Corporate Finance

Madras School of Economics

Academic Year 2023-2024
 Module 1

Introduction to Corporate finance

2
1.Corporate finance?

3
What is Corporate Finance ?

Corporate finance includes:

• Investment Decision

• Financing Decision

• Dividend decision

Objective of Corporate finance Decision ?

4
What is Corporate Finance ?

Type of Overview of the Decision Criteria for making Decision

Decision
Investment Businesses would have raised Return from Investments
Decision funds from external sources as should be greater than
well as through internal accruals minimum acceptable hurdle
(say retained profits). rate.

Where and how should these

funds be invested?

5
What is Corporate Finance ?

Type of Overview of the Decision Criteria for making Decision

Decision
Financing What are the sources from Debt/Equity proportion should
Decision which to raise funds for be such that a firms value is
investments? maximized.

What kind of Debt to be raised? Debt profile should be such

that it matches the profile of
What is the proportion of Debt the assets being funded.
and Equity to be maintained?

6
What is Corporate Finance ?
Type of Overview of the Decision Criteria for making Decision
Decision
Dividend Say a company has funds but is Funds could be returned to
Decision not able to find investments shareholders in the form of:
where it can earn hurdle rate. -Dividends and/or
-Share buybacks
Now the company may find it
optimal to return funds to The form in which funds are to
owners of the business. be returned depends on
shareholders preference.

Whether shareholders prefer

Dividend or Share buyback ?
7
Objective of Corporate Finance|

What is wrong if the objective of Corporate finance is any of the

following:

-Maximize market share?

-Profit maximization ?

-Maximize Revenue?

8
Objective of Corporate Finance|
Objective What’s wrong with these objective?
Maximize market Higher market share need not necessarily give the firm more pricing power.
share If it does not get pricing power, then higher market share will not translate to higher profits.
Hence by focusing on higher market share, the firm will be worse off.

Note: If higher market share gives the firm more pricing power, then higher market share
will lead to higher profits in future and consequently maximize firms value.
Profit maximization This may result in firms focusing on short term accounting profit rather than long term value
creation. Hence the firm may be worse off in the long run.
Maximize the Managers may be interested in creating conglomerates. This could be with the intention of
overall revenue increasing Managers power and career.

However this need not necessarily increase firms value.

So Maximizing market share , Profit and overall revenue are not the right objectives.

9
Value of the Business/ Firm value/Enterprise value
Equity & Liabilities Assets

Share capital 400 Fixed Assets 1,000

Reserves & Surplus 600 Investments 200

Long term Debt 250 Trade Receivables 300

Trade Payables 500 Inventories 150

Cash and Bank balances 100

1,750 1,750

10
Value of the Business/ Firm value/Enterprise value|

Assume the values given are market values.

Now Enterprise Value of the above firm can be calculated in 2 ways:
Method 1: =Total Assets – Trade payable
=1750-500
=1,250
Method 2: = Share capital + Reserves &Surplus + Long term Debt
=400+600+250
=1,250

11
Objective of Corporate Finance|

Objective of Corporate finance Decision

Maximize the value of the Business (firm)

Value of the Business (firm) = Value of Equity holders stake

+
Value of preference shareholders stake
+
Value of Debt holders

12
Objective of Corporate Finance|

However in practice, Institutions adopt a narrower objective of Maximizing

Equity Shareholders value.

13
Objective of Corporate Finance|
Objective Potential Challenges
Maximize firm (a)Here we make decisions that maximize firms value. However these decisions may have
value costs for the society as a whole.
Example : Think about the harmful effect of Liquor/ Tobacco companies on the society.
(b)Firm may be run by Managers. There could be conflict of interest between Managers and
Stockholders. Managers may make decisions which are in their best interest rather than the
interest of Stockholders.
Example: Say a company is not efficiently run for the last few years and there is a hostile
takeover attempt on that company. Incumbent management may try to avoid the hostile
takeover. However the hostile takeover could be beneficial to the existing shareholders.
Maximize Conflict between Stockholders and Bondholders need to be resolved.
stockholder wealth Stockholders may prefer high risk projects ; projects which are beyond the risk appetite of
the Bond holders.
Maximize stock Very often stock market price do not accurately reflect long term growth potential of a firm.
price The market may be giving too much importance to short term effects.

If this is how the stock market behaves, then if the firm tries to maximize stock price….then
it will focus on short term decisions rather than focusing on long term wealth creation.
14
Illustrative list of Corporate Finance activities|
• How to fund the regular operations?
• What are the new Investment opportunities to be taken up?
[Example: Grasim industries venturing into Paint business]
• How to fund the new investment opportunities coming up?
• What is the Capital structure to be maintained? What proportion to be
raised through Equity and what proportion to be raised through Debt?
• Developing a Dividend distribution plan. What proportion of profits to
be distributed to Shareholders?
• Whether to go for Share Buyback?
• Privately held company decides to go public. It decides to be listed on
Stock Exchange so that it can access funds from Capital markets. This
will be a Corporate Finance activity.

15
Illustrative list of Corporate Finance activities|
• Company may get a Credit Rating. Thereafter using the rating to borrow
funds.
• Borrowing money by issuing long term Bonds/ short term commercial
paper.
• Taking loan from Banks. The loans could be backed by Assets of the
company or by company’s rating.
• Defining and negotiating payment terms with Suppliers.
• Defining and negotiating payment terms with Customers.
• Mergers and Acquisitions (M&A) (Bankers facilitate M& A activities.
Bankers view M&A as a corporate finance activity)
• Management of current assets, Current liabilities and Inventory control.

16
Illustration|

Say a company is facing liquidity issues.

How can it resolve the liquidity issue?

17
Illustration|Solution

• Short term borrowing arrangements with Banks.

• Factoring arrangement.

• Negotiate credit period with Suppliers. This will enable the company to
pay at a later date.

• Instead of buying assets, take assets on lease arrangements.

18
Illustration|Solution

Factoring arrangement

[Company A sells goods worth Rs 1 crore to Company B.

