The Teacher: 2011

Tuesday, December 20, 2011

Retained Earnings

My experience with financial statements says that one of the terms in accounts which need to be understood better is Retained Earnings.
The purpose of capital retained is two folds:
· Maintain existing operations (maintenance capex) or
· To increase future earning capacity by expanding the business (growth capex).
Some companies need large amounts of new capital just to keep running. Others, however, can use the capital to grow. When you invest in a company, you should make it your priority to know how much capital the company appears to need and whether management has a track record of providing shareholders with a good return on that capital.
Most of us have no difficulty in understanding that whatever is not paid as dividend is transferred to reserves as retained earnings. Hence, retained earnings refer to funds generated by the company through its operations and ploughed back into business.
However, the problem starts when retained earnings is used to buy an asset. A lot of students assume that as retained earnings has been used to purchase the assets; retained earnings balance needs to reduce. However the same does not happen. We buy assets either by taking a loan hence debt goes up or by utilizing cash balance hence cash goes down. The rationale for not decreasing retained earnings is that retained earnings is just a “notional amount which tracks the amount invested in the company, it’s important to know where this money is going.

Now the million dollars question “How does the retained earnings than decrease?”
There are two ways:
1. There is a negative net income in other words loss.
2. The company utilizes reserves and surplus to pay dividends.even when the company has earned losses.
Relevance of reinvestment earnings
· Reinvestment of retained earnings can be an important source of financing for many companies. Lenders are often interested in the retained earnings. This is because company’s which use retained earnings to pay dividends when they are running in a loss are not preferred by lenders.
· A company’s performance is judged by it’s ability to make it’s retained earnings grow at a rate higher rate than market rate. Retained earnings should increase returns in the long run. The trouble is that most companies use their retained earnings for maintaining the status quo. If a company can use its retained earnings to produce above-average returns, then it is better off keeping those earnings instead of paying them out to shareholders.

Author: Abhishek Sinha

Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +

Sunday, December 18, 2011

Ratio Analysis - Beware - Not as easy as it appears

Ratio analysis is a mathematical tool that enables us to gauge the comparative performance of a company. Ratios could be used to compare the performance of a company:
· vis-a- vis it’s competitors,
· or to judge it’s performance compared to past performance.
Before you deep dive into the world of ratio analysis it is worthwhile to emphasise on the purpose of carrying out this exercise. The purpose of ratio analysis is not to merely calculate the value of ratios. The purpose is to gauge the health of the organization through proper analysis. Hence, emphasis should be equally on both the inputs and the formula. Following are certain checks you need to carry in order to ensure that the ratios serve the purpose for which it is being computed:
· Understanding the industry and the company: Every company has a story. Numbers just help us understand the story better. Hence, when we want to narrate a story careful choice of inputs to the ratio makes sure we have the logical understanding of the story. Here are certain illustrations to drive the home better.
1 The company which has a pension liability equivalent to the market value of debt would have to account for the pension liability value in calculating Enterprise Value (EV), for any of the EV ratios.
2 If a company has historically, been sitting on huge piles of cash it would be prudent to net out excess cash while calculating Net Working Capital.
· Consistency factor: Whenever we build a framework for analysis in the real world there are a lot of assumption that we make. However, “the logic remains fractured” if we do not make our assumptions pertaining to the numerator and denominator consistent. Here are few examples:
o Whenever we account for a Capital Lease in Return on Asset ratio we would also have to net out expenses pertaining to interest and depreciation
o Any ratio that involves both expenses (income statement item) and assets (balance sheet item ) needs to be made consistent. This is because balance sheet records an item as on date whereas income and expenditure records all entry for a period. Thus, we average the opening and closing balance sheet item to make the items comparable.
· Source of input: It takes time for an amateur to understand how the sources for the input can make a difference. The preferred source for the data generally is annual reports and conference call transcripts. However, at times we are forced to pick up data directly from the databases. When picking data from the databases it is always good to go through the definitions of the terms and remove affect of adjustments with which the analyst does not agree.

Author: Abhishek Sinha

Friday, September 23, 2011

Mr. Debit and Mr. Credit

Every accounting transactions has two parties involved : Debit and Credit.
I generally believe that the debit and credit concept should be introduced to the students along with the Accounting Equation:
Asset = Liability + Equity
Following are the pointers to be kept in mind before deep diving into the world of accounts:

Asset: Refers to any item which has a future benefit. We always look into the future standing at a point. The point is the date on which I am preparing the account. eg.fixed assets,investment etc.

