NIFM Fundamental Analysis Book PDF (Editing 09.07.2016)

Text book for
FUNDAMENTAL ANALYSIS
NIFM Educational Institutions Ltd

FUNDAMENTAL ANALYSIS 1
Fundamental Analysis
This workbook has been developed to assist students in preparing for the Fundamental Analysis.
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ABOUT FUNDAMENTAL ANALAYSIS
The purpose to write this book is to educate the investors and traders; those are working in stock
market in the hope to earn more profit from their investments. We have developed this book after
deep analysis of stock markets different segments.

CONTENT:
01. Fundamental Analysis Introduction 4

02. Economic Analysis 12
03. Industry Analysis 25
04. Company Analysis – Non Financial 32
05. Understanding Financial Statement 41
06. Ratio Analysis 67
07. Comparison Through Ratio Analysis 88
08. Time Value Of Money 92
09. Valuation Of Stock 107
10. Valuation Of Firms 125
11. Case Study 137
12. How To Prepare A Research Report 142

Fundamental Analysis
Introduction 1
What is fundamental analysis?
Fundamental analysis is a stock valuation methodology that uses financial and economic analysis to
envisage the movement of stock prices. The fundamental data that is analysed could include a
company’s financial reports and non-financial information such as estimates of its growth, demand for
products sold by the company, industry comparisons, economy-wide changes, changes in government
policies etc.
Fundamental Analysis (FA) is a holistic approach to study a business. When an investor wishes to
invest in a business for a long term (say 3 – 5 years) it becomes extremely essential to understand the
business from various perspectives. It is critical for an investor to separate the daily short term noise
in the stock prices and concentrate on the underlying business performance. Over a long term, the
stock prices of a fundamentally strong company tend to appreciate, thereby creating wealth for its
investors.
The outcome of fundamental analysis is a value (or a range of values) of the stock of the company
called its ‘intrinsic value’ (often called ‘price target’ in fundamental analysts’ parlance). To a
fundamental investor, the market price of a stock tends to revert towards its intrinsic value. If the
intrinsic value of a stock is above the current market price, the investor would purchase the stock
because he believes that the stock price would rise and move towards its intrinsic value. If the
intrinsic value of a stock is below the market price, the investor would sell the stock because he
believes that the stock price is going to fall and come closer to its intrinsic value.
To find the intrinsic value of a company, the fundamental analyst initially takes a top-down view of the
economic environment; the current and future overall health of the economy as a whole. After the
analysis of the macro-economy, the next step is to analyse the industry environment which the firm is
operating in. One should analyse all the factors that give the firm a competitive advantage in its
sector, such as, management experience, history of performance, growth potential, low cost of
production, brand name etc. This step of the analysis entails finding out as much as possible about
the industry and the inter-relationships of the companies operating in the industry. The next step is to
study the company and its products.

We have many such examples in the Indian market. To name a few, one can think of companies such
as Infosys Limited, TCS Limited, Page Industries, Eicher Motors, Bosch India, Nestle India, TTK
Prestige etc. Each of these companies have delivered on an average over 20% compounded annual
growth return (CAGR) year on year for over 10 years. To give you a perspective, at a 20% CAGR the
investor would double his money in roughly about 3.5 years. Higher the CAGR faster is the wealth
creation process. Some companies such as Bosch India Limited have delivered close to 30% CAGR.
Therefore, you can imagine the magnitude, and the speed at which wealth is created if one would
invest in fundamentally strong companies.
Can I be a fundamental analyst?
Of course you can be. It is a common misconception that only chartered accountants and
professionals from a commerce background can be good fundamental analysts. This is not true at all.
A fundamental analyst just adds 2 and 2 to ensure it sums up to 4. To become a fundamental analyst
you will need few basic skills:
1. Understanding the basic financial statements

2. Understand businesses with respect to the industry in which it operates
3. Basic arithmetic operations such as addition, subtraction, division, and multiplication
The objective of this module on Fundamental Analysis is to ensure that you gain the first two skill sets.
I’m happy with Technical Analysis, so why bother about Fundamental Analysis?
Technical Analysis (TA) helps you garner quick short term returns. It helps you time the market for a
better entry and exit. However TA is not an effective approach to create wealth. Wealth is created only
by making intelligent long term investments. However, both TA & FA must coexist in your market
strategy.
Tools of FA
The tools required for fundamental analysis are extremely basic, most of which are available for free.
Specifically you would need the following:
1. Annual report of the company – All the information that you need for FA is available in the
annual report. You can download the annual report from the company’s website for free.
2. Industry related data – You will need industry data to see how the company under
consideration is performing with respect to the industry. Basic data is available for free, and is
usually published in the industry’s association website.

3. Access to news – Daily News helps you stay updated on latest developments happening both
in the industry and the company you are interested in. A good business newspaper or services
such as Google Alert can help you stay abreast of the latest news.
4. MS Excel – Although not free, MS Excel can be extremely helpful in fundamental calculations.
With just these four tools, one can develop fundamental analysis that can rival institutional research.
You can believe me when I say that you don’t need any other tool to do good fundamental research. In
fact even at the institutional level the objective is to keep the research simple and logical.
Investible grade attributes? What does that mean?
An investible grade company has a few distinguishable characteristics. These characteristics can be
classified under two heads namely the ‘Qualitative aspect’ and the ‘Quantitative aspects’. The process
of evaluating a fundamentally strong company includes a study of both these aspects. In fact in
personal investment practice, we have to give the qualitative aspects a little more importance over the
quantitative aspects.
The Qualitative aspect mainly involves understanding the non numeric aspects of the business. This
includes many factors such as:
1. Management’s background – Who is they, their background, experience, education, do they

have the merit to run the business, any criminal cases against the promoters etc.
2. Business ethics – is the management involved in scams, bribery, unfair business practices.
3. Corporate governance – Appointment of directors, organization structure, transparency etc.
4. Minority shareholders – How does the management treat minority shareholders, do they
consider their interest while taking corporate actions.
5. Share transactions – Is the management buying/selling shares of the company through
clandestine promoter groups.
6. Related party transactions – Is the company tendering financial favors to known entities such
as promoter’s relatives, friends, vendors etc at the cost of the shareholders funds?
7. Salaries paid to promoters – Is the management paying themselves a hefy salary, usually a
percentage of profits.
8. Operator activity in stocks – Does the stock price display unusual price behavior especially at
a time when the promoter is transacting in the shares.
9. Shareholders – Who are the significant shareholders in the firm, who are the people with
above 1% of the outstanding shares of the company.
10. Political affiliation – Is the company or its promoters too close to a political party? Does the
business require constant political support?

11. Promoter lifestyle – Are the promoters too flamboyant and loud about their lifestyle? Do they
like to display their wealth?
A red flag is raised when any of the factors mentioned above do not fall in the right place. For
example, if a company undertakes too many related party transactions then it would send a signal of
favoritism and malpractice by the company. This is not good in the long run. So even if the company
has great profit margins, malpractice is not acceptable. It would only be a matter of time before the
market discovers matters pertaining to ‘related party transactions’ and punishes the company by
bringing the stock price lower. Hence an investor would be better off not investing in companies with
great margins if such a company scores low on corporate governance.
Qualitative aspects are not easy to uncover because these are very subtle matters. However a diligent
investor can easily figure this out by paying attention to annual report, management interviews, news
reports etc. As we proceed through this module we will highlight various qualitative aspects. The
quantitative aspects are matters related to financial numbers. Some of the quantitative aspects are
straightforward while some of them are not. For example cash held in inventory is straight forward
however ‘inventory number of days’ is not. This is a metric that needs to be calculated. The stock
markets pay a lot of attention to quantitative aspects.
Quantitative aspects include many things, to name few:
1. Profitability and its growth

2. Margins and its growth
3. Earnings and its growth
4. Matters related to expenses
5. Operating efficiency
6. Pricing power
7. Matters related to taxes
8. Dividends pay-out
9. Cash flow from various activities
10. Debt – both short term and long term
11. Working capital management
12. Asset growth
13. Investments
14. Financial Ratios
Why is fundamental analysis relevant for investing?

There are numerous ways of taking investment decisions in the market such as fundamental and
technical analysis.
Let’s take a look at some reasons why fundamental analysis is used for stock-picking in the markets?
Efficient Market Hypothesis (EMH)
Market efficiency refers to a condition in which current prices reflect all the publicly available
information about a security. The basic idea underlying market efficiency is that competition will drive
all information into the stock price quickly. Thus EMH states that it is impossible to ‘beat the market’
because stock market efficiency causes existing share prices to always incorporate and reflect all
relevant information. According to the EMH, stocks always tend to trade at their fair value on stock
exchanges, making it impossible for investors to either consistently purchase undervalued stocks or
sell stocks at inflated prices. As such, it should be impossible to outperform the overall market
through expert stock selection or market timing and that the only way an investor can possibly obtain
higher returns is by purchasing riskier investments. The EMH has three versions, depending on the
level on information available:
Weak form EMH
The weak form EMH stipulates that current asset prices reflect past price and volume information. The
information contained in the past sequence of prices of a security is fully reflected in the current
market price of that security. The weak form of the EMH implies that investors should not be able to
outperform the market using something that “everybody else knows”. Yet, many financial researchers
study past stock price series and trading volume (using a technique called technical analysis) data in
an attempt to generate profits.
Semi-strong form EMH
The semi-strong form of the EMH states that all publicly available information is similarly already
incorporated into asset prices. In other words, all publicly available information is fully reflected in a
security’s current market price. Public information here includes not only past prices but also data
reported in a company’s financial statements, its announcements, economic factors and others. It
also implies that no one should be able to outperform the market using something that “everybody
else knows”. The semi-strong form of the EMH thus indicates that a company’s financial statements
are of no help in forecasting future price movements and securing high investment returns in the long-
term.
Strong form EMH

The strong form of the EMH stipulates that private information or insider information too is quickly
incorporated in market prices and therefore cannot be used to reap abnormal trading profits. Thus, all
information, whether public or private, is fully reflected in a security’s current market price. This
means no long-term gains are possible, even for the management of a company, with access to
insider information. They are not able to take the advantage to profit from information such as a
takeover decision which may have been made a few minutes ago. The rationale to support this is that
the market anticipates in an unbiased manner, future developments and therefore information has
been incorporated and evaluated into market price in a much more objective and informative way
than company insiders can take advantage of.
Although it is a cornerstone of modern financial theory, the EMH is controversial and often disputed by
market experts. In the years immediately following the hypothesis of market efficiency (EMH), tests of
various forms of efficiency had suggested that the markets are reasonably efficient and beating them
was not possible. Over time, this led to the gradual acceptance of the efficiency of markets.
Academics later pointed out a number of instances of long-term deviations from the EMH in various
asset markets which lead to arguments that markets are not always efficient. Behavioral economists
attribute the imperfections in financial markets to a combination of cognitive biases such as
overconfidence, overreaction, representative bias, information bias and various other predictable
human errors in reasoning and information processing. Other empirical studies have shown that
picking low P/E stocks can increase chances of beating the markets. Speculative economic bubbles
are an anomaly when it comes to market efficiency. The market often appears to be driven by buyers
operating on irrational exuberance, who take little notice of underlying value. These bubbles are
typically followed by an overreaction of frantic selling, allowing shrewd investors to buy stocks at
bargain prices and profiting later by beating the markets. Sudden market crashes are mysterious from
the perspective of efficient markets and throw market efficiency to the winds. Other examples are of
investors, who have consistently beaten the market over long periods of time, which by definition
should not be probable according to the EMH. Another example where EMH is purported to fail are
anomalies like cheap stocks outperforming the markets in the long term.
Arguments against EMH
Alternative prescriptions about the behaviour of markets are widely discussed these days. Most of
these prescriptions are based on the irrationality of the markets in, either processing the information
related to an event or based on biased investor preferences.
The Behavioural Aspect
Behavioural Finance is a field of finance that proposes psychology-based theories to explain stock
market anomalies. Within behavioural finance, it is assumed that information structure and the
characteristics of market participants systematically influence individuals’ investment decisions as
well as market outcomes.
In a market consisting of human beings, it seems logical that explanations rooted in human and social
psychology would hold great promise in advancing our understanding of stock market behaviour. More
recent research has attempted to explain the persistence of anomalies by adopting a psychological
perspective. Evidence in the psychology literature reveals that individuals have limited information
processing capabilities, exhibit systematic bias in processing information, are prone to making
mistakes, and often tend to rely on the opinion of others.
The literature on cognitive psychology provides a promising framework for analysing investors’
behaviour in the stock market. By dropping the stringent assumption of rationality in conventional
models, it might be possible to explain some of the persistent anomalous findings. For example, the
observation of overreaction of the markets to news is consistent with the finding that people, in
general, tend to overreact to new information. Also, people often allow their decision to be guided by
irrelevant points of reference, a phenomenon called “anchoring and adjustment”. Experts propose an
alternate model of stock prices that recognizes the influence of social psychology. They attribute the
movements in stock prices to social movements. Since there is no objective evidence on which to
base their predictions of stock prices, it is suggested that the final opinion of individual investors may
largely reflect the opinion of a larger group. Thus, excessive volatility in the stock market is often
caused by social “fads” which may have very little rational or logical explanation.
There have been many studies that have documented long-term historical phenomena in securities
markets that contradict the efficient market hypothesis and cannot be captured plausibly in models
based on perfect investor rationality. Behavioural finance attempts to fill that void.
Regulatory Hindrances
In the real world, many a times there are regulatory distortions on the trading activity of the stocks
such as restrictions on short-selling or on the foreign ownership of a stock etc. causing inefficiencies
in the fair price discovery mechanism. Such restrictions hinder the process of fair price discovery in
the markets and thus represent deviation from the fair value of the stock. Then there may be some
restrictions on the price movement itself (such as price bands and circuit filters which prevent prices
of stocks moving more than a certain percentage during the day) that may prevent or delay the
efficient price discovery mechanism. Also,
many institutional investors and strategic investors hold stocks despite deviation from the fair value
due to lack of trading interest in the stock in the short term and that may cause some inefficiencies in
the price discovery mechanism of the market.

So, does fundamental analysis work?
In the EMH, investors have a long-term perspective and return on investment is determined by a
rational calculation based on changes in the long-run income flows. However, in the markets,
investors may have shorter horizons and returns also represent changes in short-run price
fluctuations. Recent years have witnessed a new wave of researchers who have provided thought
provoking, theoretical arguments and provided supporting empirical evidence to show that security
prices could deviate from their equilibrium values due to psychological factors, fads, and noise
trading. That’s where investors through fundamental analysis and a sound investment objective can
achieve excess returns and beat the market.
Steps in Fundamental Analysis
Fundamental analysis is the cornerstone of investing. In fact all types of investing comprise studying
some fundamentals. The subject of fundamental analysis is also very vast. However, the most
important part of fundamental analysis involves delving into the financial statements. This involves
looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company.
Fundamental analysts look at these information to gain an insight into a company’s future
performance.
Fundamental analysis consists of a systematic series of steps to examine the investment environment
of a company and then identify opportunities. Some of these are:
 Macroeconomic analysis - which involves analysing capital flows, interest rate cycles,
currencies, commodities, indices etc.
 Industry analysis - which involves the analysis of industry and the companies that are a part of
the sector
 Situational analysis of a company
 Financial analysis of the company
 Valuation

Economic Analysis
2
The stock market does not operate in a vacuum. It is an integral part of the whole economy of a
country, more so in a free economy like that of the United States and to some extent in a mixed
economy like ours.
To gain an insight into the complexities of the stock market one needs to develop a sound economic
understanding and be able to interpret the impact of important economic indicators, which may be
studied to assess the National economy as a whole. The leading indicators predict what is likely to
happen to the economy. Perfect examples of leading indicators are the unemployment position,
rainfall and agricultural production, fixed capital investment, corporate profits, money supply, credit
position, and index of equity share prices.
Then there are the coincidental indicators, which highlight the current position. Some examples of
coincidental indicators are Gross National Product, Index of Industrial Production, money market
rates, interest rates, and reserve funds with commercial banks.
Fundamental analysis consists of a systematic series of steps to examine the investment environment
of a company and then identify opportunities. Some of these are:
 Macroeconomic analysis- which involves analysing capital flows, interest rate cycles,
currencies, commodities, indices etc.
 Industry analysis - which involves the analysis of industry and the companies that are a part of
the sector
 Situational analysis of a company
 Financial analysis of the company
 Valuation
Long-term Economic growth: Currently, we see that there is significant divergence of standard of living
among different countries. The main reason for this varying standard of living among countries is the
different levels of economic growth in the past. Over the past several decades, economies of the
currently developed countries have shown moderate to high growth rates for a sustained period, while
the economies of developing countries have not. The developing countries may have had occasional
periods of high growth; but they have not sustained high growth performance over a long period. In
other words, the developed countries have experienced higher long-term economic growth than the
developing countries. Macroeconomics analyzes how and why different countries are growing at
different rates, and suggests how countries can accelerate their growth rates.

TABLE 1: Economic indicators and their impact on the stock market.
Indicator Favourable impact Unfavourable impact

Gross National Product High growth rate Slow growth rate
General employment position Full or almost full Underemployment and
employment unemployment
Domestic savings rate High Low
Interest rates Low High
Tax rates Low High
Foreign exchange position High Low
Balance of trade Positive Negative
Balance of payments Positive Negative
Deficit financing Low High
Inflation Low High
Agricultural production High Low
Industrial production High Low
Power supply High Low
Freight movement of railways High Low
New house construction High Low
WHAT IS AN ECONOMIC INDICATOR?
An economic indicator is simply any economic statistic, such as the unemployment rate, GDP, or the
inflation rate, which indicate how well the economy is doing and how well the economy is going to do
in the future. Economic Indicators can have one of three different relationships to the economy:
 Procyclic: A procyclic (or procyclical) economic indicator is one that moves in the same
direction as the economy. Therefore, if the economy is doing well, this number is usually
increasing, whereas if we are in a recession this indicator is decreasing. The Gross Domestic
Product (GDP) is an example of a procyclic economic indicator.
 Counter cyclic: A counter-cyclic (or countercyclical) economic indicator is one that moves in the
opposite direction as the economy. The unemployment rate gets larger as the economy gets
worse so it is a counter-cyclic economic indicator.
 Acyclic: An acyclic economic indicator is one that is not related to the health of the economy
and is generally of little use. The number of Expos hit in a year generally has no relationship to
the health of the economy, so we can say it is an acyclic economic indicator.
Economic Indicators can be leading, lagging, or coincident which indicates the timing of their changes
relative to how the economy as a whole changes.
1. Leading: Leading economic indicators are indicators, which change before the economy
changes. Stock market returns are a leading indicator, as the stock market usually begins to
decline before the economy declines and they improve before the economy begins to pull out
of a recession. Leading economic indicators are the most important type for investors as they
help predict what the economy will be like in the future.
2. Lagged: A lagged economic indicator is one that does not change direction until a few quarters
after the economy does. The unemployment rate is a lagged economic indicator, as
unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
3. Coincident: A coincident economic indicator is one that simply moves at the same time the
economy does. The Gross Domestic Product is a coincident indicator.
DIFFERENT ECONOMIC INDICATORS AND THEIR IMPACTS
Gross Domestic Product (GDP): The Gross Domestic Product (GDP) is the primary indicator used to
gauge the health of a country's economy. It represents the total value of all goods and services
produced over a specific time period - one can think of it as the size of the economy.
GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a
country's standard of living.
It is the monetary value of all the finished goods and services produced within a country's borders
calculated on an annual basis. It includes all of private and public consumption, government outlays,
investments and exports less imports that occur within a defined territory.
In layman terms GDP can be simply defined and calculated as what everybody in a particular country
has earned or spent. GDP of a country comprises of all the goods and services that are produced and
aggregated irrespective of the way of consumption, i.e., bartered or exchanged for money. Gross
Domestic Product is thus essentially a product concept to measure the production of goods and
services, but in common parlance it is also accepted as an income concept because it is equivalent to
value added, which is the summation of incomes of factors of production – land, labor, capital and
entrepreneurship that help to produce output.
Thus GDP covers everything what an economy is all about which makes it one of the most important
economic indicators. Gross Domestic Product includes production within national borders regardless
of whether the labor and property inputs are domestically or foreign owned.
GDP is a very key factor in determining other economic indicators as well. GDP has its impact on the
money markets, interest rates etc. GDP by income and by expenditure are calculated at market prices
and are published each quarter, two months after the reference period.
GDP is one of the primary measures used by decision-makers, financial and other institutions to
evaluate the health of the economy. An increase in real GDP is interpreted as a sign that the economy
is doing well, while a decrease indicates that the economy is not working at its full capacity.
SIGNIFICANCE OF GDP
1. An increase of GDP is associated with the increase in disposable income. The increase in
disposable income prompts increase in public spending. The feel good factor has a bearing on
the cost of employing people. All these factors imbibe a price rise (Popularly called inflation) in
the economy. To reduce the inflationary pressure and reduce the flow of money the Central
Bank increases interest rates on both deposits and loans. The direct impact of increase in
interest rate is on the fixed interest bearing instrument, the value of which comes down
significantly if the interest rates are hiked. Increase in interest rate brings down the profitability
of the companies eventually the cause of fall of stock markets.

2. Lower GDP figures are a result of either slowing down of economy or recession. In either case,
money moves away from the markets be it either stock market or debt market. Investors try to
find profitable areas where their investment can grow at a faster pace. This causes sort of a
drain in the money markets. To increase the flow of money in the economy, the Central Bank
decreases the lending rate vis-à-vis the deposit rates. The fall in the interest makes the fixed
interest yielding bonds issued prior to the interest fall attractive. This results in the value of
bonds appreciating sharply.
One may wonder what an ideal GDP or GDP growth rate should be. Well there is no such ideal rate; it
totally depends upon the economic condition, purchasing power, political stability etc. A developing
economy’s GDP grows at a faster rate than that of a developed economy ideally. However an ideal
growth rate would be what an economy can sustain over a considerable period of time.
Inflation: Inflation is a sustained increase in the general price level of goods and services;
alternatively, a decrease in the purchasing power of the currency. To put in the simplest of words it is
the increase in the prices, which one has to pay while buying goods or services. It is one of the most
important and basic indicators, which directly or indirectly affect the state of economy, and other
macro-economic indicators in a considerable manner. This is because inflation results in the increase
in prices so every other factor is bound to be affected by it. In fact it is a two-way effect inflation rates
are affected but these factors as well like interest rates, oil prices, monetary policies etc.
Example: an inflation of 3% would result in the price to go up to Rs.103 which was previously Rs.100.
Looking it from a different angle we can say that with the same amount of money, Rs.100 one will be
able to buy only 97% of the goods or services.
The question which comes to our mind when we talk of inflation is what causes it. What are the factors
that cause the prices to rise? There hasn’t been any pre-defined specific set of factors, which can be
said to cause inflation because there are too many to think of. But the two most common and
accepted phenomenon are the demand-pull inflation and cost-push inflation.
Demand-pull inflation happens when there is more demand than supply. It means that the prices will
go up because buyers are more than the sellers. On the other hand cost-push inflation occurs when
the cost of the company goes up forcing them to increase the prices. Cost may go up for several
reasons like increase in prices of inputs, increase in taxes etc.
Majority of the people think that inflation is bad for the economy. But this is not true. An inflation rate
of 3-4% is generally considered to be good for the economy. Inflation implies that the economy is
growing. The lack of inflation is a sign that the economy is weakening. Inflation affects different people
in different ways. It also depends on whether inflation is anticipated or unanticipated. If the inflation
rate corresponds to what the majority of people are expecting (anticipated inflation), then we can
compensate and the cost isn't high. However problem arises when there is unanticipated inflation,
Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who
borrow, this is similar to getting an interest-free loan. People living off a fixed-income, such as retirees,
see a decline in their purchasing power and, consequently, their standard of living. If the inflation rate
is greater than that of other countries, domestic products become less competitive.
There are many factors which determine the interest rates. Interest rates in India are normally
determined on the basis of wholesale price index (WPI). The inflation rate is determined on the basis
of prices of basket of primary products. These products are food, oil, lubricants etc. These products
form the primary basket, on the basis of whose prices inflation rate is determined.

