essentials of fa_chapter 4
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Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA
ESSENTIALSOF FINANCIAL
ACCOUNTING
BY ASISH K BHATTACHARYYASecond Edition
Chapter 4
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Profit or Loss for the Period
Equity = Assets Liabilities
Income increases equity and expenses reduce
equity. Equity also changes with fresh contribution
from equity participants (shareholders) and
distribution of profit to equity participants (dividend).
Therefore, increase (or decrease) in equity during
the accounting period, adjusted for change due to
contribution from or distribution of profit to equity
participants, represents profit (or loss) for theperiod.
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Equity, Net Income and Accounting Policy
Net profit (also called net income) depends on the
accounting policy of the company.
For example, Indian GAAP requires that the long-
term investment in equities issued by other entities
should be carried in the balance sheet at the
acquisition cost, while IFRS require that such
investments should be carried in the balance sheet
at fair value at the balance sheet date.
This difference in accounting principles results indifference in the measurement of equity and net
income in financial statements.
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IFRS and Indian GAAP
There are a few accounting principles and methodsstipulated in the Indian GAAP that differ from thosestipulated in the IFRS.
Entities domiciled in India are required to prepare and
present financial statements in accordance withprinciples and methods stipulated in the Indian GAAP.
India will adopt IFRS from 1 April, 2011. The adoptionwill be in stages.
In the first stage, companies with net worth of Rs. 1,000
crores and above will adopt IFRS. In addition companiesthat constitute SENSEX 30 or NIFTY 50 or which arelisted in any foreign stock exchange will apply IFRS.
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IFRS and Indian GAAP (cont.)
In due course, all companies except those unlisted
companies whose net worth is Rs. 500 crores will adopt
IFRS.
Thus, the Indian GAAP will converge with accounting
practices in more than 100 countries, which havealready adopted IFRS.
IFRS uses fair value measurement more extensively
than the Indian GAAP.
Use of fair value measurement brings volatility in thereported net profit because assets and liabilities are
restated at the fair value at the balance sheet date and
subject to a few exceptions, the change in the fair value
is reported in the profit and loss account.
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Net Profit or Loss and Other
Comprehensive Income
Both the Indian GAAP and IFRS do not permit
inclusion of a few items of income in arriving at the
profit or loss for the period covered by the profit and
loss account. IFRS require entities to present those items under
the heading othercomprehensive income
separately below the profit or loss for the period in
the profit and loss account. The amount by which the equity changed in the
current period is the total of the profit or loss for the
period and the other comprehensive income.
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Net Profit or Loss and Other
Comprehensive Income (cont.)
The Indian GAAP does not require presentation of
other comprehensive income in the profit and loss
account.
It requires those items to be presented directly in thebalance sheet as adjustments to equity.
Except for those items of income specified in
accounting standards, all items of income (including
gains) and expenses and losses are included inprofit or loss for the period.
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Revaluation Gain
Revaluation gain arising from the revaluation of an item offixed asset is not included in the profit or loss for the period inwhich the asset is revalued because that gain will not havecash consequence in the immediate future.
The gain will be realised either through use or disposal of the
asset. Therefore, the revaluation gain is transferred from revaluation
reserve, which is a part of capital reserve, to general reserve,which represents retained profit available for distribution toshareholders, on time proportion basis, over the remaininguseful life of the asset.
If the asset is disposed before the expiry of the useful life, thebalance in the revaluation reserve is transferred to profit orloss for the period in which the asset is disposed as a part ofprofit or loss on disposal.
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Revaluation Gain (cont.)
IFRS allow revaluation of fixed assets only if an
entity chooses to measure fixed assets at fair value.
Revaluation is not permitted if fixed assets are
measured at cost.
The Indian GAAP does not permit measurement of
fixed assets at fair value, but allows revaluation.
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Investment in Equity Shares: Changes in
Fair Value
Under IFRS, investments in equity shares issued by
another entity are measured at fair value.
The gain or loss arising from the change in the fair
value is recognised as profit or loss in the profit and
loss account for the period ended at the balance
sheet date.
However, if an investment is not held for trading, an
entity has to recognise such gain or loss in the
other comprehensive income.
Accumulated gain or loss is recognised in the profit and
loss account on disposal of the investment.
