Accounting Basics

Three types of statement -

1. Income Statement (Profit and Loss)

2. Balance Sheet
3. Cash Flow

In good times, investors are interested in P&L Statements however in bad times
investors assess company by looking at balance sheet

Basic Equation -
Assets = Liabilities + Equity
Cogs (Cost of Goods Sold) = Cost of Goods + Cost of Personnel involved in
production

Profit and loss statement -

Comprises of following two components -

• Revenues - The income generated by the company. It is of two type -

o Net Sales - Part of revenue which comes from core business of the
company
o Other revenue - Comes from the process or resources which are not
the central part of company's business model.
• Expenses - Cost incurred by company to provide revenue generating
services to customers. It is divided into following parts -
o Cost of goods - Cost responsible directly for production of material
o Operating Expenses (Indirect Cost)
o Depreciation (tangible Assets) and Amortization (Intangible Assets)
(Fixed Assets)
o Interest Expenses - On loans
o Taxes (penultimate line in income statement)

• Revenue - COGS = Gross Profit

• Gross profit - Operating expenses = EBIDTA (Earning before Interest,
tax, Depreciation and Amortization)
• EBIDTA - (Depreciation + Amortization) = EBIT (Earning before Income
tax)
• EBIT - Interest Expenses = EBT
 • EBT - Tax = Net Profit

Balance Sheet
Assets Liabilities Equity
Cash Accounts payable Cash at s
Financial
Receivables Retained In
Liabilities
Inventory (Raw material, Under progress, Net Profit (C
Tax liabilities
Finished) Year)
Property and Plant, Equipment Provisions

Revenue Recognition Criteria -

1. Risk and rewards have been transferred from seller to buyer

2. Seller has no control over the goods sold
3. Collection of payment is reasonably assured
4. amount of revenue can be reasonably calculated
5. Cost of earning the revenue can be reasonably measured

Basically different sections are created to record different

types of cost (and Revenues). If the transaction involves
future payment options or early payment scheme then for
the time being the cost is recorded ( Credited if taking
out/Debited if giving in) in respective accounts ( Payable/
Receivables). When the cost is realized, amount is
debited/credited from other accounts and respective
adjustments are made to cash account.

Trade receivables -

• Fall under asset, however its high value is not desirable

• Any type of credit given to customers or suppliers for which they expect
payment in future
• Depends on sales directly
 • Also shows the efficiency of company's tactics in getting back money from
invoices
• If a client cannot pay his debt on time then interest is accrued on the amount
as per sales contract. In the worst cases the client declares bankruptcy and
process takes a legal discourse. In any case, the amount declared after
bankruptcy is irrecoverable and company cuts it off from trade receivables
and submit it to cost of irrecoverable debt( lowers margin). Provisions for
irrecoverable debt can be taken in advance looking for trends.

Inventory -

• It comes under assets.

• Can be of three types - raw materials/ under process goods / finished goods
• Companies like Facebook and fed ex don't keep inventory
• COGS = beginning inventory + purchases - ending inventory
• Product cost is included in inventories while period cost is not
• Over a period of time, the price of similar products (identical sometimes)
change. To decide how to charge cost for these products, a mechanism
called cost flow mechanism.

Cost Flow Method - It is the mechanism by which a firm decides the cost of
products to be sold. It is mainly of thee types -

1. Specific Identity - individual identity of particular items is tracked and

charged the same to customers
2. First in First out - Cost (and products) are tracked by date received and
the item staying in inventory for the longest time is shipped first
3. Weighted Average - Weighted average of all the present products s taken
and every products is sold at same cost

Fixed Assets -

• They are the assets which lives with company for long term. majorly they
are of three type-
o Tangible Assets - Real material asset i.e. land, Plant, Machinery
o Intangible assets - Abstract in nature i.e. Goodwill, Intellectual
Property
o Financial assets (Bonds, Shares etc)
• One major point is how to record the cost of asset realization. Whether to
capitalize it or show it as expense. Generally, the cost incurred for
 creation of asset is capitalized and cost incurred for its maintenance is
shown as expenses for related period.
• Since fixed assets has capitalized cost over a long period, tax rates are
higher for them.
• Companies are allowed to show costs pertaining to fixed assets in either
way. however, for a fixed asset, once a method is opted then it can't be
changed. If net profit is to be increased, cost is recorded as capitalized. If
the interest rate is to be reduced, then cost is recorded as expense. This
type of accounting is not allowed for all types of assets and called fair
value accounting.