Significance of Inflation
1. As we have discussed earlier, inflation rate can be good as well as bad for the economy. A very
high or very low inflation rate is bad for an economy. High inflation with associated high
volatility in relative prices, and high nominal interest rates causes investors to shorten
horizons, thereby hurting growth. High inflation also erodes the value of the public treasury
and public finances, reducing the impact of government spending on growth. Low inflation
rates especially if it is a deflation causes a downward spiral of contracting output. As
consumers start postponing purchases it causes industries to cut back production.
2. Inflation needs to be regulated at times when it is not at the desirable rate. The most common
measure of regulating inflation rates is through monetary policies and interest rates. Through
open market operations the monetary authority increases or reduces the flow of money in the
system. If the economy is in a depressed mode and the rate of inflation has come down
steeply, the monetary authority resorts to a buying of government securities thereby giving a
push to a depressed economy. If otherwise, the monetary authority resorts to selling of
government securities.
3. Interest rates – The monetary authority uses this tool sparingly and under extreme
circumstances. In a low inflation and low growth regime to give a necessary push, the Central
Bank resorts to a decrease in interest rates. The interest rate reduction leads an increase in
the consumer spending and at the same time an increase in the investment in the economy.
This imbibes a feel-good factor in the economy and gives a vital growth impetus. The Central
Bank resorts to interest rate rise in case inflation is growing at an alarming rate and the
economy is over boiling.
Interest Rates: Interest rate sounds like a very simple term in its literal sense. It is indeed a very
simple term though with a large impact. It is a very important area of discussion and one of the chief
economic indicators. Interest rates in a country are determined by the central bank through its
monetary policies. To be precise the size and rate of growth of money supply determines the interest
rate that is prevailing in the country. Interest rates and inflation also have a very close relation with
each affecting the other in a comprehensive manner. Bank rate, CRR, Repo rates are all types of
interest rates.
Interest rates rise when the money supply is less in the economy and falls when the money supply is
more. Interest rates are also used to curb the effect of inflation especially when the inflation is high.
Interest rates can rise, which would curb the inflation to some extent. RBI does not raises the interest
rates, (the lending and borrowing rates in the market) but regulates the CRR, the bank rate which is
the rate at which bank borrows from the central bank, and the repo rates.
Bank Rate: This is also referred to as the discount rate, is the rate of interest which a central bank
charges on the loans and advances that it extends to commercial banks and other financial
intermediaries. Changes in the bank rate are often used by central banks to control the money supply.
CRR Rate: Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If
RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is
using this method (increase of CRR rate), to drain out the excessive money from the banks.
Repo Rate: Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is
the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get
money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.

Reverse Repo Rate: The reverse REPO rate is the rate at which banks park their short-term excess
liquidity with the RBI, while the REPO rate is the rate at which the RBI pumps in short-term liquidity
into the system.
SLR: SLR is the amount of liquid assets, such as cash, precious metals or other short-term securities
that a financial institution must maintain in its reserves. The statutory liquidity ratio is a term most
commonly used in India.
For different rates, please visit the RBI website.

International Trade: International trade, in nonprofessional terms, means trading of goods and
services with other countries. However, it is not as simple as it sounds. Many formalities have to be
fulfilled before one can start trading goods with other countries. There are two basic terms, which
comprises the international trade, import and export.
Let us first understand the terms import and export. Import means buying goods or services from the
sellers in other countries whereas export means selling of goods and services to other countries.
Trading globally gives consumers and countries the opportunity to be exposed to goods and services
not available in their own countries. Almost every kind of product can be found on the international
market: food, clothes, spare parts, oil, jewellery, wine, stocks, currencies and water. Services are also
traded: tourism, banking, consulting and transportation. Global trade allows wealthy countries to use
their resources - whether labor, technology or capital - more efficiently. Because countries are
endowed with different assets and natural resources (land, labor, capital and technology), some
countries may produce the same good more efficiently and therefore sell it more cheaply than other
countries. If a country cannot efficiently produce an item, it can obtain the item by trading with another
country that can.
International trade gives rise to global economy where goods and services are exchanged on a large
scale. Prices, demand & supply are affected by even a small change in any of the economies involved
in international trade.
Let us take up a hypothetical example to explain – Political change in Asia, for example, could result in
an increase in the cost of labor, thereby increasing the manufacturing costs for an Indian furnishings
company based in Malaysia, which would then result in an increase in the price that one has to pay to
buy the wooden table at your local mall. A decrease in the cost of labor, on the other hand, would
result in having to pay less for the new table.
There are a lot of benefits attached to international trade. Any economy benefits a lot when trading
with other countries. It’s not only the monetary benefit but also the welfare of the citizens. Through
international trade, countries are able to utilize the unutilized resources and exporting it to other
countries. In the same way any commodity or services, which a country cannot produce, can be
imported from other countries so in a way there is mutual benefit. Also, it may be feasible for a
particular country to produce or not produce certain goods and instead export or import because of
cost factor.
Economic Implications: The question arises here that what is the reason that a country has to start
exporting or importing goods. One can say that it is due to cost factor. But let us understand this from
an economic point of view.
1. The basic reason for international trade is opportunity cost. Countries around the world,
especially developed ones can produce what they import but they don’t do that. This is
because the opportunity cost of producing such goods would be more. This means that the
country would be better off in importing those goods and utilize their resources in those
activities where the opportunity cost is less (goods, which are exported).
2. International trade not only results in increased efficiency but also allows countries to
participate in a global economy, encouraging the opportunity of foreign direct investment (FDI),
which is the amount of money that individuals invest into foreign companies and other assets.
In theory, economies can therefore grow more efficiently and can more easily become
competitive economic participants.
3. For the receiving government, FDI is a means by which foreign currency and expertise can
enter the country. These raise employment levels and, theoretically, lead to a growth in the
gross domestic product. For the investor, FDI offers company expansion and growth, which
means higher revenues.
Foreign Exchange Reserves: Foreign exchange reserves are the foreign currency deposits held by
national banks of different nations. These are assets of governments, which are held in different
reserve currencies such as the dollar, euro and yen. These can indicate how favorable or unfavorable
are the economic condition of a country. Forex reserves rises when the economy of a country is
favorable, there is relatively huge amount of investment coming in from a different country, and
exports are rising.
According to International Monetary Fund’s definition, Forex reserve is any readily available,
controllable stock of Forex. Like any cash balance, therefore, it can still be utilized in any form, which
fits in with the repayment schedule of repayable obligations provided its utilization generates
adequate and timely cash. It must, however, be remembered that these will have to be repaid in Forex
and, therefore, either their utilization itself should generate enough Forex or the overall Forex situation
should remain comfortable when their repayments become due.
Reserves were formerly held only in gold, as official gold reserves. But under the Bretton Woods
system, the United States pegged the dollar to gold, and allowed convertibility of dollars to gold. This
effectively made dollars appear as good as gold. The US government eventually abandoned the gold
peg, making the dollar a reserve currency by fiat only.
Significance: Foreign exchange reserves are one of the most relevant points while reviewing the
performance of the economy. Globalization is the key to development and with globalization comes
trading and transactions with other countries. Due to large amount of imports and other factors a
country may experience a shortfall of its home currency. This may result in an economic crisis. This is
exactly what happened in India in 1991. Foreign exchange reserves came down to as low as $5.8 bn
which was enough to pay for only two weeks of imports. Economic reforms followed which allowed
companies to come in and invest money in India. Currently India is among the top 6 countries having
the foreign exchange reserves. India has a reserve of nearly $300 bn far behind that of China, which is
nearly $1400 bn.
India expresses its foreign exchange reserves only in dollar terms. Reserves can be used by the
country's central bank to purchase the country's currency in an intervention. This allows it to control
the exchange rate; increasing demand for the country's currency increases its value as compared to
the currencies of other nations. Countries often have reserves because they fear speculation and
economic shocks might affect their exchange rates, and they want to be able to keep their rates
steady. Though denoted in dollars, Forex reserves include a multi-currency portfolio with the euro,
pound sterling, yen and so on, all valued in US dollars; these are known as FCA or foreign currency
assets, and account for almost 95 per cent of reserves. The balance is made of SDR or `special

drawing right' (an international reserve asset that the IMF created in 1969 to supplement the official
reserves of member countries.
Another important reason for which the Forex reserves are growing at a rapid pace is the amount of
FDI’s and FII’s coming in to India. Foreign exchange flows into the country in the following forms:
1. Foreign investment in Indian primary equity market (i.e. new share issues)
2. Foreign investment in the secondary equity market (i.e. purchasing existing shares from the
share market)
3. NRI remittances to their families in India
4. Excess of export earnings over import payments
5. NRI deposits in Indian banks/companies
6. Foreign loans raised by the private sector
7. Foreign loans raised by the public sector
8. Foreign aid
The forex reserves in India have been growing at a very rapid rate in recent past. It has shown a
growth of over 10%. The foreign currency assets have a share of 96% in total reserves. Foreign
currency assets expressed in US dollars include the effect of appreciation or depreciation of other
currencies like pound sterling, euro etc.
The problem that India is facing is how to utilize these huge reserves. These reserves are good enough
for imports of at least 14 weeks. But a considerable amount of reserves are unused. India is not able
to use the huge amount of reserves. This is because if the government were to infuse this money into
the market, this would lead to excess supply of money into the market. This can bring the interest
rates down and at the same time may lead to higher inflation.
Crude Oil Prices: Any factor, which affects the economy of a country on a large scale, can be said to be
a macroeconomic indicator. Crude oil prices are no different. In recent times the crude oil prices have
been rocketing sky high and thus a topic for concern as its impact is on a large scale. Crude oil prices
affect the economy as it affects the prices of all petroleum products directly and some other key
products indirectly.
Crude oil prices have been rising for a long time now and things are not expected to change in near
future. Crude oil prices currently stand at $130per barrel. In fact some analysts have even predicted it
to go up to $200 per barrel in a year’s time. The main reason for its high and rising prices is demand
and supply. The current global demand for crude oil stands at 82 million barrel per day whereas the
production is marginally above that. The direct impact of these price hikes is on the prices of petrol,
diesel, gas and other petroleum products. The Indian economy is very sensitive to changes in the
prices.
For example, an increase of $1 per barrel of crude oil should be followed by an increase of 44 paisa in
prices of petrol, taking into consideration the taxation structure of India.
The problem doesn’t stop here. The Indian Government is a deterrent: Delay in the appointment of the
independent petroleum regulator may hamper operational freedom and players will continue to be
dependent on the government for policy related issues. With the ruling government favoring masses,
economics has taken the back seat and this has adversely impacted PSU’s profitability. Sharp spurt in
crude prices have a negative impact on the players' margins, as product prices have a tendency to

increase gradually due to political ramifications. With outlook for crude oil continuing to remain bullish,
oil PSUs will have to bear significant share of subsidies.
The government of India instead of passing on the price hike to the ultimate consumer, they have
been readily cutting taxes, duties, and the margins of the players and passing a minimal inevitable
hike to the consumer. Rationalization of tariffs on key petroleum products such as MS (petrol) and
gradual phasing out of subsidies is expected to provide a big boost for players in the sector, as it will
positively affect marketing margins in the long term. The government has already lowered customs
and excise duty on petroleum products twice and given the fact that oil-marketing companies are
bleeding, we expect more reduction to cushion the blow in the future.
Apart from this due to increase in the crude oil prices the margins in many products are decreased
and the prices have increased. As petroleum products are used in the production of virtually every
product and as a result the prices are affected.
Thus we can say that crude oil prices are of prime importance to the economy as a whole and directly
or indirectly it has a large impact on the inflation and general price level of a country.
Credit Policies: The Reserve Bank of India (RBI) is the central bank of India, and was established on
April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central
Office is located at Mumbai since inception. Though originally privately owned, since nationalization in
1949, RBI is fully owned by the Government of India. Some of its main objectives are regulating the
issue of bank notes, managing India’s foreign exchange reserves, operating India’s currency and
credit system with a view to secure monetary stability and developing India’s financial structure in line
with national socio-economic objectives and policies.
The RBI acts as a banker to Central/State governments, commercial banks, state cooperative banks
and some financial institutions. It formulates and administers monetary policy with a view to promote
stability of prices while encouraging higher production through appropriate deployment of credit. The
RBI plays an important role in maintaining the exchange value of the Rupee and acts as an agent of
the government in respect of India’s membership of IMF. The RBI also performs a variety of
developmental and promotional functions.
The Stock Market: The markets, however, move to the tune of RBI because of the link between the
interest rates and capital market yields. The RBI’s policies have maximum impact on volatile foreign
exchange and stock markets.
IMPACT OF CREDIT POLICY ON INDIAN ECONOMY: The monetary tightening action also reflects the
RBI’s concern on potential overheating in the economy. Real GDP growth has averaged 8% for the last
year. Industrial performance supported by strong manufacturing activity and expansion of services
sector continues to power this robust growth. And, with good monsoons, agriculture sector is expected
to perform better this year.
According to the RBI, the recent trends in the trade also suggest that the Indian economy has entered
an expansionary phase of the business cycle. The non-oil imports growth of 20% so far this year, come
from higher imports of capital goods, export related inputs and a range of intermediate goods like
fertilizers, non-ferrous metals and iron and steel. This reflects durable pick-up in the economy.
Non-food credit growth, which is running in excess of 30%, also points to strong growth conditions. In
last few years, a pickup in bank credit, particularly in the retail segment, has helped in achieving high
levels of growth. Financial markets have remained stable and the international investment flows into
the economy have endorsed the macro-economic fundamentals.

Foreign Investment: Foreign Investment is basically generated when one nation invests in another by
selling to it more than what it buys. Foreign investment can be freely channeled into all sectors except
for the following sectors: agriculture (excluding floriculture, horticulture, development of seeds, animal
husbandry & cultivation of vegetables, mushrooms etc. under controlled conditions and services
related to agro & allied sectors), plantations (other than tea plantations), atomic energy, gas pipelines,
courier services, trading and lottery and gambling. In most of the sectors, foreign investors can go
through the Automatic Route without need for any approvals. The investor has to merely keep the
Reserve Bank of India informed of the flow of funds and issue of shares. Full capital account
convertibility is also allowed for foreign investors.
FDI
Foreign direct investment (FDI) is the movement of capital across national frontiers in a manner that
grants the investor control over the acquired asset. It is different from Portfolio investment, because in
that, such control is not offered. Firms, which source FDI, are known as ‘Multi-National Enterprises’
(MNEs). It is seen as a catalyst to economic growth. There are several reasons that foreign direct
investment has a significant impact on economic growth. In particular, foreign direct investment (FDI)
impacts five variables – domestic investment, technology, employment generation and labor skills, the
environment, and export competitiveness.
TYPES OF FDI
Greenfield investment: It is the direct investment in new facilities or the expansion of existing facilities.
Greenfield investments are the primary target of a host nation’s promotional efforts because they
create new production capacity and jobs, transfer technology and know-how, and can lead to linkages
to the global marketplace. However, it often does this by crowding out local industry; multinationals
are able to produce goods more cheaply (because of advanced technology and efficient processes)
and uses up resources (labor, intermediate goods, etc). Another downside of Greenfield investment is
that profits from production do not feed back into the local economy, but instead to the multinational's
home economy. This is in contrast to local industries whose profits flow back into the domestic
economy to promote growth.
Mergers and Acquisitions: M&As occur when a transfer of existing assets from local firms to foreign
firms takes place. This is the primary type of FDI. Cross-border mergers occur when the assets and
operation of firms from different countries are combined to establish a new legal entity. Cross-border
acquisitions occur when the control of assets and operations is transferred from a local to a foreign
company, with the local company becoming an affiliate of the foreign company.
The number of countries showing interest to invest in India is increasing. Another encouraging factor is
that India is considered a stable country for investing in by corporate overseas. The entire gamut of
exploration, production, refining, distribution and retail marketing in the oil & gas sector presents
opportunities for FDI. The rapidly growing IT industry and IT-enabled services also offer immense
opportunities for FDI in the country.
FII: FII is an investor or investment fund that is from or registered in a country outside of the one in
which it is currently investing. Institutional investors include hedge funds, insurance companies,
pension funds and mutual funds. Large portion of the FII inflows come in broadly through four to five
categories. The first comes through India-dedicated funds (which are raised from investors with a
specific mandate to invest in the Indian markets). The second category of investments comes in as
part of the allocation to India from emerging market funds. The third segment of inflows are through
the hedge funds, which are also currently long-term investments, considering the Indian markets offer
higher returns than any other market in the world. Further, there are long-term pension funds such as
Fidelity, which also takes 5-7 year calls. All these segments will stay invested for a longer term. Indian
economy is a fast growing market. Therefore, it is being treated as an attractive destination for Foreign

Institutional Investors (FIIs). The FIIs must register themselves with the SEBI to participate in the
Indian market. One of the major market regulations pertaining to FIIs involves placing limits on FII
ownership in Indian companies.
FIIs are responsible for the high level of transparency and corporate governance standards among the
corporate sector. Such transparency benefits the shareholders to a large extent.
IMPACT: Foreign investment makes a huge impact on the state of development of an economy. This is
because foreign investors bring in huge amount of money, which at present is manipulating the fate of
the stock markets. FII’s invest heavily into the stock markets due to which we saw the Sensex
touching new highs but the problem is these investors can also lead to a crash in the stock market,
which happened in the months of May-June, 2006. In the same way foreign investment in the name of
FDI has been coming thick and fast into India. FDI norms are changing at a fast pace and the most
recent ones is FDI in retail which is now allowed under a single brand. This has prompted foreign
players to come into the fastest growing retail sector.
Thus foreign investment plays a big role in the development of a country as it also affects the
exchange rate as more foreign currency comes into India. This also affects the balance of payment
account.
The FII’s invest their money in the stock market. There are certain formalities which they have to fulfill.
They need to register themselves with SEBI with a fee of $10,000. In case of FDI, it involves a lot more
formalities. It has to be passed by the government of India. There are different FDI limits for different
sectors that are allowed by the government. Most FDI are allowed on the ‘automatic route’- only to
inform the Central Bank within 30 days of remittances. Some are allowed through FIPB. In this case
Prior Government Approval is needed and decision is generally taken within 4-6 weeks.
Most FDI goes into manufacturing – automobiles, engineering, telecom, electronics and chemicals
and up to 100% is allowed in these sectors.
Exchange Rates: The exchange rate between two currencies specifies how much one currency is worth
in terms of the other.
For example, an exchange rate of Rs.40 to the Dollar means that Rs.40 is worth the same as $1. An
exchange rate is also known as a foreign exchange rate.
The exchange rate policy in recent years has been guided by the broad principles of careful monitoring
and management of exchange rates with flexibility, without a fixed target or a pre-announced target or
a band, coupled with the ability to intervene if and when necessary. The overall approach to the
management of India’s foreign exchange reserves takes into account the changing composition of the
balance of payments and endeavors to reflect the ‘liquidity risks’ associated with different types of
flows and other requirements. Markets set exchange rates for most major currencies, but these
market levels vary over time.
A market based exchange rate will change whenever the values of either of the two component
currencies change. A currency will tend to become more valuable whenever demand for it is greater
than the available supply. It will become less valuable whenever demand is less than available supply.
An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The
higher a countries interest rates, the greater the demand for that currency.
There are three ways in which we can view the impact of exchange rate regimes on the stability of
trade policy. The first link concerns the direct effect of exchange rate policies on trade flows and,
consequently, on the introduction of commercial policies to modify these flows, usually by means of
commodity-specific tariffs and subsidies. The second link has its origin in the direct impact of

exchange rate policy on the balance of payments more generally. The third link comes from indirect
effects of exchange rate policies on domestic growth and inflation. Impact on debt - fall in rate leads to
rise in nominal value of debt (some of it borrowed in foreign currency). Impact on price of imports - fall
in rate leads to imported inflation.
The nominal exchange rate is a function of domestic price level, current account balance and the
balance of payments. Exports rise due to rise in unit value of exports as well as nominal exchange
rate. Due to Rupee depreciation, real imports into the country will decline (0.1%) despite higher
demand (absorption), i.e. price effect dominating the income effect. Since exports (as well as unit
value of exports) rise faster than imports, the trade balance will improve (1.4%). This pattern is
continued into the future until exchange rate starts falling later.
A change in the real effective exchange rate, which is the exchange rate that matters, will also affect
the degree of protection of firms and of their exposure to foreign competition. As a result, firms that
receive insufficient protection from the existing exchange rate may press for an increase in tariffs to
protect their industries. Such pressure for protection is as likely to come from exporters facing an
appreciating exchange rate, as it is from firms in import-competing sectors.
The US Factor
A surplus of deficits: A trade deficit simply means that US import more than export. The net result of
this is that more money flows out of the country than flows in. Prior to 1980, the United States was a
net exporter, selling more goods overseas than it imported. But over the last 25 years, the situation
has reversed. The trade deficit today has grown to record levels (now almost 6% of gross domestic
product), with the biggest import-export imbalances coming from China, Japan and Southeast Asian
nations.
If we talk about budget deficit then it is where US spends more than its earning and have to borrow to
fill the gap. So people there rely on credit cards to get through a budget deficit; the federal
government issues Treasury bonds to finance its shortfall.
What has changed over the last 25 years is that foreign governments, rather than U.S. citizens, have
been buying this U.S. debt (in the form of Treasury). Now, approximately half of this country's debt is
held outside the United States, primarily by China, Japan and Southeast Asian nations.
Until recently, none of this was a problem. These creditor nations, with whom the U.S. also had its
largest trade imbalances, were happy to buy up extra government debt. The system worked. Folks
here bought their exports, and they bought our debt. American consumers benefited from the flow of
inexpensive goods, and foreign creditors benefited both from their return on investment and the
continued consumption of their goods. This global interdependency helped to kept interest rates low
and the dollar relatively strong.
Through the ‘90s, as US trade deficit grew, budget deficits made up only a small percentage of their
GDP. They were easily able to service our debt. But war, tax cuts and Hurricane Katrina changed that.
And the combination of a weighty budget deficit and a record trade deficit has made these creditor
nations nervous about loading up on too much U.S. debt. It's reasonable to think that China, Japan
and Southeast Asia may soon choose to diversify their investments and stop buying US debt.
Competition for oil: The U.S. is by far the largest consumer of oil, buying almost a quarter of the total
supply. But as China and India emerge as world economic players, they are demanding significantly
more oil for autos and industry. In fact, China has become the No. 2 world consumer of oil. And with a

population almost four times than US (and yet, only slightly larger than India's), there's increasingly
more demand for oil and natural resources.
At the same time, the potential to increase the global oil supply may be more limited than in the past.
Saudi Arabia and other oil-exporting countries are already producing close to capacity. Static supply
and increased demand will inevitably cause energy prices to rise. Like budget surpluses, cheap energy
and natural resources are unlikely to return anytime soon.
So, if foreign countries stop buying US debt, that will cause long-term bond prices to drop, interest
rates to rise and the dollar to fall. Excess demand for energy and natural resources from China and
India will likely spur a rise in U.S. inflation rates. Higher interest rates and inflation coupled with a
weak dollar make long-term bonds a risky investment with very little upside. Investors looking to invest
new money in fixed income will be better off investing in short-term bonds.
The impact on the overall stock market is less clear – some sectors will benefit while others will
struggle. The drop in long-term bond prices may be harmful to certain types of financial firms, for
example. Rising oil prices may help energy companies but hurt manufacturing, while a falling dollar
may make many of products more competitive overseas.

Industry Analysis
3
Industry Analysis models such as Porter’s and PESTLE are used to analyze the industries and
economies, the BCG Analysis, developed by the Boston Consulting Group, looks at different segments
of a business unit at portfolio basis through the lenses of market growth and cash generation. BCG
created a matrix based on sensitivity of growth and cash generation as defined below in pictorial
LIFE CYCLE OF AN INDUSTRY
The second phase of fundamental analysis consists of a detailed analysis of a specific industry; it
those industries with a potential for future growth, and to invest in equity shares of companies
selected from such s characteristics, past record, present state and future prospects. The purpose of
industry analysis is to identify industries.
Every industry, and company within a particular industry, undergoes a life cycle with four distinct
phases as shown in chart: (a) pioneering stage, (b) expansion stage, (c) stagnation stage, and (d)
declining stage. You would benefit by investing in an industry only in its pioneering and expansion
stages. One should get out of industries, which have reached the stagnation stage, before they lapse
into decline. The specific phase of an industry can be understood in terms of its sales (volume and
value) and profitability.