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Structure of Profit and Loss Account
Balance sheet presents the stock of assets and
liabilities, and also the amount of equity capital at
the end of the accounting period (balance sheet
date).
Profit and loss account summarises the incomes,
gains, expenses and losses for the current period.
It provides an understanding of the performance for the
current period and also provides an overview of how
equity has changed during the current period. Profit and loss account, in a way, presents the flow of
incomes, gains, expenses and losses for the current
year.
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Expenses
Expenses measure decreases in economic benefits
during the accounting period in the form of outflows
or depletions of assets or incurrence of liabilities
that result in decreases in equity, other than those
relating to distributions to equity participants.
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Expenses (cont.)
Expenses recognised in the income statement
represent one of the following:
a) Cost of goods sold, administrative expenses, selling
expenses, distribution expenses, income tax expenses
and financing charges.b) Expenditure incurred during the period from which no
asset could be recognised (e.g. research expenses);
and
c) Allocation of expenditure incurred during the period or
in any of the previous periods and recognised as an
asset during that period (e.g. depreciation of fixed
assets).
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Distribution to Equity Participants
Transactions with equity participants (equity share
holders) in their capacity as equity participantsdo
not result in either expense or income.
Therefore, distribution to equity participants is not
an expense.
For example, dividend is not an expense. Similarly, a
drawing by a sole proprietor is not an expense.
No gain or loss is recognised from a share buy-back
transaction.
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Discretionary Expenses
The expenditure that cannot be recognised as an asset
in the balance sheet is recognised as an expense in the
income statement irrespective of whether it has
contributed to the current operation.
Examples of these expenses are research and developmentexpenses, advertisement expenses, training expenses and
preventive repair expenses.
These expenses are called discretionary expenses,
because they do not have any inputoutput relationship
with revenue for the period.A firm may improve the operating profit for the current
period by reducing discretionary expenses.
But, that improvement in the current periods profit will reduce
the long-term earning power of the firm.
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Deferred Revenue Expenditure and
Fictitious Assets
The income statement approach to accounting permits
allocation of expenditure, which is not an asset, over
more than one reporting period if, the management
estimates that the expenditure will benefit more than
one accounting periods. Such expenditures are termed as deferred revenue
expenditure.
Examples of such expenditures are advertising expenditure to
launch a product, training expenditure other than expenditure
on regular training and expenditure on voluntary retirementscheme (VRS).
Sometimes, accountants use the term fictitious asset to
represent unallocated expenditure which is not an asset, but
is shown in the assets side of the balance sheet.
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Deferred Revenue Expenditure and
Fictitious Assets (cont.)
The contemporary accounting approach, which
focuses on the balance sheet, does not recognise
the concept ofdeferred revenue expenditure.
However, Indian companies treat preliminary
expenses and share issue expenses as deferred
revenue expenditure.
In order to calculate the net worth, balance of
deferred revenue expenditures presented in the
asset side of the balance sheet as miscellaneousexpenditure to the extent not written off is deducted
from the total of share capital and reserves and
surpluses.
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Preliminary Expenses
Preliminary expenses are incurred for the incorporationof a company. They may be paid by the promoters before the company is
incorporated or by the company after it is incorporated.
Since the expenditure is incurred and paid by the promoterseven before the company is incorporated, there is normally aclause that the promoters are reimbursed of all theexpenditure.
The Indian GAAP allows companies to treat preliminaryexpenses as deferred revenue expenditure and toamortise it over a reasonable period.
Indian companies usually adjust preliminary expenses againstshare premium.
IFRS require entities to recognise preliminary expensesin the profit or loss of the year in which the expenditureis incurred.
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Share Issue Expenses
An entity incurs various costs in issuing equity
shares.
Those costs might include registration and other
regulatory fees, amounts paid to legal, accounting and
other professional advisers, printing costs and stampduties.
The Indian GAAP allows entities to treat share
issue expenses as deferred revenue expenditure.
IFRS require share issue expenses to be deductedfrom equity.
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Income
Income measures increases in economic benefits
during the accounting period in the form of inflows
or enhancements of assets or decreases of
liabilities that result in increases in equity, other
than those relating to contributions from equityparticipants.
Increase in equity, other than due to contribution
from equity participants, is income.
