Fundamentals of Finance - Module Notes PDF

Broad categories Accounting Finance  Financial Accounting  Corporate Finance  Cost Accounting  Investment Finance  Management Accounting  Personal Finance  International Finance  Behavioral Finance Language of...

Broad categories Accounting Finance  Financial Accounting  Corporate Finance  Cost Accounting  Investment Finance  Management Accounting  Personal Finance  International Finance  Behavioral Finance Language of Business Accounting process Financial Statement  Financial statements are the end products of the accounting process, which reveals the financial results of the specified period and financial position as on particular date. It is the basic and formal annual report through which a business communicates financial information to its various user groups. Definition  American Institute of certified Public Accountants  Accounting is an art of recording, classifying and summarizing in significant manner and in terms of money, transactions and events which are in part at least of financial character and interpreting the result there of. Importance of financial statement 1. Importance to management 2. Importance to Creditors, Bankers etc. 3 Importance to Employees 4. Importance to Investors 5. Importance to Government and regulatory authorities Accounting concepts  Money measurement  Separate entity  Going concern  Cost  Dual aspect  Realization  Accrual  Periodicity  Matching cost and revenue Accounting Conventions  Materiality  Consistency  Conservatism  Full disclosure Accounting Equation  An expression of equality between assets of the firm and claims against it  Total assets= Liabilities + Capital Affecting opposite side  Inc in A, Inc in L (credit purchase)  Inc in A, Inc in OE (issue of shares for cash)  Dec in A , Dec in L (payment to creditors)  Dec in A, Dec in L ( withdrawal made by owner) Affecting same side  Inc in assets , Dec in other assets( collection from debtors)  Dec in L , Inc in other liability(issuing debentures for paying creditors)  Dec in L, Inc in OE ( issue of shares in conversion of debentures) Types of Business  Proprietorship  Partnership  Company Definition of a company  A company is an artificial person created by law. A company means a group of persons associated together for the attainment of a common end, social or economic.  Section 3(1)(i) of the Companies Act, 1956 defines a company as: “a company formed and registered under this Act or an existing Company”.  ‘Existing Company’ means a company formed and registered under any of the earlier Company Laws. Characteristic of a company  SEPARATE LEGAL ENTITY- A company is in law regarded as an entity separate from its members. It has an independent corporate existence.  Any of its member can enter into contracts with it in the same manner as any other individual can and he cannot be held liable for the acts of the company even if he holds virtually the entire share capital.  The company’s money and property belongs to it and not to the shareholders (although the shareholders own the company) Characteristic of a company  COMMON SEAL- Since a company has no physical existence, it must act through its agents and all such contracts entered into by its agents must be under a seal of the company. The common seal acts as the official signature of the company.  TRANSFERABILITY OF SHARES- The capital of a company is divided into parts called shares. These shares are, subject to certain conditions, freely transferable, so that no shareholder is permanently wedded to the company. Characteristic of a company  LIMITED LIABILITY-A company may be a company limited by shares or a company limited by guarantee. In a company limited by shares, the liability of members is limited to the unpaid value of the shares.  PERPETUAL SUCCESSION-Being an artificial person a company never dies, nor does its life depend on the life of its members. Members may come and go but the company can go on forever. It continues to exist even if all its members are dead. The existence of company can be terminated only by law. It means that a company’s existence persists irrespective of the change in the composition of its membership. Characteristic of a company  SEPARATE PROPERTY: As a company is a legal person distinct from its members, it is capable of owning, enjoying and disposing of property in its own name. Although its capital and assets are contributed by its shareholders, they are not the private and joint owners of its property. The company is the real person in which all its property is vested and by which it is controlled, managed and disposed of. Classification of companies Companies are classified on the basis of 1. Incorporation 2. Liability of members 3. Number of members 4. control On