Semester 1

TIME VALUE OF MONEY:

The time value of money (TVM) is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also referred to as present discounted value.

Money can be invested in three ways:

1. Lump Sum: A lump-sum payment is a one-time payment for the value of an asset
2. Ordinary Annuity: the payments made at the end of every period are called ordinary
annuity. This is because ordinary annuity is the usual state of affairs. Usually all
annuities are paid at the end of the period.
3. Annuity Due: when annuity payments are made in advance, we call them annuity due
Basic Terminology to be known:

 Future Value (FV):

The value of present amount or Series of cash calculated at some interest rate for future
time is called future value.
 Present Value (PV):
The value of future amount or series of cash Calculated at some interest rate for present
time is called present value.
 Interest (R):
The cost of used of borrow funds.
there are two types of interest
Simple interest
Compound interest
 Time Period (n)
 Compounding (m): may be quarterly, monthly or half yearly

Future Value

1. Single cash flow FV=PV*(1+R)^n or FV=PV*(1+R/m)^(n*m)

Example PV 5000 PV 1000

Rate 13.65% Rate 8.00%
Years 18 Frequency 2
Years 5

Answer FV 50028.78 FV 1480.244

2. Multiple cash flows FV=sum(PV*(1+R)^n)

 1 2 3 4
Example PV 300 400 700 500
Rate 8.00% 8.00% 8.00% 8.00%
Years 4 3 2 1

Answer FV 408.15 503.88 816.48 540.00 2268.51

3. Annuity FV=PMT*((1+R)^n-1)/r

Example PMT 200

Rate 8.00%
Years 5

Answer FV 1173.32

4. Annuity due FV=PMT*((1+R)^n-1)/r)*(1+R)

Example PMT 200

Rate 8.00%
Years 5

FV 1267.19

Present Value

1. Single cash flow PV=FV/(1+R/m)^(n*m) or PV=FV/(1+R/m)^(n*m)

Example FV 1000 FV 600

Rate 8.00% Rate 4.50%
Years 5 Frequency 4
Years 3

Answer PV 680.58 PV 524.62

2. Multiple cash flows PV=sum(FV/(1+R)^n)

Example FV 800 0 450 650

Rate 12.00% 12.00% 12.00% 12.00%
Periods 1 2 3 4

Answer PV 714.29 0.00 320.30 413.09

 SUM 1447.67

3. Annuity PV=PMT*(1-1/(1+R)^n)/R

Example PMT 1000

Rate 8.75%
Periods 6

Answer PV 4519.6

4. Annuity due PV=PMT*(1-1/(1+R)^n)/R*(1+R)

Example PMT 139

Rate 8.75%
Periods 6
PV 683.2

CAPITAL BUDGETING AND ANALYSIS

Capital Budgeting is the process of making investment decision in fixed assets
or capital expenditure. Capital Budgeting is also known as investment, decision
making, planning of capital acquisition, planning and analysis of capital
expenditure etc.

Capital budgeting consists of various techniques used by managers such as:

1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index
brief introduction to the above methods is given below:
Payback Period

As the name suggests, this method refers to the period in which the proposal
will generate cash to recover the initial investment made. It purely emphasizes
on the cash inflows, economic life of the project and the investment made in the
project, with no consideration to time value of money

Question:
Payback period of project B is shorter than A, but project A provides higher returns.
Hence, project A is superior to B.

Net Present Value (NPV)

This is one of the widely used methods for evaluating capital investment
proposals. In this technique the cash inflow that is expected at different periods
of time is discounted at a particular rate. The present values of the cash inflow
are compared to the original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected.

Accounting Rate of Return (ARR)

It is the profitability of the project calculated as projected total net income

divided by initial or average investment. Net income is not discounted.
 OR

This method helps to overcome the disadvantages of the payback period

method. This method takes into account the entire economic life of a project
providing a better means of comparison. It also ensures compensation of
expected profitability of projects through the concept of net earnings.

 Internal Rate of Return (IRR) is the discount rate at which net present
value of the project becomes zero. Higher IRR should be preferred.

 Profitability Index (PI) is the ratio of present value of future cash flows
of a project to initial investment required for the project.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term
investments which involve more financial risks. That is why proper planning
through capital budgeting is needed.

2) Huge investments and irreversible ones: As the investments are huge

but the funds are limited, proper planning through capital expenditure is a pre-
requisite. Also, the capital investment decisions are irreversible in nature, i.e.
once a permanent asset is purchased its disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as
brings changes in the profitability of the company. It helps avoid over or under
investments. Proper planning and analysis of the projects helps in the long run.

OTHER SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial management

 Capital budgeting provides a wide scope for financial managers to evaluate different
projects in terms of their viability to be taken up for investments
 It helps in exposing the risk and uncertainty of different projects
 It helps in keeping a check on over or under investments
 The management is provided with an effective control on cost of capital expenditure
projects
 Ultimately the fate of a business is decided on how optimally the available resources are
used
 Basic Concepts of Accounting
Meaning of Accounting

Accounting is the art of recording, classifying and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and interpreting the
results thereof.’

-Committee on Terminology of the American Institute of Certified Public Accountants

BRANCHES OF ACCOUNTING

Branches of Accounting

Financial Accounting Cost Accounting Management Accounting

Financial Accounting

Financial Accounting is that branch of Accounting, which records financial transactions, summarises and
interprets them and communicates the results to users. It ascertains profit earned or loss incurred
during an accounting period and the financial position on the date when the accounting period ends.
The end product of Financial Accounting is the Profit and Loss Account for the period ended (which
shows the profit earned or losses incurred) and the Balance Sheet as on the last date of the accounting
period (which shows the financial positions).

Cost Accounting

The limitation of Financial Accounting in respect of information relating to the cost of products or
services led to the development of a specialised branch, i.e., Cost Accounting. It ascertains the cost of
products manufactured or services rendered and helps the management in decision making (say price
fixation) and exercising controls.

Management Accounting
Management Accounting is the most recently developed branch of accounting. It is concerned with
generating accounting information relating to funds, costs, profits etc., as it enables the management in
decision making. Management Accounting addresses the needs of a single user group, i.e., the
management.

SYSTEMS OF ACCOUNTING

The systems of recording transactions in the books of accounts are two namely:

1. Double Entry System

2. Single Entry System

1. Double Entry System

The Double Entry System of accounting was developed in the 15th Century in Italy by Lucas Pacioli.
Under the system, every transaction have two effects – Debit and Credit and at the time of recording, it
is recorded once on the debit side and again on the credit side. For example , at the time of cash
purchases, goods are acquired and in return cash is paid. In the transaction, two aspects are involved,
i.e., receiving goods and paying cash and under Double Entry System, both these aspects are recorded.
One part, i.e., receipt of goods is debited and the second part, i.e, payment of cash is credited.

Features of Double Entry System

1. It maintains a complete record of each transaction.

2. It recognises the two-fold aspects of every transaction, viz., the aspect of receiving and aspect of
giving.

3. In this system, one aspect is debited and other aspect is credited following the rules of debit and
credit.

4. Since, one aspect of a transaction is debited and the other is credited, the total of all debit is always
equal to total of all credits. It helps in establishing arithmetical accuracy by preparing Trial Balance.

2. Single Entry System

Single Entry System of recording transactions in the books of accounts, may be defined to be an
incomplete Double Entry System. In this system, all transactions are not recorded on the double entry
basis. As regards, some transactions, both aspects of the transactions are recorded, as regards others,
either one aspect is recorded or not recorded at all.
BASIS OF ACCOUNTING

1. Cash Basis: in this all the CASH transactions are recorded.

2. Accrual basis: In this Accrual basis of accountancy, all the transactions are recorded
when they occur.
INCOME are recorded when they are earned.
EXPENSES are recorded when they become payable.

QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION

1. Reliability:
Accounting information should be recorded on the basis of documentary evidence which is verifiabl
e & reliable. Accounting information should be verifiable, neutral and faithful.

2. Relevance:
Relevant information is any information which may change results of the business if disclosed. Every
such information any information should be included in the books of accounts. At any time, any
irrelevant or unnecessary information should be ignored.

3. Understandability:
It should be brief, clear, concise, exact and suitable to all its users. Accounting information is utilised
by various parties such as Customers, investors, Government, Workers, Employees, Analysts,
Economists and Researchers etc.

4. Comparability:
Accounting information should be recorded and presented in a consistent manner so that it can be
compared year after year. It helps in effective decision making.

MEANING AND NATURE OF ACCOUNTING PRINCILPES

Generally Accepted Accounting Principles (GAAP)

Accounting principles, concepts and conventions commonly known as Generally Accepted
Accounting Principles or GAAPs are the basic rules that define the parameters and constraints within
which accounting operates. They are those fundamental statement which are followed by
accountant in the process of accounting
Developed?
a) To bring uniformity
b) To bring transparency
BASIC ACCOUNTING CONCEPTS

Accounting concepts are the general rules of accounting to be followed and practiced by an accounta
nt while preparing the accounts of a firm. Accounting is the language of business and this language n
eeds to be
consistent for all businesses else it would be difficult for the various interested parties to interpret th
e
accounts of a business. In order to standardise this language, accounting concepts have been develop
ed over the years. Accounting Concepts are general guidelines for sound accounting practices.

Importance of Accounting Concepts:

i. Reliable Financial Statements
ii. Uniformity in presentation
iii. Generally acceptable basis of measurement
iv. Proper information to all
v. Valid and appropriate assumptions

Accounting Concepts

Business Entity Concept

According to the Business Entity Concept, business is concerned to be separate and district from its
owners. It further says that Business transactions should be recorded in the books of accounts from
the business point of view and not owners. Owners being considered separate and distinct from the
business they are considered creditors of the business to the extent of their capital. It is because of
this concept, amount invested by owner in business is considered as liability of business towards the
owner and if owner withdraw any amount for his personal use then it will be considered as reduction
in business liability towards the owner.
Money Measurement Concept

According to this concept only those transactions and events should be recorded in the books of
account whose value can be expressed in terms of money. In other words, an event how so ever
important to the organisation cannot be recorded in the books of accounts if they are unable to
expressed in terms of money.

For Example: Death of experienced marketing manager. It further says that items should be recorded
in the books of account in monetary units and not in physical unit.

Going Concern Concept

According to this concept while recording the items (asset) in the books of accounts it should be
assumed that business will run for an indefinite period of time. It is because of this concept, assets
are recorded in their cost less depreciated value, not in their market prize.

Accounting Period Concept

According to this concept after the end of a definite period, books of account should be closed in
order to check the performance and financial position of the business.

Cost Concept

The cost concept requires that all assets are recorded in the books of accounts at their cost price,
which includes cost of acquisition, transportation, installation and making the asset ready to use. The
purchase price will remain the same for all years, though its market value may change.

Dual Aspect Concept

This concept states that every transaction has a dual or two-fold effect and should therefore be
recorded at two places. In other words, at least two accounts will be involved in recording a
transaction. This type of dual effect takes place in case of all business and is also known as duality
principle. Assets = Liabilities + Capital

Revenue Recognition (Realisation) Concept

According to this concept revenue should be recorded in that period in which transaction was taken
place and not when it was received. In other words, revenue should be recorded in that period to
which is belong.
 Because of this concept following terms came into existence

 Credit Sale
 Outstanding Income

For example:

29 July sale Rs 20,000 goods and amount received – July Month (Recorded)

30 July sale Rs 15,000 goods on credit basis account received on Oct 15 – July Month (Recorded)

Bank – Deposit – Interest

On 30 June 2015 – 2015 for 1 year – Rs. 1,00,000, 8% Interest

On 3 June 2016 – 1,00,000 + Interest – Rs 1,08,000

Matching Concept

In order to know the result of business concerns for a particular period revenue of that period should be
compared with the expense of that period

Matching Concept

Revenue Expense

Rs.50,000 Rs. 40,000 = 10,000 Profit

Rs. 60,000 Rs. 65,000 = -5000 Loss

Matching concept also implies that all revenue earned during the year, whether received during that
year or not and all cost incurred, whether paid during the accounting year or not should be taken into
accounting while ascertaining profit or loss of that year.