As per sale terms, Company B is required to pay the money only after 6
months.
To raise finance upfront, Company A sells these outstanding invoices to a
Factoring company. Factoring company will pay Company A the money of
“1 Crore after deducting certain charges”.
On due date, the Factoring company will directly collect the money from
Company B]

19
2.Overview of Financial statements

20
Balance sheet| Overview
As on 31-03-2022 As on 31-03-2021
Non-Current Assets 55,090 54,476
Current Assets 14,647 13,640
Total Assets 69,737 68,116

Equity (Shareholders fund) 48,760 47,434

Non-Current Liabilities 10,033 9,841
Current Liabilities 10,944 10,841
Total Equity and Liabilities 69,737 68,116

Note: Extract from HUL Standalone Balance Sheet||Figures in Crores

21
Statement of Profit & Loss| Overview
Year ended Year ended
March 2022 March 2021
Revenue from Operations 51,193 45,996
Other Income 393 513
Total Income 51,586 46,509
Cost of materials sold 25,124 21,677
Employee Benefit Expenses 2,399 2,229
Finance Costs 98 108
Depreciation & Amortization
expenses 1,025 1,012
Other expenses 11,167 10,766
Total Expenses 39,813 35,792
Profit before Exceptional Items &
Tax 11,773 10,717
Exceptional Items (34) (227)
Profit Before Tax 11,739 10,490
Tax Expense (2,921) (2,536)
Profit after Tax 8,818 7,954
Note: Extract from HUL Standalone Profit & Loss||Figures in Crores

22
Statement of Cash flows |Overview

Year ended Year ended

March 2022 March 2021 Remarks
Cash flows from Operating Activities (A) 8,964 8,957 +ve indicates “cash
generated”.
Cash flow from Investing Activities (B) (1,732) (1,367)
-ve indicates “cash
Cash flow from Financing Activities (C) (7,984) (9,280) used”.
Net decrease in Cash & Cash Equivalents
(A+B+C) (752) (1,690)
Cash and Cash Equivalents at Beginning of
the year 1,740 3,430
Cash and Cash Equivalents at End of the year 988 1,740
Note: Extract from HUL Standalone Cashflows||Figures in Crores

23
 Balance sheet| Book Value per share & Market price by Book value
As on 31-03-2022 As on 31-03-2021
Equity (Shareholders fund) 48,760 47,434
Number of Equity Shares 234.9591 234.9568
Note: Above 2 line items in Crores
Book Value per share
(Stand alone) 207.53 201.88

Book Value per share

(Consolidated) 208.81 202.91

Market Price per Share 2048.85 2431.50

Price/Book Value
Note: Here we use consolidated
Book value per share 9.81 11.98

24
 Role of Financial statements in Corporate Finance|

• Assets currently held by the company with appropriate classification.

(Say What are the Fixed assets, Current assets, Intangibles etc?)

• What are the liabilities of the company?

• What is the profitability of the company as per accounting convention?

• What portion of the current profit is attributable to items which are not likely to
repeat in future? (Say Exceptional items)

• Likely future profitability.

25
3.Comparison between 3 companies

26
Comparison of 3 listed companies …pg 1
Ref Apollo Hospitals Nykaa NLC India ltd
As on 31-03-2023 (Figures in Crores)
A Non-Current Assets 10,091 1,044 41,493
B Current Assets 4,337 1,906 11,575
C (A+B) Total Assets 14,428 2,950 53,068
D Shareholders Net worth 6,531 1,392 17,626
E Financial liabilities 4,052 351 20,187
Other Non-current 520 9 4,042
F
liabilities
Total Non-current 4,572 360 24,228
G(E+F)
liabilities
H Current liabilities 3,325 1,198 11,214
I (G+H) Total Liabilities 7,896 1,558 35,442
J(D+I) Total Equity and liabilities 14,428 2,950 53,068

Note: Taken from Annual report

27
Comparison of 3 listed companies …pg 2

Ref Apollo Hospitals Nykaa NLC India ltd

As on 31-03-2023 (Figures in Crores)
Number of outstanding
K shares (Rs) 14,37,84,657 2,85,24,46,720 1,38,66,36,609

28
Comparison of 3 listed companies …pg 3

Ref Apollo Hospitals Nykaa NLC India ltd

As on 31-03-2023 (Figures in Crores)
Number of outstanding
K shares (Rs) 14,37,84,657 2,85,24,46,720 1,38,66,36,609

Borrowings included in
P current liabilities(Crores) 896.5 584.764 3807.55

29
Comparison of 3 listed companies …pg 4

Ref Apollo Hospitals Nykaa NLC India ltd

As on 31-03-2023 (Figures in Crores)

K Number of outstanding shares (Rs) 14,37,84,657 2,85,24,46,720 1,38,66,36,609

L Market price per share (Rs) 4310.9 124.25 75.98

M(K*L) Market capitalization in Crores 61,984 35,442 10,536

N(D/K) Book value per share (Rs) 454.24 4.88 127.11

O(L/N) Market price/Book value 9.5 25.5 0.6

Borrowings included in current

P liabilities(Crores) 896.5 584.764 3807.55
(P+E)/D Debt-Equity Ratio 0.76 0.67 1.36

30
 Shareholder composition
FSN E-
commerce
Apollo Ventures ltd Adani
hospitals (Nykaa) NLC India ltd HDFC Bank Enterprises
As on 5/1/2024
% of Shares Held by All Insider 29.33% 64.18% 82.24% 1.77% 77.25%
% of Shares Held by Institutions 44.82% 21.34% 7.68% 50.15% 12.70%
Number of Institutions Holding
Shares 263 80 28 447 115

% of Float Held by Institutions 63.42% 59.57% 43.23% 51.06% 55.85%

Source :From Yahoo finance

31
 Role of Stock market|
• Stock market plays a critical role in allocation of Economy’s capital.
• Stock market can discharge this role well only if the Price-discovery process is
efficient. For this to happen, there should be strong interaction between Demand
and Supply.
• Free float (also known as Public float) : refers to shares of a company that can be
publicly traded and are not restricted.
-All listed companies in India to maintain Minimum public float of 25%.
-Newly listed firms get 3 years to adhere to the limit of 25%.
-Stocks with lower free-float : They tend to have higher volatility.
-Stocks with larger free-float : They tend to have lower volatility since there
are more buyers and sellers.
• Free-float requirement is intended to facilitate efficient price-discovery.

32
4.Agency Problem/Corporate governance

33
Features of company|
Features of Companies
✓Company has a legal entity distinct from its members. Hence it has
perpetual succession.
✓Shareholders own the company ; however shareholders do not
manage it.
✓Shareholders vote to elect the Board of Directors.
✓Board of Directors comprises of :
- Executive Directors
- Non-Executive Directors
✓ Board appoints the top management.

34
Goal of companies & challenges|

Goal of Companies
✓Maximise Enterprise value/shareholders wealth.

Challenges
✓Interest of Managers and shareholders do not necessarily align.

35
Goal of companies & challenges|
Primary goal of a company is to maximise shareholders wealth
Take the case of a ✓ Maximization of shareholders wealth happens naturally.
small company
where Owners
and Managers are
same.

Large Companies ✓ Here there are large number of shareholders.

✓ Further management team is different from
shareholders.
Interest of Managers and Shareholders do not necessarily
coincide.