the basis of incorporation Statutory company These companies are those in corporate under special act passed by the parliament or the state legislature. The Reserve Bank of India (formed under RBI act, 1934), Life Insurance Corporation of India (formed under LIC Act, 1956). Registered companies The companies that are formed and registered under the Indian companies act. On the Basis of Liability Limited by Shares Liability of the shareholders is limited to the extent of amount unpaid on shares held by them. Necessary for these companies to use the word limited after their name. Limited by Guarantee Liability of the shareholders is limited to the extent of amount undertaken by them to contribute to the assets of the firm in the event of winding up. Unlimited Companies No limit on the liability of its shareholders. Liability of each member extends to whole amount of the company’s debts and liabilities. It may or may not have share capital. On the basis of Number of Members ❑Private Companies  Has minimum paid capital of one lakh rupees or more  Can have a minimum of 2 and maximum of 200 members  Has restricted the right to transfer its shares to any other person  Prohibits any invitation to general public for the subscription of its shares or debentures ❑Public Companies Has a minimum paid-up capital of rupees five lakhs or more Does not restrict the right to transfer its shares to any other person Can invite general public for the subscription of its shares or debentures Can invite or accept deposits from the public  On the basis of control  Holding and Subsidiary Companies  In some cases, a company’s shares might be held fully or partly by another company. Here, the company owning these shares becomes the holding or parent company. Likewise, the company whose shares the parent company owns becomes its subsidiary company.  Holding companies exercise control over their subsidiaries by dictating the composition of their board of directors. Furthermore, parent companies also exercise control by owning more than 50% of their subsidiary companies’ shares.  Associate Companies  Associate companies are those in which other companies have significant influence. This “significant influence” amounts to ownership of at least 20% shares of the associate company.  The other company’s control can exist in terms of the associate company’s business decisions under an agreement. Associate companies can also exist under joint venture agreements Shares, Debentures and retained earnings Shares  A share is one unit of ownership interest in a corporation. A share entitles its owner to a portion of the dividends and residual value of the issuing entity. A shareholder is also entitled to vote on certain issues at periodic shareholder meetings Shares  Equity or Ordinary Share  These shares have voting rights  It doesn’t offer a fixed rate of return.  They are not entitled to get capital on winding up, before paying to preference shareholders.  Preference Shares  It offers a fixed rate of dividend.  Right to get capital on winding up, before anything is paid to equity shareholders. Types of preference shares  Participating Preference Shares  Fixed rate of dividend is guaranteed.  Entitled to share the surplus profit.  Non-Participating Preference Shares  Fixed rate of dividend is guaranteed.  Does not share the surplus profit.  Redeemable Preference Shares  Shares which a company may repay after a fixed period of time or earlier.  Irredeemable Preference Shares  It do not carry the arrangement for redemption.  Shares are repayable only at winding up. Types of preference shares  Cumulative Preference Shares  Fixed rate of dividend is guaranteed.  At the time of inadequate profit, they will not loss anything.  Arrear will get in subsequent years.  Non-Cumulative Preference Shares Fixed rate of dividend is guaranteed. At the time of inadequate profit, they will not get anything.  Convertible Preference Shares  It can be converted into Equity shares within a certain period.  Non-Convertible Preference Shares  It cannot be converted into Equity shares. Debentures  DEBENTURES Debenture is a creditor ship security. It is a document that creates or acknowledge a debt. The debenture holder is entitled to get a fixed rate of interest.  The Companies Act Defines debenture as “debenture stock ,bonds and any other securities of a company, whether constituting a charge or not”. Characteristics of Debentures  Debenture holders are not the owners of the company. They are considered the creditors of the corporation or in other words, the company borrow money from them through issuing debenture.  No voting rights: The debenture-holder is not a shareholder and cannot vote in the company's general meetings.  