For Example:

Opening Stock – 5000 unit x 4 = 20,000

Manufactured – 15000 unit x 4 = 60,000

Total Goods – 20000 unit Expense = 80,000

Sale - 16,000 unit x 5 = 80,000

Closing Stock – 4,000 unit x 4 = 16,000

Revenue Expense 20,000

80,000 80,000 60,000

16,000 Profit

Full Disclosure Concept

Information provided by financial statement are used by different groups of people such as investors,
lenders, supplier and others in taking various financial decisions. In the corporate form of
organisation, there is a distinction between those managing the affairs of the enterprise and those
owning it.

The principle of full disclosure requires that all material and relevant facts concerning financial
performance of an enterprise must be fully and completely disclosed in the financial statement and
their accompanying footnotes. This is to enable the users to make correct assessment about the
profitability and financial soundness of the enterprise and help them to take informed decisions. To
ensure proper disclosure of material of accounting information, the Indian Companies Act, 1956 has
provided a format for the preparation of profit and loss account and balance sheet of a company,
which needs to be compulsorily adhered to, for the preparation of these statements. The regulatory
bodies like SEBI, mandates complete disclosure to be made by the companies to give a true and fair
view of profitability and the state of affairs.

Consistency Concept

The accounting information provided by the financial statements would be useful in drawing
conclusions regarding the working of an enterprise only when it allows comparisons over a period of
time as well as with the working of other enterprise. Thus, both inter-firm and inter-period
comparisons are required to be made. This can be possible only when accounting policies and
practices followed by enterprises are uniform and are consistent over the period of time.

Also the comparison between the financial results of two enterprises would be meaningful only if
same kind of accounting methods and policies are adopted in the preparation of financial
statements.

Consistency does not prohibit change in accounting policies.

Conservatism Concept

This concept requires that business transaction should be recorded in such a manner that profits are
not overstated. All anticipated losses should be accounted for but all unrealised gains should be
informed.

Material Concept

This concept states that accounting should focus on material facts. If the item is likely to influence
the decision of a reasonably prudent investors or creditor, it should be regarded as material, and
shown in the financial statements.

Objectivity Concept

The concept of objectivity requires that accounting transaction should be recorded in an objective
manner, free from the bias of accountants and others. This can be possible when each of the
transaction is supported by verifiable document or vouchers.

For Example: Receipts for the amount paid for purchase of a machine becomes the documentary
evidence for the cost of machine provides an objective basis for verifying this transaction is
supported by verifiable documents or vouchers.

For Example: Receipt for the amount paid for purchase of a machine and provides an objective basis
for verifying this transaction.
International Financial Reporting Standards (IFRS): These are global accounting
standards used by more than 125 countries in the world. The International Accounting
Standards Boards (IASB), a private sector body, develops and approves IFRS. The IASB replaced
the International Accounting Standards Committee in 2001. IASC issued International
Accounting Standards from 1973 to 2000. Since, then IASB has replaced some IAS with IFRS.

IFRS are principle based, drafted lucidly and easy to understand and apply. However the
application of IFRS requires an increased use of fair values for measurement of assets and
liabilities.

Goals of IFRS:
To provide a global framework for how public companies prepare and disclose their financial
statements. IFRS provides general guidance for the preparation of financial statements, rather
than setting rules for industry-specific reporting.

Focus is towards getting the balance sheet right and hence makes the income statement
subject to sudden change.

Following is the list of IFRS issued till date:

Number Name Issued

IFRS1 First Time Adoption of International Financial Standards 2008
IFRS2 Share based payments 2004
IFRS3 Business Combinations 2008
IFRS4 Insurance Contracts 2004
IFRS5 Non-Current Assets held for sale and discontinued operations 2004

IFRS6 Exploration for and evaluation of Mineral Assets 2004

IFRS7 Financial Instruments: Disclosures 2005
IFRS8 Joint Arrangements 2006
IFRS9 Financial Instruments 2013
IFRS10 Consolidated Financial Statements 2011
IFRS11 Joint Arrangement 2011
IFRS12 Disclosure of interest in other entities 2011
IFRS13 Fair Value Measurement 2011
IFRS14 Regulatory Deferral Accounts 2014
IFRS15 Revenues from Contracts with Customers 2014
Having an international standard is especially important for large companies that have
subsidiaries in different countries. Adopting a single set of world-wide standards will simplify
accounting procedures by allowing a company to use one reporting language throughout. A
single standard will also provide investors and auditors with a cohesive view of finances.
Currently, over 100 countries permit or require IFRS for public companies, with more countries
expected to transition to IFRS by 2015. Proponents of IFRS as an international standard
maintain that the cost of implementing IFRS could be offset by the potential for compliance to
improve credit ratings.

Conceptual Framework for Financial Statements issued under IFRS:

A conceptual framework can be defined as a system of ideas and objectives that lead to the
creation of a consistent set of rules and standards. Specifically, in accounting, the rule and
standards set the nature, function and limits official accounting and financial statements.

It is a practical tool that:

assists the Board to develop IFRS Standards that are based on consistent concepts
assists preparers to develop consistent accounting policies when no IFRS Standard applies to a
particular transaction or event, or when a Standard allows a choice of accounting policy.

 Purpose and objective of Financial Statements:

1. Position, Performance and Flaws: The objective of financial statements of a
business entity is to provide information about the financial position, performance
and cash flows of the entity that is useful for economic decision making by a broad
range of users.

2. Stewardship: Financial Statements show the accountability of management for the

resources entrusted to it.

 Assumptions:
1. Accrual Basis: In order to meet the objectives, Financial statements are prepared on
the accrual basis of Accounting. Thus Financial statements provide the type of
information about past transactions and other events useful I making economic
decisions.

2. Going Concern: It is assumed that the enterprise has neither the intension nor the
need to liquidate or curtail materially the scale of its operations; if such an intention
 or need exists; the financial statements may need to be prepared on a different
basis.

3. Consistency: The accounting principles are followed consistently from one period to
another; a change in an accounting policy is made only in certain exceptional
circumstances.

 Characteristics:
1. Qualitative
2. Understandability
3. Relevance
4. Reliability
5. Comparability
6. Timeliness
7. Balance between benefit and cost

Directors and Auditors Report

A director’s report is intended to explain to shareholders, the overall financial position of the Company
and its operation & Business Scope. In Companies Act,2013 , lot of sections makes it mandatory to make
disclosure in Boards report contrary to previous Act, where only section 217, talks about the Boards
Report. It is mandatory for every company, to forward to its members, along with its annual Financial
Statement the Board of Director’s report. Report of Board of Directors should be attached to the
Balance Sheet laid before the Board of directors.

Provisions Relating to Director’s Report:-

a) Applicability of Provision of Section-134 of Director Report: -

The provision of Director Report (u/s 134) is applicable only to financial year commencing on or after 1st
April, 2014.

b) Signing of Director’s Report along with Annexure:-

As per Section 134(6) Board Report and annexure thereto shall be signed by

i. its ‘CHAIRPERSON’ if he is authorized by Board of director; Where he is not so authorized by,

ii. At least 2 (Two) Director, one of whom shall be a Managing Director.

iii. If there is no Managing Director then by Two Directors.

CONTENT OF BOARD REPORT:

I. Extract of Annual Return:

II. No. of Board Meeting:

III. Comment on Auditor Report

IV. Comment on Secretarial Audit Report:

V. Particular of Loan & Investment:

VI.Disclosure of Related Party Transaction.

Auditors Report

An auditor's report provides an opinion on the validity and reliability of a company’s financial
statements. When financial statements are finalised, they usually must contain an evaluation – an
auditor's report - from a licensed accountant or auditor. This report provides an overview of the
evaluation of the validity and reliability of a company or organization’s financial statements. The goal of
an auditor's report is to document reasonable assurance that a company’s financial statements are free
from error. It is a Document prepared by the auditors appointed to examine and certify the accounting
records and financial position of a firm. It must be filed every year by an incorporated or registered firm
(along with its audited financial statements) with the appropriate regulatory authority. Also called audit
report.

Standalone Financial Statement

When one company own more than 51% in another company, the latter becomes the
subsidiary of the former. The former company is called the parent or holding company. It is
quite possible that the parent may hold 100% equity of its subsidiary.

Both the holding and subsidiary have their own businesses and draw-up their own financial
statements. The financial statements of the holding company, where the shares in the
subsidiary are shown as long term investments and the dividend received as other income,
are called standalone financial statements as they merely focus on its own, independent
business activities.
Standalone financial statements reflect the affairs of the holding and subsidiary companies
on an independent or standalone basis.

Consolidated Financial Statement

Consolidated financial statements show the financial position of the company itself along
with its subsidiary companies, associate companies and joint ventures.

Therefore, when you look at the consolidated financial statements, you are looking at the
financial position of a group of companies - taken together. In this context, there are some
questions that we should go through, to be able to understand the concept of consolidated
financial statements.

1. What are subsidiaries, associates and joint ventures?

 A subsidiary is a company that you control - normally by owning more than 50% of
the shares or by controlling the board of directors.
 An associate is a company on which you exercise significant influence - this would
mean less than control but still enough influence to control their decisions; a
thumb rule of minimum 20% holding is considered for this (less than 50%, of
course).
 A joint venture is not entirely controlled by you, but you jointly control the assets,
operations or the resources of the venture.

When an entity prepares a consolidated financial statements, it includes not only the
financial information of the company itself, but also of the above types of companies that
are included in the financial statements.

2. When does a company have to prepare consolidated financial statements?

In India (since that’s the region the question is about), preparation of Consolidated
Financial Statements is mandatory for listed companies or public companies that have a
subsidiary, associate or a joint venture. Obviously, if you have no such company, then
consolidated statements are meaningless.

However, the company is not mandated to release all the financial information every
quarter. In order to understand which information is mandatory and which is optional, you
can check out this detailed list of SEBI guidelines.
In the question description you mention that Reliance does not provide this data quarterly.
That’s not true. If you see the quarterly financial results of Reliance Industries Limited, you
will find both consolidated as well as standalone results over there. Like I said, it is
mandatory for listed companies.

When a company prepares consolidated financial statements, they have to follow the
relevant accounting standards.

3. How are consolidated financial statements prepared?

The basic idea is that financial information shown in the consolidated statements should
include information about the subsidiaries, associates and JVs also. But each of these are
treated differently. Here’s how:

1. Subsidiaries - all the assets, liabilities, incomes and expenditures of the

subsidiaries are completely added to the assets, liabilities etc. of the holding
company. So, even if you own 75% of the shares, your balance sheet will reflect
100% of the assets of your subsidiary. The balancing figure (25% that you don’t
own) will be subtracted from equity, as “minority interest”).
2. Joint ventures - all the assets, liabilities, incomes and expenditures
are proportionately added to the assets, liabilities of the holding company. For
example, if you own 51% of the joint venture, then the assets will be added only to
the extent of 51% of the JV.
3. Associates - usually, associates are consolidated using the equity method, which
means that the individual assets, liabilities etc. of the associate will not be added to
the consolidated financial statements, but the “value” of the investment in that
associates will be revised to include the proportionate value of the associate that
you own.

Really, this is too technical. I cannot simplify this further if you don’t know the basics of
accounting. But remember that the method of consolidation is different for these three, and
there are laid out standards for the same.

4. Is this data important for the investors?

Yes, it is.

Investors have invested their money in the associate, subsidiary or the JV. Hence, they need
to know whether it makes sense to continue that investment or not. As such, a company is
therefore required to disclose to their shareholders the financial results that we get from
these investments.

Presenting it separately would not add much value. Preparing consolidated financial
statements helps to reflect the true value of those investments and the correct impact they
have on the financial statements of the company. So, obviously it is a very helpful
information for the investors. Which is why it is mandatory for public listed companies in
India to release consolidated financial statements.