36
Agency problem and Agency costs|

✓ Managers are agents working on behalf of shareholders. Managers have duty to shareholders.
Still at times Managers may act in their own self interest.
This is called the Agency problem.
Agency problem arises because shareholders are not managing the affairs.
✓ Costs associated with Agency problem is called Agency costs.

✓ 2 types of Agency costs-

(a) Direct Agency costs
Example: Company needs to generate financial statements and Annual reports for shareholders.
The costs associated with this is Direct agency costs.
(b) Indirect Agency costs
Example: Cost of managers making sub-optimal decisions.
Cost of providing ESOP(Employee stock ownership plan) to motivate Managers.

37
Agency problem and Agency costs|

✓ Investors may have a large portfolio of shares.

In such cases if Investors are not happy with the management, possibly they may exit the company.
Investors may not find it worthwhile to take efforts to change the management of the company.

✓ Managers career is largely dependent on the ✓ However shareholders may hold a diversified
company. So they make take a more conservative portfolio; hence they will prefer Managers (of
approach to risk. their company) to take risk.

✓ Pecking order of finance:

Managers preference Shareholders preference
Preference 1 : Retained earnings (don’t pay Preference 1 : Debt (Interest on debt is tax
dividends) deductible. Hence cost of debt is low)
Preference 2 : Debt Preference 2 : Retained earnings
Preference 3: Fresh Equity Issue Preference 3: Fresh Equity Issue

38
Aligning Managers Interest to shareholders
How can we make Managers to act in best interest of Shareholders?
✓ Possibly by designing a suitable compensation scheme.
For instance, part of the Managers compensation could be in form of
variable pay/ ESOP’s.

Possible drawback of ESOP’s

Managers may take short term measures to boost share price……so that their
ESOP’s turn attractive.

Example : Discuss the possible reason for more buybacks in US.

39
 Objective of Corporate Governance|
Corporate Governance
✓ Corporate Governance: Set of processes and procedures intended to manage
the organizations in best interest of shareholders.

✓ Primary aim of corporate governance:

-Control over managements ability to obtain private benefit.
- Replace inefficient management in a timely manner.

✓ For instance corporate governance will include:

Various committees of the Board reviewing company’s operation periodically.
(Example: Audit committee, Remuneration committee,
Investment committee etc)

40
5. Commonly used Formulas pertaining to
Time value of money

41
Interest Rate | Effective Interest rate & Nominal Interest rate

Nominal Annual Compounding Effective annual Interest rate

Rate Interval
12% Annual
12% Semi-annual
12% Quarterly
12% Monthly
12% Daily

42
Interest Rate | Effective Interest rate & Nominal Interest rate

Nominal Annual Compounding Effective annual Interest rate

Rate Interval
=(1+0.12/1)^1 -1
12% Annual =12.00%
=(1+0.12/2)^2 -1
12% Semi-annual =12.36%
=(1+0.12/4)^4 -1
12% Quarterly =12.55%
=(1+0.12/12)^12 -1
12% Monthly =12.68%
=(1+0.12/365)^365 -1
12% Daily =12.75%

Effective Interest rate takes into account the impact of compounding (ie earning Interest on Interest)

Effective Interest rate gives the actual rate of increase over the specified time frame.

43
 What does discount rate captures?|

Discount rate reflects the following three factors :

• Rs 1 today is preferred to Rs 1 at a later point of time.

• Expected inflation.

• Cash flows that are being evaluated are not certain. The discount rate tends to
capture this uncertainty as well.

44
 Discount factor & Accumulation factor|
What is it? Purpose
Present value is calculated using Discount factors.
n year discount factor
Present value of Cashflow =
Discount factor
= 1/[(1+ Effective annual interest rate)^n]
Cashflow in year n* n year Discount factor

Accumulated value is calculated using Accumulation

factors.

Accumulation factor n year accumulation factor = Accumulated value of Cashflow at time n

(1+ Effective annual interest rate)^n =Cashflow at time 0* n year accumulation factor

Note: the above formula assumes that the rate are cumulative in nature.

45
 Annuity|
Annuity paid in arrear (also called as ordinary annuity)
At end of Time point 1 2 n-1 n
Cash flow 1 1 1 1
=(1- vn )/i

Where
Present value of annuity v = 1/(1+i) and
of n payments of 1 i is the effective interest rate
rupee each.

Payment made at the

end of each of next n
time periods.
Note: Derive the formula using sum of a geometric series.
Sum of GP series = a(1-r^n)/(1-r)

46
 Annuity|
Annuity paid in arrear & Keeps on growing
At end of Time point 1 2 3 n-1 n
Cash flow A(1+g) A(1+g)2 A(1+g)3 A(1+g)n-1 A(1+g)n
= A(1+g)[1-[(1+g)/(1+i)]n]
i-g

Where
Present value of annuity g is the growth rate
of n payments growing i is the effective interest rate
at the rate of g

Payment made at the

end of each of next n
time periods.

47
 Annuity|
Annuity paid in advance
At end of Time point 0 1 2 n-1
Cash flow 1 1 1 1
=(1- vn )/d

Present value of annuity Where

of n payments of 1 v = 1/(1+i) and
rupee each. d = i/(1+i)

Payment made at the

start of each of next n
time periods.
Note: Derive the formula using sum of a geometric series.
Sum of GP series = a(1-r^n)/(1-r)

48
Perpetuity|

Present value of a Zero-growth perpetuity

Cashflow in next year/Discount rate

Present value of Growing perpetuity

Cashflow in next year /(Discount rate- Growth rate)

49
Illustration|
Decide whether to buy car on outright basis or in installments.

Option 1: Cash Purchase

Cash Purchase price 600000

Option 2: Purchase by way of installments

Applicable Discount rate 10%
Yearly installments (at the end of each year) 235000
Number of Installments 3

Evaluate whether to go for Option 1 or Option 2

50
Illustration|
PV of cash outflows in Option 2
Approach 1

Years 1 2 3 Total
Cash flows 235000 235000 235000
Discount factor 0.909091 0.826446 0.751315
PV of Cash outflows 213636.4 194214.9 176559 584410.2

Approach 2

PV of annuity factor …..by using formula (1- vn )/I 2.486852

=(1-1/(1+0.1)^3)/0.1
PV of cash outflows (235000*2.486852) 584410.2
Decision :
Option 2: PV of cash outflow through installments (Rs 584410)
Option 1: PV of outflow is Rs 600,000.
Since PV of outflow in Option 2 lower than that in Option 1, buy through installments.

51
Illustration|

Cash flow in year 10 10,00,000

Rate of increase in cashflows every year from year 10 onwards 5%
Number of years the cashflow will continue into the future after
year 10 15
Discount rate 14%
Calculate the PV of cashflow as at the end of year 10.