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Transactions with Equity Participants
No income is recognised from a transaction with
equity participants (shareholders) in their capacity
as equity participant.
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Revenue
Revenue represents income from core (ordinary)
business of the entity.
For non-finance entities, revenue comes from sales of
goods or services, commission and government subsidy
on export and similar items. A finance entity earns revenue primarily from interest
and commission earned from variety of fund-based and
non-fund-based services being provided to constituents.
Non-finance entities record revenue at net of tradediscount, quantity discount and cash discount.
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Turnover
The term turnover is used interchangeably for
revenue for a particular period.
Turnover is defined in the UK Companies Act, 1985,
as the total revenue of an organisation derived from
the provision of goods and services, less trade
discounts, VAT, and any other taxes based on this
revenue.
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Turnover (cont.)
In the Guidance Note on Terms Usedin FinancialStatements issued by the Institute of Chartered
Accountants of Indiathe term sales turnover isdefined as:
the aggregate amount for which sales are effected orservices rendered by an enterprise.The term grossturnover and net turnover (or gross sales and netsales) are sometimes used to distinguish the salesaggregate before and after deduction of returns andtrade discounts.
The ratio of net sales to average carrying amount ofassets employed to generate the revenue is calledasset turnover ratio or simply asset turnover.
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Other Income
Income from activities other than those related to theordinary business of the entity (peripheral activities) isclassified as other income. For a non-financial entity, return on investment outside the
business (e.g. rent from investment property, interest or
dividend from investment in financial instruments such asbonds and shares issued by another entity) and income fromsale of assets other than stock-in-trade are classified as otherincome.
The term gain is often used to denote other incomesuch as income from sale of assets other than stock-in-trade.
An entity recognises other income and gains at the netamount, that is, at the gross amount less relatedexpenses.
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Short-Term Accruals
Short-term accruals are short-term timing differences
between income and cash flow.
These accruals create current assets and current
liabilities such as receivables, inventories, accrued
expenses, accrued income and pre-paid expenses. Short-term accruals record revenue when earned and
expense when incurred, and thus yield a number that
better reflects the result of the operation of the period
covered in the income statement.
Recognition of current assets and current liabilities in
the balance sheet provides useful information about the
financial condition of the reporting enterprise at the
balance sheet date.
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Long-Term Accruals
Long-term accruals arise from capitalisation.
Asset capitalisation is the process of deferring cost
incurred for the current period, whose benefits are
expected in future periods.
This process recognises long-term assets such asproperty, plant and equipment in the balance sheet and
allocates the cost of those assets over the periods,
which will benefit from their use.
This process improves the relevance of income byreducing its volatility, which arises in a cash flow basis of
accounting because investments in long-term assets are
often large and occur infrequently, and by matching
long-term investments to their benefits.
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PROFITAND LOSS ACCOUNT
STRUCTURE: INDIAN GAAPSchedule VI to the Companies Act,1956 provides rules for thepresentation of profit and loss account. It does not provide anyformat for profit and loss account. Accounting Standard (AS)5, NetProfit or Loss for the Period, Prior Period Items and Changes inAccounting Policies, stipulates principles for the preparation ofprofit and loss account.
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Schedule VI Requirements
Schedule VI of the Companies Act, 1956 provides an
exhaustive list of disclosures required in the profit and
loss account.
The following are the important disclosures required by
the schedule VI:I. Every material feature including non-recurring transactions
or transactions of an exceptional nature
II. The turnover, that is, the aggregate amount of sales
III. The value of raw materials consumed
IV. The opening and closing stock of goods produced/finishedgoods purchased
V. The gross income derived from services rendered
VI. The amount provided for depreciation, renewals or
diminution in value of fixed assets
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Schedule VI Requirements (cont.)
(vii) Interest expense(viii) Income tax expense
(ix) Expenditure incurred for each of the following itemsseparately: consumption of stores and spare parts
power and fuel
rent repair to buildings
repairs to machinery
salaries wages and bonus, contribution to provident and otherfunds, workmen and staff welfare expenses
insurance
rates and taxes miscellaneous expenses, provided that any item under which the
expenses exceed 1% of the total revenue of the company or Rs.5,000, whichever is higher, should be presented as a separateand distinct item
(x) Income from investments and
(xi) Miscellaneous income
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AS-5 Requirements
The following are the important principles stipulated
in AS-5:
a) Profit or loss from ordinary activities and extraordinary
items should be disclosed separately and
b) When items of income and expenses within profit or lossfrom ordinary activities are of size, nature, or incidence
that theirdisclosure is relevant to explain the performance
of the enterprise for the period, the nature and amount of
such items should be disclosed separately.