Balance Sheet is a statement which exhibits the company’s financial position on a

specific date, by listing out the assets, liabilities, and capital. It is used to denote the
ownership and Owings of the company, at a given point in time. It plays a pivotal role in
indicating the financial health of the entity, to help the users of the statement to take
rational decisions.

On the other hand, when the assets and equity & liabilities of a holding company and its
subsidiaries are put together in a single document, then the document is known as
Consolidated Balance Sheet. To put it in an easy way, it is a consolidation of the
balance sheet of the parent company with its subsidiaries.

The Consolidated Balance Sheet is prepared like a typical Balance Sheet, i.e. as per
Schedule VI of the Indian Companies Act, 1956, but there is no distinction made as to
which asset or liability belongs to which particular company.

Difference between standalone and consolidated statements

When one company holds a controlling interest in another company, the arrangement
can complicate the task of preparing financial statements. Even though one is a
subsidiary of the other, the two enterprises frequently remain separate legal entities,
with each responsible for its own bookkeeping. When it comes time to report results,
consolidated financial statements and stand-alone statements provide two ways of
looking at the companies' performance.

Basic Differences

 A consolidated financial statement covers the activities of the parent company

and its subsidiaries in a single report, as if they were all a single company
operating under one roof. Stand-alone financial statements, by contrast, treat
each entity as if it were entirely separate -- the parent unrelated to the
subsidiaries, and the subsidiaries unrelated to one another.

 A standalone Balance Sheet explicitly mentions the assets and liabilities of the
entity, whereas the Consolidated Balance Sheet does not separately specify as to
which assets belongs to which company.
  The preparation of the Balance Sheet is comparatively easier than the
preparation of Consolidated Balance Sheet

 Balance Sheet could be prepared by every company, whether it’s a sole

proprietorship or a corporation while the Consolidated Balance Sheet could only
be prepared by the company which has subsidiaries.

Intra-company Transactions

It's common for companies to do business with their subsidiaries -- and subsidiaries to
do business with each other -- as if they were unrelated.

Such transactions however will appear only on stand-alone financial statements

because they affect the profitability of the individual units, which is important for
internal bookkeeping and evaluation but not on consolidated statements because they
don't affect the overall state of the larger company.

Types of Transactions

 Typical transactions that appear on stand-alone statements but not on

consolidated statements include equity investments, sales and loans.
 When a parent owns stock in a subsidiary, the stock appears as an asset on the
parent's stand-alone balance sheet but as equity on the subsidiary's sheet.
 When the parent buys something from the subsidiary, or vice versa, each
accounts for the transaction separately on its cash flow or income statements.
 If one lends money to the other, the loan is an asset on the lender's balance sheet
and a liability on the borrower's.
 During consolidation, a company's accountants will eliminate these and other
intra-company transactions. If they didn't, the transactions would in effect be
recorded twice.

Requirements

When a subsidiary is wholly owned, meaning that the parent owns 100 percent of the
subsidiary, its finances are fully incorporated into the consolidated statement. In other
words, from looking at the consolidated statement, you wouldn't even know the
subsidiary exists

On the other hand if the subsidiary is not wholly owned -- that is, if another investor or
company holds a minority stake -- then that "non-controlling interest" must be
accounted for on the consolidated balance sheet. Non-controlling interest appears on
the balance sheet as a separate category under stockholders' equity.
Finally, wholly owned subsidiaries don't have to produce stand-alone financial
statements, although they frequently do for internal purposes; non-wholly-owned
subsidiaries generally have to produce stand-alone statements for the sake of their
minority owners.

Thus Companies report two types of financial statements when they have majority stake
in other entities.

E.g. Company A (Holding Company) has 80% stake in Company B and 60% in Company
C.

Standalone Financial Statements will represent the numbers of only Company A. While
Consolidated Financial Statements represent the combined results of all 3 companies:
A+B+C.

On consolidation, revenues will NOT be proportioned to respective stake-holding in the

company. Revenues are not proportioned, as if we see carefully, we can say that B, and C
are group companies of Company A, in which 20%, and 40% stake is held by outsiders.
So for Company A, the revenues will be total revenues earned by the group. However,
the proportionate part of net income is shown as a separate line item in income
statement as Non-Controlling Interest.

Off balance sheet

You are familiar with the standard ‘Big 3’ financial statements: balance sheet, income
statement and cash flow statement. Used in conjunction, these three documents can tell a lot
about a company’s financial position. An accountant or financial analyst can easily calculate
a bevy of financial ratios, monitoring leverage, liquidity, solvency, and efficiency. With just
these few metrics, analysts can assess a company’s ability to pay its bills on time, vet
expansion plans and can even critique management’s handling of corporate assets.

Perhaps the analyst determined the company’s weighted average cost of capital is too high.
By calculating the debt to equity ratio, a common measure of leverage, you determine there
is an opportunity to lower the cost of capital by taking on more debt. This is because the
interest expense on the debt ability can be written off.

Using Financial Analysis to Manage Risk

More importantly, an analyst or accountant may be able to detect risky behavior by the
company by reviewing the financial statements. Shrewd analysts can see if the company
needs to tighten up credit and collection policies with customers or raise cash to prevent a
liquidity crunch through the use of a factoring company.
Reviewing financial statements can also assess the ‘quality’ of reported corporate earnings.
For example, lesser-quality reports might show positive net earnings (on the income
statement) but cash flows from operations that are decreasing (the cash flow statement).

As you can see, a trained analyst can ascertain a large amount of information from these
basic financial statements. But what if these three statements don’t tell the whole story?

Off Balance Sheet Activity

Sometimes, companies execute transactions not recorded on any financial statement. These
‘off balance sheet (OBS)” items are assets or liabilities that exist but are not required by
IFRS to be included on financial statements (balance sheet). Off-Balance sheet financing can
de-emphasize (hide) a particular activity. Consistent use of off-balance sheet financing
lowers the quality of earnings in many analyst’s eyes and can negatively affect both credit
and equity ratings.

How Would a Company Use OBS Financing?

Here’s an example of how a company might utilize off balance sheet activity. Let’s say a
company currently has a high level of debt outstanding. It wants to make a large capital
expenditure (buying a building) but doing so would cause the company’s debt-to-equity ratio
to increase above a pre-determined threshold.

Exceeding the threshold would breach a covenant in a lending agreement the company has
with its creditor, a commercial bank. A few things could happen following a breach, none of
which are good-the bank could call in the loans, causing a potential bankruptcy if the
company was stretched thin enough. The bank could restructure the existing loans with a
higher interest rate. At the very least, it would raise future borrowing costs.

Instead, the company uses an operating lease with an off balance sheet entity that it creates,
known as a special Purpose Vehicle, SPV. The SPV actually owns the asset (the building) on
behalf of the company and leases it back to the company. So, instead of buying the building
outright, which would cause a large, covenant triggering liability (the building’s purchase
price) on the balance sheet, it enters into an ‘operating lease’ off balance sheet and records
just the small operating expense (lease payments). This method also maintains liquidity for
the company. It seems as if this would be illegal, but it’s not.

Off Balance Sheet Financing

Off-balance sheet financing is discretionary and the activity is not required to be reported on
the balance sheet. Typical items held off the balance sheet include operating leases, joint
ventures, and partnerships. Often, an analyst must locate these items which tend to be buried
in the footnotes in the company’s financial statements. But the footnotes may not actually list
the financing arrangements directly; they may simply indicate the ability to pursue future
financings.
Infamous Off Balance Sheet frauds
Even though off-balance sheet items are not required to be reported on the balance sheet, the
vast majority of items are legitimate. The problem arises when off-balance sheet items
involves dealings with questionable entities, such as offshore subsidiaries.

Even though off-balance sheet items are not required to be reported on the balance sheet, the
vast majority of items are legitimate. The problem arises when off-balance sheet items
involves dealings with questionable entities, such as offshore subsidiaries.

For example, liabilities of a subsidiary are not required to be listed in the financial statements
of the parent company. As such, liabilities can be easily transferred from the balance sheet to
a largely hidden subsidiary. This was at the heart of arguably the biggest off-balance sheet
scandal of all time-Enron.

Enron
In Enron’s case, it created SPVs which were created for the purpose of hiding debt. Enron
would also capitalize, fund, its SPVs with its own stock. Its death blow was that it guaranteed
the value of the SPVs and when the stock turned south, so did the value of all SPVs.

Further, these SPVs had clear conflicts of interest (Enron executives were principles in the
vehicles) and therefore were not operated as arms-length transactions.3 Again, no one
seemed to know the extent of the gimmickry because the SPVs were unconsolidated
subsidiaries whose actions weren’t being fully reported.

Lehman Brothers
Off-balance sheet financing also played a significant role in the Lehman Brothers
bankruptcy. Through the use of off-balance sheet entity ‘Repo 105’, Lehman was able to
move $50 billion of debt off of their balance sheet, making them appear more financially
stable before a quarter’s end.5 Since it was classified as a repurchase agreement, it was
‘bought back’ after the reporting period. To make matters worse, when the debt was
originally moved off-balance sheet, the bank recorded the debt as a ‘sale’ and booked the $50
billion as revenue!6 This type of accounting shenanigans contributed to the largest
bankruptcy in U.S. history, wiping out the life savings of thousands of employees of the
bank.

Today, accountants, auditors, and analysts are increasingly trained to check the footnotes on
these accounts. Further, the implementation of Sarbanes-Oxley made corporate directors
criminally liable for lying on financial reports. While an improvement, the regulations are
unlikely to catch all fraud. And the training if often lacking.

These scandals inevitably cost financial firms money through fines and penalties. For
example, JP Morgan was fined $135 million for its role in the Enron fraud. Today,
compliance personnel are quite busy at financial firms, managing risk whenever possible.
Risk managers are some of the most highly recruited careers in finance today.

Consider an Online Masters in Financial Crime and Compliance

Management Degree
There are a dedicated group of financial professionals that are committed to detecting,
preventing and catching accounting and financial fraud. Forensic accountants and fraud
investigators decipher off-balance sheet transactions when following a money trail, looking
to catch an employee who has committed, and is hiding, a financial crime. With the global
nature of business today, following money trails through a web of subsidiaries and offshore
entities is a daunting task.

But if you’re up for the challenge, consider furthering your career with an online Masters in
Financial Crime and Compliance Management Degree. These programs are designed to teach
the student many of the tools needed to detect and deter financial crimes, in other words,
catch fraudsters!

FINANCIAL MANAGEMENT

Financial management refers to the efficient and effective management of money (funds) in
such a manner as to accomplish the objectives of the organization. It is the specialized function
directly associated with the top management.

FORMS OF BUSINESS

 Manufacturing
 Trading
 Service

FORMS OF BUSINESS ORGANIZATION

 Proprietary firm
 Partnership firm
 LLP
 Company/ corporate form
 Private ltd
 Public ltd
 One person company

Financial markets: where funds are operated

  Primary markets: where funds are raised by markets
 Capital market: deals with long and medium term funds
 Money market: deals with short term funds
 Secondary markets: the funds traded do not affect the company per se

Finance functions

 Financing decisions: quantum of funds, various sources of raising funds, proportion,

capital structure.
 Investment decision:
 application of funds, (funds are applied in fixed assets)
 Capital budgeting decision: funds can be used to acquire CA, working capital
requirements
 Profit earned by the company

Public issue

 IPO (initial public offer): company meeting public in general to meet fund requirement
It is the first public offer

 Right issue: In order to raise finance without diluting control of the business, a rights
issue offers new shares to existing shareholders. Shares issued this way generate
goodwill and maintain the predictability of shareholder governance, but must also be
discounted (sold at an average of 31% under market price).

 Bonus issue: A bonus issue, also known as a scrip issue or a capitalization issue, is an
offer of free additional shares to existing shareholders. A company may decide to
distribute further shares as an alternative to increasing the dividend payout. For
example, a company may give one bonus share for every five shares held.