Fixed rate of interest: A debenture with a fixed charge has a fixed rate of interest. It can be presented as "10% Debenture". They earns a fixed rate of interest but has no share of the profit.  Control: Since, debentures holders are creditors of the company and not its owners, they do not have any control over the management of the company. They do not have any voting rights to elect the directors of the company or on any other matters. But, at the time of the liquidation of the company they have prior claim over share holders and if remain unpaid, they may take control over the company. Types of debentures I. Secured debentures. II. Unsecured debenture. III. Redeemable debentures. IV. Perpetual debentures. V. Convertible debenture. VI. Non-convertible debenture. VII. Coupon rate debenture. VIII. Zero coupon debenture. IX. Registered debenture. X. Bearer debenture Types of debentures  SECURED DEBENTURES : Those debentures which are secured on particular assets called secured debenture. These debenture are also called known as Mortgage debenture  UNSECURED DEBENTURES are those which are not secured fully or partially by a charge on asset. General solvency of the company is the only security for their holders. These are also called naked debenture or simple debenture.  REDEEMABLE DEBENTURES Debentures which are repayable after a stated period of time are called redeemable debenture. Debentures issued by companies are generally of this type,  IRREDEEMABLE DEBENTURES Debentures which are not repayable during the life time of the company are called irredeemable debenture. the company may repay the money at the time of liquidation or on the happening of a contingency or after the expiry of a very long period  CONVERTIBLE DEBENTURES. Debentures which are convertible in to shares or securities at the option of the holders, after a certain period , are called convertible debentures. Convertible debentures are two types ; 1.Fully convertible debentures. 2.Partly convertible debentures.  NON-CONVERTIBLE DEBENTURES Debentures which are not convertible into Shares or other securities of the company are called non- convertible debentures Types of debentures  COUPON RATE DBR.(SPECIFIC RATE) Debentures are usually issued with a specified rate of interest.This specified rate is called Coupon rate.It may be either fixed or floating.The floating interest is usually linked with the bank rate and yields on treasury bond plus a reward for risk ZERO COUPON  A ZERO COUPON BOND is one which does not carry a specified rate of interest. In order to compensate the investors such bonds are issued at a substantial discount.The difference between the face value and issue price is the total amount of interest related to the duration of the bond.  REGISTERED DEBENTURES These are debentures which are payable to the registered holders. The names of the holders of these debentures appear both on the debenture certificate and in the company’s register of debenture holders.  BEARER DEBENTURES Debentures which are payable to the bearer are called bearer debentures.The names of the debenture holders are not recorded in the register of debenture holders. They are treated as negotiable instruments and as such they are transferable by mere delivery  OTHER GOVERNING PRONOUNCEMENTS  TO OVERRIDE COMPANIES ACT 2013  THE RELEVANT LEGISLATION, IF ANY e.g. BANKING REGULATION ACT, INSURANCE ACT, ELECTRICITY ACT ETC.  ACCOUNTING STANDARDS BY MCA  GUIDANCE NOTES ISSUED BY ICAI FINAL ACCOUNTS: LEGAL PROVISONS:SEC 129 (1) The financial statements shall give a true and fair view of the state of affairs of the company or companies, comply with the accounting standards notified under section 133 an d shall be in the form or forms as may be provided for different class or classes of companies in Schedule III. (2) At every annual general meeting of a company, the Board of Directors of the company shall lay before such meeting financial statements for the financial year. FORM OF BALANCE SHEET & P&L ACCOUNT  BALANCE SHEET  SCHEDULE III PART 1  PROFIT & LOSS ACCOUNT  SCHEDULE III PART 2 SALIENT PROVISIONS OF COMPANIES ACT 2013 ON FINAL ACCOUNTS  A vertical format for presentation of balance sheet with classification of Balance Sheet items into current and non- current categories.  A vertical format of Statement of Profit and Loss with classification of expenses based on nature.  Important information is now to be furnished in terms of “Notes to Accounts”. TRADE RECEIVABLES  The term “sundry debtors” has been replaced with the term “trade receivables.” ‘Trade receivables’ are defined as dues arising only from goods sold or services rendered in the normal course of business.  Hence, amounts due on account of other contractual obligations can no longer be included in the trade receivables.  