Intangible Assets (Finite and Infinite life) -

• Finite intangible assets are amortized according to the year in which they
are going to expire
• Infinite intangible assets are valued for impairment which is determined
by a specialist (third party). the value for impairment is important as it
may offset the company's balance sheet drastically.
• Examples - Finite life - Sports contract, Software License, Concessions
• Examples - Infinite life - Company's name, brand, logo, website

When tangible assets are created internally, the amount used for its creation and
transformation is capitalized the cost incurred for its maintenance is recorded in
expense. However, for intangible assets process is different. Cost incurred for
research is immediately shown as expense while cost incurred for development
is capitalized. One exception is software R&D where capitalization of all
activities is allowed.

Trade Payables -

• It is a current liability and the period of payment is 180 days. In practice,

most vendors demand their payment in 30 days.
• The amount to be paid which is owed is delayed as the firm will be acting
on other's money and will not incur interest on that money. However, to
sort that out payment terms are included in the clause. the terms are
decided solely on how strongly leveraged one party is than the other.
• One thing to note is the interest charges levied by the vendor on delayed
payments.
 • If a formal document is signed declaring the terms of payment (Date,
Time etc.) then it is called Notes Payable. it is much more
enforceable than normal trade payables.

Debt VS Equity
There are two types of financing -

1. Debt financing - One which is sourced through loans and credits from
third party. this financial instrument contains obligation to to repay in
future.
2. Equity Financing - One which is used to finance through firms own
resources like shareholder money. here. no promise of repayment is made
but promise to share earnings is made.

• A special type of financing instrument is convertible bonds which can be

converted from one type to another called Convertible Bonds.

Loan Amortization -
Transaction cost for generating loan is also included in total loan amount in
company's balance sheet. Once the monthly payment amount is finalized,
interest accrued till then is removed then the principle sum is reduced. Interest is
counted on the remaining sum.

Debt Covenant - Mechanism included to ensure borrower's payment behavior.

It is of three types mainly -

1. Positive covenant - Enforces borrower to do something

2. Negative covenant - Prohibits borrowers from doing some specific
actions
3. Financial - Require some financial condition to be followed.

• More the debt financing vs equity ratio of the company, more it is

onsidered as risky venture for further funding. this result in more
penalizing future loans which are considered less desirable. Thus, this
mechanism limits the level of financing a firm can obtain.
 Equity Financing
Types of Equity -

1. Retained earnings -It is the portion of earning not distributed to

shareholders and used for reinvestment. Retained earnings may be
positive or negative as per profit or loss sustained. If the total
accumulated loss in this section becomes greater than rest of the equity,
then the firm is said to be in technical default.
2. Treasury Stock - It is the stock repurchased by company from
shareholders. It is shown in negative as shares are taken out from
shareholders and their balance is shown only on the basis of outstanding
shares.
3. Non Controlling interest - Minority stakeholders which own certain
portion but have negligible control over affairs.
4. Other comprehensive income - The gains which are excluded from net
income but realized in same period.

It is not always optimal to raise equity from its own earnings, specially in initial
stages as competitors may outgrow easily.
private equity funds are one notch above the venture capitals, they invest in
more proportions, generally interested in ownership stakes and have a mindset
of fixed time frame (5 years generally).

Types of Dividends -

1. Regular Dividend -Payed at regular interval of time (quarterly or

yearly). Mostly opted by mature companies with stable cash flow.
2. Special Dividends - these are special dividends paid in times of profits
and favorable conditions. They can be issued by those companies also
which do not issue special dividends.
3. Stock Dividend - It is the payment made in the form of additional shares
rather than cash. They are much less popular than above two.
4. Liquidating Dividends - These are paid when company is closing down.

Paying dividend results in reduction of share value when taken into account.