52
Illustration|

Cash flow in year 11

=1000000*(1+0.05) 10,50,000
PV factor of growing annuity (as at end of year 10)
=(1-((1+0.05)/(1+0.14))^15)/(0.14-0.05) 7.87
PV of cashflows (as at end of year 10)
=1050000*7.87 82,68,744

53
Illustration|

XYZ Bank has issued Perpetual Bond (Face value 100)

with the following features :
-Coupon on Perpetual Bond : 9%
-Required yield on similar Bonds :8%
Calculate the Price of Perpetual Bond.

54
Illustration|

Face value of Perpetual Bond 100

Coupon rate 9%
Discount rate 8%

=100*0.09/0.08
Price of the Perpetual Bond =112.50

55
Illustration|

Cash flow in year 10 10,00,000

Rate of increase in cashflows every year from year 10 onwards 5%
Number of years the cashflow will continue into the future after
year 10 Perpetual
Discount rate 14%
Calculate the PV of cashflow as the end of year 10.

56
Illustration|

Cash flow in year 11

=1000000*(1+0.05) 10,50,000
PV of cashflows (as at end of year 10)
=1050000/(0.14-0.05) 1,16,66,667

57
6. Preparation of Cash flow statements

58
Cash flow statement| Concept
• How much money has the company actually made?

• Quite a few judgement/ assumptions go into arriving at profit. From that perspective, cash flow
is better.

• Profitable company need not necessarily generate positive operating cashflow.

[Possible Questions on seeing negative operating cash flows-
- Why is there a Build up of Inventories?
- Are customers not paying?]

• Why Profit differs from cash flows?

-Revenue reported in P&L account may not have been actually received.
-Expenses booked in P&L account may not have been actually paid.

• Non-cash charge like Depreciation needs to be added back. Further if there is actual purchase of
asset during the year, it needs to be shown as outflow.

59
Cash flow statement| Example
Account Opening Closing
head balance balance
Accounts 1000 1500
receivable
Inventory 750 500

Transaction during the period : Goods costing 250 sold for 500 during the period.
Money is yet to be received.

Arrive at cash flow from operations using Indirect method.

60
Cash flow statement| Example

Solution
Profit 250

Adjustment for changes in

Working capital

Increase in Accounts (500)

Receivable
Decrease in Inventory +250

Cash flow from operations 0

61
Cash flow statement| Concept
Section head What comes here? Example for Inflow Example for Outflow

Cash flow for/ from Cash flows pertaining Money received from Payment to suppliers/
operating activities to principle revenue customers Employees
generating activities

Cash flow for/from Cash flows pertaining Receipt from sale of Payment for purchase of
Investing activities to acquisition and Assets. Asset.
disposal of long term Collection of Dividend
assets/investments. and Interest.

Cash flow for/from Cash flows pertaining Receipt from new Payment of
Financing activities to owners capital and issue of securities. Interest/Dividends.
borrowings. Money raised through Repayment of
loans. borrowings.

62
Cash flow statement| Concept
Indicators of a healthy company
Cash flow for/ from operating activities +ve
Cash flow for/from Investing activities -ve
(Reasoning: it continues to invest in Fixed Assets)

Cash flow for/from Financing activities It may be +ve or –ve.

Indicators of a company that may not be sustainable

Cash flow for/ from operating activities -ve
Cash flow for/from Investing activities +ve
Cash flow for/from Financing activities +ve

63
Cash flow statement: Indirect Method|Practice Question….page 1 of Qn
BALANCE SHEET AS AT 31ST MARCH 2022
Figures in Crores
CY CY LY LY
EQUITY & LIABILITIES

SHAREHOLDERS FUNDS
SHARE CAPITAL (PAR VALUE 10) 1100 1100
RESERVES & SURPLUS 4608 3970
5708 5070
NON-CURRENT LIABILITIES
LONG TERM BORROWINGS 3300 3000

3300 3000
CURRENT LIABILITIES
SHORT TERM BORROWINGS 550 450
TRADE PAYABLES 1250 1150
OTHER CURRENT LIABILITIES 425 425
SHORT TERM PROVISIONS 175 175
2400 2200

TOTAL OF EQUITY & LIABILITIES 11408 10270

64
Cash flow statement|Practice Question….page 2 of Qn
Balance sheet contd….
CY CY LY LY
ASSETS

NON-CURRENT ASSETS
FIXED ASSETS 5050 4600
NON-CURRENT
INVESTMENTS 550 500
LONG TERM LOANS AND
ADVANCES 550 700
6150 5800
CURRENT ASSETS
CURRENT INVESTMENTS 325 325
INVENTORIES 1650 1550
TRADE RECEIVABLES 1400 1250
CASH AND CASH
EQUIVALENTS 1608 1070
SHORT TERM LOANS AND
ADVANCES 275 275
5258 4470
TOTAL ASSETS 11408 10270
65
Cash flow statement|Practice Question….page 3 of Qn
STATEMENT OF PROFIT AND LOSS ACCOUNT FOR YEAR ENDED MARCH 2022
Figures in Crores
CY CY LY LY
REVENUE FROM OPERATIONS 13200 12020
INTEREST INCOME 90 70
TOTAL REVENUE 13290 12090

EXPENSES
MATERIAL EXPENSES 5730 5870
EMPLOYEE BENEFIT EXPENSES 2020 1820
FINANCE COSTS 310 260
DEPRECIATION 490 440
OTHER EXPENSES 2400 2100
TOTAL EXPENSES 10950 10490

PROFIT BEFORE EXCEPTIONAL AND EXTRAORDINARY ITEMS AND TAX 2340 1600
EXCEPTIONAL ITEMS 0 0
PROFIT BEFORE EXTRAORDINARY ITEMS AND TAX 2340 1600
EXTRAORDINARY ITEMS 0 0
PROFIT BEFORE TAX 2340 1600
TAX EXPENSE 702 480
PROFIT(LOSS) FOR THE PERIOD 1638 1120
DIVIDEND 1000 800

EPS 14.89091
66
Cash flow statement|Practice Question….Soln…pg 1
CASH FLOW FOR YEAR ENDED MARCH 2022
CY LY
Cash flow for/ from Operating Activities
PROFIT BEFORE TAX 2340
ADJUSTMENT FOR
DEPRECIATION 490
FINANCE COST 310
INTEREST INCOME -90
OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES 3050
MOVEMENT IN WORKING CAPITAL ACCOUNT
SHORT TERM BORROWINGS 100
TRADE PAYABLES 100
INVENTORIES -100
TRADE RECEIVABLES -150
CASH GENERATED FROM OPERATIONS 3000
INCOME TAX PAID -702
NET CASH FROM OPERATING ACTIVITIES (A) 2298