 Private placement: A private placement is the sale of securities to a relatively small

number of select investors as a way of raising capital. Investors involved in private
placements are usually large banks, mutual funds, insurance companies and pension
funds. A private placement is different from a public issue, in which securities are made
available for sale on the open market to any type of investor.
 ESOP: An employee stock ownership plan (ESOP) is a qualified defined-contribution
employee benefit (ERISA) plan designed to invest primarily in the stock of the
 sponsoring employer. ESOPs are "qualified" in the sense that the ESOP's sponsoring
company, the selling shareholder and participants receive various tax benefits

Theories of capitalization

 The cost theory of capitalization: Under this theory, the capitalization of a company is
determined by adding the initial actual expenses to be incurred in setting up a business
enterprise as a going concern. It is aggregate of the cost of fixed assets (plant,
machinery, building, furniture, goodwill, and the like), the amount of working capital
(investments, cash, inventories, receivables) required to run the business, and the cost
of promoting, organizing and establishing the business.In other works, the original total
outlay incurred on various items becomes the basis for determining the capitalization of
a company.Cost theory, no doubt, gives a concrete idea to determine the magnitude of
capitalization, but it fails to provide the basis for assessing the net worth of the business
in real terms. The capitalization determined under this theory does not change with
earnings.
 The earnings theory of capitalization: This theory assumes that an enterprise is
expected to make profit. According to it, its true value depends upon the company’s
earnings and/or earning capacity. Thus, the capitalization of the company or its value is
equal to the capitalized value of its estimated earnings. To find out this value, a
company, while estimating its initial capital needs, has to prepare a projected profit and
loss account to complete the picture of earnings or to make a sales forecast. Under the
earnings theory of capitalization, two factors are generally taken into account to
determine capitalization (i) how much the business is capable of earning and (ii) What is
the fair rate of return for capital invested in the enterprise. This rate of return is also
known as ‘multiplier’ which is 100 per cent divided by the appropriate rate of return

Internal sources of finance

 Retained profits:
Companies can increase funds by retaining profits and not distributing them as
dividends. The shareholders deprived of capital will expect retained profits to be
invested to achieve a competitive rate of return. Most big businesses retain 50% of
profits to fund expansion.

 Tighter credit control:

The remaining internal financing options increase businesses’ cash assets by decreasing
working capital items. For example, chasing trade receivables owed by credit customers
releases funds which can be re-invested in the business.
  Reduce inventories:
Purchase and storage costs use revenue that could otherwise be used to expand the
business. However, when reducing inventories enterprises should be careful to retain
the capacity to meet future demand.

 Delay paying trade payables:

This cheap form of finance extends the period before a business has to make good on
their credit payments, releasing the funds in the interim. This can come at a reputational
cost, which damages the possibility of buying on credit in the future.

External sources of finance

 Ordinary shares:
Under this arrangement, companies raise capital by selling stock in their business. This
entitles the purchaser to a voice in the decisions made by the firm. While ordinary
shares do not have a fixed rate of dividend (a share of company profits) from profits
after current liabilities and other investors are services, not paying them can diminish
share value. A business will avoid this if they hope to issue shares in the future.

 Preference shares:
Preferential shareholders receive dividends before individuals with ordinary shares.
Their lower risk and lower levels of return mean that preference shares have a less
volatile market price. These have lost popularity since, while they are alike borrowings
in many other aspects, dividend payments are not tax deductible.

 Bank overdraft:
Businesses can access funds by maintaining a negative balance on its bank account. The
advantages of using an overdraft include flexibility, competitive interest rates and can

become a long term source of finance (dependent on the confidence inspired by the
borrower). But, reliance on an overdraft can have devastating consequences, since it is
repayable on demand.

 Loan notes/stock:
This form of borrowing, exchanges capital from investors for a note representing the
loan which can then be traded on the Stock Market. The value of a loan note fluctuates
with the business’s performance.

 Finance lease:
Under this arrangement, a business will select an asset which is then purchased by a
finance company. The lease will then be paid in a series of rentals or instalments. This
avoids the large cash outflows of an outright purchase. The risks and rewards associated
with the purchased item are transferred to the lessee.
  Operating lease:
This is similar to the finance lease, except the rewards and risks of the item stay with the
owner. The asset becomes security, meaning that operating leases are usually given
without detailed credit checks. The term of an operating lease is short compared to the
useful life of the asset, and so the asset might be used by multiple lessees in its lifetime.
Businesses can, therefore, avoid obsolesce risks by this means.

 Sale and lease back:

Businesses can raise funds by leasing their unused assets to a financial institution.

 Debt factoring:
Debt collection can be outsourced to specialist subcontractors. This can increase cash
assets by providing savings in credit management and certainty in cash flows.
Stakeholder opinion should be considered before opting for this financing option, as the
use of outside agents could be viewed as an indication of financial difficulties.

 Invoice discounting:
This is a loan based on the value of a business’s outstanding credit sales. This is used as
a short term alternative to debt factoring. It is more widely used based on its low service
charges and the autonomy it gives to the business to collect payment for its own credit
sales. However, repayment of the advance not dependent on trade receivables being
collected, so a business must have confidence they can raise finance within the term of
the loan.

Authorized capital

The authorized capital of a company (sometimes referred to as the authorized share capital,
registered capital or nominal capital, particularly in the United States) is the maximum amount
of share capital that the company is authorized by its constitutional documents to issue
(allocate) to shareholders.

Issued share capital

Issued share capital is simply the monetary value of the shares of stock a company actually
offers for sale to investors. The number of issued shares generally corresponds to the amount
of subscribed share capital, though neither amount can exceed the authorized amount.

Subscribed Share Capital:

When a company prepares to "go public" by issuing stock for the first time, investors can
submit an application expressing their desire to participate. Subscribed share capital refers to
the monetary value of all the shares for which investors have expressed an interest

Called-Up vs. Paid-Up Share Capital:

Depending on the business and applicable regulations, companies may issue stock to investors
with the understanding the investors will pay at a later date. Any funds due for shares issued
but not fully paid for are called-up share capital. Any funds remitted for shares are
considered paid-up capital.

LONG TERM CONVENTIONAL SOURCES OF FINANCE

EQUITY SHARES
Equity shares are a common source of finance for big companies. Not all the businesses can use
this source as it is governed by a lot of legislations. A key feature of equity share is the ‘sharing
of ownership rights’ and therefore, the current shareholders’ rights are diluted to some extent
DEBENTURES
Debentures are another common means of finance used by companies who prefer debt over
the equity. Debt is considered to be the cheaper mode of finance compared to equity. It does
not share control with investors. It is because the interest paid to debenture holders is tax
deductible. Rest of process of debentures issue is similar to equity issue. It is offered to the
common public and therefore necessary legislations need to be complied with. Debentures also
involve some cost of issuing and they are collateralized by some assets of the company.

TERM LOAN
The characteristics of a term loan is very similar to debentures except that it does not include
too much cost of issuing because it is given by some bank or financial institutions. The common
public is not involved in it. A rigorous analysis of company’s financials and future plans is done
by the bank to judge the debt servicing capacity of the company. These loans are also secured
by some assets.

DEEP DISCOUNT BONDS

A zero-coupon bond (also discount bond or deep discount bond) is a bond bought at a price
lower than its face value, with the face value repaid at the time of maturity. Note that this
definition assumes a positive time value of money.

FINANCIAL STATEMENT ANALYSIS

As per Companies Act 2013, the financial statements include:

 Profit and Loss statement

 Balance Sheet
 Cash flow statement
 Statement showing changes in equity
 Notes to accounts/explanatory statements

Objectives are:

Profit and Loss statement – to know whether the enterprise is in profit or loss at the end of a
given period or not. The period would usually be one year. It could be as short a period as one
month even. However preparing the Profit and Loss Account every year is a must.

Balance Sheet – It is also referred to as statement of assets and liabilities. This is

as on a particular date. The objective is to know the financial position of the enterprise, how
much it owes to outsiders in the form of liabilities and how much it owns in the form of various
assets. Although it could be prepared on a monthly basis as at the end of every month, it is
prepared as a t t h e end of every year – again a statutory
r e q u i r e m e n t b e s i d e s b e i n g a b u s i n e s s necessity.

In short, the balance sheet tells us about the following:

How much money has the business enterprise raised?

Which are the sources for the money?

What is the use for this money?

Cash flow statement – as explained in the chapter on working capital management, cash flow
statement is primarily to know the cash from operations, investments and finance obtained and
manage the liquidity in the short-run. In the short-run, the objective could be financial planning.
It lists all the cash inflows and cash outflows to verify as to whether the system has the

required liquidity or not. The business should not have too little or too much cash.
The frequency of preparing it depends upon the business needs – it could even be on
a weekly basis. The minimum frequency is one month.

Key pointers to balance sheet and profit and loss statements:

 A balance sheet represents the financial affairs of the company and is also referred to
as “Assets and Liabilities” statement and is always as on a particular date and not for a
period.
 A profit and loss account represents the summary of financial transactions during a
particular period and depicts the profit or loss for the period along with income tax paid
on the profit and how the profit has been allocated (appropriated).
 Net worth means total of share capital and reserves and surplus. This includes preference
share capital unlike in Accounts preference share capital is treated as a debt. For the
purpose of debt to equity ratio, the necessary adjustment has to be done by reducing
preference share capital from net worth and adding it to the debt in the numerator.
 Reserves and surplus represent the profit retained in business
since inception of business. “Surplus” indicates the figure carried forward from the
profit and loss appropriation account to the balance sheet, without allocating
the same to any specific reserve. Hence, it is mostly called “unallocated
surplus”. The company wants to keep a portion of profit in the free form so that it is
available during the next year for appropriation without any problem. In
the absence of this arrangement during the year of inadequate profits, the company
may have to write back a part of the general reserves for which approval from the
board and the general members would be required.
 Secured loans represent loans taken from banks, financial institutions, debentures (either
from public or through private placement), bonds etc. for which the company has mortgaged immovable
fixed assets (land and building) and/or hypothecated movable fixed assets (at times even
working capital assets with the explicit permission of the working capital banks).
 Usually, debentures, bonds and loans for fixed assets are secured by fixed assets, while
loans from banks for working capital, i.e., current assets are secured by
current assets. These loans enjoy priority over unsecured loans for settlement
of claims against the company.
 Unsecured loans represent fixed deposits taken from public (if any) as per the provisions of Section58
(A) of The Companies Act, 1956 and in accordance with the provisions of Acceptance of
Deposit Rules, 1975 and loans, if any, from promoters, friends, relatives etc. for which no
security has been offered.
 Such unsecured loans rank second and subsequent to secured loans for
settlement of claims against the company. There are other unsecured creditors also,
forming part of current liabilities, like, creditors for purchase of materials, provisions etc.
 Gross block = gross fixed assets mean the cost price of the fixed assets. Cumulative
depreciation in the books is as per the provisions of The
C o m p a n i e s A c t , 1 9 5 6 , S c h e d u l e X I V . I t i s l a s t cumulative depreciation till
last year + depreciation claimed during the current year. Net block = net fixed assets
mean the depreciated value of fixed assets.
 Capital work-in-progress – This represents advances, if any, given to building
contractors, value of building yet to be completed, advances, if any, given
to equipment suppliers etc. Once the equipment is received and the building is
complete, the fixed assets are capitalized in the books, for claiming depreciation from
that year onwards. Till then, it is reflected in the form of capital work in progress.
 Investments – Investment made in shares/bonds/units of Unit Trust
of India etc. This type of investment should be ideally from the profits of the
organization and not from any other funds, which are required either for working capital
or capital expenditure. They are bifurcated in the schedule, into “quoted and traded” and
“unquoted and not traded” depending upon the nature of the investment, as to whether they can
be liquidated in the secondary market or not.
 Current assets – Both gross and net current assets (net of current liabilities)
are given in the balance sheet.
 Miscellaneous expenditure not written off can be one of the following –
 o Company incorporation expenses or public issue of share capital, debenture etc.
together known as “preliminary expenses” written off over a period of 5 years as
per provisions of Income Tax miscellaneous expense could also be other deferred
revenue expense like product launch expenses.
o Other income in the profit and loss account includes income from dividend on
share investment made in other companies, interest on fixed deposits/debentures,
sale proceeds of special import licenses, profit on sale of fixed assets and any
other sundry receipts.

o Provision for tax could include short provision made for the earlier years.
o Provision for tax is made after making all adjustments for the following:
o Carried forward loss, if any;
 Book depreciation and depreciation as per income tax and concessions available to a business
entity, depending upon their activity (export business, S.S.I. etc.) and location in
a backward area (like Goa etc.)
 As per the provisions of The Companies Act, 1956, in the event of a limited company
declaring dividend, a fixed percentage of the profit after tax has to be transferred to the
General Reserves of the Company and entire PAT cannot be given as dividend.
 With effect from 01/04/02, dividend tax on dividends paid by the company has been
withdrawn. From that date, the shareholders are liable to pay tax on dividend income.
Thus for a period of 5years, the position was different in the sense that the company was
bearing the additional tax on dividend.