Share Repurchases -
 • When the firm tries to buy its own shares from the shareholders which are
willing to sell. This is a form of payment to shareholders besides
dividends.
• Share repurchases can be done via generating tender offer which is open
to all share holders. One other method is via private negotiations which is
done with selective holders.
• On the upside, share repurchases indicate that firm's shares are
undervalued at present and price is sure to go up. However, on the
downside it also indicates that firm is lacking external investment and
growth opportunities. Ultimately it boils down to market sentiments.

STOCK SPLIT -

• It is the mechanism by which company convert its single stock into

multiple stocks. In this process the individual value of particular stock
falls while gross value remains same.
• Generally price range of 80$ to 120$ is considered optimum range.
Hence, to keep the range applicable when stock prices increase, stock
splitting is done.
• When stock splitting is announced, it is perceived as a positive signal
which indicates to upcoming growth and increased earning by the
company.

FINANCIAL STATEMENT ANALYSIS

It is continuation of accounting that uses financial figures in order to provide
some less obvious insights about the business. Once, income statement and
balance sheet are generated, Financial Statement Analysis can be taken up.
It assess the soundness and performance on the basis of four main criteria -

1. Growth - Is the company growing

2. Liquidity - Does the company has sufficient cash to meet its short term
obligations.
3. Profitability - Is the profit generated by company is satisfactory
4. Solvency - Does the company has enough assets to clear its liabilities

It is important to understand underlying business of the company to perform a

financial statement analysis. Two types of analysis are made to analyze the
company. one is analyzing the changes in revenues, expenses of the same
company year over year to check its consistency.
Other is to compare it with its peers to check for growth potential.
Financial Statement Analysis is performed generally to find the answers for
following broad questions -

• Is the company growing faster?

• Is it able to charge higher prices?
• Is it profitable?
• Is the business efficient?

Popular indicators used is analysis are -

1. Liquidity - Current Ratio , Net Trade Cycle

2. Solvency - Debt Ratio, Interest Coverage
3. Profitability - ROA , ROE
4. Growth - Revenue Growth

Current Ratio - CR = Current assets / Current Liabilities

It gives an idea of how likely company is able to clear its short term
liabilities. Its optimum value depends on underlying industry
but generally a value above 2 is considered good.
Net Trade Cycle - It is defined as the time taken by company to convert its
products and services into cash
Debt Ratio - DR = Total liabilities/Total Assets
It gives an idea of how sustainable a business is and how likely it is able to
clear its liabilities. Lower ratio is desirable and a ratio of 0.67 is generally
acceptable. However one should compare it with industry average.
Interest Coverage - IC = EBIT / Interest Expenses
It tells us how does company stands after clearing its interest expenses. A
ratio greater than 2 means company will be able to clear its interest as
well as some portion of the principal. on the other hand, ratio of less than 1
indicates that company is not able to clear even its interest accrued.
Return on Assets (ROA) - ROA = EBIT / Total Assets
It is a indicator of how profitable a company is regardless of how it is
financed.
Return on Equity - ROE = net income / Shareholder's money
It indicates how are the returns of company in comparison of how much
shareholders money is used to finance it.
Revenue Growth - RG = (Revenue this year / Revenue of last year) - 1
It indicates how fast is revenue increasing.

WORKING CAPITAL MANAGEMENT

It can be compared to a person's cost of living. The necessary expenses required
to keep the business flowing constitutes working capital. If working capital is
not provided then company's total asses will increase the total assets and it will
be very costly to liquidate that.

Working Capital = Current Assets - Current Liabilities

Operating Cash - Generally 2% of revenue is considered operating cash. If the

firms is having cash assets less than 2% of the revenue then all of the cash asset
is considered operating cash. Otherwise some excess cash is left. In some cases
operating cash is include in calculation of working capital while in some cases it
is excluded.

More the working capital, lesser will be the cash flow.

Inventory, Trade receivables and trade payable constitute significant portion of

working capital. Proper invoice collection and revising payment structures to
suppliers for delayed pending will reduce the working capital.