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Extraordinary Items
Extraordinary items are incomes or expenses that
arise from events or transactions that are clearly
distinct from ordinary activities of the firm and,
therefore, are not expected to recur frequently or
regularly. Extraordinary items are identified by the nature of the
transaction or event in relation to the business ordinarily
carried on by the enterprise rather than by the
frequency with which such events are expected to
occur.
IFRS do not recognise the concept of extraordinary
item.
However, US GAAP recognises the same.
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Hindustan Unilever Limited (HUL)Exception and Extraordinary Items in the Profit and Loss
Account for the 18 months period ended on 31 March, 2009
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Hindustan Unilever Limited (HUL)Profit and Loss Account for the 15 months period ended on
31 March 2009
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Fringe Benefit Tax
The Fringe Benefit Tax (FBT) was introduced by the
government in the year 2005 on expenses incurred
by employers towards entertainment, festival
celebrations, gift, use of club facilities, provision of
hospitality, maintenance of guest houses,conferences, employee welfare, use of health club,
maintenance of motor cars, telephone, sales
promotion and publicity, etc.
Under the current dispensation, an employer has topay FBT at 30% on the fringe benefit, the taxable
value of which is determined in accordance with a
formula.
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Earnings Per Share
Although there are lot of limitations, earnings per share
(EPS) is a widely used measure of the performance of
the enterprise.
Therefore, companies are required to present EPS as a
note below the profit and loss account. Basic EPS is calculated by dividing the net profit
(reduced by the dividend payable to preference share
holders), which is attributable to equity shareholders, by
weighted average number of shares for the period.
For example, if the number of outstanding shares at the
beginning of the year was 100 and 100 shares were issued at
the end of six months of the current period, the weighted
average number of shares for the current period is 150
(100 + 100 0.50).
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Earnings Per Share (cont.)
Dilutionis a reduction in earnings per share or an
increase in loss per share resulting from the
assumption that convertible instruments (e.g.
convertible debentures) are converted, that options
or warrants are exercised, or that ordinary sharesare issued upon the satisfaction of specified
conditions.
Diluted EPS is calculated with the assumption that
all potential equity shares, conversion of which willresult in the dilution of EPS, will be converted into
equity shares.
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Hindustan Unilever Limited (HUL)Profit and Loss Account for the 15, month period ended
on 31 March, 2009
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Sales and Excise Duty
The amount of sales recognised in profit and lossaccount includes export incentives.
The amount of excise duty included in sales is deductedto determine the amount to be recognised in the profitand loss account.
Excise duty is an indirect tax levied and collected on goodsmanufactured in India.
Generally, manufacturer of goods is responsible to pay theduty to the government.
It is collected on dispatch of the goods or on internalconsumption.
The amount of sales recognised in the profit and loss accountis net of excise duty.
Often the term gross sales is used to denote salesvalue including the amount of excise duty and the termnet sales is used to denote sales value net of exciseduty.
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Interest and Dividend Income
As required by the Companies Act, 1956, income
from trade and non-trade investments has been
presented separately.
Trade investments are those from which the
company expects trade benefits, in addition toregular return and capital gain.
Examples of trade investments are investments in
vendor companies and investment in associates.
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Schedule VI: Proposed Change
The government has proposed a change in
Schedule VI to the Companies Act, 1956. The
proposed revised Schedule VI will require a
company to present the profit and loss account in a
new format.