Liability: Refers to any liabilty to the external world by the orgnization. To determine wether a particular item is a liability we stand on a particular date and look in the future. If there is an obligation as on that date we have a liability. Equity refers to the amount invested by the shareholders/partners/sole traders in the business. This is a class of people who invest to earn profit from a business. Hence whatever profit the company earns is added to the profit.
Owners Equity: Refers to the amount of money owed to the properitor/propertiors. Readers would recall that Profit = Income - Expense
Income is the amount of money earned in a given accounting period. Period could be of any duration depending on the purpose of analysis. It should be noted that the amount received and receivable for a particular accounting period is accounted as income.

Expense refers to economic costs that is made in order to earn revenue in a given period. The word expenses is restricted to cost incurred in meeting operational need. Period could be of any duration depending on the purpose of analysis

Expenses decrease profits; while, income increase profits .

Profit is added to the owners equity. Profit is the reward for risk the owner takes.

Hence income increases equity and expenses decrease equity.

Now the rules:

Any increase in assets and expenses needs to be debited. Any increase in liability and income needs to be credited.

Any decrease in assets and expenses needs to credited. Any increase in liability and income needs to be debited.

Accounts is prepared on double entry accounting concept. Hence every debit should have a corresponding credit.

ILLUSTRATION:
Rent expenses paid Rs. 500

The two aspects of the transaction are Rent and Cash (assumed paid in cash).

Rent is an expense hence an increase in rent needs to be debited. Cash is an asset hence decrease in cash needs to be credited.

As the purpose of this blog is to connect the concept of accounts and finance rather than getting into the nitties and grities of account I am not getting into the details of " Debit and "Credit."

Author: Abhishek Sinha

Thursday, September 22, 2011

Cash Flow From Investing and Financing- the missing pieces in the cash flow puzzle

My firm belief is preparing a cash flow from investment and cash flow from financing is relatively easier than preparing cash flow from operating activities. This is because as we use direct method for preparing cash flow from investment and financing it is all about being intuitive.
Investment activities here refers to buying and selling of long term assets. As already covered in one of the earlier blogs to determine asset we need to stand at a particular point and look in the future. If the particular item has a future benefit we call it asset. Any asset which provides a benefit of more than one year is know as long term asset.
For the purpose of cash flow from investing activities we need to gauge whether:
1. The asset is being bought or sold.
2. Determine whether cash is involved.
Buying of asset generates a cash outflow or decrease in cash balance and selling of assets lead to cash inflow or increase in cash balance.
It should also be noted that when a company is expanding, it will buy more assets than it sells and this will lead to net cash outflow. In other words for a company which is growing cash flow from investment is negative.
On the other hand, financing activities refers to the process of funding the investments and operation of a business. Following are major sources for long term funding of operations and investing activities:
1. Long Term loans(Debts)(External Sources)
2. Preference Shares (Internal Sources with fixed rate of dividends)
3. Equity Share capital (Internal Sources with dividend rates not fixed).
A. The important fact to be remembered is issue of debts/equity share capital/preference capital leads to cash inflow.
B. On the other hand interests and dividends which are servicing costs associated with these sources of capital lead to cash outflow.
C. Redemption of debentures (Debt) and Equity/Preference leads to outflow of cash.
Here is a format for cash flow statement:
Cash flows from operating activities (CFO)
Profit after taxation
Add:Depreciation
Add:Interest expense
Add:Profit on the sale of property, plant & equipment
Working capital changes:
(Increase) / Decrease in trade and other receivables
(Increase) / (Decrease) in inventories
Increase / (Decrease) in trade payables
Cash Flow from Operating Activities
Cash flows from investing activities (CFI)
Less: Business acquisitions, net of cash acquired (purchases of business leads to cash outflow ; hence negative)
Less:Purchase of property, plant and equipment(PP&E) (purchases of PP&E leads to cash outflow ; hence negative)
Proceeds from sale of equipment (leads to cash inflow ; hence positive)
Less: Acquisition of portfolio investments (leads to cash outflow ; hence negative)
Add: Investment income (leads to cash inflow ; hence positive)
Net cash used in investing activities Cash flows from financing activities (CFF)
Add: Proceeds from issue of share capital (Cash inflow)
Add: Proceeds from long-term borrowings (Cash inflow)
Less: Payment of interest on long term borrowings (Cash Outflow)
Less: Payment of Dividend on preference and Equity share capital (Cash Outflow)
Redemption of shares and debentures (Debts)(Cash Outflow)
Net increase in cash and cash equivalents (CFO+CFI+CFF) Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period (Should match with the cash and cash equivalent in the balance sheet)