Optimizing the Working Capital - If the working capital is too low, then the
firm faces liquidation issues and it wont be able to generate enough cash in
hard times. However, if the working capital is too high, then it is observed as
missed other investment opportunities as lots of cash that should be free for
investment is actually tied up in working capital. Extreme cases of liquidation
issues are called Over-trading situation and extreme cases of high working
capital is called over-capitalization issue.

Managing Trade Receivables - As trade receivables affect significantly the

working capital, their management is significantly important. it is done via
bifurcating in following section.

1. Screening of Clients - We should check for credit worthiness of clients

before starting business with them. We should also keep assessing our
current clients too. Following are some methods to check for their credit
worthiness -
o Bank Reference - This documents helps a lot in client assessments
as banks have not much incentive to give false report
o Trade Reference - It is done via contacting and having
conversations with other trade partners
o Credit Rating - We should check for the credit ratings for the
company and news about their performance. Not a robust method.
o Visiting client facilities can also help
 2. Credit Term Policy - Company should prepare its credit term policy in
such a way that it is not put on a bad spot if a client is not willing to
pay. It should mention following activities -
o Frequency of payment
o Maximum total amount to be given on credit
o Penalty charges applied on delayed payment
3. Collection - Company should be diligent and consistent in following up
for outstanding payments from client. Following method should be
applied -
o One should not forget sending invoice promptly
o Individual follow ups should be done. Care should be taken to
maintain relations.
o One should sign an agreement with external debt collectors as it is
very likely to lose the credit if client declares bankruptcy.

Inventory Management -

Reorder Level - It is the technique used to determine at which stage order of

further inventories is to be placed. They mainly depend upon three following
factors -

• Lead Time - Time taken for order to reach us (in days)

• Average daily consumption
• Safety stock - Its used to compensate for margin of error in shipment

Reorder Level = Lead time x Average daily consumption - Safety stock

The process is not so straightforward as the lead time and average consumption
vary throughout the year. Extensive level of communication between warehouse
managers and production team is required to manage optimum inventory levels.

Economic order quantity - It is the another technique to check for inventory

orders. it is calculus based with major variables being -

• Expected Annual Usage (D)

• Cost of product (inc. delivery)
• Cost of Purchasing (S) - Paperwork, Follow up, Inspection
• Holding Cos (H) - Warehouse cost, Obsolescence etc.

EOQ = (22*D*S/H)^0.5
There are some limitations to this method as it considers lead time as well as
purchasing costs constant throughout which is not the case. It also don't take
into consideration the rebates on bulk orders. Otherwise it is a pretty intuitive
and practical method.
Hints of Bad Working Capital Management -

• If company is financially healthy but incurring interest charges on

delayed payments
• If company is dealing with large number of suppliers for basically similar
kind of products
• if multiple payments schedules are arranged with same supplier
• Inaccurate Cash flow forecasting
• If there are discrepancies between invoice value and client expectation

CAPITAL BUDGETING
Capital budgeting is a process used to assess the viability of investment options for
a firm. They may be of following types -

• Investment to be made in developing a new production plant

• Acquisition of new ERP system
• Research and development activities to be taken up for new projects
• Expanding existing ware houses
• Purchase or leasing of new vehicles (Assets)
• Investment to be made in employee training programs

Capital budgeting is done for projects which have following characteristics -

1. Projects are long term in nature

2. Projects are very important for company
3. Large investments are required for undertaking the project

Time Value of money - The basic concept is that money in hand today is worth
more than the same money to be received in future. It is due to the fact that we
have multiple investment options if we have money in hand today and they can
give significant returns.

Discounting Cash Flow - It is the method of getting present value for the money
that is to be received in future. Value usually reduces if payments are to be
received in more distant future. How much reduction will be faced depends on
multiple factors which will be discussed below. It is extensively used in capital
budgeting as investment returns are usually analyzed on discounted cash-
flow rates.
The major factor which helps us calculate discounted cash-flow is the discount rate
applied which is discussed below.