It requires separate disclosure of “trade receivables” outstanding for a period exceeding six months from the date the bill/invoice is due for payment.”  ASSETS  1. An asset shall be classified as current when it satisfies any of the following criteria: (a) it is expected to be realized in, or is intended for sale or consumption in, the company’s normal operating cycle; (b) it is held primarily for the purpose of being traded (c) it is expected to be realized within twelve months after the reporting date; or (d) it is Cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date.  All other assets shall be classified as non-current.” LIABILITY  A liability shall be classified as current when it satisfies any of the following criteria:— (a) it is expected to be settled in the company’s normal operating cycle; (b) it is held primarily for the purpose of being traded; (c) it is due to be settled within twelve months after the reporting date; or (d) the company does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting date.  All other liabilities shall be classified as non-current  MATERIALITY  All significant factors which will have an impact on the mind of the reader should be disclosed. For example, if a large quantity of raw materials is sold and there is a sizable profit or loss, the sale should not be included in the Sales Account; instead, the cost of the materials should be deducted from materials consumed and the profit or loss on sale of raw materials should be separately disclosed in the profit and loss account. MATERIALITY  The reader will then know why the profit or loss is and what it is; the reason will not be clear if the sale of raw materials is added to Sales or deduced from materials consumed. If, however, only a small quantity was sold leading to a rather insignificant profit or loss, separate disclosure is not necessary because such a disclosure will not change the impression of the reader about the profit situation.  BELOW THE LINE ADJUSTMENTS  The name of ‘Profit and Loss Account’ has been changed to “Statement of Profit and Loss”.  This format of Statement of Profit and Loss does not mention any appropriation item on its face. Further, ‘below the line’ adjustments are to be presented under “Reserves and Surplus” in the Balance Sheet.  ITEMS TO BE DISCLOSED SEPERATELY  Any item of income or expense which exceeds one per cent of the revenue from operations or Rs. 100,000 (earlier 1 % of total revenue or Rs. 5,000), whichever is higher, needs to be disclosed separately.  In respect of companies other than finance companies, revenue from operations need to be disclosed separately as revenue from (a) sale of products, (b) sale of services and (c) other operating revenues.  PRIOR PERIOD ITEMS  Prior-Period Items: The rule in India is that once accounts are adopted at the annual general meeting, they cannot be reopened. If any error is discovered, it can be corrected only in the accounts of the subsequent period. Apart from errors, some of the account relating to previous year may come to knowledge or may be ascertained only in the current year. EXAMPLE  Suppose rates have been revised with effect from October, 2016 but the decision was made only in March, 2018, The increased wages for 2017-18 can certainly be added to the 2017-2018 wages but the increased wages for six months of 2016-2017 will also have to be taken out into account. PRIOR PERIOD ITEMS  Errors and other items relating to previous year should be shown separately in the profit and loss account and not clubbed with the item relating to the current year unless the concerned amounts are not material.  Preferably, errors and prior year items should be stated below the line i.e. in the Profit and Loss Appropriation Account.  EXCEPTIONAL ITEMS  Even though they are considered to be part of ordinary business charges, exceptional items must be disclosed due to their sheer size or frequency.  EXTRAORDINARY ITEMS  If expenses or incomes that do not arise in the ordinary course and are material should be stated separately in the profit and loss account. For example, if a fixed asset is sold, its profit or loss has to be shown separately. Another example would be speculation loss or profit; yet another would be subsidy received from government for operational purposes. EXTRAORDINARY ITEMS  An extraordinary item consists of gains or losses included on a company's income statement from events, which are unusual and infrequent in nature.  Extraordinary items are usually explained further in the notes to the financial statements, and they are the result of unforeseen and atypical events.  