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Particulars Amount
I Revenues from operations
II Cost of sales/services
III Gross profit (III)
IV Operating expenses:(1) Selling and marketing expenses(2) Administrative expenses
Total operating expense
V Results from operating activities (IIIIV)
VI Non-operating income/expenses:(1) Gains/(losses) on sale of long-term investments
(2) Foreign currency exchangegains/(losses), net(3) Finance cost
(4) Other income(5) Other expenses
Total Non-operating income/expenses:
VII Income before income tax (V + VI)
VIII Tax expense:
(1) Current income tax(2) Deferred income tax(3) Others
IX Profit for the period (VIVII)
X Earnings per equity share:(1) Basic(2) Diluted
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PROFITAND LOSS ACCOUNT: IFRS
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Statement of Comprehensive Income
(Profit and Loss Account)
At a minimum, the statement of comprehensive
income should include line items that present the
following amounts for the period:
a) Revenue
b) Finance costs
c) Share of profit or loss of associates and joint ventures
accounted for using the equity method
d) Tax expense
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Statement of Comprehensive Income
(Profit and Loss Account) (cont.)
e) A single amount comprising the total of: the post-tax
profit or loss of discontinued operations; and the post-
tax gain or loss recognised on the measurement to fair
value less costs to sell or on disposal of the assets or
disposal group(s) constituting the discontinued
operation
f) Profit or loss
g) Each component of other comprehensive income
classified by nature (excluding amount in (h)
h) Share of other comprehensive income of associatesand joint ventures accounted for using the equity
method
i) Total comprehensive income.
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Disposal Group and Discontinued
Operation
Discontinued operationrepresents a component of thecompany that either has been disposed of or isclassified as held for sale. The component represents a separate line of business or
geographical area of operation which the entity has disposedof or has decided to dispose of as a part of single coordinated
plan. Disposal group refers to a group of assets to be
disposed of by sale or otherwise, together as a group ofsingle transaction, and liabilities directly associated withthose assets that will be transferred in the transaction. For example, if a conglomerate engaged in variety of
businesses has decided to dispose one of its businesses (e.g.manufacturing of leather accessories) and has put it on block,the assets and liabilities of that business form the disposalgroup.
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Disposal Group and Discontinued
Operation (cont.)
Non-current assets of a disposal group or
discontinued operation are measured at lower of
cost or fair value less costs to sell.
Cost represents the carrying amount determined using
the normal rules immediately before classifying thebusiness or geographical location as a disposal group.
No depreciation is charged on non-current assets of a
disposal group.
Change in fair value less cost to sell represents gain or
loss.
The gain or loss is included in profit or loss for the period.
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IAS-1 Principles
An entity should recognise all items of income and
expense in a period in profit or loss unless an IFRS
requires or permits otherwise.
When the items of income or expense are material,
an entity should disclose it nature and amountseparately.
An entity should present an analysis of expenses
using a classification based on either its nature or
its function.An entity classifying expenses by function shall
disclose additional information on the nature of
expenses.
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IAS-1 Principles (cont.)
Example of functional classification
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207 206Revenue 390,000 355,000Cost of sales (245,000) (230,000)
Gross profit 145,000 125,000
Other income 20,667 11,300Distribution costs (9,000) (8,700)Administrative expenses (20,000) (21,000)Other expenses (2,100) (1,200)
Finance costs (8,000) (7,500)Share of profit of associates 35,100 30,100
Profit before tax 161,667 128,000
Income tax expense (40,417) (32,000)Profit for the year from continuing operation 121, 250 96,000Loss for the year from discontinued operation (30,500)Profit for the year 121,250 96,000
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Cost of Sales
Cost of sales is the total of costs incurred to
manufacture (including depreciation on depreciable
assets engaged in manufacturing activities) or
purchase the goods and to bring it to the location
and condition of sale. Thus, cost of sales does not include operating
expenses and distribution costs.
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PROFIT HIERARCHY
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Financial Ratio Analysis
Absolute numbers in financial statements fail to
provide interesting insights into the performance of
the company.
Therefore, analysts have developed tools to
analyse financial statements.
The most commonly used tool is the ratio analysis.
Ratios of related numbers in financial statements
provide historical insight into the financial position
and performance of an entity.
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Financial Ratio Analysis
Analysts compare the financial ratios of an entity for
a number of past years in search of a pattern of
past performance.
A pattern of past performance helps forecast future.
However, financial ratios is one of the inputs in
forecasting future.
Analysts also compare ratios of different
comparable entities to analyse relative
performance.
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Gross Profit
Gross profitis the difference between revenue and
cost of goods sold.