Other parts of annual statements –

 The Directors’ Report on the year passed and the future plans
 Annexure to the Directors’ Report containing particulars regarding conservation of energy etc.
 Auditors’ Report as per the Manufacturing and Other Companies (Auditors’ Report)
Order, 1998) along with Annexure
 Schedules to Balance Sheet and Profit and Loss Account
 Accounting policies adopted by the company and notes on accounts giving details about
changes if any, in method of valuation of stocks, fixed assets, method of
 depreciation on fixed assets, contingent liabilities, like guarantees given by the banks
on behalf of the company, guarantees given by the company, quantitative details
regarding performance of the year passed, foreign exchange inflow and outflow etc.
 Statement of cash flows for the same period for which final accounts have been presented.

There is a significant difference between the way in which the statements of accounts are
prepared asper Schedule VI of the Companies Act and the manner in which these statements,
especially, balance sheet is analyzed by a finance person or an analyst. For example,
in the Schedule VI, the current liabilities are netted off against current assets and only net
current assets are shown. This is not so in the case of financial statement analysis. Both are shown fully
and separately without any netting off. At the end of any financial year, there are certain adjustments to
be made in the books of accounts to get the proper picture of profit or loss, as the case may be,
for that particular period. For example, if stocks of raw materials are outstanding at the
end of the period, the value of the same has to be deducted from the total of the
opening stock (closing stock of the previous year) and the current year’s purchases. This
alone would show the correct picture of materials consumed during the current year.

Other important points:

BUYBACK OF SHARES: Buyback means company is buying back its own shares by utilizing free reserves or
securities premium reserves. Basic purpose of this can be:

 To give award/reward to shareholders

 To stabilize the market price
 To improve EPS
 To increase the percentage stake of promoters

If buyback of shares is up to 10% of paid-up share capital and free reserves, only board
resolution is sufficient otherwise shareholders’ approval by special resolution (75% or 3/4th
majority) is required.

MINORITY INTEREST: The concept of minority interest appears in the consolidated balance
sheet of holding company. Example: if a company A is holding 60% shares in company B, which
means, other shareholders are holding 40% shares in subsidiary. SO in company A’s balance
sheet, this 40% stake will appear as minority interest after reserves & surplus.
MANAGEMENT ACCOUNTING
Financial Accounting
Basic objective of FA is to
understand financial
performance of the business
FA prepares P&L ac and
balance sheet
Compulsory
More useful to outsiders
Covers monetary
transactions
FA is historical accounting
It shows the results for the
company as a whole or
entire company
It shows the result for
financial year
Easy accessibility
MANAGEMENT ACCOUNTING
Cost Accounting
Basic objective is to calculate MA uses finances and cost
the cost and to control the
cost
CA prepares cost sheet
Not compulsory, however
for specific industries cost
audit is compulsory
For internal management
only
Covers monetary and non-
monetary
Historical + estimate
It shows product wise
cost/Department/ factory/
process wise cost
As and when required
No access to outsiders
Management Accounting
data and provides to the
management in such a way
so that management can
make speedy and correct
decisions
Checks performances of
middle level management.
prepares sales budget ,
marginal costing statement
discretionary
Monetary as well as non-
monetary
Historical + estimate
Helps in making strategies
and policies by using FA and
CA results
-
No access to outsiders
Covers quarterly results , Covers job costing , process
accounting standards , costing, batch costing ,
international accounting service costing etc.
standard etc.

RATIO ANALYSIS

PROFITABILITY RATIOS

Profitability ratios are always in percentage

NET PROFIT RATIO – this ratio indicates overall profit made by the company in the current year
for every 100 rupee sales. Creditors and investors use this ratio to measure how effectively a
company can convert sales into net income. Investors want to make sure profits are high
enough to distribute dividends while creditors want to make sure the company has enough
profits to pay back its loans. In other words, outside users want to know that the company is
running efficiently. An extremely low profit margin formula would indicate the expenses are too
high and the management needs to budget and cut expenses.

GROSS MARGIN RATIO - Gross margin ratio is a profitability ratio that compares the gross
margin of a business to the net sales. This ratio measures how profitable a company sells its
inventory or merchandise. In other words, the gross profit ratio is essentially the percentage
mark-up on merchandise from its cost. This is the pure profit from the sale of inventory that can
go to paying operating expenses.

RETURN ON EQUITY - The return on equity ratio or ROE is a profitability ratio that measures the
ability of a firm to generate profits from its shareholders investments in the company.ROE is
also an indicator of how effective management is at using equity financing to fund operations
and grow the company.

RETURN ON CAPITAL EMPLOYED - Return on capital employed or ROCE is a profitability ratio

that measures how efficiently a company can generate profits from its capital employed by
comparing net operating profit to capital employed.It shows how effectively assets are
performing while taking into consideration long-term financing.

LIQUIDITY RATIOS

CURRENT RATIO - The current ratio is a liquidity and efficiency ratio that measures a firm's
ability to pay off its short-term liabilities with its current assets. The current ratio is an
important measure of liquidity because short-term liabilities are due within the next year.

QUICK ASSET RATIO -The quick ratio or acid test ratio is a liquidity ratio that measures the
ability of a company to pay its current liabilities when they come due with only quick assets.
Quick assets are current assets that can be converted to cash within 6 months. Cash, cash
equivalents, short-term investments or marketable securities, and current accounts receivable
are considered quick assets.
TURNOVER RATIO

STOCK TURNOVER RATIO - The inventory turnover ratio is an efficiency ratio that shows how
effectively inventory is managed by comparing cost of goods sold with average inventory for a
period. This measures how many times average inventory is "turned" or sold during a period.

ASSET TURNOVER RATIO - The asset turnover ratio is an efficiency ratio that measures a
company's ability to generate sales from its assets by comparing net sales with average total
assets. In other words, this ratio shows how efficiently a company can use its assets to generate
sales.

ACCOUNTS RECEIVABLE TURNOVER RATIO - Accounts receivable turnover is an activity ratio

that measures how many times a business can turn its accounts receivable into cash during a
period. In other words, the accounts receivable turnover ratio measures how many times a
business can collect its average accounts receivable during the year.

SOLVENCY RATIO
DEBT EQUITY RATIO - The debt to equity ratio is a financial, liquidity ratio that compares a
company's total debt to total equity. The debt to equity ratio shows the percentage of company
financing that comes from creditors and investors. A higher debt to equity ratio indicates that
more creditor financing (bank loans) is used than investor financing (shareholders).

CAPITAL MARKET RELATED RATIOS

EARNINGS PER SHARE - Earning per share, also called net income per share, is a market
prospect ratio that measures the amount of net income earned per share of stock outstanding.
In other words, this is the amount of money each share of stock would receive if all of the
profits were distributed to the outstanding shares at the end of the year.

PRICE EARNINGS RATIO - The price earnings ratio, often called the P/E ratio, is a market
prospect ratio that calculates the market value of a stock relative to its earnings by comparing
the market price per share by the earnings per share. It shows what the market is willing to pay
for a stock based on its current earnings.

DIVIDEND PAY-OUT RATIO - The dividend payout ratio measures the percentage of net income
that is distributed to shareholders in the form of dividends during the year. In other words, this
ratio shows the portion of profits the company decides to keep funding operations and the
portion of profits that is given to its shareholders.
DIVIDEND YIELD RATIO - The dividend yield is a financial ratio that measures the amount of
cash dividends distributed to common shareholders relative to the market value per share. The
dividend yield is used by investors to show how their investment in stock is generating either
cash flows in the form of dividends or increases in asset value by stock appreciation.

COST ACCOUNTING

Cost Accounting may be defined as “Accounting for costs classification and analysis of
expenditure as will enable the total cost of any particular unit of production to be ascertained
with reasonable degree of accuracy and at the same time to disclose exactly how such total
cost is constituted”. Thus Cost Accounting is classifying, recording an appropriate allocation of
expenditure for the determination of the costs of products or services, and for the presentation
of suitably arranged data for the purpose of control and guidance of management.
 BUDGETING

Budget is a plan which covers quantitative as well as monetary information. It is for specific
period and works as a target to be achieved by utilizing specific resources. It covers planning,
coordination and control.

CASH BUDGET

A cash budget is a budget or plan of expected cash receipts and disbursements during the
period. These cash inflows and outflows include revenues collected, expenses paid, and loans
receipts and payments. In other words, a cash budget is an estimated projection of the
company's cash position in the future.
Management usually develops the cash budget after the sales, purchases, and capital
expenditures budgets are already made. These budgets need to be made before the cash
budget in order to accurately estimate how cash will be affected during the period. For
example, management needs to know a sales estimate before it can predict how much cash will

be collect Management uses the cash budget to manage the cash flows of a company. In other
words, management must make sure the company has enough cash to pay its bills when they
come due. For instance, payroll must be paid every two weeks and utilities must be paid every
month. The cash budget allows management to predict short falls in the company's cash
balance and correct the problems before payments are due during the period.

FLEXIBLE BUDGET

A flexible budget calculates different expenditure levels for variable costs, depending upon
changes in actual revenue. The result is a budget that varies, depending on the actual activity
levels experienced. Actual revenues or other activity measures are entered into the flexible
budget once an accounting period has been completed, and it generates a budget that is
specific to the inputs. The budget is then compared to actual information for control purposes.

MARGINAL COSTING

The ascertainment of marginal costs and of the effect on profit of changes in volume or type of
output by differentiating between fixed costs and variable cost.

In this technique of costing only variable costs are charged to operations, processes or
products, leaving all indirect costs to be written off against profits in the period in which they
arise.

Thus, in this context, marginal costing is not a system of costing such as process costing, job
costing, operating costing, etc. but a technique which is concerned with the changes in costs
and profits resulting from changes in the volume of output. Marginal costing is also known as
‘variable costing’.The technique of marginal costing is based on the distinction between
product costs and period costs. Only the variable costs are regarded as the costs of the
products while the fixed costs are treated as period costs which will be incurred during the
period regardless of the volume of output.

SALES – VARIABLE COST = FIXED COST + PROFIT

STANDARD COSTING

Standard costing is the practice of substituting an expected cost for an actual cost in the
accounting records, and then periodically recording variances showing the difference between
the expected and actual costs. This approach represents a simplified alternative to cost layering
systems, such as the FIFO and LIFO methods, where large amounts of historical cost
information must be maintained for items held in stock.

Standard costing involves the creation of estimated (i.e., standard) costs for some or all
activities within a company. The core reason for using standard costs is that there are a number
of applications where it is too time-consuming to collect actual costs, so standard costs are
used as a close approximation to actual costs.