DISCONTINUED OPERATIONS  A discontinued operation occurs when a segment or certain product line in a company's business has been sold, disposed of or abandoned and is subsequently reported on the company's income statement as income separate from continued operations. CHANGES IN ACCOUNTING POLICIES  It is well known that if there is any change in an accounting policy, say method of valuation of inventories or of change in depreciation, there has to be disclosure about the fact of the change and of the effect on profit or loss resulting from such a change. Ratio Analysis  Why are these Ratios Important ? Every firm is most concerned with its Profitability and Efficiency. Profitability measures are important to company managers, owners, investors, banks and creditors. These show a company's overall efficiency and performance.  IS THE PERFORMANCE GETTING BETTER OR WORSE? HOW IT IS IT GENERATING PERFORMS PROFITS ? COMPARED TO ITS PEERS?  Ability to translate sales into profits Ability to generate returns for its shareholders  Gross Profit Margin Looks at the cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its 1. inventory 2. manufacturing products The calculation is: 𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕 𝑮𝑷𝑴 = × 𝟏𝟎𝟎 𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔  The larger the gross profit margin, the better for the company.  Operating Profit Margin Operating profit is also known as EBIT (earnings before interest and taxes). The operating profit margin looks at EBIT as a percentage of sales. The operating profit margin ratio is a measure of overall operating efficiency, incorporating all of the expenses of ordinary, daily business activity. The calculation is: 𝑬𝑩𝑰𝑻 𝑶𝑷𝑴 = × 𝟏𝟎𝟎 𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔  Net Profit Margin The net profit margin shows how much of each sales shows up as net income after all expenses are paid. For example, if the net profit margin is 5 %, that means that 5 paisa of every Rupee are profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. The calculation is: 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝑵𝑷𝑴 = × 𝟏𝟎𝟎 𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 WIDGET MANUFACTURING COMPANY CONDENSED INCOME STATEMENT FOR YEAR ENDING MAR. 31, 2017 Net Sales 112,500 Cost of Goods Sold (COGS) 85,040 Gross Margin 27,460 Operating Expenses (Marketing & Administrative) 18,950 Net Income Before Taxes (EBIT) 8,510 Less: Income Taxes 4,163 Net Income After Taxes 4,347 27460 𝐺𝑃𝑀 = × 100 = 24% 112500 8510 𝑂𝑃𝑀 = × 100 = 7% 112500 4347 𝑁𝑃𝑀 = × 100 = 4% 112500 Interpretation of Increase/decrease in Gross Profit Margin 1. The selling price of goods has gone up without corresponding increase in the cost of goods sold. 2. The cost of goods sold has gone down without corresponding decrease in the selling price of the goods. 3. Stock at the end may have been undervalued or the opening stock may have been overvalued. Interpretation of Increase/Decrease in Operating Profit Margin- 1) Operating profit is the company’s earnings before interest deductions and taxes.So,increase in operating profit margin shows better control over costs and expenses related to the business operations. 2) Costs related to the manufacturing labor, to the supplies necessary for the manufacturing process or to the direct purchase of inventories may have been cut. 3) Other small expenses like Electricity bills may have been reduced and cheaper insurance coverage may have been chosen so as to reduce the premium. Interpretation of Increase/Decrease in Net Profit Margin- The Net Profit Margin reflects the company’s ability to turn revenue into net profit after accounting for all the expenses of running the business including taxes and debt payments. 1)If the Gross Profit Margin is constant than an increase in Net Profit Margin indicates improvement in the operational efficiency of the business while decrease in NPM indicates degrading operational efficiency. 2)An increase in NPM may also occur if production is increased as the cost of each item decreases without affecting the selling price. Expense ratio 𝑨𝒅𝒎𝒊𝒏+𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔  𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 𝒓𝒂𝒕𝒊𝒐 = × 𝟏𝟎𝟎 𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 𝑨𝒅𝒎𝒊𝒏 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔  𝑨𝒅𝒎𝒊𝒏𝒊𝒔𝒕𝒓𝒂𝒕𝒊𝒗𝒆 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 𝒓𝒂𝒕𝒊𝒐 = × 𝟏𝟎𝟎 𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔  𝑺𝒆𝒍𝒍𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 𝒓𝒂𝒕𝒊𝒐 = × 𝟏𝟎𝟎 𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔 Return On Assets  Measure of how efficiently firm utilizes its assets.  A high value means that company is efficiently generating earnings using its assets 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙  𝑹𝑶𝑨 𝒓𝒂𝒕𝒊𝒐 = 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 Return On Equity  Measures a corporation’s profitability by revealing how much profit a company generates with the money that shareholders have invested.  