Sales Stagnation
Stage
Expansion
Stage
Declining
Stage
Pioneering
Stage
Invest Disinvest
Years
Chart 1: Life cycle of an industry and investment approach
Industries doing well today, may be faced with stagnation and decline in future, as a result of changes
in social habits (e.g., the film industry is bound to suffer with the growing popularity of pirated VCDs),
or from changes in statutory controls (e.g., the Indian Liquor Industry has been a victim of uncertain
state-level policies on prohibition), or from excess capacity and consequent cut-throat competition, or
as a result of rising prices. Such analytical insights into various industries are essential for investors.
Let us discuss each stage of the Industry Life Cycle:
1. Pioneering Stage: The first stage in the industrial life cycle of a new industry where the
technology as well as the product are relatively new and have not reached the state of
perfection. In these early days it may actually make losses. At this time there may also not be
many companies in the industry. One should understand that initial 5 to 10 years are the most
critical period. At this time the companies have the greatest chance of failing. It takes time to
establish companies and new products. There may be losses and the need for large injections
of capital. This stage is characterized by a rapid growth in demand for output of industry. In
such a scenario weak firms are ultimately eliminated and a lesser number of businesses
survive this stage.
2. Expansion Stage: Once an industry is established it enters expansion stage. As the industry
grows many new companies enter the industry. Here each company finds a market for itself
and develops its own strategies to sell and maintain its position in market. The competition
among the surviving companies brings about improved product at lower prices. At this stage
investors can get high reward at a low risk since demand is far more than the supply. These
companies are quite attractive for investment purposes. Companies will earn increasing
amounts of profits and pay attractive dividend.
Note: This is the time to invest in emerging blue chips.
3. Stagnation Stage: This is the third stage in industry life cycle. Here in this stage the growth of
industry stabilizes. Ability of the industry to grow appears to have been lost. Sales may be
increasing though at a slower rate than that experienced by competitive industries or the over-
all economy. Two important reasons for this transition are changes in social habits and
development of improved technology. Sometimes an industry may stagnate only for a short
period. By the introduction of a technological innovation or a new product, it may resume a
process of growth, thereby starting a new cycle. Therefore an investor has to monitor the
industry developments constantly and with diligence. An investor should dispose of his
holdings in an industry which begins to pass from the expansion stage to the stagnation stage
because what is to follow is declining stage.
Note: During this phase, things tend to slow down sometimes with an emphasis on increasing
profit rather than achieving growth. Debts are normally re-paid out of internal accruals.
However, maturity slowly degenerates into stagnation and sometimes even creeps into
decline. When a company enters the maturity phase, it is time for the smart investor to quit.
4. Declining Stage: Finally the industry declines. This occurs when its products are no longer
popular. The risk at this time in investing in these companies is high but the returns are low,
even negative. An investor should get out of the industry before the onset of the declining
stage.
Note: As a typical mature company loses its competitive nerve, it declines over a period of time
into bankruptcy and winding up. At this bleak stage, there will be no takers for the scrip.
‘S’ CURVE
The profit associated with different stages in the life of an Industry can be illustrated on form of an
inserted ‘S’ curve.
The ‘S’ curve cannot strictly be compared with technical charts of share prices, because the later may
not truly reflect the on-going financial situation prevailing in a company. The ‘S’ curve helps you to
achieve a board perspective of the 4 phases in the life cycle of a company, and understand how well-
managed companies create new ‘S’ curves in a planned manner.
Maturity The new ‘S’ curve

Phase
Decline
Growth Phase
Phase
Divest
Here
Invest Again
Initial
Phase
Invest Discontinuity Phase

Here
Chart 2: The ‘S’ Curve
The Discontinuity Phase: Before an eventual decline sets in, you often find certain discontinuities
intervening in the management of companies. The ownership may be transferred, a new management
takes charge, fresh funds are pumped in, and new collaboration agreements are entered into. Such
changes often lead to a turn-around and the companies’ fortune suddenly looks up. A new ‘S’ curve starts,
signalling a fresh investment opportunity for smart investors.
The New ‘S’ Curve: The new ‘S’ curve can come after an unplanned discontinuity (like change of
ownership and subsequent revival by the new team) or by planned change through sound corporate
planning strategies. When large, established companies like ITC, HLL, Reliance, and etc. diversify into
unrelated areas, they can manage their existing business well even if the diversification fails. When ITC
had to write off the losses in its deep-sea fishing business, its basic corporate viability was not in any
way jeopardized. But if relatively new companies like NCL Industries were to make a serious mistake in
diversification (e.g. into Bison Boards), its basic function could be destroyed. Unrelated diversification is
a luxury exclusively reserved for large companies, small companies can’t afford it.
Note: When an emerging company diversifies into an unrelated area, no matter how promising it may
appear, it is a clear signal for the smart investor to quit.
SWOT ANALYSIS
Evaluation of an industry should encompass four critical areas:
1. What are the strengths of the industry?

2. What are its vulnerabilities?
3. What are the opportunities available to it?
4. What are the threats faced by it?
Such a comprehensive analysis is obviously not a simple exercise. You need to evaluate an industry
with the help of all the financial and non-financial data you have access to. Relevant questions which
may be asked in conducting an industry analysis are suggested below for illustrative purpose:
1. Are the sales of the industry growing or are they stagnant in relation to the growth in GNP?
2. What are the profit margins enjoyed by the industry? What is the important cost component?
How likely is it to go up? What is the overall Return on Investment (ROI) for the industry?
3. Does the success or failure of the industry depend upon any single factor? If so, it could be
very risky. In the past, the impressive success of certain companies in the Ferro-silicon
industry was due to the availability of power from certain state electricity boards at cheap
rates.
4. Is the industry dominated by one or two major companies? Are they Indian or multinational
companies?
5. What is the impact of taxation on the industry? Is the industry crippled by excessive doses of
excise duties and other forms of direct and indirect taxes?
6. Is the industry affected very strongly by business cycles?
7. Are there any rigorous statutory controls in matters of raw materials allotment, price controls
or distribution controls, etc.?
8. Is the industry highly competitive? How are the new entrants faring? Is it necessary to spend
large sums of money on advertisement, selling, distribution, etc.?
9. Is there sufficient export potential? Is it being fully exploited? Are international prices
comparable to domestic prices?
10. Is the industry highly technology oriented? What is the present stage of technological advance
in the field?
11. How does the stock market estimate the industry? How are the leading scripts in the industry
evaluated by the stock market?
The market evaluation of an industry can be assessed by referring to the industry-wise equity index
published by the financial dailies. Industry analysis can be of immense help to an investor. When a
particular industry is enjoying a boom, the leaders as well as the laggards benefit. Similarly, when a
particular industry is in the doldrums the marginal firms become extinct and the leaders suffer as well.
An intelligent investor, therefore, has to make a detailed industry analysis before he decides to buy or
sell shares of a company in that industry.
KEY CHARACTERISTICS OF INDUSTRY ANALYSIS
In an industry analysis, any number of key characteristics must be considered at some point by
analyst. These characteristics include:
1. Past sale and earning performance
2. Labor conditions within the industry
3. Attitude of government towards the industry
4. Competitive conditions
5. Stock prices of firms in the industry relative to their earning
Past sale & earning performance: One of the most effective steps in forecasting is looking at the
historical performance of sales and earnings. The historical record of the industry is crucial for
calculation of average levels and stability of performance in sales and earnings. These records are
also used to calculate growth rate apart from sales earnings & growth rate, analyst must also consider
the cost structure of the industry i.e. fixed and variable cost. The higher the fixed cost, the greater the
sales volume required to achieve break –even point and vice versa. With knowledge and
understanding of past behavior, analyst is better able to assess the performance of future.
Permanence of the Industry: Another Important factor in industry analysis is relative permanence of
the industry. Permanence of industry is related to the products and technology of the industry. In the
age of rapid technological advancement, the study of degree of permanence has become very
important step in study analysis. If analyst feel that the need for particular industry will vanish in
future, then it will be foolish to invest in that industry.
Example: Rise in the automobile caused a decline in the importance of carriage and buggy whip.
Attitude of Government towards Industry: It is important for the analyst to consider the role that
government will play in the industry, will it provide or will it restrain the industry’s development through
restrictive legislation and legal enforcement. As government becomes more influential in regulating
business and advocating consumer protection, the performance of the industry might be affected.
Profit of the industry can be substantially lowered. And sometime importance of industry declines
because of legal restrictions placed on it. On the other hand Government can assist selected
industries.
Labour conditions: If an analyst deals with very labour intensive production process or very mechanized
capital intensive process where labour performs crucial operations, then detail study of labour condition
became very important. In these industries possibility of strikes looms as an important factor to be dealt
with. If strikes occur, it deeply affects the profit and the costumer goodwill of the company. And at the
end it will affect the performance of the industry.
Stock Prices of firms in industry: Having evaluated the various characteristics of past sales and
earnings industry performance, government attitude, labour conditions, and industry competitive
conditions an analyst reaches a considered investment decision. However even through all the
indications are favorable, it does not imply the fund must be invested immediately. An analyst must
also study current prices of the securities and calculate risk and returns of the industry.
COMPETITIVE CONDITIONS
In a free market environment which is rapidly emerging in India, analysis of competitive conditions
prevailing in an industry becomes crucial in the context of investment. The nature of competitive
conditions existing in an industry provides useful information in assessing its futures. For detailed
understanding of competitive condition we must go through market structure.
MARKET STRUCTURE: Competitive conditions may vary from industry to industry. Competitiveness is
continuous from absolute monopoly to perfect competition, as shown in Chart 3.
Absolute monopoly is exercised through market dominance and lack of choice for customers.
Eventually, these monopolies are destroyed by high costs, inefficiencies and powerful competition.
Perfect competition occurs when no producer can affect the market price because there are
numerous small firms offering an identical product or service. At the going market price, a perfect
competitor can sell any amount of products. In a perfectly competitive industry, profit margins tend to
be very low and unattractive for newcomers.
Imperfect competition lies between absolute monopoly and perfect competition. You have an
intermediate form of imperfect competition. There are a few suppliers who can exercise some degree
of control over price. It is said that most industries are imperfectly competitive – a blend of monopoly
and competition. There are three models of imperfect competition:
 Collusive oligopoly: A few suppliers collude to form a cartel in order to avoid competition and
maximize profits. Manufacturers of Tyres in India are often accused of cartelization.
 Dominant firm oligopoly: There is a dominant leader surrounded by a number of small
competitors. The toothpaste market in India is a classic case of dominant firm oligopoly.
 Monopolistic competition: Products are differentiated under monopolistic competition,
whereas they are identical under perfect competition. The bath soap industry is a good
example of monopolistic competition in India with several differentiated soaps being marketed
by a number of producers.

Market Structure of an Industry
Absolute Imperfect Perfect

Monopoly Competition Competition
Collusive Monopolistic
Oligopoly Dominant Firm Competition
Oligopoly
Chart 3: Market structure of an industry
COMPETITIVE CONDITIONS
Salient factors, which influence competitive conditions prevailing in an industry, are outlined below:
 Product differentiation advantages through patents, brand-value, technology, market-access,

after-sales service, specification in purchase orders, etc.
 Absolute cost advantages through lower costs, high volumes, control over key resources,
learning and experience curves.
 Economies of scale through high capital costs, large scale operations, massive logistics
management, etc.
MICHAEL PORTER FIVE FORCES’ MODEL
COMPETITIVE FORCES AND INDUSTRY PROFITABILITY: Michael Porter of Harvard Business School
identified five competitive forces that determine industry profitability:
 Entry of new competitors
 The threat of substitutes
 The bargaining power of the buyers
 The bargaining power of the suppliers
 The rivalry among the existing competitors.
Chart-4: The Five Competitive Forces
According to Porter, the collective strength of these five competitive forces determine the ability of a
firm in an industry to earn, on average, rates of return on investment in excess of the cost of capital.
The five forces determine industry profitability because they influence the prices, costs and required
investment of firms in an industry – the elements of return on investment.
The important point of the Porter analysis is that industry profitability is a function of industry
structure. Investors must analyze industry structure to assess the strength of the five competitive
forces, which in turn determine industry profitability.

Company Analysis – Non

Financial 4
At the final stage of fundamental analysis, the investor analyses the company. It is imperative that one
should look at the politico economic analysis and the industry analysis before a company is analyzed
because company’s performance is the reflection of the economy, political situation and the industry.
Even though a particular industry may be thriving, certain companies in that industry may not be doing
very well. On the other hand, it is quite likely that a few companies would do well despite the rest of
the companies in that industry facing difficulties. Hence, selecting individual companies for
investment based on the industry performance is terribly tricky.
Money invested in the market is always a bet on the future performance of businesses. As analysts,
we understand that great earnings and assets make a business valuable; and, earnings and assets
are determined by the qualitative aspects of businesses. One must appreciate that sooner or later,
‘Great Quality’ would reflect into ‘Great Quantity’ for investors.
 How are things changing around (consumer tastes and preferences)?

 What would be relevant tomorrow and what would become irrelevant?
 How is competition shaping up in the industry? Who are the new entrants including external
ones?
 What are the entry barriers in the business and will they remain intact in the future?
 Why would a business continue to lead?
 Is there a chance of regulatory changes in the industry?
 What are the threats to the business?
 What are the opportunities to the business and whether business has required execution
capabilities to address the opportunities effectively?
 How is the quality of management?
 What is the perception of customers towards the products and services?
 Why customers buy the products/services. Is there strong brand association?
 Are the distributors/retailers happy selling the products/services?
 How is organization structured? Are the people happy lot in the company?
 What are perception of bankers and other stakeholders of the company towards it?
 Is the company following governance oriented policies/follow various compliance
requirements seriously?
There are two major components of company analysis: financial and non-financial. A good analyst tries
to give a balanced weight age to both these aspects. Overemphasis on either may lead to distorted
analysis.
The different issues regarding a company that should be examined are:
a. The Management
b. The Company
c. The Annual Report
d. Ratios
e. Cash Flow
Here at this point of time we would be discussing non-financial aspects. Financial aspects will be dealt
in next chapter.
THE MANAGEMENT – Non Financial Aspect
One of the most important factors one should consider when investing in a company is its
management. It is upon the quality, competence and vision of management that the future of the
company rests. A good, competent management can do wonders with a company while a weak,
inefficient management can destroy a thriving company. In India, management can be broadly divided
into two parts:
1. Family Management: These companies are managed by members of controlling family. The
chairman or the CEO is usually a member of the “ruling” family and Board of Directors are
people who are closely connected to the family. This is necessarily bad. The policies are
decided by ruling family and some of the policies may not necessarily always be in the
shareholders’ best interest.
Though now in the current scenario there has been some change in the way family controlled
business are managed. Earlier it used to be very orthodox, autocratic, traditional, rigid and
averse to change. This is not the situation now. The sons and grandsons of the founding
fathers have been educated at the best business schools around the world and exposed to
modern methods of management. So consequently, in many such companies, although the
man at the helm is a successor of the family, his subordinates are graduates of business
schools i.e. professional managers.
To an extent this combines the better of two worlds and many such businesses are very
successful.
2. Professional Management: Professionally managed companies are those that are managed by
employees. In these companies CEO often does not have any financial stake in the company.
He is at the helm of affairs because of this competence, ability and experience.
The professional manager is a career employee and he remains in power as long as he is fulfilling his
commitments and meeting the targets. So he is result oriented and his aim is often short term – the
meeting at annual budget. He is generally not driven by loyalty towards company. As he is a
professional he is usually aware of the latest trends in management and tries to implement them.
Professionally managed companies are usually well organized, growth oriented and good performers.
Investors are the recipients of regular dividends and bonus issues.
However, there is often a lack of long term commitment and sometimes a lack of loyalty. This is
because the professional manager has to step down in time, to retire, and he cannot therefore enjoy
the fruit of his labor for ever. Another reason can be in search of better career opportunity they often
change jobs.
Analysis: It would be unfair to state that one should invest in professionally managed company only. He
must look for:

i. Integrity of management. If someone has a doubt about the integrity of the management he
should not invest in such a company. Investor should check who the major shareholders of the
company are because there is some management who has a record of manipulating share
prices.
ii. Competence of management. Here one should have a look at the track record of
management. One should check the growth figures of company under the management.
iii. Management rating by its peer in the industry. One should check that what regards the
industry has of the management of a company.
iv. Performance during adverse period. During the good time everyone does well. One should
check that how tactfully management was able to drive the company during the adverse
phases. One who can manage well during bad times will definitely do well during the best
times.
v. Innovativeness of management. Investor should know how open, innovative and tactful the
management is. It should be dynamic.
vi. Investor should stay away from investing in companies that are yet to professionalize because
in such companies decisions are made on the whims of the CEO and not with the good of the
company in mind.
vii. One should avoid investing in family managed business if there is some family feud going on
because at the end of day whoever win the feud shareholders loose.
General Analysis of Companies
TABLE 1: A framework for general (non-financial) analysis of companies
Aspects Review Questions

History, Promoters How old is the company? Who are the promoters? Is it family managed or
and Management professionally managed? What is the public image and reputation of the
company, its promoters and its products?
Technology, Does the company use relevant technology? Is there any foreign
Facilities and collaboration? Where is the unit located? Are the production facilities well
Production balanced? Is the size the right economic size? What are the production
trends? What is the raw material position? Is the process power- intense? Are
there adequate arrangements for power?
Product range, What is the company’s product range? Are there any cash cows among the
Marketing, Selling product portfolio? And How distribution effective is the marketing network?
and Distribution What is the brand image of the products? What is the market share enjoyed
by the products in the relevant segments? What are the effects and costs of
sales promotion and distribution?
Industrial relations, How important is the labour component? What is the labour situation in
Productivity and general?
Personnel
Environment Are there any statutory controls on production, price, distribution, raw
material, etc? Is there any major legal constraint? What are the government
policies on the industry (domestic as well as related to imports and exports of
the final products and raw materials)?

SWOT Analysis
Positive Negative
Strengths Weaknesses
Latest Technology Loose controls
Lower delivered Cost Untrained labour force
Internal
Established products Strained cash flows

Committed manpower Poor product quality
Advantageous location Family funds
Strong finances Poor public image
Well- known brand names
Opportunities Threats
Growing domestic demand Price War
Expanding export markets Intensive competition
External
Cheap labour Undependable component

Booming capital markets Suppliers
Low interest rates Infrastructure bottlenecks
Power cuts.
Chart 1: SWOT analysis

Numerous non-financial aspects of a company have to be evaluated by investors. An investor should
take qualitative impression of a company; such information may be gathered from various sources like
a prospectus, a stock exchange, annual reports of the company, newspapers and magazine reports,
etc. A useful framework is suggested in Table 1. There could be various other aspects (e.g., research
and development, new licenses issued, imports of foreign goods, emergences of substitutes, etc.),
which may be included in such an analysis.
A very useful tool of the company analysis is SWOT analysis, which examines the strengths,
Weaknesses, Opportunities and Threats in the specific context of a company, whereas opportunities
and threats are incumbent upon the external environment. A typical SWOT analysis is presented in
Chart 1.
SWOT analysis is a powerful tool to assess the internal and external situation with references to any
specific company and investors can use SWOT analysis for investment and disinvestments decisions
with the help of Chart 2.
SUITABLE STOCK
Just as there are different ways of reaching God, there are numerous ways of making money on the
stock market. You can choose from a variety of equity stocks to suit your investment objectives,
depending on your ability and willingness to take risks, the size of your wallet etc. essentially, seven
types of equity share are important from the investors point of view.
1. Super Stocks
2. Emerging Blue Chips
3. Defensive Stocks
4. Cyclical Stocks
5. Turnaround Stocks
6. PSU Stocks
7. MNC Stocks
The above classification has to be understood in a broad sense for there is scope of overlap, as the
last two categories are based on ownership. It is possible to classify the PSU stocks and the MNC
stocks into one for the first five categories. A particular share may change its colors with the passage
of time, or due to a change in the fortunes of the industry in which it is operating.
Super Stock: Shares of established companies whose assets, sales turnover and Profit continue to
grow rapidly are called super stocks. Rapid growth can be achieved by following an aggressive policy
of expanding of profitable manufacturing facility and widening the market network or else through
diversification into profitable by a very high growth rate oriented entrepreneurial type of management.
They enjoy full advantage of tax incentive available for growth through expansion, modernization,
diversification, mergers and acquisition.
What better an example of a super stock than Reliance Industries Limited, the one that created the
equity cult. Reliance Industries has been maintaining margins and robust growth for the past two
decades and shows no signs of slowing down. Because of the nature of the business that they are in
(polymers and hydrocarbons) you can expect this stock to be a sure winner for an investor of any risk
appetite.
One of the other classic examples of a super stock is Hero Honda. A company that has catapulted the
Indian two wheeler industry to dizzy heights deserves to be recognized. Consistently meeting (and
invariably breaking!!) its own ambitious targets it is one scrip that should always look attractive. Now
that Honda is in the JV for another 10 years the worry of Honda launching its own bikes are gone. And
we can expect more from the world’s no 1 two wheeler company. Oh by the way it also paid out a huge
dividend. Now that’s super!!
NOTE: The ultimate test of a super stock is the quality of its management as evidenced by a strong
and growing EPS (Earning per share) and a relatively high market price.
Emerging Blue Chips: Shares of relatively newer companies which are performing in an outstanding
manner are known as emerging blue chip companies. Such companies are usually headed by
ambitious first new generation entrepreneurs. They succeed based on technology, pricing, marketing,
or other uniqueness.
If you had one stock to bet in the deregulated Indian Telecom Industry we suggest that should be
Bharti Telecom. With the wily Sunil Mittal at the helm Bharti has gone from strength to strength with a
nationwide presence in cellular services. It is by far the biggest operator in the cellular market and has
held on to its market despite competitive pressures from both cellular and WLL companies. In fact
subscriber base has shown impressive increase in the past year. The debt equity ratio at 0.65 is not
bad going for a telecom company and they should be able to raise finances for the expansions they
are planning. Here’s one scrip that is literally likely to ring the cash registers.
Balaji Telefilms: This scrip has got capital opportunity written all over it with a capital K! It is
dominating the current TV scene with 38 of the top 50 programs being its own soaps. The amazing
rate at which they have churned out successful serials has baffled one and all. With entertainment
suggested being a sunrise industry Ekta Kapoor seems to have the best view of the sunrise right now.
Thus Balaji Telefilms should be a winner in the long run.
NOTE: Emerging Blue chips eventually graduates into super stocks. With age they mature, gather
financial muscles and marketing and become market leaders in there product – market segment.
Defensive Stocks: Typically, these are shares of traditional companies engaged in stable and mature
industries. Their earnings do not fluctuate very widely from year to year. Over the years, they develop
standard dividend payment practices and follow them scrupulously. The market prices of defensive
shares tend to fluctuate within a narrow range. The dividend yield, that is, dividend expressed as a
percentage of market price usually works out higher than that of super stocks and emerging blue
chips.
With gas strikes at strategic locations and a good presence overseas ONGC seems to be one stock
that should survive any recession that might hit the oil industry. As India moves towards a market
based pricing for gas ONGC should be comfortably placed.
One of the other classic examples of a defensive stock today is Nestle. Nestle management is
committed to continue enhancing relationships with shareholders. Concerted efforts of the
management to maintain the price of products (in some cases even reduction of prices), better
working capital management, continuous improvement of supply chain and a focus on flagship
brands, contributed significantly towards it’s profitability. The favorable impact of the commodity
prices during parts of the year and the product mix, also contributed significantly towards
improvement in profitability.
NOTE: Defensive Stocks are typically companies engaged in utilities, like transport and electric supply,
and mature commodity type industries.
Cyclical Stock: These are the shares of the companies engaged in business which are susceptible to
fluctuation caused by trade cycle. They are extremely doing well during boom period but hit the bottom
during recession. Due to this cyclical nature of the fortunes of such industries, the share prices also go
up and down in a cyclical manner.
Balrampur Chini is a classic example of a cyclical stock. There have been quite a number of positive
signs for the sugar business in recent times. The most notable is the fact that the government has
decontrolled the sector, meaning 100% of sugar produced by any company can now get market-
related price. Sugar is probably the only business that had so many government controls. In the
coming months much of these controls are expected to be relaxed in phases. So Balrampur Chini
which was out of favor has again retained some interest.
NOTE: These are typical companies engaged in the business of aluminium, automobile, machinery,
housing, airlines, travel and leisure, shipping plantation, sugar industry etc.
Turnaround Stock: A turnaround share is one whose market price is currently lower than its intrinsic
value because the company has recently gone through a bad patch. When such a company begin to
turn the corner, or is taken over by another more successful company, shrewd bargain and reap a
fortune when the anticipated favorable turn of events taken place.
After seven successive quarters of loses TELCO is finally back in the black. Its new C segment car
Indigo has a good off-take as has the commercial vehicles market that has shown signs of growth.
Moreover, TELCO is executing a turnaround plan through cost reduction and manpower rationalization.
It appears that they should turn the corner soon and be back in black for good.
Public Sector Undertakings (PSU Stocks): During the last few years, the Government of India has
initiated steps to disinvest it’s holdings in selected public sector undertakings. Disinvestment is no
longer a matter of choice, but an imperative. The prolonged ‘fiscal hemorrhage’ cannot be sustained
any longer. The answer to the Central government’s revenue accounts in deficit is ‘Disinvestments’.

