit Generating Ability)
o ROTA = PBIT / TA or (EBIDTA/TA)
o ROCE = PBIT / CE
 This is Distribution ability
o ROE = PAT/ Equity
o EPS = PAT / No of Shares
o DPS (Dividend Per Share)
 Basic EPS
 Diluted EPS
 Numerator shows the money available to the denominator

ROCE = PBIT / CE = 25%

ROCE is a function of (Operational Decisions, Investment Decisions, Financing Decisions)

Root Cause Analysis of Financial Elements

 OD = PBIT / Sales
o 1-(Expenses/Sales)
 Expenses
 COGS / Sales
 Admin / Sales
o Salary/Sales
 Officers/Sales
 Non Executive Salary/Sales
o Rent/Sales
 o Electricity/Sales
 Sales and Distribution/Sales
 Depreciation/Sales
 Amortization/Sales
 ID = Sales / Total Assets
o Sales/FA
 Sales/Plant
 Sales/Furniture
 Sales/Equipments
 Sales/OFA
o Sales/Investments
o Sales/Current Assets
 Sales/Cash
 Sales/Debtors
 Sales/Inventory
 FD = TA / CE
o TA/LTD
o TA/E
 TA/Capital
 TA/RS

ROCE = PBIT * Sales * Total Assets

Sales * Total Assets * Capital Employed
Dupont Chart can be created for any of ROCE, ROTA and ROE

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Dupont Analysis

 Helps us to understand the drivers of ROI

 Dupont analysis is the process of decomposing the ROI based on OD, ID and FD

Question:
Can a Company destroy the wealth of the Shareholders despite having positive ROE, EPS?
 Yes, if ROE is less than Ke
o One of the limitations of the ROI is that
 Financing Anomalies: ROI ignores cost of Equity, Ke
 Accounting Anomalies: ROI is subject to accounting assumptions
 To address these limitations, we have another Performance indicator called EVA which means Economic
Value Added

o EVA = NOPAT – CC
 NOPAT – Net Operating Profit (before interest) after tax
 CC = Capital Charge = WaCC*CE
 EVA depends on
 NOPAT (Operating Decision)
 CE (Investing Decision) >> By managing assets!! So investing!!!
 WaCC (Financing Decision)
o NOPAT = Sales – COGS – Operating Expense – Depreciation – Tax (No Amortization)!!
o NOPAT : Profit of an Unlevered Firm
o Profit adjusted for financial anomalies and accounting anomalies
DAY 4

 EPS
o Basic EPS = PAT / Weighted Average No of Shares
o Diluted EPS = Adjusted PAT / Adjusted Weighted Average no of shares
 Adjusted No of Shares = Actual number of shares + Potential Shares (For eg. Conv.
Debentures etc)
 Hypothetical EPS that if all bonds would be converted to shares
 Adjusted PAT = PAT + Interest – Tax Benefit on Interest

(EVA / CE) =((NOPAT/CE) - WaCC)

>> EVA = ((NOPAT/CE) - WaCC) * CE
ARR

 EVA will also address the accounting anomalies

o Accounting anomalies arise due to accounting assumptions
 COGS
 Opening stock + Purchases – closing stock
 Depreciation
 Economic Depreciation
 Amortization of R/D, Goodwill
 Lease (OL vs FL)
 Deferred Tax Assets and Liabilities

Common Accounting Adjustment

COGS and Inventory

Principle: Inventory should be valued at Cost or the Market whichever is lower.

 Opening stock = 0
 Purchases = 50000
 Closing Stock = 20000
 MV of Closing Stock = 25000
 For Accounting Calculation: Stock will be shown at Cost or the Market whichever is lower.
o COGS = 0+ 50000 – 20000 = 30000
o IS : Expense COGS = 30000
o BS: Stock = 20000
 For EVA Calculation: Stock will shown at MV
o COGS = 0 + 50000 – 25000 = 25000
o IS : Expense COGS = 30000
o BS: Stock = 20000
 Accounting Adjustments
o Adjustments required converting accounting profit into NOPAT and accounting Capital employed
into economic Capital Employed.
o NOPAT = PAT + Adjustment of Financing anomalies + Adjustments of Accounting Anomalies
o Economic CE = TA – NIBCL +/- Accounting Adjustments
 ROI : GAAP Number
 EVA : Non GAAP Number

 For the EVA, don’t amortize the R&D but impairment the R&D.

Accounting for Tax

  Tax – Income Tax
 IT = Tax Rate * Taxable Profit
Question

Is TP same as Accounting Profit (PBT)? >> Answer is No. TP is not equal to AP (PBT)
 AP is determined as Tax Profit is determined as per tax laws.
 Why is it not same? What are the causes for difference between AP and TP?
o Causes can be classified into two broad categories
 Permanent Differences
 Exempted Incomes
 Disallowed Expenses
 Temporary Differences
 Depreciation
 Amortization
 COGS
Example

 Sales = 500000; COGS = 50000; Dep = 20000; Income from FTZ = 20000. Find AP; Cost of Asset =
100000

o Accounting Profit = 450000

o Find Tax Profit with the following assumptions
 Depreciation for Taxation is 100000
 FTZ income is fully exempted
 TP = 500000 – 50000 – 100000 = 350000
o TP is not equal to AP due to the following
 Depreciation
 Exempted FTZ Incomes.
o Find Tax at 30%
o 30% on 350000 = 105000 (Tax Reporting)
o 30% on 450000 = 135000(Acc Reporting)

 Permanent difference
o 20000 (FTZ)
 Temporary difference
o 80000 (Depreciation)

 Deferred Tax :
o TAX ON DIFFERENCE BETWEEN THE ACCOUNTING PROFIT AND TAX PROFIT
ARISING DUE TO THE TEMPORARY DIFFERENCES
Tax Rate * Temporary Difference = 30%*80000= 24000
 Deferred Tax Liability