67
Cash flow statement|Practice Question….Soln…pg 2
CASH FLOW FOR YEAR ENDED MARCH 2022
CY LY
Cash flow for/from Investing activities
INTEREST INCOME 90
PURCHASE OF FIXED ASSETS -940
INCREASE IN NON CURRENT INVESTMENT -50
DECREASE IN LONG TERM LOANS AND ADVANCES 150
NET CASH USED IN INVESTMENT ACTIVITIES(B) (750)

Cash flow for/from financing activities

FINANCE COST -310
DIVIDEND PAID -1000
INCREASE IN LONG TERM BORROWINGS 300
Net cash used in Financing activities (C ) (1010)

Net cash generated (A+B+C) 538

CASH AND CASH EQUIVALENT AT BEGINNING OF THE PERIOD 1,070
CASH AND CASH EQUIVALENT AT END OF THE PERIOD 1,608

68
7. Operating & Financial Leverage

69
Financial statements| Framework
Income Statement for the year
ended March 2022 Balance sheet as at 31st March 2022

Revenue Equity & Liabilities Assets

Less Cost of Goods sold Shareholder Equity Fixed Assets

Gross profit Non-Current Liability Other Non-Current Assets

Less Operating Expenses Current Liability Current Assets:

-Inventories
Operating profit -Trade Receivables
Add Non-operating income -Cash & Bank balances
Less Non-operating Expenses Total of Equity and Liabilities Total of Assets
Earnings before interest and tax
(EBIT)
Note:
Finance cost (Interest expense) If a company does not have any non-operating income and
Earnings before tax(EBT) non-operating expenses, then EBIT will be same as Operating profit.
Less Tax
PAT

70
 Operating Leverage|
Base Up Scenario Down Scenario
SALE PRICE PER UNIT 1 1 1
VARIABLE EXPENSES PER UNIT 0.5 0.5 0.5
UNITS SOLD 2000 2200 1800

SALES(A) 2000 2200 1800

VARIABLE OPERATING
EXPENSES (B) 1000 1100 900
FIXED OPERATING EXPENSE(C) 600 600 600
OPERATING PROFIT (D)
[A-B-C] 400 500 300
OPERATING PROFIT %
[D/A] 20.00% 22.73% 16.67%

71
 Operating Leverage|
Nr = [Change in EBIT]/[EBIT]

Dr = [Change in Sales]/[Sales]

Degree of Operating Leverage = Nr/Dr

Note: Companies don’t disclose the break up between Fixed cost and
Variable cost in financial statements. These are internal information.
However by using above formula across years, we can arrive at
Operating leverage.

72
 Operating Leverage using base scenario of 2000 units|
Base Calculated with reference to Calculated with reference to
Base scenario of 2000 units Base Scenario of 2000 units
UNITS SOLD 2000 2200 1800
SALES(A) 2000 2200 1800
OPERATING PROFIT[A-B-C] 400 500 300
Increase in Sales +10% -10%
Increase in Operating profit +25% -25%
Degree of operating leverage 2.5 2.5
@ 2000 units

Application of Operating leverage

Increase in Sale of 10% * Operating leverage of 2.5 = Increase in operating profit of 25%

73
 Operating Leverage|

To do

Calculate operating leverage with Base sale of 1800 units.

74
 Operating Leverage using base scenario of 1800 units |
Base Up Scenario Down Scenario
SALE PRICE PER UNIT 1 1 1
VARIABLE EXPENSES PER UNIT 0.5 0.5 0.5
UNITS SOLD 1800 2000 1600

SALES(A) 1800 2000 1600

VARIABLE OPERATING
EXPENSES (B) 900 1000 800
FIXED OPERATING EXPENSE(C) 600 600 600
OPERATING PROFIT (D)
[A-B-C] 300 400 200
OPERATING PROFIT %
[D/A] 16.67% 20.00% 12.50%

75
 Operating Leverage using base scenario of 1800 units|
Base Calculated with reference to Calculated with reference to
Base scenario of 1800 units Base Scenario of 1800 units
UNITS SOLD 1800 2000 1600
SALES(A) 1800 2000 1600
OPERATING PROFIT[A-B-C] 300 400 200
Increase in Sales +11.1% -11.1%
Increase in Operating profit +33.3% -33.3%
Degree of operating leverage
@ 1800 units 3

Learning : Operating leverage varies at different volume of sales.

At 2000 units, operating leverage was 2.5

At 1800 units, operating leverage is 3.0

76
 Operating Leverage|

Higher the operating leverage, higher the operating risk. Why?

Because of fixed operating costs.

So if sales drop, operating profit will drop by a greater extent.
[If sales increase, then operating profit will also increase by a
greater extent]

77
 Operating Leverage|

Other Impact on Operating Profit

In the Preceding example, it was presumed that sales price per unit is
constant for all scenarios.
However in reality, company may have to reduce sales price per unit to
achieve higher quantity of sales.

Thus operating profit is influenced by:

- Fixed operating expenses and/or
- Sale price per unit.

78
 Breakeven sales|

To do

Calculate Breakeven point for the initial illustration.

79
 Breakeven sales|

Break even point

= Fixed cost/contribution per unit
= 600/0.5
= 1200 units.

80
 Financial Leverage|

Degree of Financial Leverage = Nr/Dr

Nr = Earnings before Interest & Tax (EBIT)

Dr = Earnings before tax (EBT)

Financial Leverage

-Financial leverage indicates use of debt.

-Use of debt can make profit available to shareholders more volatile.
[If a company is doing well, then it can improve ROE]

81
 Financial Leverage| Alternate formula

Degree of Financial Leverage = Nr/Dr

Nr = [Change in EBT]/[EBT]

Dr = [Change in EBIT]/[EBIT]

Note : Results of using both the formulas will be the same.

82
Financial Leverage|Different capital structure

No Debt Low Debt Higher Debt

ASSETS 4,000 4,000 4,000
DEBT - 1,000 2,000
EQUITY 4,000 3,000 2,000
INTEREST RATE ON DEBT 8% 8% 8%

Calculate PAT,ROE, ROCE and Degree of financial

leverage for aforesaid 3 scenarios.