NOTE: The public perception of public sector companies is that they will underperform and, therefore,
the prices of shares fell in a number of cases after sale. How the market prices of PSUs are picking up
after a few major disinvestments.
Multinational Corporations (MNC Stocks): There are several reputed multinational companies
operating in India successfully. Prior to the dismantling of the restrictive provisions of FERA (Foreign
Exchange Regulation Act), these were generally known as FERA companies. With FERA practically
redundant, it is more appropriate to refer to them as MNCs.
HLL – There is this saying in mutual fund circles, “No one ever got fired for buying HLL stock”! That
pretty much epitomizes the sort of scrip this is. Here’s why, if you had put Rs.1 lakh into HLL in 1984,
it would be worth Rs.1 crore even at the depressed value that it is trading at today. Also you would be
earning annual dividends of Rs.5 on your initial Rs.1.6 investment!! Almost a gold standard in terms of
stocks HLL has always been a sure bet for good returns.
Certain stocks inherit greatness because of their successful, high profile parents.
Look at a case where Tata Consultancy Services (TCS) was floating its IPO. The Tata group’s name, the
fact that the company is in the ‘sunrise’ sector of Information Technology (IT) and the evidence of
phenomenal financial performance make for a heady cocktail that should catapult the stock to ‘great’
status in no time!
Some stocks have greatness thrust upon them: Some stocks have greatness thrust upon them
because of extraneous reasons even though their performance may be nothing to rave about.
Have you ever noticed how some cricket stars are seen to have great potential just because of ‘flash
in the pan’ performance or some ex-cricketer puts in a good word about him. Similarly some stocks
can be the talk of the town based on one off performance or some super broker’s recommendation.
But ultimately, they may turn out to be duds. Stocks like Himachal Futuristic Communication Limited
(HFCL) which bore the brunt of the Ketan Parekh scam is such an example.
NOTE: They are likely to decline in value sooner rather or later because they posses little or no
significant intrinsic strength and value.
Some stocks achieve greatness: These are genuine super stocks which have achieved success
through sustained hard work and performance over a number of years, and not by accounting
gimmicks or fancy financial footwork.
To put simply ‘Performance has no equal’ and stocks like Infosys are apt examples of this philosophy.
Infosys has shown that business excellence need not require much else beyond a good, de-risked and
sustainable business model. And no wonder it is the darling of the bourses nowadays.
In the remaining portion, we present different methods of classifying and analyzing stocks so that you
can choose the ones that suit you the best. So, lets go stock shopping!
These classifications are based on different criteria:

a) Quality and Price
b) Life Cycle
c) Management and Investor rewards.
MANAGEMENT AND INVESTOR REWARDS

There is yet another way of scouting for a suitable stock based on two vital criteria:
a) Weighing the aggressive approach of the management
b) Studying the investor rewards.
In the chart below we present an analytical matrix of these two criteria. The analysis shows up 7
different types of companies.
Established Growth Stock

HIGH
Companies
REWARDS TO INVESTORS
Emerging Blue
Chip Companies
Mature Companies in
MEDIUM Special situation
Companies
*Turnaround
*Restructuring
Companies in [Transition Phase]

LOWER decline Companies in Start-up
Trouble Ventures
[Terminal Phase]
[Initial Phase]
Passive Cautious Very Aggressive
Reactive Calculative & highly
Uncompetitive Competitive competitive
MANAGEMENT STYLE
Chart 8: Types of Companies
Start-up companies: These are new companies, started by new promoters or existing business groups.
They approach the investing public with a prospectus. Every year you have many new issue offerings in
the market. These companies have to face a lot of initial teething trouble before things stabilize. Many
start-up companies succumb to pressures and become companies in trouble awaiting either
restructuring (i.e. takeover) or winding up. If the new ventures are able to overcome these initial
problems, they slowly rise to the next category: emerging blue chips. When a start-up company fails, it
is not news but when it rewards investors, that is news.
Emerging blue chip companies: After overcoming the initial hurdles, these companies start
experiencing growth in sales and profits. By ploughing back the surpluses, they achieve a high rate of
growth in assets. The promoters of these companies and their ambitious plans enjoy a very high
profile among the press and the investing public. They launch new projects, acquire new outfits and
raise more and more money from the investors. Their critics attribute their success to fortune rather
than merit.
Established super stock companies: The next stage of evolution for blue chips is to graduate into
established super stock companies with assured leadership in target markets, possess a strong
financial position, a well organized management system and a high profile corporate citizenship based
on social responsibility. They have ‘a lever sufficiently long and a fulcrum sufficiently strong’, single-
handedly they can move the world.

Mature companies: Established growth stock companies eventually become mature enterprises with
very little enterprises with very little enterprise and enthusiasm still left with them. They lag behind
their competitors in technology, marketing and business strategy. Procedures become more important
than performance. Bureaucracy soon rules the roost. Having become shadows of their former glory,
eventually they fade away.
Companies in trouble: Companies in trouble head towards financial sickness although they may still
be remotely viable. They need a drastic remedy like change of ownership or change of management.
Without such a radical solution, they languish for some more time before their final decline and decay.
As a Czech proverb maintains, misfortunes always come in by a door that has been left open for them.
Companies in transition: Companies in transition are those undergoing major internal reorganization
and external restructuring. After transition, these companies are expected to emerge as blue chips
once again. If the restructuring fails, they become companies in trouble and companies in decline.
Companies in decline: This is the sunset phase. It is a terminal ward, a dead end street. After a company
gets into this phase, there will be no takers, at any throwaway price. The only viable solution is mercy
killing through winding up.
You may have noticed that there is a grey area between emerging blue chips and established stocks.
Many emerging blue chips at the final stages resemble established super stocks very closely.
However, in the initial stages they can be easily distinguished as shown in the table below.
You may notice from the chart that the status of an emerging blue chip is a passing phase. Today’s
super stocks were emerging blue chips some years ago. Similarly some of the new issues could
emerge as blue chips if they perform well. There is big money to be made if you can spot an emerging
blue chip early enough for investment. So is the case with turnaround stocks, which are going through
a transition phase.
Thus, no matter whichever way you look at it, you have more or less the same types of stocks going
around. These different types of classifications of stocks provide a multi-dimensional view to the
investment.
TABLE 2: A Comparative perspective of Emerging blue chips and Super stocks

Items Emerging Blue Chips Super Stocks
Equity Base Small Large
Top Management Entrepreneurial Professional
Employees Young and Aggressive Superior and experienced
Rocked by teething trouble. Single Stable equilibrium in operations Multi
Operations
Product single plant product Multi unit.
Capacity to absorb
Limited ability to withstand shocks Great ability to withstand shocks
shocks
Mortality High infant mortality Limited old age mortality
Debt/Equity Ratio High Low
Growth Strategy Aggressive Cautious and Calculated
Family frauds and infighting among Creeping bureaucracy and old age of
Great Dangers
partners founders.

Understanding Financial
Statement 5
Finance – An Introduction
The study of finance consists of three interrelated areas (i) money and capital markets. (ii)
investments, which focuses on the decisions of individual and financial and other institutions as they
choose securities for their investments portfolios, and (iii) managerial finance (business finance)
which involves the actual management of the firm. In general the three areas are interrelated.
Money and Capital Markets: These include all institutions or organizations that are involved in financial
intermediation between savers (those who have surplus money) and borrowers (those who have deficit
of funds). These include banks and non-bank financial institutions, insurance companies, stock markets,
brokerage and dealers firms, savings and loans and institutions, and credit unions etc. Working in these
institutions requires knowing both the micro and macro operations including changes interest rates,
fiscal policies, monetary policies, and business operations. The institutions by themselves are also firms
and they behave like any other firm, for profit maximization.
Investment: This involves determining where to make investments from individuals to companies, and
determining the optimal mix of securities and other investments. Knowledge of investment analysis is
very important in order to decide whether a project is financially, economically and socially viable.
Managerial Finance: Managerial finance is important to all types of businesses, whether they are
public or private, deals with financial services or are manufacturers. Issues related to managerial
finance range from decisions regarding expanding a business to choosing what types of securities to
issue or finance and what type of investments to undertake.
Managerial finance also involves analyzing the performance of the firm in order to forecast its future
performance. It involves making decisions regarding working capital issues such as level of inventory,
cash holding, credit levels, etc. It requires the need to know how to raise funds from the money and
capital markets. It involves decisions regarding whether to merge or acquire a firm, how much of the
generated funds should be distributed or reinvested. Managerial finance touches upon money and
capital markets, and investments.
The field of finance integrates concepts from economics and a number of other related areas. The
central goal of finance is the relationship of risk and return. It reminds an investor that there are no
free lunches. For whatever decisions made there is a trade-off to make in term of the risks and the
returns. For example, an accountant may wish to change the accounting method for reporting
inventories. Such a change has its risk and returns to the firm’s financial performance. To the overall
economy the change in accounting policy may send a message (signals) to the market about the
efficiency and effectiveness of the firm’s operations, hence affecting the performance of the share
price in the capital market.

A financial manager has to link the interactions of financing and investment decisions open to the
organization. Table 1 below shows the functions of financial manager.
The financial manager or consultant places primary emphasis on decision making. It uses the financial
statements prepared by accountants to make decisions about the firm’s financial condition and to
advise others about possible losses and profits. In some cases, finance is more a type of leadership
position. A financial manager has to deal not only with finance, but also with economics, accounting,
statistics, math, and management. For example, people working with stocks and bonds have to
understand and analyze how the underlying companies are performing. How a given company is going
to perform during recession? Should they sell or buy stocks or bonds. How a decrease in the interest
rate may affect the projects a company has in that country. Finance also deals a lot with risk.
Enhanced risk can be countered by being hedged by Derivative Securities. Risk managers are in great
demand everywhere. Most finance majors find jobs in banks and other financial institutions,
government, real estate, consultant companies, insurance, investment companies, stock market
exchanges, fundraising, and any firm that needs someone to make financial decisions.
TABLE 1: Functions of the Financial Manager
Maximization of Share Holders Wealth

Daily Activities Working Capital Management
Issue of Shares
Trade-Off
Issue of Bonds
Occasional Activities Profitability-Risk
Capital Budgeting
Dividend Decisions
Introduction to Financial Statements
Financial statements, as used in corporate business houses, refer to a set of reports and schedules
which an accountant prepares at the end of a period of time for a business enterprise. The financial
statements are the means with the help of which the accounting system performs its main function of
providing summarized information about the financial affairs of the business.
Financial information, which accounting helps to standardize, is presented in the companies’ financial
reports. Indian listed companies must periodically report their financial statements to the investors
and regulators. Why is this so? The laws and rules that govern the securities industry in the India
derive from a simple and straightforward concept: all investors, whether large institutions or private
individuals, should have access to certain basic facts about an investment prior to buying it. To
achieve this, the Securities and Exchange Board of India (SEBI), the market regulator in India, requires
public companies to disclose meaningful financial and other information to the public. This provides a
common pool of knowledge for all investors to use to judge for themselves if a company’s securities
are a good investment. Only through the steady flow of timely, comprehensive and accurate
information can people make sound investment decisions.
3.1 Where can one find financial statements?

Listed companies have to send all their shareholders annual reports. In addition, the quarterly
financials of the company can be found on the stock exchanges’ websites and on the website of the
company
The primary and most important source of information about a company are its Annual Reports,
prepared and distributed to the shareholders by law each year. Annual Reports are usually well
presented. A tremendous amount of data is given about the performance of a company over a period
of time. If an Annual Report is impressive about the operations and future direction, if the company
has made a profit and if a reasonable dividend has been paid, the average investor is typically content
in the belief that the company is in good hands. However, for a fundamental analyst or for that matter
any investor, this alone must not be the criterion by which to judge a company. The intelligent investor
must read the annual report in depth; he must read between and beyond the lines; he must peep
behind the figures and find the truth and only then should he decide whether the company is doing
well or not.
The Annual Report is usually broken down into the following specific parts:
1. The Director’s Report

2. The Auditor’s Report
3. The Financial Statements
1. Balance sheet or positional statements
2. Profit and loss account or income statement
4. The Schedules and Notes to the Accounts
The Director’s Report
The Director’s Report is a report submitted by the directors of a company to shareholders, informing
them about the performance of the company, under their stewardship:
1. It enunciates the opinion of the directors on the state of the economy and the political
situation vis-à-vis the company.
2. Explains the performance and the financial results of the company in the period under review.
This is an extremely important part. The results and operations of the various separate
divisions are usually detailed and investors can determine the reasons for their good or bad
performance.
3. The Director’s Report details the company’s plans for modernization, expansion and
diversification. Without these, a company will remain static and eventually decline.
4. Discusses the profits earned in the period under review and the dividend recommended by the
directors. This paragraph should normally be read with sane scepticism as the directors will
always argue that the performance was satisfactory. If profits have improved the reasons
stated would invariably be superior technology adopted, intense marketing and hard work in
the face of severe competition etc. If profits are low, adverse economic conditions are usually
blamed for the same.
5. Elaborates on the directors’ views of the company’s prospects for the future.
6. Discusses plans for new acquisitions and investments.
An investor must intelligently evaluate the issues raised in a Director’s Report. If the report
talks about diversification, one must the question that though diversification is a good
strategy, does it make sense for the company? Industry conditions, the management’s
knowledge of the new business must be considered. Although companies must diversify in
order to spread the risks of economic slumps, every diversification may not suit a company.
Similarly, all other issues raised in the Director’s Report should be analysed. Did the company
perform as well as others in the same industry? Is the finance being raised the most logical
and beneficial to the company? It is imperative that the investor read between the lines of the
Director’s Report and find the answers to these and many other questions. In short, a
Director’s Report is valuable and if read intelligently can give the investor a good grasp of the
workings of a company, the problems it faces, the direction it intends taking and its future
prospects.
The Auditor’s Report
The auditor represents the shareholders and it is the auditor’s duty to report to the shareholders and
the general public on the stewardship of the company by its directors. Auditors are required to report
whether the financial statements presented do in fact present a true and fair view of the state of the
company. Investors must remember that the auditors are required by law to point out if the financial
statements are true and fair. They are also required to report any change, such as a change in
accounting principles or the non-provision of charges that result in an increase or decrease in profits.
It is really the only impartial report that a shareholder or investor receives and this alone should spur
one to scrutinize the auditor’s report minutely. Unfortunately, more often than not it is not read. There
can be interesting contradictions. It was stated in the Auditor’s Report of ABC Co. Ltd. for the year
1999-2000 that, “As at the year-end 31st March 2000 the accumulated losses exceed the net worth
of the Company and the Company has suffered cash losses in the financial year ended 31st March
2000 as well as in the immediately preceding financial year. In our opinion, therefore, the Company is
a sick industrial company within the meaning of clause (O) of Section 3(1) of the Sick Industrial
Companies (Special Provisions) Act 1985”. The Director’s report however stated, “The financial year
under review has not been a favourable year for the Company as the computer industry in general
continued to be in the grip of recession. High input costs as well as resource constraints hampered
operations. The performance of your Company must be assessed in the light of these factors. During
the year manufacturing operations were curtailed to achieve cost effectiveness. Your directors are
confident that the efforts for increased business volumes and cost control will yield better results in
the current year”. The auditors were of the opinion that the company was sick whereas the directors
spoke optimistically of their hope that the future would be better! They could not, being directors, state
otherwise.
At times, accounting principles are changed or creative and innovative accounting practices resorted
to by some companies in order to show a better result. The effect of these changes is at times not
detailed in the notes to the accounts. The Auditor’s Report will always draw the attention of the reader
to these changes and the effect that these have on the financial statements. It is for this reason that a
careful reading of the Auditor’s Report is not only necessary but mandatory for an investor.
Financial Statements
The published financial statements of a company in an Annual Report consist of its Balance Sheet as
at the end of the accounting period detailing the financing condition of the company at that date and
the Profit and Loss Account or Income Statement summarizing the activities of the company for the
accounting period and the Statement of Cash Flows for the accounting period.
Balance Sheet

The Balance Sheet details the financial position of a company on a particular date; the company’s
assets (that which the company owns), and liabilities (that which the company owes), grouped logically
under specific heads. It must however, be noted that the Balance Sheet details the financial position
on a particular day and that the position can be materially different on the next day or the day after.
Sources of funds
A company has to source funds to purchase fixed assets, to procure working capital and to fund its
business. For the company to make a profit, the funds have to cost less than the return the company
earns on their deployment. Where does a company raise funds? What are the sources? Companies
raise funds from its shareholders and by borrowing.
(a) Shareholders’ Funds (Total Share Capital in XYZ’s Balance Sheet)

A company sources funds from shareholders by the issue of shares. Shareholders’ funds is the
balance sheet value of shareholders’ interest in a company. For the accounts of a company with no
subsidiaries it is total assets minus total liabilities. For consolidated group accounts the value of
minority interests is excluded. Minority interest refers to the portion of a subsidiary corporation’s stock
that is not owned by the parent corporation.
Shareholders’ funds represent the stake shareholders have in the company, the investment they have
made.
Share Capital: Share capital represents the shares issued to the public. This is issued in following
ways:
Private Placement - This is done by offering shares to selected individuals or institutions.
Public Issue - Shares are offered to public. The details of the offer, including the reasons for raising
the money are detailed in a prospectus and it is important that investors read this.
Rights issues - Companies may also issue shares to their shareholders as a matter of right in
proportion to their holding. So, if an investor has 100 shares and a company announces a 2:1 rights,
the investor stands to gain an additional 200 shares. Rights issues come at a price which the
investors must pay by subscribing to the rights offer. The rights issues were often offered at a price
lower than the company’s market value and shareholders stood to gain. With the freedom in respect
of pricing of shares now available, companies have begun pricing their offerings nearer their intrinsic
value. Consequently, many of these issues have not been particularly attractive to investors and
several have failed to be fully subscribed. However, strong companies find subscribers to thier rights
issues as investors are of the view that their long term performance would lead to increase in share
prices.
Bonus shares - When a company has accumulated a large reserves out of profits, the directors may
decide to distribute a part of it amongst the shareholders in the form of bonus. Bonus can be paid
either in cash or in the form of shares. Cash bonus is paid in the form of dividend by the company
when it has large accumulated profits as well as cash. Many a times, a company is not in a position to
pay bonus in cash (dividend) in spite of sufficient profits because of unsatisfactory cash position or
because of its adverse effects on the working capital of the company. In such a case, the company
pays a bonus to its shareholders in the form of shares. Bonus shares are shares issued free to
shareholders by capitalizing reserves. No monies are actually raised from shareholders. Nothing stops
a company from declaring a bonus and dividend together if it has large accumulated profits as well as
cash.
Reserves - Reserves are profits or gains which are retained and not distributed. Companies have two
kinds of reserves - capital reserves and revenue reserves:
Capital Reserves – Capital reserves are gains that have resulted from an increase in the value of
assets and they are not freely distributable to the shareholders. The most common capital reserves
one comes across are the share premium account arising from the issue of shares at a premium and
the capital revaluation reserve, i.e. unrealized gain on the value of assets.
Revenue Reserves - These represent profits from operations ploughed back into the company and not
distributed as dividends to shareholders. It is important that all the profits are not distributed as funds
are required by companies to purchase new assets to replace existing ones, for expansion and for
working capital.
(b)Loan Funds
The other source of funds a company has access to is borrowings. Borrowing is often preferred by
companies as it is quicker, relatively easier and the rules that need to be complied with are much less.
The loans taken by companies are either :
Secured loans - These loans are taken by a company by pledging some of its assets or by a floating
charge on some or all of its assets. The usual secured loans a company has are debentures and term
loans.
Unsecured loans - Companies do not pledge any assets when they take unsecured loans. The comfort
a lender has is usually only the good name and credit worthiness of the company. The more common
unsecured loans of a company are fixed deposits and short term loans. In case a company is
dissolved, unsecured lenders are usually paid after the secured lenders have been paid. Borrowings or
credits for working capital which fluctuate such as bank overdrafts and trade creditors are not
normally classified as loan funds but as current liabilities.
Fixed Assets (Net Block in XYZ’s Balance Sheet) - Fixed assets are assets that a company owns for use
in its business and to produce goods. Typically it could be machinery. They are not for resale and
comprises of land, buildings i.e. offices, warehouses and factories, vehicles, machinery, furniture,
equipment and the like. Every company has some fixed assets though
the nature or kind of fixed assets vary from company to company. A manufacturing company’s major
fixed assets would be its factory and machinery, whereas that of a shipping company would be its
ships. Fixed assets are shown in the Balance Sheet at cost less the accumulated depreciation.
Depreciation is based on the very sound concept that an asset has a useful life and that after years of
toil it wears down. Consequently, it attempts to measure that wear and tear and to reduce the value of
the asset accordingly so that at the end of its useful life, the asset will have no value.
As depreciation is a charge on profits, at the end of its useful life, the company would have set aside
from profits an amount equal to the original cost of the asset and this could be utilized to purchase
another asset. However, in the inflationary times, this is inadequate and some companies create an
additional reserve to ensure that there are sufficient funds to replace the worn out asset. The common
methods of depreciation are:
Straight line method - The cost of the asset is written off equally over its life. Consequently, at the end
of its useful life, the cost will equal the accumulated depreciation.

Reducing balance method - Under this method, depreciation is calculated on the written down value,
i.e. cost less depreciation. Consequently, depreciation is higher in the beginning and lower as the
years progress. An asset is never fully written off as the depreciation is always calculated on a
reducing balance.
Land is the only fixed asset that is never depreciated as it normally appreciates in value. Capital work
in progress - factories being constructed, etc. - are not depreciated until it is a fully functional asset.
Investments
Many companies purchase investments in the form of shares or debentures to earn income or to
utilize cash surpluses profitably. The normal investments a company has are:
Trade investments - Trade investments are normally shares or debentures of competitors that a
company holds to have access to information on their growth, profitability and other details.
Subsidiary and associate companies - These are shares held in subsidiary or associate companies.
The large business houses hold controlling interest in several companies through cross holdings in
subsidiary and associate companies.
Others - Companies also often hold shares or debentures of other companies for investment or to park
surplus funds.
Investments are also classified as quoted and unquoted investments. Quoted investments are shares
and debentures that are quoted in a recognized stock exchange and can be freely traded. Unquoted
investments are not listed or quoted in a stock exchange. Consequently, they are not liquid and are
difficult to dispose of. Investments are valued and stated in the balance sheet at either the acquisition
cost or market value, whichever is lower. This is in order to be conservative and to ensure that losses
are adequately accounted for.
Current assets - Current assets are assets owned by a company which are used in the normal course
of business or are generated by the company in the course of business such as debtors or finished
stock or cash.
The rule of thumb is that any asset that is turned into cash within twelve months is a current asset.
Current assets can be divided essentially into three categories :
Converting assets - Assets that are produced or generated in the normal course of business, such as
finished goods and debtors.
Constant assets - Constant assets are those that are purchased and sold without any add-ons or
conversions, such as liquor bought by a liquor store from a liquor manufacturer.
Cash equivalents - They can be used to repay dues or purchase other assets. The most common cash
equivalent assets are cash in hand and at the bank and loans given.
The current assets a company has are:
Inventories - These are arguably the most important current assets that a company has as it is by the
sale of its stocks that a company makes its profits. Stocks, in turn, consist of:

Raw materials - The primary purchase which is utilized to manufacture the products a company
makes.
Work in progress - Goods that are in the process of manufacture but are yet to be completed.
Finished goods - The finished products manufactured by the company that are ready for sale.
Valuation of stocks
Stocks are valued at the lower of cost or net realizable value. This is to ensure that there will be no
loss at the time of sale as that would have been accounted for. The common methods of valuing
stocks are:
FIFO or first in first out - It is assumed under this method that stocks that come in first would be sold
first and those that come in last would be sold last.
LIFO or last in last out - The premise on which this method is based is the opposite of FIFO. It is
assumed that the goods that arrive last will be sold first. The reasoning is that customers prefer newer
materials or products. It is important to ascertain the method of valuation and the accounting
principles involved as stock values can easily be manipulated by changing the method of valuation.
Debtors - Most companies do not sell their products for cash but on credit and purchasers are
expected to pay for the goods they have bought within an agreed period of time - 30 days or 60 days.
The period of credit would vary from customer to customer and from the company to company and
depends on the credit worthiness of the customer, market conditions and competition. Often
customers may not pay within the agreed credit period. This may be due to laxity in credit
administration or the inability of the customers to pay. Consequently, debts are classified as:
1. Those over six months, and

2. Others
These are further subdivided into;
1. Debts considered good, and

2. Debts considered bad and doubtful.
If debts are likely to be bad, they must be provided for or written off. If this is not done, assets will be
overstated to the extent of the bad debt. A write off is made only when there is no hope of recovery.
Otherwise, a provision is made. Provisions may be specific or they may be general. When amounts are
provided on certain identified debts, the provision is termed specific whereas if a provision amounting
to a certain percentage of all debts is made, the provision is termed general.
Prepaid Expenses - All payments are not made when due. Many payments, such as insurance premia,
rent and service costs, are made in advance for a period of time which may be 3 months, 6 months, or
even a year. The portion of such expenses that relates to the next accounting period are shown as
prepaid expenses in the Balance Sheet.
Cash & Bank Balances - Cash in hand in petty cash boxes, safes and balances in bank accounts are
shown under this heading in the Balance Sheet.