Cost of goods soldis the cost of manufacturing or
procurement of finished goods sold.
It includes expenses incurred to bring the goods to the
location and condition of sale, but does not include
expenses relating to activities performed after the goods
are placed in the warehouse.
Analysts calculate gross profit ratio to measure theefficiency and effectiveness of manufacturing and
procurement activities.
The ratio is calculated by dividing gross profit by net
sales, which is the amount of sales less excise duty.
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Earnings Before Interest Tax Depreciation and
Amortisation (EBITDA)
EBITDA is often called cash margin.
Depreciation and amortisation are considered non-cash
expenses.
EBITDA is the amount of margin over cash
operating expenses, including the cost of goodssold.
The ratio of EBITDA to sales ratio is called cash
margin to sales ratio.
It measures margin over cash manufacturing andoperating expenses.
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Earnings Before Interest Tax Depreciation and
Amortisation (EBITDA) (cont.)
It is a good measure of margin for businesses
operating in capital intensive industries in which
initial investment in infrastructure is very high while
subsequent investments in fixed assets are
relatively small (e.g. telecommunication industry). The ratio also helps compare the margin of different
companies in the same industry.
Depreciation and amortisation depends on investment in
fixed asset. Investment in fixed assets to create the same capacity
in different points in time, might be different.
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Earnings Before Interest and Tax (EBIT)
Earnings before interest and tax (EBIT) is
calculated by deducting depreciation and
amortization from EBITDA.
EBIT is often called operating profit.
To be precise, EBIT represents operating profit only if,other income does not include non-operating income.
Non-operating income is income from non-
operating assets, which do not contribute to the
operations of the enterprise. An example of non-operating assets is investment in
investment property. Therefore, rent from investment
property is a non-operating income.
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Earnings Before Interest and Tax (EBIT)
(cont.)
Exceptional items should be excluded from EBIT to
calculate the ratio.
EBIT to sales ratio is used to measure the operating
marginearned by an entity engaged in a
commercial venture.
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Net Profit
Profit or loss for the period (often referred as net
profit) is a single numberthat is widely used as a
bench mark to measure the performance of an
entity.
It is calculated by deducting tax expenses andfinance cost from EBIT.
This is the amount of operating surplus that belongs
to shareholders after paying the governments
share (income tax) and debt holders share (financecost).
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Net Profit (cont.)
Preference dividend is deducted from the net profit
to calculate the profit attributable to equity
shareholders.
Subject to legal provisions regarding distribution of
profit, the profit attributable to equity shareholdersis available for distribution as dividend.
Decision on what part of the available profit should
be distributed is a part ofoverall financing decision.
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P/ERatio
Fair measurement of net profit is important because
it is used on the denominator to calculate the P/E
ratio.
It is the most common measure of how expensive a
stock is.
It is equal to a stocks market capitalization divided
by its after-tax earnings over a twelve-month
period, usually the trailing period but occasionally
the current or forward period.
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P/ERatio (cont.)
The value is the same whether the calculation isdone for the whole company or on a per-share basis.
The higher the P/Eratio, the more the market is
willing to pay for each rupee of annual earnings.
The last year's price/earnings ratio (P/Eratio) would
be actual, while current year and forward year
price/earnings ratio (P/Eratio) would be estimates,
but in each case, the P in the equation is the
current price. Companies that are not currently profitable (that is, ones
which have negative earnings) do not have a P/Eratio at
all.
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Comprehensive Income
Comprehensive income is calculated by adding othercomprehensive income to the amount of profit or loss
for the period.
Comprehensive income represents the amount by
which the equity has changed during the currentperiod, other than changes arising from transactions
with equity participants (shareholders).
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OPERATING RATIOS
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Operating Ratios
In most industries operating expenses are drivenby revenue.
Therefore, it is quite logical to assume that there is
a correlation between revenue for the period and
each item of expense recognised in the profit andloss account.
Analysts calculate the ratio of each item of expense
to net sale to capture the effectiveness in using in
different types of resources or services. Operating ratios are also used as inputs to forecast
future performance.
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Operating Ratios (cont.)
Discretionary expenses have no cause and effectrelationship with the revenue recognised for the
period.
However, ratio of an item of discretionary expense
to net sale provides an insight into whether theentity has cut the discretionary expense to present
better performance than what it really is.