83
Financial Leverage|Assessing profitability @2000
Sales of 2000 No Debt Low Debt Higher Debt
SALES 2000 2000 2000
OPERATING PROFIT(EBIT)
400 400 400
INTEREST ON DEBT 0 80 160
TAXABLE INCOME (EBT) 400 320 240
TAX @ 35% 140 112 84
PAT 260 208 156
DEGREE OF FINANCIAL
LEVERAGE
(EBIT/EBT) 1.00 1.25 1.67

84
Financial Leverage|Assessing profitability @2000
Sales of 2000 No Debt Low Debt Higher Debt
SALES 2000 2000 2000
OPERATING PROFIT(EBIT)
400 400 400
INTEREST ON DEBT 0 80 160
TAXABLE INCOME (EBT) 400 320 240
TAX @ 35% 140 112 84
PAT 260 208 156
RETURN ON CAPITAL
EMPLOYED(ROCE)
[EBIT/(Debt+Equity)] =10.00% 10.00% 10.00%
RETURN ON EQUITY (ROE)
[PAT/Equity] 6.50% 6.93% 7.80%
DEGREE OF FINANCIAL
LEVERAGE
(EBIT/EBT) 1.00 1.25 1.67

85
Financial Leverage|Assessing profitability @2200

Sales of 2200 No Debt Low Debt Higher Debt

SALES 2200 2200 2200
OPERATING PROFIT 500 500 500
INTEREST ON DEBT 0 80 160
TAXABLE INCOME (EBT) 500 420 340
TAX @ 35% 175 147 119
PAT 325 273 221

86
Combined leverage|
Table 1 No Debt Low Debt Higher Debt
Operating profit @ sale of 2000 400 400 400
Operating profit @ sale of 2200 500 500 500
Increase in operating profit 25% 25% 25%
Cross check:
Increase in operating profit = Increase in sales of 10%* operating leverage of 2.5

Table 2 No Debt Low Debt Higher Debt

Taxable income @sale of 2000 400 320 240
Taxable income @ sale of 2200 500 420 340
Increase in taxable income when sale is
2200 25% 31.25% 41.67%
Financial leverage calculated earlier 1.00 1.25 1.67
Cross check:
Increase in Taxable income = Increase in Operating profit(in table 1)* Financial leverage

87
Combined(Total) leverage|
Combined leverage = Degree of operating leverage * Degree of financial leverage

Table 3 No Debt Low Debt Higher Debt

Increase in sales 10% 10% 10%
Increase in taxable income 25% 31.25% 41.67%
Operating leverage calculated earlier 2.5 2.5 2.5
Financial leverage calculated earlier 1.00 1.25 1.6667
Combined leverage 2.5 3.125 4.16667
Cross check:

Increase in Taxable income = Increase in sales * Combined leverage

88
8. ROA VS ROCE VS ROE

89
 ROA VS ROCE VS ROE|
Formula used in this section Other Alternate formulas

Return on Assets [EBIT/Total Assets]*100 [Profit after tax/ Average Total Assets]*100
(ROA)
or

[EBIT*(1-t)/Average Total Assets]*100

Return on Capital [EBIT/Capital Employed]*100 [EBIT*(1-t)/Capital Employed]*100

Employed (ROCE)
Return on [[PAT-Preference Dividend]/[Equity
Equity(ROE) shareholder funds]]*100

90
ROA VS ROCE VS ROE|
No Debt Low level of Debt Intermediate level of Debt Higher level of Debt
ASSETS 4,000 4,000 4,000 4,000

TRADE PAYABLES 200 200 200 200

DEBT - 1,000 2,000 3,000
EQUITY 3,800 2,800 1,800 800

INTEREST RATE ON DEBT 8% 8% 8% 8%

OPERATING PROFIT (EBIT) 400 400 400 400

INTEREST ON DEBT (0) (80) (160) (240)
TAXABLE INCOME (EBT) 400 320 240 160
TAX @ 35% (140) (112) (84) (56)
PAT 260 208 156 104

ROA 10.00% 10.00% 10.00% 10.00%

RETURN ON CAPITAL
EMPLOYED(ROCE) 10.53% 10.53% 10.53% 10.53%
RETURN ON EQUITY (ROE) 6.84% 7.43% 8.67% 13.00%
91
 ROA VS ROCE VS ROE| Inference

• Even if a company borrows, ROE need not necessarily be higher

than ROCE. It depends on the Quantum of debt (& debts impact on
interest outflow and tax outflow).

Low level of Intermediate Higher level of

No Debt Debt level of Debt Debt
Nr for ROE 260 208 156 104
Dr for ROE 3,800 2,800 1,800 800
ROE % 6.84% 7.43% 8.67% 13.00%

92
9.Financial statement analysis (Ratio Analysis)

93
Financial statement Analysis| Theory
Objective :
Understand company’s financial performance/ position better.

Data to be analysed :
-Financial statements and Annual Reports of the company.
(to be done across a suitable time frame)
-Data pertaining to Industry in which the company operates.
-Comparison with Competitor’s/ Industry’s average.

One of the tools available for financial analysis and planning is Ratio Analysis.

Ratio :
Example : Gross profit ratio.
Gross profit alone may not convey meaning; however when it is expressed as % of
Revenue , it conveys meaning.
94
Financial statements| Framework for understanding Ratios
Income Statement for the year
ended March 2022 Balance sheet as at 31st March 2022

Revenue Equity & Liabilities Assets

Less Cost of Goods sold Shareholder Equity Fixed Assets

Gross profit Non-Current Liability Other Non-Current Assets

Less Operating Expenses Current Liability Current Assets:

-Inventories
Operating profit -Trade Receivables
Add Non-operating income -Cash & Bank balances
Less Non-operating Expenses Total of Equity and Liabilities Total of Assets
Earnings before interest and
tax(EBIT)
Finance cost (Interest expense)
Earnings before tax(EBT)
Less Tax
PAT

95
Types of Ratios| Theory

• Liquidity Ratios (Short term solvency)

• Financial leverage ratios (Long term solvency)

• Activity or Productivity or Asset Utilization ratios

• Profitability ratios

96
1.Liquidity Ratios|
Overview
• Liquidity refers to short term solvency.
• Ability of business to pay short term liabilities.
• Short term lenders/ creditors are interested in knowing the liquidity position.
• If a firm is unable to pay short term liabilities….then it adversely impacts its credibility.
• Current Assets : This is referred to as “Working capital”. They are used in day to day operations of the
company.

Types of Liquidity Ratios

1.1 Current Ratio
1.2 Quick Ratio or Acid test Ratio
1.3 Net Working Capital
1.4 Changes in Net Working Capital

97
 1.Liquidity Ratios |
1.1 Current Ratio
Formulae = Current Assets/Current Liabilities

Whether firm has enough Current Assets to meet Current obligations?

Note: Desirable Ratio is 2.
List of items normally treated as Current Assets:
Inventories
Trade Debtors / Receivables
Cash and Bank balances
Marketable securities grouped as Current Assets
Pre-paid expenses
Accrued Income shown as Asset in Balance sheet
Any other current assets …….please use judgement.

List of items normally treated as Current Liabilities:

Trade Creditors/Accounts payables
Short term borrowings (Bank Overdraft, Cash Credit)
Outstanding expenses
Tax provision
Proposed Dividend
Any other current liabilities …….please use judgement.