Loans & Advances - These are loans that have been given to other corporations, individuals and
employees and are repayable within a certain period of time. This also includes amounts paid in
advance for the supply of goods, materials and services.
Other Current Assets - Other current assets are all amounts due that are recoverable within the next
twelve months. These include claims receivable, interest due on investments and the like.
Current Liabilities - Current liabilities are amounts due that are payable within the next twelve months.
These also include provisions which are amounts set aside for an expense incurred for which the bill
has not been received as yet or whose cost has not been fully estimated.
Creditors - Trade creditors are those to whom the company owes money for raw materials and other
articles used in the manufacture of its products. Companies usually purchase these on credit - the
credit period depending on the demand for the item, the standing of the company and market
practice.
Accrued Expenses - Certain expenses such as interest on bank overdrafts, telephone costs, electricity
and overtime are paid after they have been incurred. This is because they fluctuate and it is not
possible to either prepay or accurately anticipate these expenses. However, the expense has been
incurred. To recognize this the expense incurred is estimated based on past trends and known
expenses incurred and accrued on the date of the Balance Sheet.
Provisions - Provisions are amounts set aside from profits for an estimated expense or loss. Certain
provisions such as depreciation and provisions for bad debts are deducted from the concerned asset
itself. There are others, such as claims that may be payable, for which provisions are made. Other
provisions normally seen on balance sheets are those for dividends and taxation.
Sundry Creditors - Any other amounts due are usually clubbed under the all-embracing title of sundry
creditors. These include unclaimed dividends and dues payable to third parties.
Income Statement
The Profit and Loss account summarizes the activities of a company during an accounting period
which may be a month, a quarter, six months, a year or longer, and the result achieved by the
company. It details the income earned by the company, its cost and the resulting profit or loss. It is, in
effect, the performance appraisal not only of the company but also of its management - its
competence, foresight and ability to lead.
Sales - Sales include the amount received or receivable from customers arising from the sales of
goods and the provision of services by a company. A sale occurs when the ownership of goods and the
consequent risk relating to these goods are passed to the customer in return for consideration, usually
cash. In normal circumstances the physical possession of the goods is also transferred at the same
time. A sale does not occur when a company places goods at the shop of a dealer with the clear
understanding that payment need be made only after the goods are sold failing which they may be
returned. In such a case, the ownership and risks are not transferred to the dealer nor any
consideration paid.
Companies do give trade discounts and other incentive discounts to customers to entice them to buy
their products. Sales should be accounted for after deducting these discounts. However, cash

discounts given for early payment are a finance expense and should be shown as an expense and not
deducted from sales.
There are many companies which deduct excise duty and other levies from sales. There are others
who show this as an expense. It is preferable to deduct these from sales since the sales figures would
then reflect the actual mark-up made by the company on its cost of production.
Other Income - Companies may also receive income from sources other than from the sale of their
products or the provision of services. These are usually clubbed together under the heading, other
income. The more common items that appear under this title are:
Profit from the sale of assets - Profit from the sale of investments or assets.
Dividends - Dividends earned from investments made by the company in the shares of other
companies.
Rent - Rent received from commercial buildings and apartments leased from the company.
Interest - Interest received on deposits made and loans given to corporate and other bodies.
Raw Materials - The raw materials and other items used in the manufacture of a company’s products.
It is also sometimes called the cost of goods sold.
Employee Costs - The costs of employment are accounted for under this head and would include
wages, salaries, bonus, gratuity, contributions made to provident and other funds, welfare expenses,
and other employee related expenditure.
Operating & Other Expenses - All other costs incurred in running a company are called operating and
other expenses, and include.
Selling expenses - The cost of advertising, sales commissions, sales promotion expenses and other
sales related expenses.
Administration expenses - Rent of offices and factories, municipal taxes, stationery, telephone and
telex costs, electricity charges, insurance, repairs, motor maintenance, and all other expenses
incurred to run a company.
Others - These include costs that are not strictly administration or selling expenses, such as donations
made, losses on the sale of fixed assets or investments, miscellaneous expenditure and the like.
Interest & Finance Charges - A company has to pay interest on money it borrows. This is normally
shown separately as it is a cost distinct from the normal costs incurred in running a business and
would vary from company to company. The normal borrowings that a company pays interest on are:
1. Bank overdrafts.
2. Term loans taken for the purchase of machinery or construction of a factory.
3. Fixed deposits from the public.
4. Debentures.
5. Inter-corporate loans.
Depreciation - Depreciation represents the wear and tear incurred by the fixed assets of a company,
i.e. the reduction in the value of fixed assets on account of usage. This is also shown separately as the
depreciation charge of similar companies in the same industry will differ, depending on the age of the
fixed assets and the cost at which they have been bought.
Tax - Most companies are taxed on the profits that they make. It must be remembered however that
taxes are payable on the taxable income or profit and this can differ from the accounting income or
profit. Taxable income is what income is according to tax law, which is different to what accounting
standards consider income to be. Some income and expenditure items are excluded for tax purposes
(i.e. they are not assessable or not deductible) but are considered legitimate income or expenditure
for accounting purposes.
Dividends - Dividends are profits distributed to shareholders. The total profits after tax are not always
distributed – a portion is often ploughed back into the company for its future growth and expansion.
Companies generally pay an interim and / or final dividend. Interim dividend usually accompanies the
company’s interim financial statements. The final dividend is usually declared after the results for the
period have been determined. The final dividend is proposed at the annual general meeting of the
company and paid after the approval of the shareholders.
Transfer to Reserves - The transfer to reserves is the profit ploughed back into the company. This may
be done to finance working capital, expansion, fixed assets or for some other purpose. These are
revenue reserves and can be distributed to shareholders as dividends.
Contingent Liabilities - Contingent liabilities are liabilities that may arise up on the happening of an
event. It is uncertain however whether the event itself may happen. This is why these are not provided
for and shown as an actual liability in the balance sheet. Contingent liabilities are detailed in the
Financial Statements as a note to inform the readers of possible future liabilities while arriving at an
opinion about the company. The contingent liabilities one normally encounters are:
 Bills discounted with banks - These may crystallize into active liabilities if the bills are o
dishonoured.
 Gratuity to employees not provided for
 Claims against a company not acknowledged or accepted
 Excise claims against the company etc.
Schedules and Notes to the Accounts
The schedules and notes to the accounts are an integral part of the financial statements of a company
and it is important that they be read along with the financial statements.
Schedules - The schedules detail pertinent information about the items of Balance Sheet and Profit &
Loss Account. It also details information about sales, manufacturing costs, administration costs,
interest, and other income and expenses. This information is vital for the analysis of financial
statements.
The schedules enable an investor to determine which expenses increased and seek the reasons for
this. Similarly, investors would be able to find out the reasons for the increase or decrease in sales
and the products that are sales leaders. The schedules even give details of stocks and sales,
particulars of capacity and productions, and much other useful information.
Notes - The notes to the accounts are even more important than the schedules because it is here that
very important information relating to the company is stated. Notes can effectively be divided into:
Accounting policies - All companies follow certain accounting principles and these may differ from
those of other entities. As a consequence, the profit earned might differ. Companies have also been
known to change (normally increase) their profit by changing the accounting policies. For instance,
ABC Co. Ltd.’s Annual Report stated among other things, “There has been a change in the method of
accounting relating to interest on borrowings used for capital expenditure. While such interest was
fully written off in the previous years, interest charges incurred during the year have been capitalized
for the period upto the date from which the assets have been put to use. Accordingly, expenditure
transferred to capital account includes an amount of Rs. 46.63 crores towards interest capitalized.
The profit before taxes for the year after the consequential adjustments of depreciation of Rs. 0.12
crore is therefore higher by Rs. 46.51 crores than what it would have been had the previous basis
been followed”. This means that by changing an accounting policy ABC Co. Ltd. was able to increase
its income by Rs. 46 crore. There could be similar notes on other items in the financial statements.
The accounting policies normally detailed in the notes relate to:
 How sales are accounted for?

 What the research and development costs are?
 How the gratuity liability is expensed?
 How fixed assets are valued?
 How depreciation is calculated?
 How stock, including finished goods, work in progress, raw materials and o consumable goods
are valued? How investments are stated in the balance sheet?
 How has the foreign exchange translated?
Contingent liabilities - • As noted earlier, contingent liabilities that might crystallize upon the
happening of an uncertain event. All contingent liabilities are detailed in the notes to the accounts and
it would be wise to read these as they give valuable insights. The more common contingent liabilities
that one comes across in the financial statements of companies are:
 Outstanding guarantees.
 Outstanding letters of credit.
 Outstanding bills discounted.
 Claims against the company not acknowledged as debts.
 Claim for taxes.
 Cheques discounted.
 Uncalled liability on partly paid shares and debentures.
Others - It must be appreciated that the purpose of notes to the accounts is to inform the reader more
fully. Consequently, they detail all pertinent factors which affect, or will affect, the company and its
results. Often as a consequence, adjustments may need to be made to the accounts to unearth the
true results. The more common notes one comes across are:
 Whether provisions for known or likely losses have been made.

 Estimated value of contracts outstanding.
 Interest not provided for.
 Arrangements agreed by the company with third parties.
 Agreement with labour.

 The importance of these notes cannot be overstressed. It is imperative that investors read
these carefully.
Of course, in addition to the above, a business may also prepare:
1. A Statement of Retained Earnings.

2. A Statement of Changes in Financial position.
These give a full view of the financial affairs of an undertaking. In India, every company has to present
its financial statements in the form and contents as prescribed under Section 211 of the Companies
Act 1956. The significance of these statements is given below:
Balance Sheet or Position Statement: Balance sheet is a statement showing the nature and amount of
a company’s assets on one side and liabilities and capital on the other. In other words, the balance
sheet shows the financial conditions or state of affairs of a company at the end of a given period
usually at the end of one year period. Balance sheet shows how the money has been made available
to the business of the company and how the money is employed in the business.
Profit and Loss Account or Income Statement: Earning profit is the principal objective of all business
enterprises and Profit and Loss account or Income statement is the document which indicates the
extent of success achieved by a business in meeting this objective. Profits are of primary importance
to the Board of directors in evaluating the management of a company, to shareholders or potential
shareholders in making investment decisions and to banks and other creditors in judging the loan
repayment capacities and abilities of the company. It is because of this that the profit and loss or
income statement is regarded as the primary statement and commands a careful scrutiny by all
interested parties. It is prepared for a particular period which is mentioned along with the title of these
statements, which includes the name of the business firm also.
Statement of Retained Earnings: This statement is also known as Profit and Loss Appropriation
Account and is generally a part of the Profit and Loss Account. This statement shows how the profits of
the business for the accounting period have utilized or appropriated towards reserves and dividend
and how much of the same is carried forward to the next period. The term ‘retained earnings’ means
the accumulated excess of earnings over losses and dividends. The balance shown by Profit and Loss
Account is to be transferred to the Balance Sheet through this statement after making necessary
appropriations.
Statement of Changes in Financial Position: This is a statement which summarizes for the period, the
cash made available to finance the activities of an organization and the uses to which such cash have
been put. This statement is also known as Cash Flow Statement which summarizes the changes in
cash inflows and outflows, by showing the various sources and applications of cash.
Cash Flow Statement
Complementing the balance sheet and income statement, the cash flow statement (CFS) allows
investors to understand how a company’s operations are running, where its money is coming from and
how it is being spent.
The Structure of the CFS

The cash flow statement is distinct from the income statement and balance sheet because it does not
include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore,
cash is not the same as net income, which, on the income statement and balance sheet, includes
cash sales and sales made on credit. Cash flow is determined by looking at three components by
which cash enters and leaves a company, its core operations, investing activities and financing
activities.
Cash Flow from Operations
Measuring the cash inflows and outflows caused by core business operations, the operations
component of cash flow reflects how much cash is generated from a company’s products or services.
Generally, changes made in cash, accounts receivable, depreciation, inventory and accounts payable
are reflected in cash from operations. Cash flow is calculated by making certain adjustments to net
income by adding or subtracting differences in revenue, expenses and credit transactions (appearing
on the balance sheet and income statement) resulting from transactions that occur from one period to
the next. These adjustments are made because non-cash items are calculated into net income
(income statement) and total assets and liabilities (balance sheet). So, because not all transactions
involve actual cash items, many items have to be re-evaluated when calculating cash flow from
operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the total
value of an asset that has previously been accounted for. That is why it is added back into net sales
for calculating cash flow. The only time income from an asset is accounted for in cash flow statement
calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must
also be reflected in cash flow. If accounts receivable decreases, this implies that more cash has
entered the company from customers paying off their credit accounts - the amount by which accounts
receivable has decreased is then added to net sales. If accounts receivable increases from one
accounting period to the next, the amount of the increase must be deducted from net sales because,
although the amounts represented in accounts receivable are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money to
purchase more raw materials. If the inventory was paid with cash, the increase in the value of
inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory
was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the
amount of the increase from one year to the other would be added to net sales.
The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has
been paid off, then the difference in the value owed from one year to the next has to be subtracted
from net income. If there is an amount that is still owed, then any differences will have to be added to
net earnings.
Cash Flow from Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes
from investing are a “cash out” item, because cash is used to buy new equipment, buildings or short-
term assets such as marketable securities. However, when a company divests of an asset, the
transaction is considered “cash in” for calculating cash from investing.

Cash Flow from Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from
financing are “cash in” when capital is raised, and they’re “cash out” when dividends are paid. Thus, if
a company issues a bond to the public, the company receives cash financing; however, when interest
is paid to bondholders, the company is reducing its cash.
A company can use a cash flow statement to predict future cash flow, which helps with matters in
budgeting. For investors, the cash flow reflects a company’s financial health: basically, the more cash
available for business operations, the better. However, this is not a hard and fast rule. Sometimes a
negative cash flow results from a company’s growth strategy in the form of expanding its operations.
By adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what
some people consider the most important aspect of a company: how much cash it generates and
particularly, how much of that cash stems from core operations.
Financial Statement Analysis and Forensic Accounting
A comprehensive financial statement analysis provides insights into a firm’s performance and/or
standing in the areas of liquidity, leverage, operating efficiency and profitability. A complete analysis
involves both time series and cross-sectional perspectives. Time series analysis examines trends
using the firm’s own performance as a benchmark. Cross sectional analysis augments the process by
using external performance benchmarks (Industry or peers) for comparison purposes.
Comparative and Common-size Financial Statements
As seen in the previous NCFM module4, we often use comparative financial statements in order to
compare different financial ratios of a firm with the industry averages and other peers in the industry
whereas we use common-size financial statements in order to compare performance of a firm or two
firms over time. Financial ratios in isolation mean nothing. We need to observe them change over time
or compare financial ratios of a cross section of firms in order to make sense of them.
Preparation of Balance Sheet

The Balance Sheet is prepared either in horizontal form (account form) or in vertical form (report
form). In horizontal form various assets are shown on the right hand side and various liabilities
including owner’s equity (capital) are shown on the left hand side. In vertical form, however, assets
and liabilities including owner’s equity are shown one below the other.
An abridged format of the balance sheet under horizontal form and vertical form:
HORIZONTAL FORM OR ACCOUNT FORM
…….. Company Ltd.
Balance Sheet as at ……………..
Liabilities Rs. Assets Rs.

Share Capital Fixed Assets
A. Authorized: Goodwill

…… Shares of Rs…. each Issued: Land
…… Shares of Rs….. each Buildings
(Distinguishing equity and preference Plant and machinery
shares)
Furniture
Vehicles
B. Subscribed:
(Original cost plus additions and less
…... Shares of Rs….. each depreciation)
Less: Calls in arrear
Add: Forfeited shares
Reserves and Surplus Investments
Capital reserves Government securities
Share premium Shares and debentures
Other reserves Immovable properties
Profit and Loss A/c
Secured Loans Current Assets, Loans and Advances
Debentures A. Current Assets:
From Banks Interest accrued
Mortgages Stores and spares
Unsecured Loans Loose tools
Fixed deposits Stock-in-trade
Short-term loans Work-in-progress
Sundry debtors
Cash and bank balances
Current Liabilities and Provisions B. Loans and Advances:
A. Current Liabilities: Prepayments
Sundry Creditors Bills of exchange
Outstanding expenses Miscellaneous Expenditure
Unclaimed dividends Preliminary expenses
Interest accrued Brokerage
B. Provisions: Underwriting commission
Provision for taxation Discount on issue of shares and
Proposed dividend debentures
Interest payment
Profit and Loss Account
VERTICAL OR REPORT FORM
…….. Company Ltd.
Balance Sheet as at ……………..

Schedule Figures as at the end of the current

No. year (Rs.)
I. Sources of Funds
(1) Shareholder’s funds
(a) Capital
(b) Reserves and Surplus
(2) Loan Funds
(a) Secured Loans
(b) Unsecured Loans
Total
II. Application of Funds
(1) Fixed Assets
(a) Gross Block
(b) Less: Depreciation
(c) Net Block
(d) Work-in-progress
Total
(2) Investments
(3) Current Assets, Loans and Advances
(a) Inventories
(b) Sundry Debtors
(c) Cash and Bank Balances
(d) Other Current Assets
(e) Loans and Advances
Less: Current Liabilities and Provisions
(a) Liabilities
(b) Provisions
Net Current Assets
(a) Miscellaneous Expenditure to the extent not
written off or adjusted
(b) Profit and Loss Account
Total
Preparation of Profit and Loss Account
The Profit and Loss Account is generally prepared in an account form with items of cost, expenses and
losses appearing on the left hand (debit) side while items of revenue and income appearing on the
right hand (credit) side. It consists of several stages:

a) ‘Gross profit’, which is calculated in the first stage by deducting cost of goods or services sold
from the sales value of such goods and services.
b) ‘Net profit on sales’ or ‘Net operating profit’ is the residue left after deducting selling, general
and administrative expenses from “Gross profit”.
c) Total net profit before tax is arrived at after adding and subtracting non-operating and non-
recurring gains and losses from the figure of “Net operating profits”.
d) When income tax is deducted from this profit we arrive at net profit after tax.
The net profit so arrived is carried forward to an account known as Profit and Loss Appropriation
Account. This account may also be presented as a part of main Profit and Loss Account. In this
account appropriations to various funds and reserves are shown from the total net profits. It shows
the uses to which the available net profits have been put or will be put, the balance being termed as
“Retained Earnings”. The Profit and Loss Account can also be prepared in a report/statement form.
ACCOUNT FORM
….. COMPANY LTD.
Profit and Loss Account for the year ended ………
Rs. Rs.
To Stock (opening) ………………….. By Sales …………………..
To Purchases ………………….. By Stock (closing) …………………..
To Wages …………………..
To Coal and coke …………………..
To Carriage inward …………………..
To Gross Profit c/d …………………..
To General and ………………….. By Gross profit b/d …………………..

administration salaries ………………….. …………………..
To Sales salaries ………………….. …………………..
To Advertising ………………….. …………………..
To Travel and entertainment ………………….. …………………..
To Rates and taxes ………………….. …………………..
To Insurance ………………….. …………………..
To Freight and delivery ………………….. …………………..
To Depreciation ………………….. …………………..
To Net operating profit c/d ………………….. …………………..
To Interest paid ………………….. By Operating profit b/d …………………..

To Provision for taxes ………………….. By Interest and dividend …………………..
To Net profit c/d ………………….. earned
By Income from rent …………………..
By Gain on sale of …………………..
investment
….. COMPANY LTD.

Profit and Loss Appropriation Account for the year ended ………

Rs. Rs.
To General reserves …………………..
To Sinking fund …………………..
To Interim dividend ………………….. By Net profit b/d …………………..
To Final dividend-proposed …………………..
To Balance c/d …………………..
The above specimen shows the multiple stages in preparing profit and loss account. However, this is
not required under the law. Hence most companies prepare a single step Profit and Loss Account. A
specimen of single-step profit and loss accounts is given below:
….. COMPANY LTD.

Rs. Rs.
To Cost of goods sold ………………….. By Sales (net of discount, …………………..
To General and administrative ………………….. returns and allowances)
expenses ………………….. By Dividends …………………..
To Depreciation ………………….. By Interest …………………..
To Selling expenses ………………….. By Royalties …………………..
To Interest on bonds ………………….. By Gain on sale of assets …………………..
To Loss on sale of property ………………….. By Miscellaneous receipt …………………..
To Provisions for income-tax …………………..
To Net income after taxes
The single step arrangement, by eliminating the possibility of misleading subtotals of multi-step profit
and loss account allows you to make your own combination of figures for analysis and conclusions. In
most cases, the appropriation account is generally not prepared separately but is shown below the
profit and loss account as its part after arriving at the net profits after taxes. Another form, in which
the Profit and Loss Account or Income Statement is prepared, is the report from. A specimen is given
as under.
REPORT FORM
….. COMPANY LTD.


Rs. Rs. Rs.

Sales: ………………….. ………………….. …………………..
Cash ………………….. ………………….. …………………..
Credit ………………….. ………………….. …………………..
Less: Returns ………………….. ………………….. …………………..

Net Sales ………………….. ………………….. …………………..
Less: Cost of goods sold ………………….. ………………….. …………………..
Gross Profit ………………….. ………………….. …………………..
Less: Operating expenses ………………….. ………………….. …………………..
General and ………………….. ………………….. …………………..
administrative
expenses ………………….. ………………….. …………………..
Selling expenses
Net operating profit
Add: Non-operating incomes/ ………………….. ………………….. …………………..
Less: Non-operating expenses ………………….. ………………….. …………………..
Net profit before interest and ………………….. ………………….. …………………..
tax
Less: Interest on debentures ………………….. ………………….. …………………..
Net profit before tax ………………….. ………………….. …………………..
Less: Provision for taxation ………………….. ………………….. …………………..
Net profit after tax ………………….. ………………….. …………………..
Reserves ………………….. ………………….. …………………..
Sinking fund ………………….. ………………….. …………………..
Proposed dividend ………………….. ………………….. …………………..
Balance of profit carried
forward
Net Sales (1) 100
Direct Costs (2) 20
Earnings before Interest Tax Depreciation and Amortization (EBITDA) (3) = (1) – (2) 80
EBITDA Margin (4) = (3)/ (1) 80%
Depreciation/ Amortization (5) 20

EBIT 60
Interest (6) 20
Other Income (7) 5
Profit before Tax (8) = (3) – (5) – (6) + (7) 45
Tax (9) [@ 30%] = (8) * 30% 13.5
Profit after Tax (PAT) (10) = (8) – (9) 31.5
PAT Margin (11) = (10)/ (1) 31.5%
CHARACTERISTICS OF A WELL PREPARED PROFIT AND LOSS ACCOUNT
An income statement, in whichever form used, must have the following characteristics if it has to
achieve its objectives and be available for meaningful analysis and interpretation:
a. It should be headed by the name of the organization, title of the statement, and the period
covered.
b. It should be prepared according to the accepted principles and practices of accounting
prevailing in the specific line of business. Any deviation from such accepted practices should
be clearly mentioned in the statement.
c. It should disclose the sources of revenue, costs and expenses or principal business
operations.
d. It should indicate clearly the operating income or losses (preferably separately from each
principal activities) and net income or loss for the period.
e. It should show separately and describe gain and loss items which are extraordinary and non-
recurrent, and items which are related to previous periods.
f. It should state specifically the income tax.
g. It should give comparative data for prior periods.
h. It should disclose in parenthetical or foot note form important explanatory information, such as
details of amounts and method of depreciation, inventory pricing methods, effect on net
income of changes made in accounting practices during period, etc.
Preparation of Statement of Cash Flows
A firm’s cash-generating ability affects its solvency, its capacity to pay dividends and interest, and the
price of its securities. Accordingly, a firm’s ability to generate cash is important to financial statement
users. Statement of Cash Flows is designed to provide information about a firm’s inflows and outflows
of cash during a period of time.
ACCRUAL EARNINGS VERSUS CASH FLOW AS A PERFORMANCE MEASURE: One should remember
that accrual earnings (net income from the income statement) do not necessarily reflect cash flows.
Many revenue and expense transactions have no immediate cash flow effect. Nevertheless, net
income is a very useful performance measure. It reflects accomplishments by the firm (such as
credit sales that will subsequently result in cash inflows) as well as resources consumed by the firm
in generating revenue (for example, employee salaries that remain unpaid at the end of a period). If
net income is a useful performance measure, why is cash flow information needed?
Earnings and cash flows are different performance measures of a business organization. They should
be viewed as complements, rather than substitutes. Each measure contains information not
necessarily reflected in the other. In particular, the statement of cash flows provides information
about a firm’s liquidity and financial flexibility (the ability to respond to unexpected events by altering
the amounts and timing of its cash flows).
….. COMPANY LTD.
Statement of Cash Flows (Direct Approach) for the year ended ………
Rs. Rs.
Cash flows from operating activities:
Cash received from customers 68,200
Interest received 1,300
Payments to employees (17,100)
Payments to suppliers (40,500)
Interest paid (800)
Taxes paid (2,000)
Net cash provided from operating activities 9,100
Cash flows from investing activities:
Purchase of equipment (3,500)
Purchase of stock (12,000)
Net cash used in investing activities (15,500)
Cash flows from financing activities:
Proceeds from issuing long-term debt 25,000
Proceeds from issuing common stock 5,000
Payment of short-term debt (12,000)
Net cash provided by financing activities 18,000
Net increase in cash 11,600
Cash at beginning of year 22,000
Cash at end of year 33,600
CASH AND CASH EQUIVALENTS: Firms can elect to focus their statement of cash flows on either (1)
cash or (2) cash and cash equivalents. The term cash includes cash on hand and cash in bank
accounts that can be withdrawn on demand. Cash equivalents are short-term, highly liquid financial
instruments with maturities of less than three months; they are quickly convertible into cash.
Examples include money market funds, treasury bills, and certificates of deposit (CDs). Because cash
equivalents are so similar to cash, many firms prefer to combine them with cash, rather than with
other investments.
Firms must consistently apply a policy of using either cash or cash and cash equivalents. Additionally,
the beginning and ending balances that appear on the statement of cash flows must correspond to
similarly titled items on the balance sheet.
DIRECT VERSUS INDIRECT APPROACH: Statement of cash flows in Table 1 is prepared based on the
direct approach. Under the direct approach, a separate line item is provided for each type of operating
cash inflow and outflow. These items usually correspond to categories on the income statement. For
example, cash received from customers corresponds to sales revenue on the income statement. Keep
in mind, however, that the income statement and the statement of cash flows provide different
information. For example, the income statement discloses sales made to customers during the year,
regardless of whether cash has been collected during the year. The statement of cash flows indicates
the amount of cash collected during the year from customers for the current year’s sales, past years’
sales, and even future sales if the firm has collected cash prior to the point of sale.
An acceptable alternative in preparing the operating activities section is the indirect approach. This
method begins with net income and makes adjustments to it in order to arrive at cash generated by
operating activities. The indirect approach is illustrated in Table 2.
Although both the direct and indirect approaches produce the same figure for cash provided from
operating activities, the internal compositions of the statements differ substantially. A major
advantage of the direct method is that the primary sources and uses of cash are listed. A major
advantage of the indirect method is that the reasons for the difference between net income and cash
generated by operations are detailed. This can help reduce uncertainties or answer questions raised
by financial statement readers.
As Table 2 shows, under the indirect approach, depreciation expense is added to net income. Because
of this, some financial statement readers erroneously believe that depreciation expense is a source of
cash. It is not. Depreciation expense is added to net income in arriving at cash provided from
operating activities because (1) it has already been subtracted in the computation of net income and
(2) it does not involve any cash outflow. Adding depreciation expense to net income therefore
eliminates the effect of this non-cash expense.