Since standard costs are usually slightly different from actual costs, the cost
accountant periodically calculates variances that break out differences caused by such factors
as labour rate changes and the cost of materials. The cost accountant may also periodically
change the standard costs to bring them into closer alignment with actual costs

DERIVATIVES

DERIVATIVES

Derivative is a product whose value is derived from the value of one or more basic variables,

called bases (underlying asset, index, or reference rate), in a contractual manner.

TYPES OF DERIVATIVES

The most commonly used derivatives contracts are forwards, futures and options

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the

obligation to buy a given quantity of the underlying asset, at a given price on or before a

given future date. Puts give the buyer the right, but not the obligation to sell a given quantity
of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of up to one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated options are

called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are

options having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset

is usually a moving average of a basket of assets. Equity index options are a form of basket

options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are :

 Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.

 Currency swaps: These entail swapping both principal and interest between the

parties, with the cash flows in one direction being in a different currency than those in

the opposite direction.

Terminology of Derivatives

1.) Spot price (ST)

Spot price of an underlying asset is the price that is quoted for immediate delivery of the

asset. For example, at the NSE, the spot price of Reliance Ltd. at any given time is the price
at which Reliance Ltd. shares are being traded at that time in the Cash Market Segment of the

NSE. Spot price is also referred to as cash price sometimes.

2.) Forward price or futures price (F)

Forward price or futures price is the price that is agreed upon at the date of the contract for

the delivery of an asset at a specific future date. These prices are dependent on the spot price,

the prevailing interest rate and the expiry date of the contract.

3.) Strike price (K)

The price at which the buyer of an option can buy the stock (in the case of a call option) or

sell the stock (in the case of a put option) on or before the expiry date of option contracts is

called strike price. It is the price at which the stock will be bought or sold when the option is

exercised. Strike price is used in the case of options only; it is not used for futures or

forwards.

4.) Expiration date (T)

In the case of Futures, Forwards, Index and Stock Options, Expiration Date is the date on

which settlement takes p lace. It is also called the final settlement date.

5.) Types of options

Options can be divided into two different categories depending upon the primary exercise

styles associated with options. These categories are:

i. European Options:

European options are options that can be exercised only on the expiration date.

ii. American options:

American options are options that can be exercised on any day on or before the expiry

date. They can be exercised by the buyer on any day on or before the final settlement
date or the expiry date.

6.) Contract size

As futures and options are standardized contracts traded on an exchange, they have a fixed

contract size.

7.) Contract Value

Contract value is notional value of the transaction in case one contract is bought or sold. It is

the contract size multiplied but the price of the futures. Contract value is used to calculate

margins etc. for contracts. In the example above if BHEL futures are trading at Rs. 2000 the

contract value would be Rs. 2000 x 300 = Rs. 6 lacs.

8.) Margins

In a derivatives contract, a person enters into a trade today (buy or sell) but the settlement

happens on a future date. Because of this, there is a high possibility of default by any of the

parties.

This margin is a percentage (approximately 20%) of the total contract value. Thus, for the a
forementioned example, if a person wants to buy 100 Infosys futures, then he will have to pay
20% of the contract value of Rs 2,00,000 = Rs 40,000 as a margin to the clearing corporation.
This margin is applicable to both, the buyer and the seller of a futures contract.

OPTIONS

Options are derivative contracts that give the holder the right, but not the obligation, to buy or
sell the underlying instrument at a specified price on or before a specified future date.

There are two types of options —call options and put options —which are explained below.

A. Call option
A call option is an option granting the right to the buyer of the option to buy the underlying
asset on a specific day at an agreed upon price, but not the obligation to do so. It is the
seller who grants this right to the buyer of the option.

This price is known as the strike price of the contract (call option strike price in this case).
 B. Put option

A put option is a contract granting the right to the buyer of the option to sell the underlying

asset on or before a specific day at an agreed upon price, but not the obligation to do so. It
is

the seller who grants this right to the buyer of the option.

This price is known as the strike price of the contract (put option strike price in this case).

Moneyness of an Option

“Moneyness” of an option indicates whether an option is worth exercising or not i.e. if the

option is exercised by the buyer of the option whether he will receive money or not.

“Moneyness” of an option at any given time depends on where the spot price of the

underlying is at that point of time relative to the strike price. The premium paid is not taken

into consideration while calculating moneyness of an Option, since the premium once paid is

a sunk cost.

The following three terms are used to define the moneyness of an option.

1.) In -the -money option

An option is said to be in- the - money if on exercising the option, it would produce a cash

inflow for the buyer. Thus, Call Options are in -the- money when the value of spot price of

the underlying exceeds the strike price. On the other hand, Put Options are in- the - money

when the spot price of the underlying is lower than the strike price.

2.) Out-of- the -money option

An out- of - the - money option is an opposite of an in- the - money option. An option- holder

will not exercise the option when it is out- of- the - money. A Call option is out- of - the -

money when its strike price is greater than the spot price of the underlying and a Put option is

out- of-the money when the spot price of the underlying is greater than the option’s strike
price.

3.) At- the-money option

An at-the- money- option is one in which the spot price of the underlying is equal to the strike

price. It is at the stage where with any movement in the spot price of the underlying, the

option will either become in- the - money or out- of-the- money.

BLACK-SCHOLES MODEL

The Black-Scholes formula (also called Black-Scholes-Merton) was the first widely used model
for option pricing. It's used to calculate the theoretical value of European-style options using
current stock prices, expected dividends, the option's strike price, expected interest rates, time
to expiration and expected volatility.

Figure 1: The Black-Scholes pricing formula for call options.

The model is essentially divided into two parts: the first part, SN (d1), multiplies the price by the
change in the call premium in relation to a change in the underlying price. This part of the
formula shows the expected benefit of purchasing the underlying outright. The second part, N
(d2) Ke-rt, provides the current value of paying the exercise price upon expiration (remember,

the Black-Scholes model applies to European options that can be exercised only on expiration
day). The value of the option is calculated by taking the difference between the two parts, as
shown in the equation.

ADVANTAGES & LIMITATIONS

Advantage: The main advantage of the Black-Scholes model is speed -- it lets you calculate a
very large number of option prices in a very short time.
Limitation: The Black-Scholes model has one major limitation: it cannot be used to accurately
price options with an American-style exercise as it only calculates the option price at one point
in time -- at expiration. It does not consider the steps along the way where there could be the
possibility of early exercise of an American option.

OPTIONS GREEKS

What can option Greeks do for you?

Consider some of the things Greeks may help you do:

 Gauge the likelihood that an option you're considering will expire in the money (Delta).

 Estimate how much the Delta will change when the stock price changes (Gamma).

 Get a feel for how much value your option might lose each day as it approaches expiration
(Theta).

 Understand how sensitive an option might be to large price swings in the underlying stock
(Vega).

 Simulate the effect of interest rate changes on an option (Rho).

Delta

Delta , are measures of risk from a move of the underlying price. For example, if you buy an at-
the-money call or put, it will have a Delta of approximately 0.5, meaning that if the underlying
stock price moves 1 point, the option price will change by 0.5 points (all other things remaining
the same). If the price moves up, the call will increase by 0.5 points and the put will decrease by
0.5 points.

Vega

When any position is taken in options, not only is there risk from changes in the underlying but
there is risk from changes in implied volatility. Vega is the measure of that risk. When the
underlying changes, or even if it does not in some cases, implied volatility levels may change.

Theta
Theta is a measure of the rate of time premium decay and it is always negative (leaving
position Theta aside for now). As soon as you own an option (a wasting asset), the clock starts
ticking, and with each tick the amount of time value remaining on the option decreases, other
things remaining the same.
Gamma
Delta measures the change in price of an option resulting from the change in the underlying
price. However, Delta is not a constant. When the underlying moves so does the Delta value on
any option. This rate of change of Delta resulting from movement of the underlying is known
as Gamma. And Gamma is largest for options that are at-the-money, while smallest for those
options that are deepest in- and out-of-the-money.

Rho

Rho is a risk measure related to changes in interest rates. When interest rates rise, call prices
will rise and put prices will fall. Just the reverse occurs when interest rates fall. Rho is a risk
measure that tells strategists by how much call and put prices change as a result of the rise or
fall in interest rates.

Conclusion
A summary of the risk measures known as the Greeks is presented, noting how each expresses
the expected changes in an option's price resulting from changes in the underlying (Delta),
volatility (Vega), time value decay (Theta), interest rates (Rho) and the rate of change
of Delta (Gamma).

MERGERS AND ACQUISITION

Difference between mergers and acquisition and why do companies indulge in these
processes

Merger and acquisition are the two most commonly applied corporate restructuring strategies,
which are often uttered in the same breath, but they are not one and the same. These are the
form of external expansion, whereby through corporate combinations, business entities
purchases a running business and grows overnight. It helps the business in maximizing the
profit and growth by increasing the level of production and marketing operation. While merger
means “to combine”,Acquisitionmeans“toacquire.”

This table illustrates the difference between Merger and Acquisition :

TYPES OF MERGERS:

 Nature of Investor Financial (Primarily VC and PE) and Strategic

 Geography Inbound, Outbound and Domestic
 Stage of Investment Seed / Friends and Family, Angel, Crowd Funding, Series A, Series B,
Series C, Series D, IPO, etc.
 Level of Stake Minority, Significant minority, Majority and Buy out / 100% acquisition,
etc.
 Transaction Structure Amalgamation / merger, Demerger, Slump sale, Primary vs.
Secondary Transaction, etc.
  Assets Being Transferred Asset Purchase, Business sale, Brand sale, Marketing rights,
etc.
 Consideration Cash, Stock, Shares and Cash, Share Swap, Deferred Consideration, etc.
 Accounting Standards Issued by ICAI/Central Government, Indian Accounting Standards,
IFRS, US GAAP, etc
 Taxation Income Tax Act, 1961 T

Also types of mergers can be classified as

By concept, merger increases the size of the undertakings. Following are major types of
mergers:

(i)Horizontal Merger:

The two companies which have merged are in the same industry, normally the market share of
the new consolidated company would be larger and it is possible that it may move closer to
being a monopoly or a near monopoly to avoid competition.

(ii)Vertical Merger:

This merger happens when two companies that have ‘buyer-seller’ relationship (or potential
buyer-seller relationship) come together.

(iii)Conglomerate Mergers:

Such mergers involve firms engaged in unrelated type of business operations. In other words,
the business activities of acquirer and the target are neither related to each other horizontally
(i.e., producing the same or competiting products) nor vertically (having relationship of buyer
and supplier).In a pure conglomerate merger, there are no important common factors between
the companies in production, marketing, research and development and technology. There may
however be some degree of overlapping in one or more of these common factors. Such
mergers are in fact, unification of different kinds of businesses under one flagship company.
The purpose of merger remains utilization of financial resources, enlarged debt capacity and
also synergy of managerial functions.

(iv)Congeneric Merger:

In these mergers, the acquirer and the target companies are related through basic
technologies, production processes or markets. The acquired company represents an extension
of product-line, market participants or technologies of the acquirer. These mergers represent
an outward movement by the acquirer from its current business scenario to other related
business activities within the overarching industry structure
(v)Reverse Merger:

Such mergers involve acquisition of a public (Shell Company) by a private company, as it helps
private company to by-pass lengthy and complex process required to be followed in case it is

interested in going public. Sometimes, it might be possible that a public company continuously
a public traded corporation but it has no or very little assets and what remains only its internal
structure and shareholders. This type of merger is also known as ‘back door listing’. This kind of
merger has been started as an alternative to go for public issue without incurring huge
expenses and passing through cumbersome process.

CORPORATE STRATEGY V/S BUSINESS UNIT STRATEGY

Business Unit strategy:

The decisions a company makes on its way to creating, maintaining and using
its competitive advantages are business-level strategies.

Corporate strategy:

Corporate strategy, on the other hand, determines how the corporation as a

whole supports and enhances the value of the business units within it.
“Total value of corporation is greater than sum of values of individual business units.”