Taxation in FS
 Show the tax payable as per the IT rules in the Current Tax
 Show the deferred Tax = Tax Rate * Temporary Difference
Discussion on EVA Case
EVA= NOPAT – (WaCC * CE)
NOPAT= PAT * Interest (1-t) +/- AA
CE = TA – NIBCL+/- AA
CE = E + D+ IBCL +AA

AA
 COGS and Inventory
 Depreciation and PPE
 Amortization and intangibles
 Lease
Example of some AA
 Opening BS
o Retained Profits = 10000
o Closing BS = 15000
o Dividend paid 10000
 Opening RP (BS) + Add Profit (IS) – Cash Dividend (CFS)– Stock Dividend (BS) =
Closing RP ( BS)
 10000 + x – 10000 - = 15000
 Opening BS = DTL = 10000
 Closing BS: DTL = 12000
o Change in DTL is the DT for year

From the Case: Outsource Inc.

Opening DTL: 4850

Closing DTL: 6784
Difference in DTL is the DT for the current year = 6784 – 4850 = 1934

Issue:
 Stock Price is not rising despite good accounting performance
 Work to Do
o Find the
o NOPAT
o Capital Employed
o Capital Charge
o WaCC
o EVA

 PBIT
 PAT
 CFO
 NOPAT
 OCF
 FCF
First three are GAAP driven indicators
Last three are Non GAAP indicators
Sources = Assets
Sources
 Equity
 LTL
 CL
Assets
 PPE
 CA: stock etc
 Investments
o Credit Instruments: Bonds, debentures, loans –
 Interest (Recurring)
 Return of Capital at the end of the tenure
o Equity Instruments: Common Shares or Preference Shares
 Dividend on Common Stock
 Capital Gains
 Right to Vote
 Right to controlling

 Focus will be on Equity Instruments – Equity Shares

Accounting for Equity Instruments

 Accounting at the buying – Initial recognition
o Purchase price
 Subsequent recognition

Accounting at the buying – Initial recognition

o Purchase price
 Purchase price depends on the following
 PV of the FCF
 Sustainable Earnings
 TA – Liabilities – Net Asset
 MP per share
 Negotiation
 PP is called Purchase Consideration: Amount Payable by the buyer to the seller
o Determination of PC
 PV of FCF
 PC = Net Assets = Net Worth = Equity = A-L
 Book value
 Market Value
 PC = MP

o Discharge of PC
 Cash
 Shares
 Debt
 Combination of debt and shares
PC = 5000 (A wants to take over B)

Book Called “Face Value”

Q1) PC = 20*20 = 400

 Initial Recognition = 400 in Investments
Q2) PC = 180 * 15.83 = 2849.4
Subsequent Recognition:

 Dividend Received
 Value of the Investment
o Should be it at cost or at the MV?
 If MV, what to do with the change in the value of the investment!!
 Profit due to revaluation
 Loss due to revaluation
 Treatment of change in value of the investment depends on the type of investment
 HTM
 AFS
 Trading Securities
 Loans and Advance

o Short Term Securities

 Show profit/losses in income sheet
o Long Term Securities
 Show profit/losses in Balance sheet

 If Cost, No problem
 Equity Investments and Nature of Control (Degree of Control):
o If the investment leads to Control:
 Subsidiary company
o If the investment leads to no control but significant influence
 Can stop decision making
 Associated and Subsidiary company
o No Control and no influence
 Just a Investment
Accounting Treatments

If Equity investment is not S or A

 Show the investments at Cost and subsequent treatment will depend on the classification of the investment
(ST or LT)
If Equity Investment is S
 Have control
 Initial recognition = PC
 The books of the subsidiary are to be consolidated with the parent company
o Consolidation of Financial Statements

All assets of the seller are added to the asset of the buyers
All liabilities of the seller are added to the liabilities of the buyers

The Price paid for the investment by the buyer minus the proportionate equity acquired of the seller becomes the
Goodwill of the asset
Good will only appears on the consolidated balance sheet.
Negative Goodwill the excess of equity over the PC

 GW = Excess of PC over the proportionate equity acquired

o Total Equity of seller = 9500
o Proportionate stake taken = 80%
 (80% of Net worth) = 7600
 GW = 0 since the price paid is equal to the stake obtained with the book value
 The difference between Total Equity of the acquired – Acquired Equity of the acquired
 Minority Interest is the term used for this
 o MI = 9500 – 7600 = 1900
 We need not show the Minority Interest if we proportionately consolidate the asset of the
acquired company.
 Subsidiaries
o Consolidation is required
 PC: Determination and Discharge
 Total Equity: Acquired E and Mi
 Goodwill = PC – Acquired Equity
 Associates
o No Consolidation is required
o Investment will be shown by using Equity Method
 Stand Alone
o No Consolidation, No equity method
o Show it as investment
 AFS/ HTM/ FVPL
A has investments as follows
 B 5%
 C 35%
 D 90%

Equity Method in Case of Associate Companies

 Initial Recognition at Purchase Price

o Cash goes down. Investment is on the asset side
 Subsequent Recognition
o Investment should be adjusted to reflect the change in the equity of the seller
o If the equity of the seller increases,
 Investment should be increased to that extent
o Example
 Opening Equity = 9500
 PAT of Current Year = 1000
 Therefore, New Equity = 10500
 A’s Stake= 35%
 =.35 * 10500 = 3675
 Investment has increased by 350
 350 is nothing but the stake on the PAT of the acquired company
o Example
 Old Equity = 10500
 Dividend = 200
 New Equity = 10300
 A’s Share = 35% of 10300 = 3605

 Treatment of Dividend
o Increase the cash
o But don’t record it as an income