….. COMPANY LTD.
Statement of Cash Flows (Indirect Approach) for the year ended ………
Rs. Rs.
Cash flows from operating activities:
Net income 5,300
Adjustments to net income:
Depreciation expense 2,000
Increase in accounts receivable (500)
Decrease in interest receivable 200
Increase in inventory (1000)
Increase in accounts payable 3,000
Decrease in salaries payable (100)
Increase in interest payable 200
Net cash provided from operating activities 9,100
Cash flows from investing activities:
Purchase of equipment (3,500)
Purchase of stock (12,000)
Net cash used in investing activities (15,500)
Cash flows from financing activities:
Proceeds from issuing long-term debt 25,000
Proceeds from issuing common stock 5,000
Payment of short-term debt (12,000)
Net cash provided by financing activities 18,000
Net increase in cash 11,600
Cash at beginning of year 22,000
Cash at end of year 33,600
CLASSIFICATION OF ACTIVITIES: As illustrated about … Company Ltd., a firm’s cash flows are placed in
one of three categories: operating, investing, or financing. This section describes each of these
categories. Examples of each activity are given below in Table 3.
Operating activities typically involve transactions related to providing goods and services to customers.
They reflect the cash flow effects of the typical and recurring transactions that appear on the income
statement. Examples of operating cash inflows are receipts from customers and the receipt of interest
and dividends from investments. Operating cash outflows include payments to employees and
suppliers and payments for interest and taxes.
Investing activities usually involve cash flows from the acquisition and disposal of Non-current assets.
Cash outflows arise from purchasing (investing in) property, plant, and equipment, making loans, and
acquiring investments in other corporations. Cash inflows result from disposing of property, plant, and
equipment; collecting loans (other than the interest); and selling investments.
Financing activities include cash flows from obtaining and repaying financing. Cash inflows result from
contributions by owners (issuing stock to shareholders in exchange for cash) and from loans. Cash
outflows arise from payments to shareholders (as dividends or payments to repurchase their shares)
and the repayment of loans (but not the associated interest).
Table 1 shows that the net cash provided (or used) in each of the three classifications is summarized
in the far right column of the statement. The sum of these amounts equals the change in the cash
balance that occurred during the period. This change is added to the cash balance at the beginning of
the year to compute the ending cash balance. These beginning and ending cash amounts must, of
course, correspond to the cash figures appearing on the balance sheet.
TABLE 3: Summary of Activities Generating Cash Flows
Operating Activities
Cash Inflows Cash Outflows
From customers To employees
From interest To suppliers
From dividends For interest
All other cash inflows not defined as an For taxes
investing or financing activity All other cash outflows not defined as an
investing or financing activity
Investing Activities
Sale of property, plant & equipment Purchase of property, plant & equipment
Collections of loans Making of loans
Sale of investments Acquisition of investments
Financing Activities
Issuing common stock Reacquiring common stock
Obtaining loans Repaying loans
Paying dividends
Non-cash Investing and Financing Activities: A firm may engage in investing and financing activities
that do not involve cash. For example, a firm might acquire property by issuing common stock.
Although no cash is involved, this transaction is both an investing activity (the acquisition of a non-
current asset) and a financing activity (the issuance of stock). Because these transactions do not
involve cash, they do not appear in the major sections of the statement of cash flows. However, non-
cash investing and financing activities are summarized in a schedule that appears at the end of the
statement. This provides readers of the cash flow statement with a complete picture of a firm’s
investing and financing activities.

USING CASH FLOW INFORMATION
Operating Activities: Many financial statement users find the operating activities section to be quite
informative. Creditors, for example, recognize that loans can only be repaid with cash and that a firm’s
operations are a likely source of cash for debt repayment.
Because the ability to generate cash determines dividends and share price, shareholders and their
advisors are interested in cash provided by operating activities. Moreover, some analysts believe that
because reported net income can be manipulated by accounting ploys, cash flow from operating
activities is a more reliable performance measure than net income.
Keep in mind, however, that not all healthy firms have a large positive cash flow from operations.
Firms that experience growth in sales invariably need to expand their accounts receivable and
inventory. These asset acquisitions must be financed, and cash generated by operations is a
frequently used source.
Investing and Financing Activities: The investing activities section of the statement of cash flows
summarizes the cash inflows from disposing of investments, and the cash outflows from purchasing
investments.

Ratio Analysis
6
Ratio Analysis
An absolute figure often does not convey much meaning. Generally, it is only in the light of other
information that significance of a figure is realized. ‘A’ weighs 70 kg. Is he fat? One cannot answer this
question unless one knows A’s age and height. Similarly, a company’s profitability cannot be known
unless together with the amount of profit and the amount of capital employed. The relationship
between the two figures expressed arithmetically is called a ratio. The ratio between 4 and 10 is 0.4 or
40% or 2:5. “0.4”, “40%” and “2:5” are ratios. Accounting ratios are relationships, expressed in
arithmetical terms, between figures which have a cause and effect relationship or which are
connected with each other in some other manner.
Accounting ratios are a very useful tool for grasping the true message of the financial statements and
understanding them. Ratios naturally should be worked out between figures that are significantly
related to one another. Obviously no purpose will be served by working out ratios between two entirely
unrelated figures, such as discount on debentures and sales. Ratios may be worked out on the basis
of figures contained in the financial statements.
Ratios provide clues and symptoms of underlying conditions. They act as indicators of financial
soundness, strength, position and status of an enterprise.
Interpretation of ratios forms the core part of ratio analysis. The computation of ratio is simply a
clerical work but the interpretation is a taste requiring art and skill. The usefulness of ratios is
dependent on the judicious interpretations.
USES OF RATIOS: A comparative study of the relationship, between various items of financial
statements, expressed as ratios, reveals the profitability, liquidity, solvency as well as the overall
financial position of the enterprises.
Ratio analysis helps to analyze and understand the financial health and trend of a business, its past
performance makes it possible to have forecast about future state of affairs of the business. Inter-firm
comparison and intra-firm comparison becomes easier through the analysis. Past performance and
future projections could be reviewed through ratio analysis easily. Management uses the ratio analysis
in exercising control in various areas viz. budgetary control, inventory control, financial control etc. and
fixing the accountability and responsibility of different departmental heads for accelerated and
planned performance. It is useful for all the constituents of the company as discussed under:
Management: Management is interested in ratios because they help in the formulation of policies,
decision-making and evaluating the performances and trends of the business and its various
segments.

Shareholders: With the application of ratio analysis to financial statements, shareholders can
understand not only the working and operational efficiency of their company, but also the likely effect
of such efficiency on the working and operational efficiency of their company, but also the likely effect
of such efficiency on the net worth and consequently the price of their shares in the Stock Exchange.
With the help of such analysis, they can form opinion regarding the effectiveness or otherwise of the
management functions.
Investors: Investors are interested in the operational efficiency, earning capacities and ‘financial
health’ of the business. Ratios regarding profitability, debt-equity, fixed assets to net worth, assets
turnover, etc., are some measures useful for the investors in making decisions regarding the type of
security and industry in which they should invest.
Creditors: Creditors can reasonably assure themselves about the solvency and liquidity position of the
business by using ratio-analysis. Such analysis helps to throw light on the repayment policy and
capability of an enterprise.
Government: The Government is interested in the ‘financial health’ of the business. Carefully worked
ratios will reflect the policy of the management and its consistency or otherwise with the overall
regional and national economic policies. Such ratios help in better understanding of cost-structures
and may justify price controls by the Government to save the consumers.
Analysts: Ratio analysis is the most important technique available to the financial analysts to study the
financial statements to compare the progress and position of various firms with each other and vis-à-
vis the industry.
CLASSIFICATION OF RATIOS: Different ratios calculated from different financial figures carry different
significance for different purposes. For example, liquidity and solvency ratios for the creditors are
more significant than the profitability ratios, which are of prime importance for an investor. This means
that ratios can be grouped on different basis depending upon their significance. The classification is
rather crude and unsuitable to determine the profitability or financial position of the business. In
general, accounting ratios may be classified on the following basis leading to overlap in many cases.
According to the statement upon which they are based: Ratios can be classified into three groups
according to the statements from which they are calculated:
a) Balance Sheet Ratios: They deal with relationship between two items appearing in the balance
sheet, e.g., current assets to current liability or current ratio. These ratios are also known as
financial position ratios since they reflect the financial position of the business.
b) Operating Ratios or Profit and Loss Ratios: These ratios express the relationship between two
individual and group of items appearing in the income or profit and loss statement. Since they
reflect the operating conditions of a business, they are also known as operating ratios, e.g., gross
profit to sales, cost of goods sold to sales, etc.
c) Combined Ratios: These ratios express the relationship between two items, each appearing in
different statements, i.e., one appearing in balance sheet while the other in income statement,
e.g., return on investment (net profit to capital employed); Assets turnover (sales) ratio, etc.
Since both the statements are involved in the calculation of each of these ratios, they are also
known as inter-statement ratios.

Since the balance sheet figures refer to one point of time, while the income statement figures refer to
events over a period of time, care must be taken while calculating combined or inter-statement ratios.
For example while computing assets turnover ratio, average assets should be taken on the basis of
opening and ending balance sheets.
a) Functional classification: The classification of ratios according to the purpose of its computation
is known as functional classification. On this basis ratios are categorized as follows:
b) Profitability Ratios: A Profitability ratio gives some yardstick to measure the profit in relative
terms with reference to sales, assets or capital employed. These ratios highlight the end result of
business activities. The main objective is to judge the efficiency of the business.
c) Turnover Ratios or Activity Ratios: These ratios are used to measure the effectiveness of the use
of capital/assets in the business. These ratios are usually calculated on the basis of sales or
costs of goods sold and are expressed in integers rather than as percentages.
d) Financial Ratios or Solvency Ratios: These ratios are calculated to judge the financial position of
the organization from short-term as well as long-term solvency point of view. Thus, it can be sub-
divided into: (a) Short-term Solvency Ratios (Liquidity Ratios) and (b) Long-term Solvency Ratios
(Capital Structure Ratios).
e) Market Test Ratios: These are of course, some profitability ratios, having a bearing on the market
value of the shares.
Classification according to “importance”: This classification has been recommended by the British
Institute of Management for inter-firm comparisons. It is based on the fact that some ratios are more
relevant and important than others in the process of comparisons and decision-making. Therefore,
ratios may be treated as primary or secondary.
a) Primary Ratio: Since profit is primary consideration in all business activities, the ratio of profit to
capital employed is termed as ‘Primary Ratio’. In business world this ratio is known as “Return on
Investment”. It is the ratio which reflects the validity or otherwise of the existence and
continuation of the business unit. In case if this ratio is not satisfactory over long period, the
business unit cannot justify its existence and hence, should be closed down. Because of its
importance for the very existence of the business unit it is called ‘Primary Ratio’.
b) Secondary Ratios: these are ratios which help to analyze the factors affecting “Primary Ratio”.
These may be sub-classified as under:
(i) Supporting Ratios: These are ratios which reflect the profit-earning capacities of the business
and thus support the “Primary Ratio”. For example sales to operating profit ratio reflects the
capacity of contribution of sales to the profits of the business. Similarly, sales to assets
employed reflect the effectiveness in the use of assets for making sales, and consequently
profits.
(ii) Explanatory Ratios: These are ratios which analyze and explain the factors responsible for the
size of profit earned. Gross profit to sales, cost of goods sold to sales, stock-turnover, debtors
turnover are some of the ratios which can explain the size of the profits earned. Where these
ratios are calculated to highlight the effect of specific activity, they are termed as ‘Specific
Explanatory Ratios’. For example, the effect of credit and collection policy is reflected by
debtors’ turnover ratio.

The classification of the structure of ratio analysis cuts across the various bases on which it has been
made. The determinations of activity and profitability ratios are drawn partly from the balance sheet
and partly from the profit and loss account. Ratios satisfying the test of liquidity or solvency take the
items of the balance sheet and income statement, some activity ratios coincide with those satisfying
the test of liquidity, some leverage ratios belong to the category of income statement. This clearly
indicates that one basis of classification crosses into other category. However, for the purpose of
consideration of individual ratios, a classification of ratio on functional basis is discussed further.
PROFITABILITY RATIOS
A measure of ‘profitability’ is the overall measure of efficiency. In general terms efficiency of business
is measured by the input-output analysis. By measuring the out-put as a proportion of the input and
comparing result of similar other firms or periods the relative change in its profitability can be
established.
The income (output) as compared to the capital employed (input) indicates profitability of a firm. Thus
the chief profitability ratio is:
{Operating Profit (net margin)/Operating Capital Employed} x 100
Once this is known, the analyst compares the same with the profitability ratio of other firms or periods.
Then, when he finds some contrast, he would like to have details of the reasons. These questions are
sought to be answered by working out relevant ratios. The main profitability ratio and all the other sub-
ratios are collectively known as ‘profitability ratios’.
Profitability ratio can be determined on the basis of either investments or sales. Profitability in relation
to investments is measured by return on capital employed, return on shareholder’s funds and return
on assets. The profitability on relation to sales is profit margin (gross and net) and expenses ratio or
operating ratio.
Return on Investment: This ratio is also known as overall profitability ratio or return on capital
employed. The income (output) as compared to the capital employed (input) indicates the return on
investment. It shows how much the company is earning on its investment. This ratio is calculated as
follows:
Return on Investment = (Net Operating Profit x 100)/Capital Employed
Operating profit means profit before interest and tax. In arriving at the profit, interest on loans is treated
as part of profit (but not the interest on bank overdraft or other short-term finance) because loans
themselves are part of the input, i.e., the capital employed and hence, the interest on loans should also
be part of the output and should not be excluded there from. All non-business income or rather income
not related to normal operations of the company should be excluded. Thus profit figure shall be IBIT,
i.e., Income before Interest and Taxation (excluding non-business income).
The income figure is reckoned before taxation because the amount of tax has no relevance to the
operational efficiency. Both interest and taxation are appropriations of profit and do not reflect
operational efficiency. Moreover, to compare the profitability of two different organizations having
different sources of finance and different tax burden, the profit before interest and taxation is the best
measure.

Capital employed comprises share capital and reserves and surplus, long-term loans minus non-
operating assets and fictitious assets. It can also be represented as net fixed assets plus working
capital (i.e., current assets minus current liabilities). Thus capital employed may comprise:
Share Capital + Reserve and Surplus + Long-term Loans – Non-operating Assets – Fictitious Assets
In using overall profitability ratio as the chief measure of profitability, the following two notes of
caution should be kept in mind:
a) First, the figure of operating profit shows the profit earned throughout a period. The figure
capital employed on the other hand refers to the values of assets as on a balance sheet date.
As the values of assets go on changing throughout a business period it may be advisable to
take the average assets throughout a period, so that the profit are compared against average
capital employed during a period.
b) Secondly, in making comparison between two different units on the basis of the overall
profitability ratio, the time of incorporation of the two units should be taken care off. If a
company incorporated in 1980 is compared with that incorporated in 1995, the first
company’s assets will be appearing at a much lower figure than those of second company.
Thus the former will show a lower capital base and if profits of both the companies are the
same, the former will show a higher rate of return. This does not indicate higher efficiency; only
the capital employed is lower because of the reason that it started 15 years earlier. Hence, in
such cases the present value of the fixed assets should be considered for calculating the
capital employed.
In the end, it may be stated that the limitations of the ratio should be kept in mind while forming an
opinion. The ‘profits’ and “capital employed” figures are the result of a number of approximations
(example, depreciation) and human judgment (valuation of assets). The purpose of calculation of the
ratio should be kept in view and appropriate figures should be selected having regard to impact of
changing price levels. “Return on capital employed” is an instrument to be used cautiously with clear
understanding of its limitations.
Ex: Suppose a company has the following items on the liabilities side and it shows underwriting
commission of Rs.100,000 on the assets side:
Rs.
13% Preference capital 10,00,000
Equity capital 30,00,000
Reserves 26,00,000
Loans @ 15% 30,00,000
Current Liabilities 15,00,000
Its profit, after paying tax @ 50% is Rs.14,00,000. Profit before interest and tax will be Rs.32,50,000 as
shown below:
Rs.
Profit after tax 14,00,000
Tax 14,00,000
Interest @ 15% on Rs.30,00,000 04,50,000
32,50,000
The operating capital employed is Rs.95,00,000 i.e. total of all the items (excluding current liabilities)
less Rs.100,000, a fictitious asset. The ROI comes to {32,50,000/95,00,000} x 100 or 34.21%

The overall profitability ratio has two components. These are the net profit ratio (operating profit/sales
x 100) multiplied by turnover ratio (sales/ capital employed). Therefore, ROI, in terms of percentage:
(Operating Profit/Capital Employed) x 100 = 100 x (Operating Profit/Sales) x (Sales/Capital Employed)
NOTE: If a management wants to maximize its profitability, it could do so by improving its net profit
ratio and turnover ratio. The former refers to the margin made in each sale in terms of percentage
whereas, the latter shows the utilization, i.e., rotation of the capital in making the sale. If the selling
price of an article is Rs.10 whose cost is Rs.6, there is a margin of Rs.4 or 40%. This shows the gap
between selling price and cost price in the percentage form. The overall profitability is also dependent
upon the effectiveness of employment of capital. If in this case, sales Rs.200 were made with a
capital of Rs.100 then the rotation, i.e., the turnover is 200/100 or 2 times. Thus the business has
earned a total profit of Rs.80 with a capital of Rs.100, profitability ratio being 80%, i.e., Net profit ratio
x Turnover ratio = 40% x 2 = 80%.
Illustration: Determine which company is more profitable:

A Ltd. B Ltd.
Net Profit Ratio 3% 4%
Sales/Capital Employed 5 times 3 times
Solution: Judging from the net margin ratio B Ltd. appears to be more profitable. But the criteria for
determining profitability are return on capital employed which in this case works out to 15% and 12%
respectively for A Ltd. and B Ltd. Hence A Ltd. is undoubtedly more profitable.
Return on investment is a good measure of profitability in as much as it is an extension of the input-

output analysis. Moreover, it aids in comparing the performance efficiency of dissimilar enterprises.
Return on Shareholder’s Funds: It is also referred to as return on net worth. In this case it is desired to
work out the profitability of the company from the shareholder’s point of view and it is computed as
follows:
{Net Profit after Interest and Tax/Shareholders Funds} x 100
Modifications of the ‘return on capital employed’ can be made to adopt it to various circumstances.
Thus if it is required to work out the profitability from the shareholder’s point of view, then the profit
figure should be after interest and taxation and the capital employed should be after deducting the
long-term loans. The ratio would reflect the profitability for the shareholders. To extend the idea
further, the profitability from equity shareholder’s point of view can also be worked out by taking the
profits after preference dividend and comparing against capital employed after deducting both long-
term loans and preference capital.
Return on Assets: Here the profitability is measured in terms of the relationship between net profits
and assets. It shows whether the assets are being properly utilized or not. It is calculated as:
{Net Profit after Tax/Total Assets} x 100
This ratio is a measure of the profitability of the total funds or investment of the organization.
Gross Profit Ratio or Gross Margin: Gross profit ratio expresses the relationship of gross profit to net
sales or turnover. Gross profit is the excess of the proceeds of goods sold and services rendered

during a period over their cost, before taking into account administration, selling and distribution and
financing changes. Gross profit ratio is expressed as follows:
{Gross Profit/Net Sales} x 100
This ratio is important to determine general profitability since it is expected that the ratio would be
quite high so as to cover not only the remaining costs but also to allow proper returns to owners.
Any fluctuation in the gross profit ratio is the result of a change either in ‘sales’ or the ‘cost of goods
sold’ or both. The rise or fall in the selling price may be an external factor over which the management
may have little control, especially when prices are controlled. The management, however, must try to
keep the other end of the margin (i.e., cost) at least steady, if not reduce it. If the gross profit ratio is
lower than what it was previously, when the selling price has remained steady, it can be reasonable
concluded that there is an increase in the manufacturing cost. Since manufacturing overheads include
a fixed element as well, a fall in the volume of sales will also lower the rate of gross profit and vice-
versa.
Net Profit Ratio or Net Margin: One of the components of return on capital employed is the net profit
ratio (or the margin on sales) calculated as:
{Operating Profit/Sales} x 100
It indicates the net margin earned in a sale of Rs.100. Net profit is arrived at from gross profit after
deducting administration, selling and distribution expenses; non-operating income, such as dividends
received and non-operating expenses are ignored, since they do not affect efficiency of operations.
If the expenses met out of the gross profit are disproportionately heavy, the net profit ratio will go
down. If gross profit ratio is 40%, but the net profit ratio is 15% it means the expenses ratio is 25%.
Thus a complement of the net profit ratio is {(Administration expenses + Selling expenses)/Sales} x
100. Proceedings upwards from net profit, we can arrive at gross profit if administrative and selling
expenses are added back. Similarly, if we add administrative and selling expenses ratio to the net
profit ratio we can get the gross profit ratio.
Operating Profit Ratio or Operating Margin: The ratio of all operating expenses (i.e., materials used,
work-force, factory overheads, office maintenance and selling expenses) to sales is the operating
ratio.
A comparison of the operating ratio would indicate whether the cost content is high or low in the figure
of sales. If the annual comparison shows that the sales have increased, the management would be
naturally interested and concerned to know as to which element of the cost has gone up.
It is not necessary that the management should be concerned only when the operating ratio goes up.
If the operating ratio has fallen, though the unit selling price has remained the same, still the position
needs analysis as it may be the sum total of efficiency in certain departments and inefficiency in
others. A dynamic management should be interested in making a fuller analysis.
It is, therefore, necessary to break up the operating ratio into various cost ratios. The major
components of cost are: material, labour and overheads. Therefore, it is worthwhile to classify the cost
ratio as:
Material cost ratio = (Material consumed/Sales) x 100

Labour cost ratio = (Labour cost/Sales) x 100
Factory overheads cost ratio = (Overheads cost/Sales) x 100
Administrative expenses ratio = (Administrative expenses/Sales) x 100
Selling & distribution expenses ratio = (Selling & distribution expenses/Sales) x 100
Generally all these ratios are expressed in terms of percentage. They total up to the Operating Ratio.
This, deducted from 100 will be equal to the Net Profit Ratio.
If possible, the total expenditure for effecting sales should be divided into two categories, viz., fixed &
variable – and then ratios should be worked out. The ratio of variable expenses to sales will be
generally constant; fixed expenses should fall if sales increase; it will increase if sales fall.
ACTIVITY RATIOS OR TURNOVER RATIOS

The ratios used to measure the effectiveness of the employment of resources are termed as activity
ratios. Since these ratios relate to the use of assets for generation of income through turnover they
are also known as turnover ratios, as we have seen already, the overall profitability of the business
depends on two factors i.e., (i) the rate of return on sales and (ii) the rate of return on capital
employed i.e., the speed at which the capital employed in the business relates. More efficient the
operations of an undertaking – the quicker and more number of times the rotation is. Thus the overall
profitability ratio is calculated as – Net Profit Ratio x Turnover Ratio. The net profit ratio has already
been discussed. Now the important turnover ratios as regards capital employed and assets are
discussed further.
Capital Turnover (Sales to Capital Employed) Ratio: This ratio shows the efficiency of capital employed
in the business and is calculated as follows:
Capital Turnover Ratio = (Net Sales/Capital Employed)
The higher the ratio the greater are the profits.
Total Assets Turnover Ratio: This ratio is ascertained by dividing the net sales by the value of total
assets. Thus,
Total Assets Turnover Ratio = (Net Sales/Total Assets)
A high ratio is an indicator of overtrading of total assets while a low ratio reveals idle capacity. The
total Assets Turnover Ratio can be segregated into:
a) Fixed Assets Turnover Ratio: This ratio indicates the number of times fixed assets are being
turned over in a stated period. It is calculated as:
Fixed Assets Turnover Ratio = (Net Sales/Fixed Assets)
This ratio is an indicator of the extent to which investment in fixed assets contributes to
generate sales. The fixed assets are to be taken net of depreciation. The higher is the ratio
the better is the performance.
b) Working Capital Turnover Ratio: This ratio shows the number of times working capital is
turned-over in a stated period. This ratio is calculated as:
Working Capital Turnover Ratio = (Net Sales/Working Capital)
It indicates to what extent the working capital funds have been employed in the business towards
sales.