Author: Abhishek Sinha

Thursday, September 15, 2011

Score Keeper prepares a cash flow from operations statement statement

I believe that at times drawing analogies help in understanding a concept better. A lot of beginners find difficulty in understanding how a cash flow is derived from an income statement. Even though constructing a cash flow by direct method is easier it is not what companies prefer.
Before I start I would like to revisit the Income Statement :
Schedule 1:
Sales
Less: Cost of Goods sold
Gross Profit
Less: Operating Expenses(Excluding Depreciation Expenses)
EBIDTA
Less: Depreciation
EBIT
Less: Interest
Add: Other Income (Profit on sale of investments)
EBT
Less: Tax
Net Income

Following are the points to be noted:
1. We are adding all income - paid in cash or outstanding
2. We are subtracting all expenses - paid in cash or outstanding
3. Expenses also include non cash expenses such as depreciation. They are notional figures which do not really involve cash.
4. All income and expenses are recurring in nature

Here I have drawn a parallel between "book keeping" and "score keeping again".
The game, cash flow has three parts:
Cash flow from operations
Cash Flow from investments
Cash Flow from Financing activities

The results of cash flow from operations is derived from net income statement.

To start with imagine that the results of the game income statement is already available. The result of this game is known as "net profit". Look at Schedule 1 to get a better understanding of the same.

Now if someone asks you to derive cash flow from operations from the results of an income statement the first thing you need to understand is the difference between the two.
1. We do not include income which is not in cash. Example, profit on sales of assets is not in cash hence not included.The same is included in income statement.
2. We do not include expenses not in cash. Depreciation is not in cash hence not included.
3. Outstanding expenses and income due but not received also is included in income statement but need to be removed to get the cash flow from operations.

The facts that we need to know before we start converting the results of one game to another:
1. If we want to annul the impact of a positive number we subtract.
2. If we want to annul the impact of a negative number we add.
3. All income items are positive. Hence to annul it's impact we subtract.
4. All expense items are negative. Hence to annul it's impact we add.
5. We need to annul impact of non cash expenditure such as depreciation. Hence if the net income is given we add back depreciation.
6. We need to annul impact of non cash income such as profit from sale of assets. Hence we subtract the item from net income.
7. Interest is amount paid on financing activities. Hence it has no place in cash flow from operating activities. Thus we add interest paid to net income.
8. There are certain items such as credit sales and credit purchases which cannot be ascertained from income statement. Now we need to take the help of balance sheet.We can find credit sales as the difference between accounts receivable (current year)and accounts receivable (last year). A positive credit sales leads to increase in net income. Hence to annul it's impact the bookkeeper subtracts increase in accounts receivable and adds back decrease in accounts receivable.
9. Following the same principle any increase in non cash current asset needs to be subtracted and any decrease needs to be added.
10. In case of increase in current liabilities we add back as increase in current liabilities denote increase in credit expenses. To remove the effect of unwanted cash we need to add back.

Following is how a cash flow from operations looks:
Profit after taxation
Adjustments for:
Depreciation (Non Cash Expense)(Hence add back)
Interest expense (Non Operating expense)(Hence add back)
Profit on the sale of property, plant & equipment (Increase in profits, not in cash flow)Note: total cash from sales has been recorded as a separate
Working capital changes:
Add Decrease in trade and other receivables
Add Decrease in inventories
Add Increase in trade payable

Cash generated from operations

Hence, here the book keeper has converted the income statement into cash flow from operating statement. Comment awaited.

Author: Abhishek Sinha

Tuesday, August 30, 2011

Socrates Teaches Balance Sheet

Of late, I am trying to adapt socractic method of teaching. Here is my attempt to explain the concept of Balance Sheet using one of the most intuitive methods of teaching.

The teacher enters the class and writes on the board - Balance Sheet. Then he asks one of the most studious student in class, "Can you please define this for us?"

"A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders."

Ramesh the mathematics wizard of the batch adds:

The balance sheet is based on the following formula. Assets = Liabilities + Shareholders' Equity

The teacher thanks both and asks his next question "Could you please tell me what is the relevance of specific point in time."

Ravi who always loves to show his ability to understand concepts chips in "It is akin to standing at a particular point and looking in the future. The teacher is elated as Ravi has taken in the direction he wanted the discussion to follow.
The teacher then asks what do you mean by company's assets, liabilities and shareholders' equity . Ramesh who likes rules based approaches and has not spoken yet jumps at this chance "We assume we are standing on that particular date and we look at the future. Every item then is put through a test based on the following rules.:
1. If the item creates a benefit in the future it is known as an asset.
2. If the item creates an obligation in the future it can either be a liability or equity.
3. If the item has an obligation in the future towards the people who run the business the term owner's equity is used.
4. If the obligation is created towards outsiders the term liability is used.