Shareholder’s fund doesn’t include preference shares. 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙−𝑷𝒓𝒆𝒇.𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅  𝑹𝑶𝑬 𝒓𝒂𝒕𝒊𝒐 = 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒇𝒖𝒏𝒅 Return On Capital Employed  Measures company’s profitability with which its capital is employed.  Unlike ROE, which only analyzes profitability related to company common equity, it also considers debt and other liabilities as well. 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙  𝑹𝑶𝑪𝑬 𝒓𝒂𝒕𝒊𝒐 = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅 Cap employed= shareholder’s fund + total debt OR Cap employed = Total assets-current liabilities Earning Per Share  EPS is the portion of the company’s profit allocated to each share of the stock.  Really important tool to gauge the profitability of a company. 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙  𝑬𝑷𝑺 = 𝑵𝒐.𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙  𝑫𝒊𝒍𝒖𝒕𝒆𝒅 𝑬𝑷𝑺 = 𝑵𝒐.𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔+𝒄𝒐𝒏𝒗𝒆𝒓𝒕𝒊𝒃𝒍𝒆 𝒅𝒆𝒃𝒕+𝒄𝒐𝒏𝒗𝒆𝒓𝒕𝒊𝒃𝒍𝒆 𝒑𝒓𝒆𝒇 Dividend Per Share  DPS is the total dividend paid out by the company for every share of the stock.  Something that investors look for. 𝑻𝒐𝒕𝒂𝒍 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝑷𝒂𝒊𝒅  𝑫𝑷𝑺 = 𝑵𝒐.𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 Dividend Payout Ratio  Dividend payout ratio provides an indication about how much money a company is returning as compared to its earnings. 𝑫𝑷𝑺  𝑫𝑷𝑹 = 𝑬𝑷𝑺 Dividend Payout Ratio  DPR can provide us with significant information about a firm.  DPR is often decided considering a company’s future earning expectations.  Steady increase in a firm’s DPR indicates healthy operation Fixed Assets Turnover Ratio  It is the ratio of sales to the value of fixed assets.  It indicates how well the business is using its fixed assets to generate sales. 𝑺𝒂𝒍𝒆𝒔  𝑭𝑨𝑻𝑹 = 𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔  Or 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅  𝑭𝑨𝑻𝑹 = 𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 Inventory Turnover Ratio  It measures how many times a company has sold and replaced its inventory during a certain period of time. 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒈𝒐𝒐𝒅𝒔 𝒔𝒐𝒍𝒅  𝑰𝑻𝑹 = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒂𝒕 𝒄𝒐𝒔𝒕 Debtors Turnover Ratio  It simply measures how many times the receivables are collected during a particular period.  Also, Known as Accounts receivable turnover ratio 𝑵𝒆𝒕 𝑪𝒓𝒆𝒅𝒊𝒕 𝑺𝒂𝒍𝒆𝒔  𝑰𝑻𝑹 = 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 (𝒏𝒆𝒕) Liquidity ratio  Measure the short-term solvency of the business, i.e. the firm’s ability to meet its current obligations.  Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety  Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.  Bankruptcy analysts and mortgage originators use liquidity ratios to evaluate going concern issues, as liquidity measurement ratios indicate cash flow positioning Liquidity ratio  Few ratios included are: 1. Current Ratio 2. Quick Ratio 3. Super Quick ratio Current Ratio  The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations.  Current ratio can be used to make a rough estimate of a company's financial health. 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔  C𝑹 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔  It is mainly used to give an idea of a company's ability to pay back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, accounts receivable). Current Ratio  Generally, a current ratio of 2:1 is considered healthy  2:1 implies that current assets are twice its current Liabilities. ❑Significance:  provides a measure of degree to which current assets cover current liabilities.  Should neither be very high nor very low. Example Company Current Assets Current Liabilities Current Ratio Apple Inc. $128.65 billion $100.81 billion 𝟏𝟐𝟖.𝟔𝟓 =1.28 𝟏𝟎𝟎.𝟖𝟏 Walt Disney Co. $15.89 billion $19.6 billion 𝟏𝟓.𝟖𝟗 = 0.81 𝟏𝟗.𝟔 Costco Wholesale $17.32 billion $17.5 billion 𝟏𝟕.𝟑𝟐 =0.98 𝟏𝟕.𝟓 Acceptable current Ratios vary depending on the industry. Generally, a current ratio in the range of 1:1.5 to 1:3 is considered good. The current ratio is also known as the Working Capital Ratio Working Capital = Current Assets – Current Liabilities Quick Ratio  The quick ratio is an indicator of a company’s short-term liquidity,  and measures a company’s ability to meet its short-term obligations with its most liquid assets. 