Business Unit strategy includes:

What are the drivers of industry profitability?

How can a firm create a competitive advantage?

Corporate strategy includes:

What is the mix of industries we should be in?

How do we add value in eachunit
Which geography / market?
Which part of the value chain?

VALUE AND VALUE CREATION

Value :
The monetary worth of an asset, business entity, good sold, service rendered , or liability or
obligation acquired.”

“The worth of all the benefits and rights arising from ownership:-
the utility of a good or service, and
power of a good or service to command other goods, services, or money, in voluntary
exchange.”

Value Creation :
Value creation is a primary aim for any business entity.
Creating value for customers helps to sell products and services.
Creating value for shareholders in the form of increases in stock price.

Misconception
Value creation means do whatever it takes to engineer an ever increasing
market price.

REASONS FOR MERGERS AND ACQUISITIONS

 Scalability and Growth

 Economies of scale
 Market share and Competition
 Technology and Innovations
 Intellectual property
 Customer contracts and history
 Raw material linkages
 Risk mitigation
 Market entry and / or expansion
 Vertical and / or lateral integration
 Diversification
 Funding requirements
 Regulatory requirements
 Reduction of Leverage
 Economic environment
 Political environment
 Consolidation
 Other synergies
 Attractive valuation –Opportunistic
 Tax efficiencies
 Stock market trends

GOVERNING LAWS (in India)

 Income tax Act, 1961
 Companies Act, 2013 (to the extent notified)
 Stamp duty laws
 Patents Act / Trademarks Act
 FDI Policy
  SEBI Takeover Code
 Copyrights Act
 Special Economic Zones (SEZ) Act
 Labor Laws
 Foreign Exchange & Management Act, 1999
 Accounting Standards and IFRS
 Limited Liability Partnership Act, 2008

Regulatory Authorities
 Securities & Exchange Board of India (SEBI)
 Reserve Bank of India (RBI)
 Registrar of Companies (ROC)
 Competition Commission of India (CCI)
 Director General of Foreign Trade (DGFT)

PROCESS OF ACQUISITION

Acquisition process includes the following steps :

The acquisition process involves the following essential stages:

(i) Defining the Acquisition Criteria

(ii) Competitive analysis;
(iii) Search and screen.
(iv) Strategy development.
(v) Financial evaluation.
(vi) Target contact and negotiation.
(vii) Due Diligence (in the case of a friendly acquisition
(viii) Arranging for finance for acquisition
(ix) Putting through the acquisition and Post merger integration

VALUATION OF COMPANY

Methods of valuation

1)EARNINGS BASED VALUATION

Discounted Cash Flow/Free Cash Flow valuation:

This discounted cash-flow technique being the most common technique takes into
consideration the future earnings of the business and hence the appropriate value depends on
projected revenues and costs in future, expected capital outflows, number of years of
projection, discounting rate and terminal value of business. This methodology is used to value
companies since firms are essentially collection of projects. There are six steps involved in the
valuation

Step 1: Determine Free Cash Flow Free cash flow to the Firm (FCFF) is the cash flow available to
all investors in the company — both shareholders and bondholders after consideration for
taxes, capital expenditure and working capital investment. Free cash flow to Equity (FCFF) is the
cash flow available to only the equity shareholders after bondholders are paid their interest and
the committed principal repayment for the year,

Free Cash Flow to Firm (FCFF) = NOPAT + Depreciation and Amortization – (Capital

expenditure + Working capital investment) Estimate the most likely incremental cash flows to
be generated by the target company with the acquirer as owner (and not on as-is basis). Note
that financing is not incorporated in the cash flows. Suitable adjustments for the specific
financing of the acquisition will be made in the discount rate.

Step 2 : Estimate a suitable Discount Rate for the Acquisition

The acquiring company can use its weighted average cost of capital based on its target capital
structure only if the acquisition will not affect the riskiness of the acquirer. If the acquirer
intends to change the capital structure of the target company, suitable adjustments for the
discount rate should be made. The discount rate should reflect the capital structure of the
company after the acquisition. The appropriate discount rate for discounting FCFF is the
Weighted Average Cost of Capital (WACC) and the discount rate for discounting FCFE is the Cost
of Equity.

Step 3 : Calculate the Present Value of Cash Flows

Since the life of a going concern, by definition, is infinite, the value of the company is,

= PV of cash flows during the forecast period + Terminal value

We can set the forecast period in such a way that the company reaches a stable phase after
that. In other words, we are assuming that the company will grow at a constant rate after the
forecast period.

Step 4 : Estimate the Terminal Value

Generally it is quite difficult to estimate Terminal Value (TV) of a company because the end of
explicit period represents a date when forecasted projections have no more meaning. Generally
analysts assumes that after explicit period the company enters in its maturity phase of business
cycle.
(i) On the basis of Capital Employed

Usually this basis is used in some specific type of industries e.g. mining etc. Where we estimate
liquidation value by adding up realizable value of various assets. Thus, under this method it is
assumed that the company has a finite life, therefore scrap or realizable value of all assets is
computed.

(ii) On the basis of Multiple of Earnings: Under this approach TV is determined by multiplying
the forecasted terminal year profits by an available/appropriate price earning multiple.
Normally, the current P/E multiple can also be used as proxy for future P/E multiple and can be
calculated as follows:

TV = Current market value of company/Current profit after tax

Suppose, if the current market value of company is576.20 crore and profit after tax is82.30
crore,

Then P/E = 576.20/82.30 = 7

Further if last year’s profit are

201.20 crore, then TV shall be

= Last year’s profit × P/E multiple

201.20 crore × 7 =

Rs`1408.40 crore

(iii) On the basis of Free Cash Flow:

This is one of the popular method of estimating TV because future expected cash flows are
discounted at a rate that reflects the riskiness of the projected cash flows. It should however
be noted that following two approaches can be employed to compute the TV.

(a) Growing Perpetuity

Under this approach we assume that cash flow grows at a constant

rate after forecasted period and it is calculated as follows:

TV = [CFt (1 + g)] / (k – g)

where,

CFt

= Cash flow in the last year

g = Constant Growth Rate

k = Discount rate or Cost of Capital

(b) Stable Perpetuity:

This approach is followed when there is no Capital Expenditure or if it is there then it is equal
to depreciation charged. In other words capital does not grow any more. In such situations cash
flows becomes equal to Profit After Tax (PAT). Therefore, we can assume that the company
earns a rate of return on capital employed is equal to Cost of Capital irrespective of Sales
Growth.

The TV in such case shall be calculated as follows:

TV = Free Cash Flow/ Discount Rate (Cost of Capital)

= FCF/k

Step 5 :

Add Present Value of Terminal Value = TV x PVIFk,n

Step 6 :

Deduct the Value of Debt and Other Obligations Assumed by the Acquirer. Thus, the method
adopted by the analyst affects the final value placed on the company’s equity. These four
methods might give four different answers. However, the DCF approach can capture the value
of assets in place. Some components of the acquisition are hard to quantify. Consequently, the
final price paid by the acquirer might be much higher than the DCF value obtained. But the
premium paid for the so-called synergy should not be out of proportion. We could think of the
target company’s value as,

Value of buyer = Value of seller + Value added by buyer + Change in value to buyer if target firm
is acquired by competitor.
The first component is the DCF value of the targetfirm in its current form with the current
growth rate, current financial plan, etc.

The second component, value added by acquirer comprises of synergy to acquirer, cost savings,
value of new strategy after the acquisition, proceeds from sale of redundant assets adjusted for
taxes benefits from improvement in credit-rating and other financing side-effects.

The third component is the gain or loss to the acquirer if the competitor manages to acquire
the target. The sum total of these three components gives the maximum value of the target. A
sensitivity analysis may be conducted for pessimistic and optimistic values of key financial
variables like sales growth rate, profit margin, working capital investment, capital expenditure,
period of high growth, etc. The end product of such an analysis is a range of prices within the
acquisition price may lie. Obviously, the acquirer would want to lower the price as much as
possible and the opposite is true for the target.

2) Market Based Valuation

While using the market based valuation for unlisted companies, comparable listed companies
have to be identified and their market multiples
(such as market capitalizations to sales or stock price to earnings per share)
are used as surrogates to arrive at a value.

PROBLEMS FOR M&A in India

 Indian corporate are largely promoter-controlled and managed. The ownership stake
should, in the normal course, inhibit any rational judgment on this sensitive issue. It is
difficult for either of the two promoters to voluntarily relinquish management control in
favour of the other, as a merger between two companies implies. In some cases, the
need for prior negotiations and concurrence of financial institutions and banks is an
added rider, besides SEBI’s rules and regulations.

 The reluctance of financial institutions and banks to fund acquisitions directly.

 The BIFR route, although tedious, is preferred for obtaining financial concessions.
 Lack of Exit Policy for restructuring/downsizing.
 Absence of efficient capital market system makes the Market capitalisation not fair in
some cases.
 Valuation is still evolving in India.

Wealth Management
SESSION 1: INTRODUCTION TO FINANCIAL PLANNING
Planning doesn’t come naturally to most of us. In a way it challenges optimism and compels you to
think about uncertainties. Implementing a plan doesn’t always guarantee, but it ensures that the
odds of success increase manifold.

What is financial planning?

Financial planning is the process of managing one’s finances with the objective of achieving life
goals. These goals could vary from buying a house to going on a dream vacation to more serious
goals like retirement planning or child education planning. A good financial plan requires analyzing
the financial status, outlining the goals and understanding the means for achieving these goals.

Why financial planning?

Financial Planning provides direction and meaning to your financial decisions. One feels more
secure and more adaptable to life changes, once they measure that they are moving closer to
realization to their goals. Implementing a financial plan offers an unrivalled peace of mind. It removes

Myths about financial planning

Myth 1: I need to have a substantial sum of money/assets before thinking about financial
planning
Myth 2: I am already saving enough. Why do I need financial planning?

Myth 3: I cannot afford a financial planner or financial plan.

Myth 4: I am too young to worry about financial planning.

Myth 5: I am nearing retirement. Isn't it too late for financial planning?

Myth 6: My children will take care of me post-retirement. I don't need to think about planning
for retirement.

Myth 7: I know enough about investing and have good knowledge of markets and financial
products.

Session 2: INSURANCE PLANNING

An individual undergoes various life stages, each characterized with specific goals. When you are single,
usually up to 25 years of age, you start laying the foundation for the financial security of your future. Once
you get married and have children, your priority is asset accumulation and wealth generation. And then
your pre-retirement and finally the retirement phase are characterized by wealth utilization and
distribution.
A proper financial planning at each stage of life leads to a secure financial future. But, we have to
consider the time value of money as well. The present value of the money will not be the same in future.
For example, your monthly expenses of Rs. 30,000 today will be Rs. 38,288 after five years, assuming
inflation at 5%.
All these show that life is constantly changing. Your life stages change and so do goals and priorities. The
financial position and the cost of living also changes with time.
In order to have a secure financial future, you have to plan according to these changing situations. But
one factor that you are always exposed to at all times is risk.

How much life insurance should one buy?

Life insurance is meant to provide with the enough money to your dependents to replace your income in
case you die. Ideally, your life cover must take care of the following things:

a) Family expenses till lifetime;

b) Liabilities outstanding and

c) Family and children goals.

This worksheet will help you determine how much coverage you will need:

1. Providing for family expenses till lifetime

Annual expenses required for dependents Rs.2,40,000

Number of years for which you wish to provide above 25 years

Expenses

A: Corpus required for funding family expenses Rs.60,00,000

2. Liabilities Outstanding

Home loan Rs.15,00,000

 B: Corpus required for repaying liabilities Rs.15,00,000

3. Family Goals

Child education (today’s cost) Rs.8,00,000

Child marriage (today’s cost) Rs.10,00,000

C: Corpus required for fulfilling goals Rs.18,00,000

A + B + C = The estimated amount of life insurance you Rs.93,00,000

will need

Thumb rule to calculate life cover

As a thumb rule, every earning individual has to have a life cover of 10 to 20 times of annual income
depending on their age. For people aged from 25 to 40, a life cover equal to 20 times of annual income
and for people above the age of 40, a life cover equal to 10 times of annual income would be the thumb
rule.