Stock Turnover Ratio (Inventory Turnover Ratio): This ratio is an indicator of the efficiency of the use of
investment in stock. It is calculated as:
Stock Turnover Ratio = (Cost of Goods Sold/Average Inventory)

or
Stock Turnover Ratio = (Sales/Average Inventory)
Too large an inventory will depress the ratio; control over inventories and active sales promotion will
increase the ratio. If desired this ratio may be split into two ratios, for raw materials and for finished
goods:
a) (Material consumed/Average raw material stocks); and

b) (Sale or Cost of goods sold/Average stocks of finished goods)
This analysis will throw a better light on the inventory position. Average inventory is calculated on the
basis of the average inventory at the beginning and at the end of the accounting period.
Debtors Turnover Ratio (Debtor’s Velocity): These days some amount of sales are always locked up in
the form of book debts. Efficient credit control and prompt collection of amounts due will mean lower
investments in book debts. This ratio measures the net credit sales of a firm to the recorded trade
debtors thereby indicating the rate at which cash is generated by turnover of receivable or debtors.
This ratio is calculated as:
Debtors Turnover Ratio = (Net sales/Average debtors)
Average debtors refer to the average of opening and closing balance of debtors for the period. Debtors
include bills receivables but exclude debts which arise on account of transactions other than sale of
goods. While calculating debtors’ turnover, it is important to note that provision for bad and doubtful
debts are not deducted from total debtors in order to avoid the impression that a larger amount of
receivables have been collected.
Debt Collection Period: This ratio indicates the extent to which the debts have been collected in time.
This ratio is in fact, interrelated with and dependent upon the debtors’ turnover ratio. It is calculated
by dividing the days in a year by the debtors’ turnover. This ratio can be computed as follows:
{(Months/Days in a Year)/Debtors Turnover} Or
{[(Average Debtors x Months)/Days in a Year]/Net Credit Sales for the Year} Or
{Average Debtors/ (Average Monthly/Daily Credit Sales)}
Debtor’s collection period shows the quality of debtors since it measures the speed with which money
is collected from them. It is rather difficult to specify a standard collection period for debtors. It
depends upon the nature of the industry, seasonal character of the business and credit policy of the
firm etc.
Illustration: From the following information, calculate, debtors turnover ratio and average collection
period.
Rs.
Total debtors (on 1.4.2002) 200,000
Cash sales 150,000
Credit sales 1000,000
Cash collected 780,000
Sales returns 60,000
Bad debts 40,000
Discount allowed 20,000
Provision for bad debts 25,000
No. of days in a year – 360
Calculation of Closing Balance of Total Debtors
Total Debtors Account

Dr. Cr.
Rs. Rs.
To Balance b/d 200,000 By Cash 780,000
To Credit sales 100,000 By Sales returns 60,000
By Bad debts 40,000
By Discount allowed 20,000
By Balance c/d 300,000
1200,000 1200,000
Debtors Turnover Ratio = Credit Sales/Average Debtors

Average Debtors = (Opening Debtors + Closing Debtors)/2
= (Rs.200,000 + Rs.300,000)/2
= Rs.250,000
Debtors Turnover Ratio = Rs.1000,000/Rs.250,000
= 4 times
Average Collection Period = Days in the Year/Debtors Turnover Ratio
= 360/4
= 90 days.
Creditors Turnover Ratio (Creditor’s Velocity): Like debtor’s turnover ratio, this ratio indicates the
speed at which the payments for credit purchases are made to creditors. This ratio is computed as
follows:
Creditors Turnover Ratio = (Credit Purchases/Average Creditors)
The term ‘creditors’ include, trade creditors and bills payable. In case the details regarding credit
purchases, opening and closing balances of creditors are not available, then instead of credit
purchases, total purchases may be taken and in place of average creditors, the balance available may
be substituted.
Debt Payment Period: This ratio gives the average credit period enjoyed from the creditors. It can be
computed as under:

{(Months/Days in a year)/Creditors Turnover} Or
{[(Average Creditors x Months)/Days in a Year]/Credit Purchases in the Year} Or
{Average Creditors/ (Average Monthly/Daily Credit Purchases)}
Both above ratios determine the average age of payables, on the basis of which it can be
compensated as to how prompt or otherwise the company is making payments for credit purchases
affected by it. A high creditor’s turnover ratio or low debt payment period shows that creditors are
being paid promptly, hence enhancing the credit worthiness of the company. However, a very
favorable ratio to this effect also shows that the business is not taking full advantage of credit
facilities allowed by the creditors.
Financial Ratios
Financial statements of a firm are analyzed for ascertaining its profitability as well as financial
position. A firm is said to be financially sound provided if it is capable of meeting its commitments
both short-term and long-term. Accordingly, the ratios to be computed for judging the financial position
are also known as solvency ratios and those are computed for short-term solvency is known as
liquidity ratios.
In a short period, a firm should be able to meet all its short-term obligations i.e., current liabilities and
provisions. It is current assets that yield funds in the short period – current assets are those assets
which the firm can convert it into cash within one year or short run. Current assets should not only
yield sufficient funds to meet current liabilities as they fall due but also to enable the firm to carry on
its day to day activities. The ratios to test the short-term solvency or liquidity position of an enterprise
are discussed further.
Liquidity Measurement Ratios
The first ratios we’ll take a look at are the liquidity ratios. Liquidity ratios attempt to measure a
company’s ability to pay off its short-term debt obligations. This is done by comparing a company’s
most liquid assets (or, those that can be easily converted to cash) and its short term liabilities.
In general, the greater the coverage of liquid assets to short-term liabilities, the better it is, since it is a
clear signal that a company can pay debts that are going to become due in the near future and it can
still fund its on-going operations. On the other hand, a company with a low coverage rate should raise
a red flag for the investors as it may be a sign that the company will have difficulty meeting running its
operations, as well as meeting its debt obligations.
The biggest difference between each ratio is the type of assets used in the calculation. While each
ratio includes current assets, the more conservative ratios will exclude some current assets as they
aren’t as easily converted to cash. The ratios that we’ll look at are the current, quick and cash ratios
and we will also go over the cash conversion cycle, which goes into how the company turns its
inventory into cash.
Current Ratio: Current Ratio also known as the working capital ratio is the most widely used ratio. It is
the ratio of total current assets to current liabilities and is calculated by dividing the current assets by
current liabilities.
Current Ratio = (Current Assets/Current Liabilities)

Current assets are those assets which can be converted into cash in the short-run or within one year.
Likewise, current liabilities are those which are to be paid off in the short run. Current assets normally
include cash in hand or at bank, inventories, sundry debtors, loans and advances, marketable
securities, pre-paid expenses, etc. while current liabilities consist of sundry creditors, bills payable,
outstanding and accrued expenses, provisions for taxation, proposed and un-claimed dividend, bank
overdraft etc.
Current ratio indicates the firms commitment to meet its short-term obligations. It is a measure of
testing short-term solvency or in other words, it is an index of the short-term financial stability of an
enterprise because it shows the margin available after paying off current liabilities.
Generally 2:1 ratio is considered ideal for a concern. If the current assets are two times of the current
liabilities, there will be no adverse effect on the business operations when the payment of liabilities is
made. In fact a ratio much higher than 2:1 may be unsatisfactory from the angle of profitability,
though satisfactory from the point of view of short-term solvency. A high current ratio may be taken as
adverse on account of the following reasons:
 The stock might be piling up because of poor sales.

 The amount might be locked up in debtors due to slack collection policy.
 The cash or bank balances might be lying idle because of no proper investment.
Liquid Ratio: This ratio is also known as Quick Ratio or Acid Test Ratio. This ratio is calculated by
relating liquid or quick assets to current liabilities. Liquid assets mean those assets which are
immediately converted into cash without much loss. All current assets except inventories and prepaid
expenses are categorized as liquid assets. The ratio can be computed as:
Liquid Ratio = (Liquid Assets/Current Liabilities)
Liquidity ratio may also be computed by substituting liquid liabilities in place of current liabilities.
Liquid liabilities means those liabilities which are payable with a short period. Bank overdraft and cash
credit facilities, if they become a permanent mode of financing are to be excluded from current
liabilities to arrive at liquid liabilities. Thus:
Liquid Ratio = (Liquid Assets/Liquid Liabilities)
This ratio is an indicator of the liquid position of an enterprise. Generally, a liquid ratio of 1:1 is
considered as ideal as the firm can easily meet all current liabilities. The main difference in current
ratio and liquid ratio is on account of inventories and therefore a comparison of two ratios leads to
important conclusions regarding inventory holding up.
Debt Ratios
These ratios give users a general idea of the company’s overall debt load as well as its mix of equity
and debt. Debt ratios can be used to determine the overall level of financial risk a company and its
shareholders face. In general, the greater the amount of debt held by a company the greater the
financial risk of bankruptcy. The ratios covered in this section include the debt ratio, which is gives a
general idea of a company’s financial leverage as does the debt-to-equity ratio. The capitalization ratio
details the mix of debt and equity while the interest coverage ratio and the cash flow to debt ratio
show how well a company can meet its obligations.

Overview Of Debt
Before discussing the various financial debt ratios, we need to clear up the terminology used with
“debt” as this concept relates to financial statement presentations. In addition, the debt related topics
of “funded debt” and credit ratings are discussed below.
There are two types of liabilities - operational and debt. The former includes balance sheet accounts,
such as accounts payable, accrued expenses, taxes payable, pension obligations, etc. The latter
includes notes payable and other short-term borrowings, the current portion of long-term borrowings,
and long-term borrowings. Often times, in investment literature, “debt” is used synonymously with
total liabilities. In other instances, it only refers to a company’s indebtedness.
The debt ratios that are explained herein are those that are most commonly used. However, what
companies, financial analysts and investment research services use as components to calculate these
ratios is far from standardized.
In general, debt analysis can be broken down into three categories, or interpretations: liberal,
moderate and conservative.
• Liberal - This approach tends to minimize the amount of debt. It includes only long-term debt as it is
recorded in the balance sheet under noncurrent liabilities.
• Moderate - This approach includes current borrowings (notes payable) and the current portion of
long-term debt, which appear in the balance sheet’s current liabilities; and of course, the long-term
debt. In addition, redeemable preferred stock, because of its debt-like quality is considered to be debt.
Lastly, as a general rule, two-thirds (roughly one-third goes to interest expense) of the outstanding
balance of operating leases, which do not appear in the balance sheet, are considered debt principal.
The relevant figure will be found in the notes to financial statements and identified as “future
minimum lease payments required under operating leases that have initial or remaining non-
cancelable lease terms in excess of one year.”
• Conservative - This approach includes all the items used in the moderate interpretation of debt, as
well as such non-current operational liabilities such as deferred taxes, pension liabilities and other
post-retirement employee benefits.
Investors may want to look to the middle ground when deciding what to include in a company’s debt
position. With the exception of unfunded pension liabilities, a company’s non-current operational
liabilities represent obligations that will be around, at one level or another, forever - at least until the
company ceases to be a going concern and is liquidated. Also, unlike debt, there are no fixed
payments or interest expenses associated with non-current operational liabilities. In other words, it is
more meaningful for investors to view a company’s indebtedness and obligations through the
company as a going concern, and therefore, to use the moderate approach to defining debt in their
leverage calculations. Funded debt is a term that is seldom used in financial reporting. Technically,
funded debt refers to that portion of a company’s debt comprised, generally, of long-term, fixed
maturity, contractual borrowings. No matter how problematic a company’s financial condition, holders
of these obligations, typically bonds, cannot demand payment as long as the company pays the
interest on its funded debt. In contrast, long-term bank debt is usually subject to acceleration clauses
and/or restrictive covenants that allow a lender to call its loan, i.e., demand its immediate payment.
From an investor’s perspective, the greater the percentage of funded debt in the company’s total debt,
the better.
Lastly, credit ratings are formal risk evaluations by credit agencies such as CRISIL, ICRA, CARE, and
Fitch - of a company’s ability to repay principal and interest on its debt obligations, principally bonds
and commercial paper. Obviously, investors in both bonds and stocks follow these ratings rather
closely as indicators of a company’s investment quality. If the company’s credit ratings are not
mentioned in their financial reporting, it’s easy to obtain them from the company’s investor relations
department.
The Debt Ratio - The debt ratio compares a company’s total debt to its total assets, which is used to
gain a general idea as to the amount of leverage being used by a company. A low percentage means
that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others.
The lower the percentage, the less leverage a company is using and the stronger its equity position. In
general, the higher the ratio, the more risk that company is considered to have taken on.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995
(balance sheet) and total assets of 22,036 (balance sheet). By dividing, the equation provides the
company with a low leverage as measured by the debt ratio of 9%. The easy-to-calculate debt ratio is
helpful to investors looking for a quick take on a company’s leverage. The debt ratio gives users a
quick measure of the amount of debt that the company has on its balance sheets compared to its
assets. The more debt compared to assets a company has, which is signalled by a high debt ratio, the
more leveraged it is and the riskier it is considered to be. Generally, large, well-established companies
can push the liability component of their balance sheet structure to higher percentages without getting
into trouble. However, one thing to note with this ratio: it isn’t a pure measure of a company’s debt (or
indebtedness), as it also includes operational liabilities, such as accounts payable and taxes payable.
Companies use these operational liabilities as going concerns to fund the day-to-day operations of the
business and aren’t really “debts” in the leverage sense of this ratio. Basically, even if you took the
same company and had one version with zero financial debt and another version with substantial
financial debt, these operational liabilities would still be there, which in some sense can muddle this
ratio. The use of leverage, as displayed by the debt ratio, can be a double-edged sword for companies.
If the company manages to generate returns above their cost of capital, investors will benefit.
However, with the added risk of the debt on its books, a company can be easily hurt by this leverage if
it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified
by the use of leverage in the company’s capital structure.
Debt-Equity Ratio: Debt-equity ratio is the relation between borrowed funds and owner’s capital in a
firm; it is also known as external-internal equity ratio. The debt-equity ratio is used to ascertain the
soundness of long-term financial policies of the business. Debt means long-term loans i.e., debentures
or long-term loans from financial institutions. Equity means shareholder’s funds i.e., preference share
capital, equity share capital, reserves less loss and fictitious assets like preliminary expenses. It is
calculated in the following ways:
{Debts/Equity (Shareholder’s Funds)} Or
{Debts/Long-term Funds (Shareholder’s Funds + Debts)}
The main purpose of this ratio is to determine the relative stakes of outsiders and shareholders.
Normally in India a debt equity ratio of 2:1 if it is calculated as (i) above or 0.67:1 if calculated as (ii)
above is considered as ideal. This means that a company may borrow up to twice the amount of its
capital and reserves or it may raise two-thirds of its long-term funds by way of loans. Generally loans
are very profitable for shareholders since interest at a fixed rate only is payable whereas the yield
generally is much higher and income-tax authorities allow interest as a deductible expenses, thus
effectively reducing the interest burden of the company. A higher proportion would be risky because
loans carry with them for obligation to pay interest at a fixed rate which may become difficult if profit is
reduced. However a lower proportion of long-term loans would indicate an undue conservation and
unwillingness to take every normal risk. Both these affect the image of the company and the value
placed by the market on shares.
Proprietary Ratio: This ratio is a variant of debt-equity ratio which establishes the relationship between
shareholders funds and total assets. Shareholder’s fund means, share capital both equity and
preference and reserves and surplus less losses. This ratio is worked out as follows:
Proprietary Ratio = (Shareholder’s Funds/Total Assets)
This ratio indicates the extent to which shareholder’s funds have been invested in the assets.
Fixed Assets Ratio: The ratio of fixed assets to long-term funds is known as fixed assets ratio. It
focuses on the proportion of long-term funds invested in fixed assets. The ratio is expressed as
follows:
Fixed Assets Ratio = (Fixed Assets/Long-term Funds)
Fixed assets refer to net fixed assets (i.e., original cost-depreciation to date) and trade investments
including shares in subsidiaries. Long-term funds include share capital, reserves and long-term loans.
This ratio should not be more than 1. It is the principle of financial management that not merely fixed
assets but a part of working capital also should be financed by long-term funds. As such it is desirable
to have the ratio at less than one i.e., say 0.67 to indicate the fact that the entire fixed capital plus a
portion of the working capital are financed by long-term funds.
Debt-Service Ratio: This ratio is also known as Fixed Charges Cover or Interest Cover. This ratio
measures the debt servicing capacity of a firm in so far as fixed interest on long-term loan is
concerned. It is determined by dividing the net profit before interest and taxes by the fixed charges on
loans. Thus:
Debt Service Ratio = (Net Profit before Interest and Tax/Interest Charges)
This ratio is expressed as ‘number of times’ to indicate that profit is number of times the interest
charges. It is also a measure of profitability. Since a higher ratio leads to a higher profitability, the
ideal ratio should be 6 to 7 times.
Capital Gearing Ratio: The proportion between fixed interest or dividend bearing funds and non-fixed
interest or dividend bearing funds in the total capital employed in the business is termed as capital
gearing ratio. Debentures, long-term loans and preference share capital belong to the category of fixed
interest/dividend bearing funds. Equity share capital, reserves and surplus constitute non-fixed
interest or dividend bearing funds. This ratio is calculated as follows:
Capital Gearing Ratio = (Fixed Interest Bearing Funds/Equity Shareholder’s Funds)

In case the fixed income bearing funds are more than the equity shareholder’s funds, the company is
said to be highly geared. A low capital gearing implies that equity funds are more than the amount of
fixed interest bearing securities. This ratio indicates the extra residual benefits accruing to equity
shareholders. Whether the concern is operating on trading on equity can be judged by this ratio.
Market Test Ratios
These ratios are calculated generally in case of such companies whose shares and stocks are traded
in the stock exchanges. Shareholders, present and probable, are interested not only in the profits of
the company but also in the appreciation of the value of their shares in the stock market. The value of
shares in the stock market, besides other factors, also depends upon factors like dividends declared,
earnings per share, the pay-out policy, etc., of the companies. The following ratios reflect the effect of
these factors on the market value of the shares.
Earnings Per Share (EPS): The profit available to the equity shareholders on a per share basis is
calculated by EPS. This is calculated as under:
EPS = (Net profit After Pref. Dividend / No. of equity shares)

Ex: Suppose, the net income of company after preference dividend is Rs.40,000 and
the number of equity shares is 6000 then,
EPS = (Rs.40,000/6000) = Rs.6.66 per share.
It should be noted that net income here is the net income in income statement for the period, after
taking into consideration operating, non-operating and other items like income-tax. It should be
remembered that if any dividend is payable to the preference shareholders, it has to be deducted
before arriving at net income for this purpose. This ratio is of considerable importance in estimating
the market price of the shares. A low EPS means lower possible dividends and so lower market value,
while a high EPS has a favorable effect on the market value of the shares.
However, the EPS alone does not reflect the effect of various financial operations of the business.
Also, its calculation may be affected, to a considerable extent, by different accounting practices and
policies relating to valuation of stocks, depreciation, etc. Therefore, this ratio should be cautiously
interpreted.
Price Earning Ratio: This ratio establishes relationship between the market price of the shares of a
company and it’s earning per share (EPS). It is calculated as under:
Price Earning Ratio (PER) = (Market value per equity share/Earning per share)
Example: Assuming the market value of a share to be Rs.40 and the EPS Rs.6.66 per share as
calculated in EPS example above, then the PER comes to (Rs.40/6.66) or 6 times.
This ratio helps in predicting the future market value of the shares within reasonable limits. It also
helps in ascertaining the extent of under and over – valuation in the market price, thus pointing to the
effect of factors generated by the company’s financial position. This can be illustrated by the following
example:
Example: Suppose, the actual market value per share is Rs.45 while on the basis of PER and EPS it
should be 6 times of EPS, i.e., Rs.6.66 x 6 = Rs.40. The excess of Rs.5 between anticipated and

actual market price reflects the effect of general economic and political conditions, the image of the
company, etc… which cannot be made out from company’s financial statements.
A reciprocal of this ratio gives the capitalization rate of current earnings per share.
Pay-out Ratio: This ratio expresses the relationship between what is available as earnings per share
and what is actually paid in the form of dividends out of available earnings. It is a good measure of the
dividend policy of the company. A higher payout ratio may mean lower retention and plough-back of
profits, a deteriorating liquidity position and little or no increase in the profit-earning capacity of the
company. This ratio is calculated with the help of the following formula:
Pay-out Ratio = (Dividend per equity share/Earnings per share)
ADVANTAGES OF RATIO ANALYSIS: Ratio analysis is a powerful tool of financial analysis. An absolute
figure generally conveys no meaning. It is seen that mostly figure assumes importance only in
background of other information. Ratios bring together figures which are significantly allied to one
another to portray the cause and effect relationship. The following advantages can be attributed to the
technique of ratio analysis:
 It helps to analyze and understand financial health and trend of a business, its past
performance, and makes it possible to forecast the future state of affairs of the business. They
diagnose the financial health by evaluating liquidity, solvency, profitability etc. This helps the
management to assess the financial requirements and the capabilities of various business
units. It serves as a media to link the past with the present and the future.
 Compares the performance of the business and the performance of similar types of business.
 Ratio analysis plays a significant role in cost accounting, financial accounting, budgetary
control and auditing.
 It helps in the identification, tracing and fixing of the responsibilities of managerial personnel at
different levels.
 It accelerates the institutionalization and specialization of financial management.
 Accounting ratios summarize and systematize the accounting figures in order to make them
more understandable in a lucid form. They highlight the inter-relationship which exists between
various segments of the business expressed by accounting statements.
LIMITATIONS OF RATIO ANALYSIS
Ratio analysis is a widely used technique to evaluate the financial position and performance of a
business. But these are subject to certain limitations:
 Usefulness of ratios depends on the abilities and intentions of the persons who handle them.
It will be affected considerably by the bias of such persons.
 Ratios are worked out on the basis of money-values only. They do not take into account the
real values of various items involved. Thus, the technique is not realistic in its approach.
 Historical values (especially in balance sheet ratios) are considered in working out the various
ratios. Effects of changes in the price levels of various items are ignored and to that extent the
comparisons and evaluations of performance through ratios become unrealistic and
unreliable.

 One particular ratio, in isolation is not sufficient to review the whole business. A group of ratios
are to be considered simultaneously to arrive at any meaningful and worthwhile opinion about
the affairs of the business.
 Since management and financial policies and practices differ from concern to concern, similar
ratios may not reflect similar state of affairs of different concerns. Thus, comparisons of
performance on the basis of ratios may be confusing.
 Ratio analysis is only a technique for making judgments and not a substitute for judgment.
 Since ratios are calculated on the basis of financial statements which are themselves affected
greatly by the firm’s accounting policies and changes therein, the ratios may not be able to
bring out the real situations.
 Ratios are at best, only symptoms; they may indicate what is to be investigated – only a careful
investigation will bring out the correct position.
 Ratios are only as accurate as the accounts on the basis of which these are established.
Therefore, unless the accounts are prepared accurately by applying correct values to assets
and liabilities, the statements prepared there from would not be correct and the relationship
established on that basis would not be reliable.
DU-PONT ANALYSIS
COMBINING FINANCIAL RATIOS
There is a useful method for combining financial ratios known as Dupont analysis. To explain it, we
first need to define some financial ratios, together with their abbreviations, as follows:
Ratio Calculation Abbreviation

Profit margin Net income/sales NI/S
Asset turnover Sales/total assets S/TA
Return on assets Net income/total assets NI/TA
Leverage Total assets/common equity TA/CE
Return on equity Net income/common equity NI/CE
Now these ratios can be combined as follows:
And
In Summary:

This equation says that:
Profit Margin × Asset Turnover × Leverage = Return on Equity.
Also, this equation provides a financial approach to business strategy. It recognizes that the ultimate
goal of business strategy is to maximize stockholder value, that is, the market price of the common
stock. This goal requires maximizing the return on common equity. The Dupont equation above breaks
the return on common equity into its three component parts: Profit Margin (Net Income/Sales), Asset
Turnover (Sales/Total Assets), and Leverage (Total Assets/Common Equity). If any one of these three
ratios can be improved (without harm to either or both of the remaining two ratios), then the return on
common equity will increase. A firm thus has specific strategic targets:
1. Profit Margin improvement can be pursued in a number of ways. On the one hand, revenues
might be increased or costs decreased by:
 Raising prices perhaps by improving product quality or offering extra services. Makers of luxury
cars have done this successfully by providing free roadside assistance and loaner cars when
customer cars are being serviced.
 Maintaining prices but reducing the quantity of product in the package. Candy bar
manufacturers and other makers of packaged foods often use this method.
 Initiating or increasing charges for ancillary goods or services. For example, banks have
substantially increased their charges to stop cheques and for cheques written with insufficient
funds. Distributors of computers and software have instituted fees for providing technical
assistance on their help lines and for restocking returned items.
 Improving the productivity and efficiency of operations.
 Cutting costs in a variety of ways.
2. Asset Turnover may be improved in ways such as:
 Speeding up the collection of accounts receivable.
 Increasing inventory turnover, perhaps by adopting “just in time” inventory methods.
 Slowing down payments to suppliers, thus increasing accounts payable.
 Reducing idle capacity of plant and equipment.
3. Leverage may be increased, within prudent limits, by means such as:
 Using long-term debt rather than equity to fund additions to plant, property, and equipment.
 Repurchasing previously issued common stock in the open market.
The chief advantage of using the Dupont formula is to focus attention on specific initiatives that will
improve return on equity by means of enhancing profit margins, increasing asset turnover, or
employing greater financial leverage within prudent limits.
The importance of ROE as an indicator of performance makes it desirable to divide the ratio into
several components that provide insights into the causes of a firm’s ROE or any changes in it. The
return on equity (ROE) ratio can be broken down into two ratios that we have discussed – net profit
margin and equity turnover.