98
 1.Liquidity Ratios |
1.1 Current Ratio
• Current ratio of 3 : Company has current assets of 3 for every 1 of current liabilities.
• Drop in Current Ratio may be a possible indication that the company is in financial problem.
• Comparison with historical trend and/or that of the industry/competitors may give better insights.
Remarks • Current Ratio need to be assessed along with operating cycle. For a company with short operating cycle, Current Ratio
of 2 may be excessive. It has blocked money in low/non-earning assets.
• Higher current ratio than competitors. Check if the company has blocked excessive money in low/non-earning assets.
If that’s the case, then company’s profitability may be lower.

Note: Liquidity needs to be evaluated along with “Operating cycle” of the company.

1.2 Quick Ratio (Acid test ratio)

= Quick Assets/Current Liabilities
Quick Assets = Current Assets – Inventories – Prepaid expenses
Formulae Note: Desirable Ratio is 1.
• Quick assets factors only those current assets that be converted into cash quickly. Hence Inventory and Pre-paid
expenses removed.
Remarks • Alternate explanation : Assume we can’t sell any further, then is it possible to meet current liabilities from available
Current Assets (other than Inventory and pre-paid expenses).
• For a company that has Inventory, “Quick ratio” will always be less than “Current Ratio”.

99
 1.Liquidity Ratios|
1.3 Net Working capital
Formulae = Current Assets minus Current Liabilities
Current Assets : This represents use of funds. Current Assets is often referred to as Working capital.
Current liabilities : This is a source of funding. Hence reduce it.

Why is a company forced to invest in Working capital?

-Inventory : Say a manufacturing firm will have to purchase raw materials…..stock it for some days….and then
make final product……..final product may be stocked for some days……before being sold.
-Accounts Receivables : Customers may pay only after a specified period.
-Cash and Bank balance : Company will have to retain cash to meet day to day expenses.
Positive Net working capital indicates the following:
“Cash likely to be generated in the next 12 months” greater than “Cash needed to meet liabilities due in the next
12 months”

Possible situation:
Remarks There could be certain industries where Net working capital is negative. An Industry where Suppliers are
extending credit and your sale is mainly in Cash.
Example : Restaurants, online retailers, Established brands that have good command over suppliers.
Company saves on interest cost; but for the credit by suppliers you would have to take loan from Bank.

So negative net-working capital need not necessarily be bad. 100

 1.Liquidity Ratios |
1.4 Changes in Net Working capital
Formulae = Net working capital for Current Year minus Net working capital for Last Year
• This is likely to be positive for a company that is fast growing.
Remarks • Say changes in net working capital is positive; this can be inferred as an investment made by
the company.

101
2.Financial Leverage|
Overview of Financial Leverage
• Measures the extent to which company has used Debt financing (rather than Equity).
• Evaluates long term solvency position.
Is taking on Debt good ?
• In case of a company that is low risk and earns healthy profit……financial leverage is good.
• However if a company is loss making…then use of debt magnifies the loss since company is bound to
make interest payment.

Debt comprises of :
• Short term debt (Bank loans, commercial paper)
• Long term debt(Bonds, Bank loans)
Note: In case of Debt, there is a promise to pay interest and re-pay principal component. This makes Debt
risky.

Note:
Accounts Payable , Accrued Liabilities etc are not Debt. View this as liabilities arising in the normal
operations.

102
2.Financial Leverage|
2.1 Capital structure Ratios
How the company has financed the business operations ?
Objective
It shows the proportion in which company has availed funding from different sources.

2.1.1 Debt-Equity Ratio ---------This is a capital structure ratio.

Objective This evaluates the quantum of Debt.
Formulae Debt/ Shareholders Equity
• Ratio of 2:
Remarks This indicates that for every 1 Rupee of funds contributed by shareholders………company
has borrowed 2.
• Lenders will prefer the Debt-Equity ratio to be low.

103
2.Financial Leverage|
2.2 Coverage Ratios
Objective Assess company’s ability to service its debt.
This covers 2 Ratios :
Formulae -Interest coverage Ratio
-Debt service coverage Ratio

2.2.1 Debt service Coverage Ratio (DSCR)

= Nr/ Dr
Formulae
Nr will be [PAT+ Depreciation + Amortizations + Interest].
Dr will be [Interest + Loan repayment instalment for the year]
• DSCR >=2 is considered desirable.
Remarks
• Say a project is financially viable. However DSCR is less than 2. Now Bank may consider
extending the repayment period.

104
3.Activity Ratios|
Activity Ratios
• Activity ratios also called as Productivity or Asset utilization ratios.
• Indicates how effectively the firms assets are utilised to generate Revenue.
Remarks
• Analyse Receivables, Inventory and Fixed Assets separately.

Different types of Activity Ratios

3.1 Asset turnover ratio
-Fixed Assets turnover ratio
-Total assets turnover ratio
-Capital turnover ratio
3.2 Working capital turnover ratio
-Inventory turnover ratio
-Receivables turnover ratio

105
3.Activity Ratios|
3.1.1 Fixed Assets turnover ratio
Revenue/ Net fixed assets
Formulae Note:
Net fixed Assets = Gross block – Accumulated Depreciation
• Higher the ratio….more efficient is the firm in utilization of Fixed Assets.
• The ratio may not be entirely comparable between that for a company established many
Remarks
years back and that of a recently established company.
[Reason : Net fixed assets for a recently established company may be higher……hence the Fixed
Assets turnover ratio may be lower].

3.1.2 Total Assets turnover ratio

Formulae Revenue/ Total Assets
Remarks • Say ratio of 1.3…..this indicates that each Rupee of Asset generated 1.3 of Revenue.
3.1.3 Capital turnover ratio
Revenue/ Capital Employed

Where
Formulae
Capital Employed = Equity + Long term debt
or
Total Assets - Current liabilities 106
 3.Activity Ratios |
3.2.1 Inventory turnover
= Cost of goods sold/ Average Inventory
Formulae
Note: Average Inventory = [Opening inventory + Closing Inventory]/2
• This indicates how efficiently the company is managing Inventory.
• A high Inventory turnover ratio is desirable from liquidity perspective.
• A company which has larger Inventory…..the denominator would be higher; consequently the ratio
will be lower.
Remarks
• Say the ratio is 5. This means the company has “created stock and then sold” stock 5 times during the
year.
• Example: A retail chain may stock large quantity of stock prior to Diwali. However this level of stock
may not be appropriate during other periods. This inconsistency is overcome by using Annual figure in
numerator and Average figure in the denominator.
3.2.2 Accounts Receivable turnover
• Credit sales/ Average Accounts Receivable
Formulae
Note: If credit sale figure not available, assume overall sale as “Credit Sale”
• This indicates how efficiently the company is managing Accounts receivables.
• A company which offers customers long credit period…..the denominator would be higher;
Remarks
consequently the ratio will be lower.
• Say the ratio is 5. This means the company has turned over Accounts Receivables 5 times during the
year.
107
3.Activity Ratios | Operating cycle
3.2.3 Days sales in Inventory
Average Inventory/(Cost of goods sold/365)
Formulae or
365/ Inventory turnover ratio
• Represents number of days of Inventory held by the company.
Remarks
• Say year end Inventory not representative of the usual level of stock, then try using Monthly
or Quarterly average.
3.2.4 Day sales o/s (or) Average Collection Period
Average Accounts Receivables/(Credit sales/365)
Formulae or
365/Accounts Receivables Turnover Ratio
• “Average Collection Period” can be compared with “Average Payment period”.
• Depending on the industry……the difference between “Average Collection Period” and
Remarks
“Average Payment period” will vary.
Example :Say a norm could be say “Average collection period” not to exceed “Average payment
period” by more than 15 days.