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔−𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆𝒔  𝑸𝑹 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔 𝒄𝒂𝒔𝒉 𝒂𝒏𝒅 𝒆𝒒𝒖𝒊𝒗𝒂𝒍𝒆𝒏𝒕𝒔 + 𝒎𝒂𝒓𝒌𝒆𝒕𝒂𝒃𝒍𝒆 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔 +𝒕𝒓𝒂𝒅𝒆/𝒂𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆  𝑸𝑹 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔  Example (In Millions) Procter&Gamble Johnson & Kimberly-Clark Johnson Current Assets $26,494 $65,032 $5,115 Less: Inventories ($4,624) ($8,144) ($1,679) Quick Assets $21,870 $56,888 $3,436 Current Liabilities $30,210 $26,287 $5,846 Quick Ratio 0.7239 2.16 0.5878 Generally, Companies with a quick ratio of less than 1 are not able to pay their current liabilities on time. It is only good in comparing companies within same industry. The quick ratio is also known as the Acid-Test Ratio Super Quick Ratio or Cash Ratio  This ratio goes one step ahead of current ratio and liquid ratio. 𝑺𝒖𝒑𝒆𝒓 𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔  𝑺𝑸𝑹 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔  Strictly includes only cash & marketable securities 𝑪𝒂𝒔𝒉+𝒎𝒂𝒓𝒌𝒆𝒕𝒂𝒃𝒍𝒆 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔  𝑺𝑸𝑹 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔 Find the super quick assets and super quick ratio.  𝑪𝒂𝒔𝒉+𝒎𝒂𝒓𝒌𝒆𝒕𝒂𝒃𝒍𝒆 𝒔𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔 𝑺𝑸𝑹 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔 𝟐𝟎,𝟎𝟎𝟎+𝟏,𝟓𝟎,𝟎𝟎𝟎 𝑺𝑸𝑹 = = 2.833 𝟔𝟎,𝟎𝟎𝟎 Higher the super quick ratio, the better the liquidity of business. In this case, for every 1 unit of current liability, the company has 2.833 units of super quick assets, which is good.  Solvency ratio  Determines the ability of the business to service its debt in the long run ❑ Debt-Equity ratio  measures the relationship between long-term debt and equity 𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔  𝑫/𝑬 = 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒇𝒖𝒏𝒅𝒔  Safe ratio= 2:1 (but varies from industry to industry). ❑ Significance:  Measures the degree of indebtedness of an enterprise.  Higher Ratio is good and bad depending on different perspectives.  𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔 𝑫/𝑬 = 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒇𝒖𝒏𝒅𝒔 Long term debt/Debt = LT borrowings + other LT liabilities + LT provisions Debt = 4,00,000 + 40,000 + 60,000 Debt = 5,00,000 Shareholder’s fund/ Equity = Share capital + Reserves and Surplus + Money received against share warrants Equity = 12,00,000 + 2,00,000 + 1,00,000 Equity = 15,00,000  Alternatively, Shareholder’s Fund/ Equity = Non-current assets + Current Assets – Current liabilities – Non-current Liabilities Equity = 18,00,000 + 7,00,000 – 5,00,000 – 5,00,000 Equity = 15,00,000 𝑫 𝟓,𝟎𝟎,𝟎𝟎𝟎 = = 0.33:1 𝑬 𝟏𝟓,𝟎𝟎,𝟎𝟎𝟎 Part 2- Finance  Definition of Return and Risk  Time value of money  Discounting  Compounding  Relevant and irrelevant cash flow  Capital budgeting -DCF method  Net present value  Profitability Index Return  Return is the actual income received plus change in market price of an asset/investment. Rate of return = Dividend yield + Capital gain yield DIV1 P1 − P0 DIV1 + (P1 − P0 ) R1 = + = P0 P0 P0 Risk  The variability of actual return from expected returns associated with a given asset/investment is defined as a risk.  The greater the variability the greater the risk.  It can be measured using Variance or Standard deviation Variability  Year-to-Year Total Returns on HUL Share 50 40.94 40 36.99 30 21.84 Total Return (%) 20 15.65 12.83 10.81 10 2.93 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 -10 -6.73 -20 -16.43 -30 -27.45 -40 Year  Higher the variability higher is the risk Example  The possible returns of an investment are 10%, 15%, 20%, 25%, and 30%. What is the expected risk?  The most popular measure of risk is the variance or standard deviation of the possible returns.  The S.D. of the above return series is calculated as:  RISK xi xi -x (xi –x)2 10 -10 100 15 -5 25 20 0 0 25 5 25 30 10 100 n n  Xi =100 i =1  (Xi-X)2 = 250 i =1  TVM help us in knowing the value of money invested. As time changes value of money invested on any project/ firm also changes Time value of money refers to the fact that a Rupee in hand today is worth more than a dollar promised at some time in the future Which would you rather have – Rs.1,000 today or Rs.1,000 in 5 years? Reason for Time value of Money 1. Risk and Uncertainty – As we know future is never certain and we can’t determines the risk involved in future because outflow of cash is in our hand as payment where as there is no certainty for future cash inflows. 2. Inflation - In an inflationary economy, the money received today, has more purchasing power than the money to be received in future. In other words, a rupee today represents a greater real purchasing power than a rupee in future.. 