The teacher then started throwing terms at the class. The class knew exactly what to do. They had to explain the term and then with reasons categorize it. As asset liability or equity. This is the list of answers he got:

1, Share capital - A future obligation to pay the amount invested to "owners", The class had also pointed out that there could be two classes of shares: equity shares and preference shares.
a. Equity Share Capital - referred to shares that had uncertain level of dividends.Investors generally invested in this class of shares to make profit out of change in profits. During wounding up of company they would be the last ones to be paid.

b. Preference Share Capital - The teacher loved to call this class of shares as quasi debt because dividends on these shares were fixed akin to interest on debts.

c.Debentures - are credit instruments that have fixed interest rates. Raj had added that to be make debentures interesting a lot of companies these days were adding a clause which made them convertible. Convertible debentures, had the feature wherein it would convert to equity shares as and when the need

c.Stock Options and Warrants - are a class of liability that the holders of the instrument have a right to exercise after a specified period of time.

d. Reserves and Surplus: The part of profit that is transferred to the balance sheet is accumulated as Reserves and Surplus in Balance Sheet. Generally, the company decides on the particular reserve in which it wants to transfer the profit.In certain sectors such as Banking the government regulates the amount to be transferred to statutory reserves to ensure the solvency of the firm.
The amounts transferred to the balance sheet is profit net of dividends paid out to the shareholders and is known as retained earnings. As the reserves and surplus is transferred technically out of net profit which is the the reward of Equity shareholders for taking risks, Hence,it is shown along with the capital as it is the obligation to be paid to the equity shareholders.

e. Current Liabilities:

Refers to the liabilities or obligations that the company needs to pay in the the short term. It includes
A. Accounts Payable/ Creditors - amount to be paid with respect to credit purchases ONLY for goods pertaining to SALES.
B. Bank Overdraft - Amount withdrawn in excess of bank balance.
C. Outstanding Expenses - Expenses which have not been paid yet.

On the asset side the class mentioned items such as :

1. Fixed Assets which consists of both tangible and intangible assets.
Tangible Fixed Assets include Plant Property and Equipment (PP&E). They also added that the tangible assets include those fixed Assets which can be seen.
Intangible assets include Goodwill and Patents.
2. Investments include investments of companies in different classes of instruments.
3. Current Assets include those assets which have a benefit of less than one year. The students could not elaborate much on current assets due to lack of time. However,it became clear the items had a benefit of not more than one year.It was also clear from the discussion that current assets included accounts receivable which shows the accumulated credit sales; cash;inventories and prepaid expenses.The teacher added that some companies prefer to show current asset as net of current liabilities.
He ended the discussion by adding the following points :

1. He told the students that fixed assets are recorded in the books on net book value (value at which it was purchased less depreciation/amortization) not at the prevailing market value.On the other hand inventories was recorded at book value or market value whichever is lower.

2. He reminded the students that liabilities are recorded in the books at book value too.

3. On the other hand equity share was recorded at face value. According to the teacher this face value was different from market value at which it was issued.

4. He ended the discussion with the caveat that list he has given is not exhaustive,and student should use the socractic method to tackle any new items he encounters.

He also asked them to refer to www.investopedia.com to look for terms that they were still confused with.

Saturday, August 27, 2011

Income Statement - A score keeper versus book keeper

We have always been blaming accounts for not being intuitive. However, the perspective at which we have been looking at an accountant is what should be blamed rather than the school of knowledge on which accounts is based.

To look at it from the right perspective,it is important to understand that the job of the accountant is akin to that of a score keeper. He needs to understand the rules of the games and make entries in the books so as to represent the financial transactions of the entity in the same way in which the score keeper records the proceedings of the games. Each game has a rule in the same way each book has its rules too.

To illustrate, I have taken PROFIT AND LOSS ACCOUNT statement:
PROFIT AND LOSS ACCOUNT

Following are the rules of this game:
1. Expenses and Income related to a particular year are the players who participate in the game
2. Expenses are recurring (occur again and again) in nature and it does not matter wether thay are paid or outstanding
3. Income is also recurring and it does not matter wether thay are received or outstanding
4. Purchase and Sale of Assets and Liablities are not recorded in income statement.
5. However profit or Loss from sale of asset is recorded. Similarly fall in the value of fixed assets which is known as depreciation is recorded in the books as expense.
Now there are two sides to the score board we maintain: Debit and credit:
6. We debit all expenses and we credit all income gains.Profit or Loss is the final score.
7. Dividend is distibution of income and not income hence does not appear in the income statement.
So any book keeper who wants to be as efficient as a score keeper and contribute to the success of the company has to remember thes rules.
Now if you look at the book with these rules in mind; I am sure accounts will be more intuitive.