Discount Rate - (Further study required) DIscount rate is calculated by

analyzinfg and putting into calculation the following factors -

1. Cost of debt - It is the average interest rate company pays on its

borrowings. In 100% debt financed projects, discount rate is equal to cost of
debt.
2. Cost of Equity (CAPM - Capital Asset Pricing Model) - It is equal to
discount rate if project is 100% equity financed. It is calculated with
following formula -

COE = Risk free rate + (b x Market risk premium)

o Risk free rate - It is the rate of return on investment with zero risk.
Generally a 10 year government bond is considered as reference.
o b (beta) - It is a statistical value calculated by dividing co-variance of
returns on risk free and normal market investments by variance of
market returns. If beta > 1, then stock is more volatile then market. If
beta = 1, then the stock is as volatile as market. If beta < 1, then
stock is less volatile then market. One thing to be noted is that beta
for the company may be different from the beta for the project
undertaken by the company.
o Market risk premium - It is the average expected market return minus
the risk free rate. Its value is generally 5%.
2. Weighted Average Cost of Capital (WACC) - It is the average discount
rate applied when project has some proportion of both equity and debt
financing. It is calculated by a formula which represents the portion of both
equity and debts financing and also the tax shield is used to reduce the cost
in the portion of debt financing.

In a nutshell, for capital budgeting, we calculate the initial investment to be made

plus the working capital for running the project as cost and future returns as cash-
flow are calculated. Except those, residual value of project is also accounted for by
calculating the scrap value of remaining components and their degree of
obsolescence. These are calculation intensive activities and takes time and serious
time is also devoted to calculate alternatives at each stepa and for a project as a
whole.
 COMPANY VALUATION
Proper valuation of company is required in many cases for example - Mergers and
acquisitions, Subsidiary sales, Startups, IPOs etc.
It is important from both buyers and sellers perspectives.

Investor perspective - Primary motive of any investor to look for valuation of a

company is to assess how much money can be made buy investing in it. The
returns are divided into three major variables -

1. Purchasing price
2. Dividends
3. Selling Price

Stock price of the company is estimated on the basis of upcoming dividends to be

paid to shareholders.
Cash-Flow is the main driving factor behind estimating the values of dividends. If
the company is not in the practice of giving dividends, then also the final share
price majorly depends on cash-flow being generated.

CASH-FLOW Calculation
Revenues - Expenditure - Investments = Cashflow
The above universal equation for calculation of cash-flow suggests that cash-
flow is mainly affected by revenues and profitability of the company (directly
proportional in both the cases).

• In cash-flow calculations, mainly NOPAT (Net Operating Income After

Taxes) Is used. Interest expenses are not taken into account.
• Interest expenses are not taken into account as there is a common theorem
(Given by --??) that states - In an efficient market, value of firm is not
affected by how it is financed.

Revenues
-Cost of Goods sold
-Operating Expenses
-D&A
=EBIT
-Operating Taxes
=NOPAT
+D&A
+/-Working Capital (Net value)
-Capex (Capital Expenditure)
+/- Other operating assets and liabilities
=Unlevered Free Cash-flow

• If an asset directly contributes to the operations of business then it is

considered as operating assets. Same goes for liabilities

Discounted Cash-Flow - It uses the concept of time value of money to get the
correct assessment of present value of cash-flow by discount the future cash-flows.
Discount factor depends on the type of cash-flow under assessment. Generally
WACC (Weighted average cost of capital) is used.
Future forecasting of cashflow is generally divided into two parts -

1. Cashflow being generated in near future (Generally a period of 5-10

years)
2. Terminal Cashflow (Removing near future value from the life of company)

Cash-flow for near future is calculated then for the terminal value of cash-flow, all
the subsequent years cashflow keep on decreasing and their cumulative value is
calculated by following term -
FCF5 * (1-g) / WACC - g

• FCF = Free cash flow (5 for 5 years period considered for near future)
• g = long term growth rate

Present value = Future Value / (1 - WACC)

here - n = number of the year, cash-flow for each particular year is calculated then
divided by discount factor raised to the power equal to that of the year.Cumulative
value is taken by adding all individual cash-flows' present value.

Present Value of Cash-flow (Cumulative)

+Present value of Terminal Value
+Non Operating Expenses
=Enterprise Value
-Financial Liabilities
+Cash
-Debt Like Items (Pensions, Provident Funds etc)
= Equity Value
/ No. of Shares Issued
= Price Per Share

Valuation Stages -