3. Consumption - Individuals generally prefer current consumption to future consumption. 4. Investment opportunities - An investor can profitably use the received money today to get higher return tomorrow or after a certain period of time Future Value of money  Future value refers to the amount of money an investment will grow to over some length of time at some given interest rate  To determine the future value of a single cash flows, we need: 1. present value of the cash flow (PV) 2. interest rate (r), and 3. time period (n)  𝑭𝑽 = 𝑷𝑽 (𝟏 + 𝒓)𝒏  The factor (1+i)n is called the compounding factor or the CV factor. Compounding  Compounding is the process of the exponential increase in the value of an investment due to earning interest on both principal and accumulated interest.  Suppose that a sum of $1,000 is invested for four years at an annual rate of interest of 3%. What is the future value of this sum  In this case, n=4 ; r=3; PV = $1,000  Using the future value formula, 𝑭𝑽 = 𝑷𝑽 (𝟏 + 𝒓)𝒏 FV = 1,000(1+0.03)4 FV = 1,000(1.125509) FV = $1,125.5 Present Value of money  Discounting is the process of translating a future value or a set of future cash flows into a present value.  To compute present value of a single cash flow, we need: 1. Future value of the cash flow (FV) 2. Interest rate (r) and 3. Time Period (n) Present value  The formula for present value is: 𝑭𝑽 P𝑽 = (𝟏+𝒓)𝒏 Where: FV = Future value in future period r = the periodic interest (also called the discount rate or the required rate of return) n = number of periods 𝟏  The factor is called the discounting factor or the PV factor. (𝟏+𝒓)𝒏 Present value  Let's look at an example. Assume that you would like to put money in an account today to make sure your child has enough money in 10 years to buy a car. If you would like to give your child Rs.10,000 in 10 years, and you know you can get 5% interest per year from a saving account during that time, how much should you put in the account now?  The present value formula tells us: 𝟏𝟎𝟎𝟎𝟎 P𝑽 = 𝟏𝟎 (𝟏+𝟎.𝟎𝟓)  PV= Rs 6,139.13  Thus, Rs. 6,139.13 will be worth Rs. 10,000 in 10 years if you can earn 5% each year.  In other words, the present value of Rs. 10,000 in this scenario is Rs. 6,139.13. Profitability vs. Wealth Maximization  Ambiguity  Quality of benefits  Timings of benefit Capital budgeting decisions  classification is as follows:  Expansion of existing business  Expansion of new business  Replacement and modernisation Relevant and Irrelevant cash flows  Variable and Fixed cost  Sunk Cost  Opportunity Cost  Depreciation  Working Capital  Taxes  Effect on other project cash flows Techniques of evaluation  Discounted Cash Flow (DCF) Criteria  Net Present Value (NPV)  Profitability Index (PI) Net Present Value  It is the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows  To find present value-a rate of discount must be specified  Rate of discount- could be the rate of return, opportunity rate of return, minimum return requirement  Net Present Value  Calculation of NPV : On the basis of the definition of the NPV, it may be defined as :  Example of NPV  Assume that Project X costs Rs. 2,500 now and is expected to generate year-end cash inflows of Rs. 900, Rs. 800, Rs. 700, Rs. 600 and Rs. 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10%. Find the NPV and whether to accept the project? Evaluation criteria of NPV  Accept the project when NPV is positive NPV > 0  Reject the project when NPV is negative NPV < 0  May accept the project when NPV is zero NPV = 0  The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected. Net Present value  NPV is most acceptable investment rule for the following reasons: 1. Time value 2. Measure of true profitability 3. Value-additivity 4. Shareholder value  Limitations: 1. Involves cash flow estimation 2. Discount rate difficult to determine Profitability Index  comparing the present value of the future cash inflows with the present value of the future cash outflows.  Benefit-cost ratio or Present Value index  Tells about the benefits (in present value terms) per rupee invested in the proposal. Profitability Index  For example, a firm is evaluating a proposal which requires a cash outlay of Rs.40,000 at present and, of Rs.20,000 and at the end of 3rd from now. It is expected to generate cash inflows of Rs.20,000, Rs.40,000 and Rs. 20,000 at the end of 1st year, 2nd year, and 4th year respectively. Given the rate of discount of 10%, Find the PI. Profitability Index Present value of cash outflows = Rs.40,000+15,020 = 55,020. Present value of cash inflows = Rs.18,180+33,040+13,660 = Rs.64,880. PI = 1.18 Profitability Index  The Decision Rule : ‘Accept’ - PI is more than 1  Indifferent- if the PI is equal to 1  ranking of mutually exclusive proposals- the highest positive PI THANK YOU !