108
3.Activity Ratios | Operating cycle
3.2.5 Days purchases o/s (or) Average Payment Period
Formulae Average Accounts Payables/(Credit Purchases/365)
• Number of days it takes for the company to pay Creditors.
• If company purchases goods on credit….then the number of days the cash is locked up in
Remarks operation is reduced.
• If credit purchase figure available use it. Otherwise assume that entire purchase is on credit.
• If purchase figure not directly given, deduce it from Cost of goods sold as follows:
Purchases = Cost of goods sold + Closing Inventory- Opening Inventory

3.2.6 Operating cycle

Formulae Days sales in Inventory + Days sales outstanding

3.2.7 Net Operating cycle

Formulae Days sales in Inventory + Days sales outstanding - Days Purchases outstanding

109
4.Profitability Ratios|
4.1 Profitability ratios related to Sales
4.1.1 Gross profit margin
[Gross Profit/ Sales]*100
Formulae
Where Gross Profit = [Sales – Cost of goods sold]
Remarks • Gross profit of 30%; this indicates that 30% of revenue is available to cover “Other costs”

4.1.2 Net profit margin

Formulae [Profit after tax/ Sales]*100

4.1.3 Operating profit margin

[Operating profit/ Sales]*100

Alternatively it is [EBIT/Sales]*100
Formulae Note:
a)Operating profit = Sales – Cost of goods sold – operating expenses.
b)EBIT = Operating profit +Nonoperating income -Nonoperating expenses
c)To arrive at operating profit and EBIT, we have not reduced interest and tax.
110
4.Profitability Ratios|
4.2 Profitability ratios related to overall Investment made

4.2.1 Return on Total Assets (ROA)

[Profit after tax/ Average Total Assets]*100
Formulae or
[EBIT*(1-t)/Average Total Assets]*100

4.2.2 Return on Capital Employed (ROCE)

a)[EBIT/Average Capital Employed]*100
EBIT stands for “Earnings before interest and tax”.
Capital Employed = Equity + Long term debt
or
Total Assets - Current liabilities
Note : Intangible assets to form part of Capital Employed.
Formulae
Fictitious assets not to form part of Capital Employed.

b)Alternatively we can do it post tax as follows:

[EBIT*(1-t)/Capital Employed]*100

c)ROCE to be higher than Cost of funds.

111
4.Profitability Ratios|
4.2.3 Return on Equity(ROE)

Formulae [[PAT-Preference Dividend]/[Average Equity shareholder funds]]*100

Remarks Measure of returns on funds invested by Equity shareholders.

112
4.Profitability Ratios|
4.3 Profitability ratios to assess performance from Owners view point
4.3.1 Earnings per share (EPS)
Formulae =(PAT – Preference Dividend)/ Number of outstanding Equity shares
4.3.2 Dividend per share (DPS)
Formulae = Aggregate Dividend paid to Equity Shareholders/Number of outstanding Equity shares

4.3.3 Dividend pay-out ratio

Formulae = Dividend per share/ Earning per share
This indicates what proportion of Earnings has been distributed as Dividends. Possible to assess
Remarks
if company can sustain dividend payment.
Remarks Retention Ratio = 1- [Dividend pay-out ratio]

4.3.4 Dividend yield

= Dividend per share/Market price per share
Formulae
Note: We are calculating this for Equity shares.
Remarks In case company does not pay dividend…..then Dividend yield will be 0.

113
4.Profitability Ratios|
4.4 Profitability ratios related to market

4.4.1 Price Earnings Ratio (P/E ratio)

a)P/E ratio = Market price per share/ Earnings per share
Formulae
b)Earnings per share (EPS) = (PAT – Preference Dividend)/ Number of outstanding Equity shares

a)P/E ratio of 25 : This means that investors are willing to pay 25 for 1 Rupee of Earnings.

b)P/E ratio increases when market price per share increases or Earnings per share declines.

c)Possible justification for high PE ratio : substantial growth potential in company’s future
earnings.
Remarks
d)High P/E ratio ; possibly this indicates markets have high confidence in company’s future
performance.

e) 2 types of P/E ratio –

- Trailing P/E ratio (here we use latest available EPS)
- Forward P/E ratio (here we use forecast EPS)
114
Profitability Ratios|
Price Earnings Ratio (P/E ratio)
f) Another way of interpreting P/E ratio :

Say P/E ratio of 25.......

Assume current EPS continues………
Now it takes 25 years for the investor to recoup the price paid per share only through profits.

g) Low P/E stocks:

Remarks Normally these are considered as value stocks. Here the payback period is lower.

h)High P/E stocks:

These are called Growth stocks. Here investors are relying more heavily on future growth in
EPS.

i) P/E ratio cannot be used when EPS is negative or very low.

115
Profitability Ratios |
4.4.2 Book value per share
Formulae Shareholder Equity / Number of outstanding Equity shares
Shareholder Equity =
Remarks Paid up Equity share capital+ Share Premium account+ Retained Earnings+ Accumulated other
comprehensive income – Treasury stock

4.4.3 Market value/Book value

Formulae Market price per share/ Book value per share
Remarks Home work : Compare this for Private sector banks vs Public sector banks.

116
10.Analysis of Risk factors mentioned in
IPO advertisement of Jyoti CNC Automation ltd

117
• Critically analyse and discuss the risk factors.

118
• IPO closing date - January 11,2024
• Overall issue subscribed : 40 times.
(employee category oversubscribed by 13 times)
• Closing market price on January 17,2024 : Rs 428.

• Additional points to be learned:

-Difference between IPO/FPO
-Difference between Offer for sale and Fresh issue of
shares.
-Assess Debt-Equity ratio post public issue of shares.
-Overall cost of capital; the weights to be used are
market weights.
119
Thank you

120