Insurance coverage given by life insurance companies

The life insurance companies provide life cover to individuals based on two main factors – Age and
Income. Since life cover replaces an individual's income for the family, income is the main factor. As age
increases, the risk of natural death increases and hence, age too plays a role in determining how much of
life cover can be provided to an individual. Apart from these two factors, there are a lot of other factors
like personal health, family's medical history, usage of tobacco, etc.

The below is an indicative table which provides the maximum life cover which can be offered based on
age. The slabs might vary from one company to another.

Age group Maximum life cover offered

18 – 35 20 times of annual gross income

 36 – 45 15 times of annual gross income

46 – 55 10 times of annual gross income

56 – 60 5 times of annual gross income

SESSION 3: RETIREMENT PLANNING

Following are a few key reasons that call for prudent retirement planning:

 Social changes
 Increasing life expectancy
 No benefits from employers

 Rising medical expenses

 Increased standard of living
 Rising inflation

A. Some of the investment options are:

1. Employee provident fund (EPF)

2. Public provident fund (PPF)

3. Pension products from insurance companies

4. New Pension System (NPS).

5. Mutual Funds

B. Life after retirement

If you have already retired or are at the threshold of retirement, it is essential to invest in low-risk
instruments so that there is no capital erosion. Hence it makes more sense to invest in instruments with a
greater exposure to debt.

Some of the preferred options are:

1. Annuity from insurance companies

An Annuity is a very useful retirement planning tool that offers unique benefits to senior citizens. Annuity
is a series of regular payments over a period. An annuity is a contract with an insurance company under
which you receive fixed payments on an investment for a lifetime or for a specified number of years.
Annuities can be classified into different categories.

On the basis of purpose of the investment, annuities can be termed as deferred or immediate.

a. Deferred annuities: In this type of annuity, the investor saves in a systematic manner to build up
sufficient funds for retirement. The withdrawals commence after the retirement of the investor. They are
best suitable for a long period and not suitable for short term wealth generation.

b. Immediate annuities: The holder of immediate annuity makes one-time lump sum payment, and
begins receiving payments immediately. Immediate annuities provide guaranteed flow of income for the
rest of life and for a period defined by the investor. It is wise to invest in immediate annuities if you are
close to retirement.

On the basis of nature of the investment, annuities can be fixed or variable.

a. Fixed annuities: As the name suggests, holders of fixed annuities receive an assured rate of interest
for a certain period. In this case, both interest and principal are guaranteed and the payout amount
remains constant throughout the term.

b. Variable annuities: Holders of variable annuities receive varying payouts. This is to take into account
the inflation.

Both deferred and immediate annuities can be fixed or variable.

There are various payment options that annuity holders can opt for. You should selection the options that
suit your specific needs the best.

2. Fixed deposits (FD)

FDs as the name suggests provide a fixed return. This is a low risk instrument by banks and so the
returns are also low (7-9 percent). The stability of the returns is what makes this instrument a very
attractive one for conservative investors, including retired persons. Besides banks, FDs are now
provided by Non-banking Financial Institutions (NBFCs). In comparison, FDs from NBFCs offer higher
interest rates. While investing in these FDs it is essential to look at their credit rating. The FDs with a
high credit rating will offer you stable and higher returns whereas a low credit score can be slightly risky.

3. Post Office Monthly Income Scheme (PO MIS)

PO MIS currently provides an interest rate of 8.4% percent per annum which is paid monthly. The
minimum amount to be invested is Rs. 1,500 and the maximum is Rs. 4.5 lakh. PO MIS has a maturity
period of 5 years.

4. Senior Citizens Savings Scheme

As the name indicates, this scheme is available for senior citizens. The scheme is available to - 1. Who
has attained age of 60 years or above on the date of opening of the account. 2. Who has attained the
age 55 years or more but less than 60 years and has retired under a Voluntary Retirement Scheme or a
Special Voluntary Retirement Scheme on the date of opening of the account within three months from
the date of retirement. 3. No age limit for the retired personnel of Defence services provided they fulfill
other specified conditions. Investments can be made in any post-office by opening an account. Only one
deposit can be made in each account; the deposit amount shall be a multiple of Rs.1,000 and should not
exceed Rs. 15 lakh. The scheme has tenure of 5 years

5. Monthly Income Plan (MIP)

MIP of mutual fund is a debt-oriented scheme that aims to provide reasonable returns on a monthly
basis through investment in debt (75-80 percent of its corpus) as well as a small portion in equities. MIPs
aim to provide investors with regular pay-outs (through dividends). They invest predominantly in interest
yielding debt instruments (commercial paper, certificate of deposits, government securities and treasury
bills). The debt investments ensure stability and consistency while the equity instruments in the portfolio
boost the returns.

6. House rentals

This can be useful to generate steady returns against your earlier property investment. If you have a
second house and if it is rented out, then it is a good source of income during your retired life.

SESSION 4: INVESTMENT PLANNING

Power of Compounding
To define compounding, it is the ability of an asset to generate returns, which when re-invested generates
further returns. In simple words, when your money is allowed to remain invested for a long period of time,
the interests earned will add to the seed capital and will in turn earn further interests. This method of
multiplying your investment capital is called compounding.

To work, the compounding process requires two things: (1) re-investing the returns earned, and (2) time.
The more time you give your investments, the more you are able to accelerate the income potential of your
original investment.

Let’s take an example to demonstrate the power of compounding:

Consider, you have Rs.100 and you invest it at 10 percent.

Time Principal (Rs.) Interest (Rs.) Total amount (Rs.)

After 1 year 100.00 10.00 110.00

After 2 years 110.00 11.00 121.00

After 3 years 121.00 12.10 133.10

After 4 years 133.10 13.31 146.41

After 5 years 146.41 14.64 161.05

Total Compound Interest earned 61.05

Investment Planning Process

Building an investment portfolio largely entails the following steps:

Step 1: Ascertaining risk profile

Every person is unique in various ways. Similarly, your investment capability may not be the
same as your sibling, friend or your colleague. You are the best person to understand your
own ability to invest and bear the risk associated with it. Risk is a deviation of outcome from
the expected standard end result. Risk basically means future issues that can be mitigated
or avoided by taking informed decisions.

Step 2: Identifying appropriate asset allocation according to a risk profile

Asset allocation is the process by which investors can distribute their investment capital
between various asset classes within their portfolio. The goal of asset allocation is to create
a well-diversified portfolio. That is, one which effectively reduces the overall portfolio risk
while maintaining the expected level of returns.

Asset allocation is the process of choosing the right mix of available asset classes for
investment. The major asset classes are: Equity, Fixed income or debt, and Cash and cash
equivalent. A right asset allocation ensures that an individual’s surplus is apportioned
among various asset classes that best suits his/her financial objectives. An ideal portfolio
should have a mix of the entire major asset classes in various proportions depending on the
person’s risk profile, age and time period to achieve the goal.

Broad Asset Classes

Equity Debt Real estate

Cash Commodities Alternative Assets

Step 3: Have adequate diversification with your asset allocation

When allocating your portfolio between various investments, your goal is to effectively and
efficiently diversify your portfolio. By adding different investments in your portfolio, you can
reduce the overall portfolio risk while maintaining the average expected return. But for the
diversification of capital to be effective it is more than simply adding different investments to
the portfolio. They need to be the right kind of investments.

For successful diversification, you need to spread your assets so that the same factors do
not affect all the investments in the same way. The ideal situation will be when one asset
class is negatively impacted by a systemic risk, another asset class benefits from that same
factor. This provides protection to your portfolio.

Step 4: Stay true to your allocation by regularly rebalancing

Asset Allocation is not static. It changes with time, as the age of the investor increases and
risk profile changes. Also, whenever there is a change in the portfolio mix due to the returns
generated by the various asset classes, there is a requirement for re-balancing the portfolio
to bring it back to the initial allocation. If not rebalanced, the portfolio might take a hit on the
returns generated over a period of time.

Asset class Amount (Rs.) % of allocation

Equity 50,000 50%

Fixed income 30,000 30%

Money market 20,000 20%

Total 1,00,000 100%

After a year, this is how his portfolio looks like:

Asset class Returns % p.a Amount (Rs.) with returns % of allocation by year end

Equity 30% 65000 55%

Fixed income 10% 33000 28%

Money market 5% 21000 17%

Total 19% 119000 100%

The asset allocation pattern has changed from the initial allocation, due to the different
returns generated by different asset classes. Hence, we need to re-balance the portfolio
back to the initial allocation pattern by selling some equity and investing into fixed income
and money market instruments. Let's see the effect of ignoring re-balancing.

Effect of ignoring portfolio re-balancing

Given below are 2 scenarios, one if the investor has ignored portfolio re-balancing and another, if the
investor has rebalanced his portfolio. In the first case, the asset allocation pattern has changed,
whereas in the second case, the investor has sold some of his equity portion and increased his fixed
income and money market portion to bring back the asset allocation to the initial level.
 Ignoring Portfolio Rebalancing Re-Balanced Portfolio

Asset class Amount % of Asset class Amount (Rs.) % of

(Rs.) allocation allocation

Equity 65,000 55% Equity 59,500 50%

Fixed 33,000 28% Fixed 35,700 30%

Income income

Money mkt 21,000 17% Money 23,800 20%

market

Total 1,19,000 100% Total 1,19,000 100%

Let's see the effect of both the above scenarios, after completion of Year 2

Ignored Portfolio Rebalanced portfolio

Closing
Asset Class Returns Opening bal Closing bal Opening bal bal

Equity -11.00% 65,000 57,850 59,500 52,955

Fixed 15.00% 33,000 37,950 35,700 41,055

Income

Money market 8.00% 21,000 22,680 23,800 25,704

Total 1,19,000 1,18,480 1,19,000 1,19,714

Understanding Return Concepts

Absolute Return: The absolute return or simply return is a measure of the gain or loss on
an investment portfolio expressed as a percentage of invested capital.

It is calculated as:

( (End Value – Beginning Value)/Beginning Value ) x 100

The rate of return is converted into percent terms by multiplying by 100.

Example: You invested Rs. 100 in a stock and it appreciated to Rs. 120. The absolute return would
be:

( (120-100)/100) ) x 100 = 20%

Annualized Return: Annualized return is a standardized measure of return on investments

in which the return is computed as percent per annum (% p.a.).

It is calculated as:

(End value - Beginning value)/Beginning value) x 100 x (1/ holding period of investment in
years)

All annualized returns are represented as “% p.a.” If the p.a. is missing, it is usually a simple
absolute non-annualized return.

Total Return: Investments can give returns in different forms such as interest income
(debentures, bank deposits), dividend (mutual funds, equity shares) and profits on sale
(capital gain on selling a house). Total return is the return computed by comparing all forms
of return earned on the investment with the principal amount. Thus total return is the
annualized return calculated after including all benefits from the investment. Total return can
be positive as well as negative.

Nominal Rate of Return vs. Real Rate of Return: Suppose we invest Rs.100/- into a Fixed
Deposit for 1 year at an interest rate of 7% p.a. At the end of the year, we would get
Rs.107/-. This 7% here is referred to as the nominal interest rate.

Tax Adjusted Return: Tax-adjusted return is the return earned after taxes have been paid
by the investor. Since taxes actually reduce the money in the hands for an investor, it is
necessary to adjust for them to get a realistic view of returns earned. Suppose an investor
earns an interest of 10% on an investment of Rs.1000. If this interest is taxed at 20%, then
we calculate tax adjusted return as follows:

Nominal interest rate = 10%

Interest received = 10% of 1000 = 100

Tax payable = 20% of 100 = 20

Net interest received= 100- 20 = 80

Post tax return = 80/1000 = 8%