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O ti R ti Hi d t U il
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Operating Ratios: Hindustan Unilever
Limited (HUL)
Data from annual reports
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Particulars 2008-2009
(15 months)
2007
(12 months)
Sales 2,023,933 1,367,543
Material consumed and
purchase of goods
1,125,948 741,295
Employee compensation 115,212 76,781
Processing charges 21,040 13,614
Consumption of stores and
spare parts
12,056 8,752
Repairs and maintenance 11,080 8,893
Power, light, fuel and water 30,137 19,889
Rent 17,188 12,053
Advertising and sales
promotion
213,092 144,022
Carriage and freight 113,668 73,141
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Operating Ratios: HUL (cont.)
Operation ratios
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2008-2009
(15 months)
2007
(12 months)
Material consumed and
purchase of goods/sales
55.63% 54.21%
Employee compensation/sales 5.69% 5.61%
Processing charges/sales 1.04% 1.00%
Consumption of stores and
spare parts/sales
0.60% 0.64%
Repairs and maintenance/sales 0.55% 0.65%
Power, light, fuel and
water/sales
1.49% 1.45%
Rent/sales 0.85% 0.88%Advertising and sales
promotion/sales
10.53% 10.53%
Carriage and freight/sales 5.62% 5.35%
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Operating Ratios: HUL (cont.)
Notes:
i. In the denominator, we have not included other income
because other income does not create any significant
demand on operating activities and does not create any
demand on material.ii. Comparison of ratios for two years is not sufficient to
understand the relationship between expenses and sales,
and to capture the pattern of change in that relationship, if
any.
iii. Actual ratios should be compared with bench mark ratiosto evaluate the performance.
iv. Financial analysts compare financial ratios of comparable
companies to assess relative performance.
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PROFITABILITY RATIOS
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Profitability Ratio
Profitabilityis the rate (per annum) at which profit isgenerated.
It is expressed as profit per unit of input.
Profitability is usually presented as a percentage such
as return on investment. The ratio is calculated by taking a measure of profit in
the numerator and a measure of input in the
denominator.
Usually, EBIT or net operating profit less adjustedtax (NOPLAT) is used in the numerator and
invested capital, capital employed or total asset is
used in the denominator.
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Profitability Ratio (cont.)
The limitation of profitability is that it focuses onprofit and ignores quality.
Profitability has severe limitations as a measure for
decision making.
For example, profit cannot be managed directlybecause it is remote from value creation activities.
Similarly, it fails to provide any insight into the business
dynamics.
However, the greatest advantage is that once theinput is well defined, it is easily understood by all
who are concerned with the performance of an
entity engaged in commercial ventures.
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Annualisation
To calculate a ratio we use one number from theprofit and loss account, and another number from
the balance sheet.
The number from the profit and loss account should
be annualised if the period covered by the profitand loss account is shorter or longer than twelve
months.
The annualized number is calculated by multiplying
average per month figure by 12. We use annualised profit in the numerator to calculate
the profitability of an entity for a specified period.
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Net Operating Profit Less Adj sted Ta
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Net Operating Profit Less Adjusted Tax
(NOPLAT)
NOPLAT is a profit measure that is not affected bythe capital structure of the entity.
EBIT is also not affected by the capital structure of
the entity.
The difference between the two profit measures isthat NOPLAT is profit before interest but after
income tax expense and EBIT is before interest and
tax.
NOPLAT is calculated using the following formula: NOPLAT = Net Profit Exceptional Income
(1 Tax Rate) + Interest Expense (1 Tax Rate)
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Profitability
Profitabilityis calculated taking any of the followingthree measure of investment as input: invested
capital, capital employed, and total asset.
Return on invested capital=
(EBIT/Invested Capital) or (NOPLAT/Invested Capital)
Return on capital employed=
(EBIT/Capital Employed) or (EBIT/Capital Employed)
Return on total asset=
(EBIT/Total Asset) or (EBIT/ Total Asset)
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Profitability (cont.)
Invested capital is the total of equity and debt in thebalance sheet.
Capital employed is the total of equity and long
term debt in the balance sheet.
Therefore, we should use Earnings before long-terminterest and taxin the numerator to calculate return on
capital employed.
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