This breakdown is an identity because we have both multiplied and divided by net sales. To maintain
the identity, the common equity value used is the year-end figure rather than the average of the
beginning and ending value. This identity reveals that ROE equals the net profit margin times the
equity turnover, which implies that a firm can improve its return on equity by either using its equity
more efficiently (increasing its equity turnover) or by becoming more profitable (increasing its net profit
margin).
As noted previously, a firm’s equity turnover is affected by its capital structure. Specifically, a firm can
increase its equity turnover by employing a higher proportion of debt capital. We can see this effect by
considering the following relationship:
Similar to the prior breakdown, this is an identity because we have both multiplied and divided the
equity turnover ratio by total assets. This equation indicates that the equity turnover ratio equals the
firm’s total asset turnover (a measure of efficiency) times the ratio of total assets to equity, a measure
of financial leverage. Specifically, this latter ratio of total assets to equity indicates the proportion of
total assets financed with debt. All assets have to be financed by either equity or some form of debt
(either current liabilities or long-term debt). Therefore, the higher the ratio of assets to equity, the
higher will be the proportion of debt to equity. A total asset/equity ratio of 2, for example, indicates
that for every two rupees of assets there is a rupee of equity, which means the firm financed one-half
of its assets with equity. This implies that it financed the other half with debt. A total asset/equity ratio
of 3 indicates that only one third of total assets were financed with equity, so two-thirds must have
been financed with debt. This breakdown of the equity turnover ratio implies that a firm can increase
its equity turnover either by increasing its total asset turnover (becoming more efficient) or by
increasing its financial leverage ratio (financing assets with a higher proportion of debt capital). This
financial leverage ratio is also referred to as the financial leverage multiplier whereby the first two
ratios (profit margin and total asset turnover) equal return on total assets (ROTA) and ROTA times the
financial leverage multiplier equals ROE.
Combining these two breakdowns, we see that a firm’s ROE is composed of three ratios as follows:
As an example of this important set of relationships, the figures below indicate what has happened to
the ROE for Company X and the components of its ROE during the 20-year period from 1986 to 2005.
As noted, these ratio values employ year-end balance sheet figures (assets and equity) rather than the
average of beginning and ending data so they will differ from our individual ratio computations.
Cash Conversion Cycle
This liquidity metric expresses the length of time (in days) that a company uses to sell inventory,
collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the
number of days a company’s cash is tied up in the production and sales process of its operations and
the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the
company’s working capital position is. The CCC is also known as the “cash” or “operating” cycle.

DIO is computed by
 Dividing the cost of sales (income statement) by 365 to get a cost of sales per day.
 Calculating the average inventory figure by adding the year’s beginning (previous yearend 2.
amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to
obtain an average amount of inventory for any given year; and
 Dividing the average inventory figure by the cost of sales per day figure

Comparison through Ratio

Analysis 7
Principles of Inter-Firm Comparison
Requirements of effective comparison: It is not sufficient merely to know that another company has an
overall better performance. If the management are to employ their efforts to match such performance
effectively they also need to know in just which areas of performance the other company is ahead of
them. A company may waste considerable time investigating those matters in which it is doing well,
e.g. labor efficiency, selling, before discovering that, say, material is being uneconomically used. A
good comparison schemes then will not only compare overall performance in as many facets of the
business as is practical.
Main forms of comparison: Of these many facets the following are among the most common measures
of performance:
1. Return on Capital
2. Percentage profit on sales
3. Capital turnover, i.e. sales/capital employed
4. Percentage to sales of:
i. Production cost;
ii. Selling distribution cost; and
iii. Administration cost
5. Ratio of sales to current assets
6. Ratio of sales to fixed assets
7. Ratio of current assets to current liabilities
8. Ratio of liquid assets to current liabilities
9. Technical measures such as direct labor hours per sales and material cost per unit produced
Initial requirements for an IFC scheme: There are a few requirements need to be met before initiating
an IFC scheme:
1. Participants must be assured that their data will be kept confidential.

2. The participants must form a relatively homogeneous group.

3. There must be a uniform costing system.
Use of ratios: It is better to use ratios than absolute figures when comparing performance. A larger
company may make more profit than a small company but if its ratio of profit to capital employed is
lower than that of the small company it is almost certainly lower in performance achievement.
Psychological effect of comparison: The psychological effect of comparison must be neither forgotten
nor underestimated. Managers accept that quality of management that is measured by performance;
to discover that other managers have achieved a better performance possibly stimulates a manger
more than anything else. It is, after all, a reflection on his competence.
‘Pyramid’ of ratios
Comparison of firms starts with the most fundamental ratio of all – profit to capital employed – which
is than analyzed into component ratios, i.e. profit to sales and sales to capital employed. These ratios
are in turn analyzed, as are the resulting sub-ratios, such continuous breakdown proceeding until
further detailed analysis is impossible or irrelevant. The advantage of this type of scheme is that
participants can see at just which point’s competitors having a better return on capital are superior,
and, moreover, the extent to which any factor contributes to the higher return.
Comparing Gujarat Ambuja Cements with other players in the industry (based on pyramid ratios)
Figure 1: “Pyramid” of Ratios – Gujarat Ambuja Cements

Exhibit 1: Data Sheet –Participating Companies

As we see from the comparison of various parameters relating to the fundamental ratio – operating
profit/operating assets, Gujarat Ambuja Cements stand tall within major players in its peer-group in
the top two parameters. But as far as utilizing the operating asset efficiently is concerned, Gujarat
Ambuja is below average in the industry.
This is done by benchmarking the Median of each ratio for comparison.
When we further break up the composition of the operating assets, we found that, the company has a
problem in the administrative expenses. So after further breaking up the administrative expenses into
its components, we see that the audit expenses, insurance and director’s remuneration are higher in
case of Gujarat Ambuja as compared to the peer-groups.

Exhibit 2: Pyramid of ratios – Gujarat Ambuja Cement

Time Value of Money

8
Concept
Time Value of Money (TVM) is an important concept in financial management. It can be used to
compare investment alternatives and to solve problems involving loans, mortgages, leases, savings,
and annuities.
TVM is based on the concept that a rupee that you have today is worth more than the promise or
expectation that you will receive a rupee in the future. Money that you hold today is worth more
because you can invest it and earn interest. After all, you should receive some compensation for
foregoing spending. For instance, you can invest your rupee for one year at a 7% annual interest rate
and accumulate 1.07 at the end of the year. You can say that the future value of the rupee is 1.07
given a 7% interest rate and a one-year period. It follows that the present value of the 1.07 you expect
to receive in one year is only 1.
For example, Rs. 100 of today’s money invested for one year and earning 5% interest will be worth Rs.
105 after one year. Hence, Rs. 100 now ought to be worth more than Rs. 100 a year from now.
Therefore, any wise person would chose to own Rs. 100 now than Rs. 100 in future. In the first option
he can earn interest on on Rs. 100 while in the second option he loses interest. This explains the ‘time
value’ of money. Also, Rs. 100 paid now or Rs. 105 paid exactly one year from now both have the
same value to the recipient who assumes 5% as the rate of interest. Using time value of money
terminology, Rs. 100 invested for one year at 5% interest has a future value of Rs. 105. The method
also allows the valuation of a likely stream of income in the future, in such a way that the annual
incomes are discounted and then added together, thus providing a lump-sum “present value” of the
entire income stream. For eg. If you earn Rs. 5 each for the next two years (at 5% p.a. simple interest)
on Rs. 100, you would receive Rs. 110 after two years. The Rs. 110 you earn, can be discounted at 5%
for two years to arrive at the present value of Rs. 110, i.e. Rs. 100.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or
receipts promised in the future can be converted to an equivalent value today. Conversely, you can
determine the value to which a single sum or a series of future payments will grow to at some future
date.
The time value of money is based on the premise that an investor prefers to receive a payment of a
fixed amount of money today, rather than an equal amount in the future, all else being equal. In
particular, if one received the payment today, one can then earn interest on the money until that
specified future date.
Time Lines: One of the most important tools in time value analysis is the time line, which is used by
analysts to help visualize what is happening in a particular problem and then to help set up the
problem for solution. To illustrate the time line concept, consider the following diagram:

Time: 0 1 2 3 4 5
Time 0 is the beginning of the period, Time 1 is one period from the beginning, or the end of Period 1;
Time 2 is two periods from the beginning, or the end of Period 2; and so on. Thus, the numbers above
the tick marks represent end-of-period values. Often the periods are years, but other time intervals
such as semi-annual periods, quarters, or months can be used. If each period on the time line
represents a year, the interval from the tick mark corresponding to 0 to the tick mark corresponding to
1 would be Year 1, the interval from 1 to 2 would be Year 2, and so on. Note that each tick mark
corresponds to the end of one period as well as the beginning of the next period. In other words, the
tick mark at Time 1 represents the end of Year 1, and it also represents the beginning of Year 2
because Year 1 has just passed.
Cash flows are placed directly below the tick marks, and interest rates are shown directly above the
time line. Unknown cash flows, which you are trying to find in the analysis, are indicated by question
marks. Now consider the following time line:
Time: 0 1 2 3 4 5
10%
Cash Flows: -1000 ?
Here the interest rate for each of the five periods is 10 percent; a single amount (or lump sum) cash
outflow is made at Time 0; and the Time 5 value is an unknown inflow. Since the initial Rs. 1000 is an
outflow (an investment), it has a minus sign. Since the Period 5 amount is an inflow, it does not have a
minus sign, which implies a plus sign. No cash-flow is observed at times 1 and 2 in the above
representation.
Future Value of a Single Deposit
As we have already discussed that a rupee in hand today is worth more than a rupee to be received in
the future because, if you had it now, you could invest it, earn interest, and end up with more than one
Rupee in the future. The process of going from today’s values, or present values (PVs), to future values
(FVs) is called compounding. To illustrate, suppose you deposit Rs. 1000 in a bank that pays 10
percent interest each year. How much would you have at the end of one year?
Valuing future cash flows that may arise from an asset such as stocks, is one of the cornerstones of
fundamental analysis. Cash flows from assets make them more valuable now than in the future and to
understand the relative difference we use the concepts of interest and discount rates. Interest rates
provide the rate of return of an asset over a period of time, i.e., in future and discount rates help us
determine what a future value of asset, value that would come to us in future, is currently worth.
The present value of an asset could be shown to be:

Where PV = Present Value FV = Future Value r = Discount Rate t = Time
PV = present value, or beginning amount, in your account.

i = interest rate the bank pays on the account per year.
INT = Amount of Interest
FVn = future value, or ending amount, of your account at the end of n years.
n = number of periods involved in the analysis.
FVn = FV1 = PV + INT
= PV + PV (i)
= PV (1+i)
= 1000(1+0.10)
= 1100
Thus, the future value (FV) at the end of one year, FV 1, equals the present value multiplied by 1 plus
the interest rate, so you will have Rs.1100 after one year.
What would you end up with if you left your Rs.1000 in the account for five years? Here is a time line
set up to show the amount at the end of each year:
Time: 0 1 2 3 4 5
10%
Cash Flows: -1000

FV1=? FV2=? FV3=? FV4=? FV5=?
FV5 = FV4 (1+i)
= FV3 (1+i) (1+i)
= FV2 (1+i) (1+i) (1+i)
= FV1 (1+i) (1+i) (1+i) (1+i)
= PV (1+i) (1+i) (1+i) (1+i) (1+i)
= PV (1+i)5
In general, the future value of an initial lump sum at the end of n years can be found by applying the
following Equation:
FVn = PV (1+i)n
In the above case Future value at the end of year 5 = 1000 (1+0.10) 5 = 1610.51 Rs.
Present Value of a Single Deposit
From the future value example, we saw that an initial amount of 1000 invested at 10 percent per year
would be worth 1610.51 at the end of five years. The Rs. 1000 is defined as the present value, or PV,
of Rs. 1610.51 due in five years when the opportunity cost rate is 10 percent. If the price of the
security were less than 1000, you should buy it, because its price would then be less than the 1000
you would have to spend on a similar-risk alternative to end up with 1610.51 after five years.
Conversely, if the security cost is more than 1000, you should not buy it, because you would have to
invest only 1000 in a similar-risk alternative to end up with 1610.51 after five years. If the price were
exactly 1000, then you should be indifferent—you could either buy the security or turn it down.
Therefore, 1000 is defined as the security’s fair, or equilibrium, value.
In general, the present value of a cash flow due n years in the future is the amount which, if it were on
hand today, would grow to equal the future amount. Since 1000 would grow to 1610.51 in five years
at a 10 percent interest rate, 1000 is the present value of 1610.51 due in five years when the
opportunity cost rate is 10 percent.
Finding present values is called discounting, and it is the reverse of compounding— if you know the PV,
you can compound to find the FV, while if you know the FV, you can discount to find the PV. When
discounting, you would follow these steps:
Time: 0 1 2 3 4 5
10%
PV= ? 1610.51
To develop the discounting equation, we begin with the future value equation
FVn = PV (1+i)n
To find out the PV, we can rearrange the equation:

PV = FVn / (1+i)n
In the above case Present value = 1610.51/ (1+0.10) 5 = 1000 Rs.
Solving for Interest Rate and Time: There are four variables in the above equations—PV, FV, i, and n
and if you know the values of any three, you can find the value of the fourth very easily.
Solving for I: Suppose you can buy a security at a price of 1000, and it will pay you 1610.51 after five
years. Here you know PV, FV, and n, and you want to find i, the interest rate you would earn if you
bought the security. Such problems are solved as follows:
Time: 0 1 2 3 4 5
i=?
-1000 1610.51
FVn = PV (1+i)n
1610.51 = 1000 (1+i)5
1610.51 / 1000 = (1+i)5

1.61051 = (1+i)5
(1.61051)1/5 = 1+i
1.1 = 1+i
i = 0.01 = 10%
Therefore, the interest rate is 10 percent.
Solving for n: Suppose you invest Rs. 1000 at an interest rate of 10 percent per year. How long will it
take your investment to grow to 1610.51? You know PV, FV, and i, but you do not know n, the number
of periods.
Time: 0 10% 1 2 n-2 n-1 n= ?
-1000 1610.51
FVn = PV (1+i)n
1610.51 = 1000 (1+0.1)n
1610.51 / 1000 = (1+0.1)n
1.61051 = (1+0.1)n
LN (1.61051) = LN (1+0.1)n
n = 5 Years (Approx.)
Therefore, 5 is the number of years it takes for 1000 to grow to 1610.51 if the interest rate is 10
percent.
Future Value of an Annuity
An annuity is a series of equal payments made at fixed intervals for a specified number of periods. For
example, 1000 at the end of each of the next three years is a three-year annuity. The payments are
given the symbol PMT, and they can occur at either the beginning or the end of each period. If the
payments occur at the end of each period, as they typically do, the annuity is called an ordinary, or
deferred, annuity. Payments on mortgages, car loans, and student loans are typically set up as
ordinary annuities. If payments are made at the beginning of each period, the annuity is an annuity
due. Rental payments for an apartment, life insurance premiums, and lottery payoffs are typically set
up as annuities due.
Ordinary Annuities: An ordinary, or deferred, annuity consists of a series of equal payments made at
the end of each period. If you deposit 1000 at the end of each year for three years in a savings
account that pays 10 percent interest per year, how much will you have at the end of three years? To
answer this question, we must find the future value of the annuity, FVA n. Each payment is
compounded out to the end of Period n, and the sum of the compounded payments is the future value
of the annuity, FVAn.

Time: 0 1 2 3
10%
1000 1000 1000
1100
1210
FVA3 = 3310
FVAn= PMT (1+i)n-1 + PMT (1+i)n-2 + PMT (1+i)n-3 + ………+ PMT (1+i)0
= PMT [(1+i)n – 1] / i
= 1000 [(1+0.10)3 – 1] / 0.10
= 3310.00
Each term is the compounded amount of a single payment, with the superscript in each term
indicating the number of periods during which the payment earns interest. For example, because the
first annuity payment was made at the end of Period 1, interest would be earned in Periods 2 through
n only, so compounding would be for n - 1 periods rather than n periods. Compounding for the second
payment would be for Period 3 through Period n, or n - 2 periods, and so on. The last payment is made
at the end of the annuity’s life, so there is no time for interest to be earned. The Second line is
different — it is found by applying the algebra of geometric progressions.
Present Value of an Annuity
Suppose you were offered the following alternatives: (1) a three-year annuity with payments of 1000
or (2) a lump sum payment today. You have no need for the money during the next three years, so if
you accept the annuity, you would deposit the payments in a bank account that pays 10 percent
interest per year. Similarly, the lump sum payment would be deposited into a bank account. How large
must the lump sum payment today be to make it equivalent to the annuity?
Ordinary Annuities: If the payments come at the end of each year, then the annuity is an ordinary
annuity, and it would be set up as follows:
Time: 0 1 2 3
10%
1000 1000 1000
909.09
826.45
751.31
PVA = 2486.85
PVAn = PMT (1/1+i)1 + PMT (1/1+i)2 + ……..+ PMT (1/1+i)n
= PMT [1 – {1/ (1+i)n}] / i
= 1000 [1 – {1/(1+0.1)3}] / 0.1
= 2486.85
Annuities Due
Had the three 1000 payments in the preceding example been made at the beginning of each year, the
annuity would have been an annuity due. Each payment would be shifted to the left one year, so each
payment would be discounted for one less year.
Time: 0 1 2 3
10%
1000 1000 1000
909.09
826.45
PVA (Annuity Due) = 2735.54
Again, we find the PV of each cash flow and then sum these PVs to find the PV of the annuity due.
PVAn (Due) = PMT (1/1+i)0 + PMT (1/1+i)1 + ……..+ PMT (1/1+i)n-1
= PMT ([1 – {1/ (1+i)n}] / i) (1+i)
= 1000 ([1 – {1/(1+0.1)3}] / 0.1) (1+0.1)
= 2735.54
Perpetuities
Most annuities call for payments to be made over some finite period of time—for example, 100 per
year for three years. However, some annuities go on indefinitely, or perpetually, and these are called
perpetuities. The present value of perpetuity is found by applying the Equation:
PV (Perpetuity) = Payment / Interest Rate
Suppose there is a payment of 1000 Rs. for an indefinite time period at 5% interest rate.
PV (Perpetuity) = 1000 / 0.05 = 20000 Rs.
Now suppose the interest rate rose to 10%, then
PV (Perpetuity) = 1000 / 0.10 = 10000 Rs.
Thus, we see that the value of a perpetuity changes dramatically when interest rates change.
Uneven Cash Flow Streams
The definition of an annuity includes the words constant payment—in other words; annuities involve
payments that are the same in every period. Although many financial decisions do involve constant
payments, other important decisions involve uneven or non constant, cash flows. For example,
common stocks typically pay an increasing stream of dividends over time, and fixed asset investments
such as new equipment normally do not generate constant cash flows. We generally consider payment
(PMT) for annuity situations where the cash flows are equal amounts, and the term cash flow (CF) to
denote uneven cash flows.
Present Value of an Uneven Cash Flow Stream: The PV of an uneven cash flow stream is found as the
sum of the PVs of the individual cash flows of the stream. For example,
Time: 0 1 2 3 4 5 6 7
10%
PV = ? 100 200 200 200 200 0 1000
The PV will be found by applying this general present value equation:
PV = CF1 (1 / 1+i)1 + CF2 (1 / 1+i)2 +……………..+ CFn (1 / 1+i)n
Time: 0 1 2 3 4 5 6 7
10%
PV = ? 100 200 200 200 200 0 1000

90.9
0
165.28
150.26
136.60
124.18
0.00
51.31
718.56
The present value of a cash flow stream can always be found by summing the present values of the
individual cash flows as shown above.
Future Value of an Uneven Cash Flow Stream: The future value of an uneven cash flow stream
(sometimes called the terminal value) is found by compounding each payment to the end of the
stream and then summing the future values:
FVn = CF1 (1+i)n-1 + CF2 (1+i)n-2 + …….+ CFn-1 (1+i) + CFn

Time: 0 1 2 3 4 5 6 7
10%
100 200 200 200 200 0 100

0
0.0
0
242.00
266.20
292.82
322.1
0
177.15
1400.2
7
The future value of our illustrative uneven cash flow stream is 1400.27.
Solving for i with Uneven Cash Flow Streams: It is relatively easy to solve for i numerically when the
cash flows are lump sums or annuities. However, it is extremely difficult to solve for i if the cash flows
are uneven, because then you would have to go through many tedious trial-and-error calculations. It is
easy to find the value of i with a spread sheet model.
Growing Annuities: Normally, an annuity is defined as a series of constant payments to be received

over a specified number of periods. However, the term growing annuity is used to describe a series of
payments that is growing at a constant rate for a specified number of periods. The most common
application of growing annuities is in the area of financial planning, where someone wants to maintain
a constant real, or inflation adjusted income over some specified number of years. For example,
suppose a 60-year-old person is contemplating retirement, expects to live for another 25 years, has 1
Lakh of investment funds, expects to earn 10 percent on the investments, expects inflation to average
6 percent per year, and wants to withdraw a constant real amount per year. What is the maximum
amount that he or she can withdraw at the end of each year?
First we calculate the expected real rate of return as follows, where rr is the real rate and rnom is the
nominal rate of return:
Real Rate = rr = [(1+rnom)/ (1+Inflation)] -1
= (1.10/1.06)-1
= 3.7736%
With the help of annuity formula, we can find out the payment amount i.e. 6248.92. The actual
payments will be growing at 6 percent per year to offset inflation. The (nominal) value of the portfolio
will be growing at first and then declining, and it will hit zero at the end of the 25th year.
Other Compounding Periods: In almost all of our examples thus far, we have assumed that interest is
compounded once a year, or annually. This is called annual compounding. Suppose, however, that you
put 1000 into a bank which states that it pays a 10 percent annual interest rate but that interest is
credited each six months. This is called semi-annual compounding. How much would you have
accumulated at the end of one year, two years, or some other period under semi-annual
compounding? Note that virtually all bonds pay interest semi-annually, most stocks pay dividends
quarterly, and most mortgages, student loans, and auto loans require monthly payments. Therefore, it
is essential to understand non-annual compounding.
Types of Interest Rates: Compounding involves three types of interest rates: nominal rates, i Nom;
periodic rates, iPER; and effective annual rates, EAR or EFF%.
1. Nominal, or quoted, rate - This is the rate that is quoted by banks, brokers, and other financial
institutions. So, if you talk with a banker, broker, mortgage lender, auto finance company, or
student loan officer about rates, the nominal rate is the one he or she will normally quote you.
However, to be meaningful the quoted nominal rate must also include the number of
compounding periods per year. For example, a bank might offer 6 percent, compounded
quarterly, on CDs, or a mutual fund might offer 5 percent, compounded monthly, on its money
market account. The nominal rate on loans to consumers is also called the Annual Percentage
Rate (APR). For example, if a credit card issuer quotes an annual rate of 18 percent, this is the
APR.
2. Periodic rate, iPER - This is the rate charged by a lender or paid by a borrower each period. It can
be a rate per year, per six-month period, per quarter, per month, per day, or per any other time
interval. For example, a bank might charge 1.5 percent per month on its credit card loans, or a
finance company might charge 3 percent per quarter on instalment loans. We find the periodic
rate as follows:
Periodic rate, iPER = iNom/m
Here iNom is the nominal annual rate and m is the number of compounding periods per year.
If there is only one payment per year, or if interest is added only once a year, then m = 1, and the
periodic rate is equal to the nominal rate. The periodic rate is the rate that is generally shown on
time lines and used in calculations.
For example suppose you invest 1000 in an account that pays a nominal rate of 12 percent,
compounded quarterly. How much would you have after two years?
For compounding more frequently than annually, we use the following modification of Equation
FVn = PV (1+ iPER)Number of periods = PV (1+inom/m)mn
Time: 0 1 2 3 4 5 6 7 8
3
Quarters
%
-1000 FV = ?
FV = 1000 (1+0.03)8
= 1266.77

3. Effective (or equivalent) annual rate (EAR) - This is the annual rate that produces the same
result as if we had compounded at a given periodic rate m times per year. The EAR, also called
EFF% (for effective percentage), is found as follows:
EAR = (1+inom / m)m -1
For example, suppose you could borrow using either a credit card that charges 1 percent per month or
a bank loan with a 12 percent quoted nominal interest rate that is compounded quarterly. Which
should you choose? To answer this question, the cost rate of each alternative must be expressed as
an EAR:
Credit Card Loan: EAR = (1+0.01)12 – 1 = 12.6825%
Bank Loan: EAR = (1+0.03)4 -1 = 12.5509%
Thus, the credit card loan is slightly more costly than the bank loan. This result should have been
intuitive to you—both loans have the same 12 percent nominal rate, yet you would have to make
monthly payments on the credit card versus quarterly payments under the bank loan.
The EAR rate is not used in calculations. However, it should be used to compare the effective cost or
rate of return on loans or investments when payment periods differ, as in the credit card versus bank
loan example.
Amortized Loans
One of the most important applications of compound interest involves loans that are paid off in
installments over time. Included are automobile loans, home mortgage loans, student loans, and most
business loans other than very short-term loans and long-term bonds. If a loan is to be repaid in equal
periodic amounts (monthly, quarterly, or annually), it is said to be an amortized loan.
A firm borrows 1,000, and the loan is to be repaid in five equal payments at the end of each of the
next five years. The lender charges a 10 percent interest rate on the loan balance that is outstanding
at the beginning of each year. The first task is to determine the amount the firm must repay each year,
or the constant annual payment.
Time: 0 10% 1 2 3 4 5
1000 PMT PMT PMT PMT PMT
Using the annuity formula we can find out PMT as 263.79 Rs.

Loan Amortization Schedule (10 Percent)
Year Beginning Amount Payment Interest Repayment of Principal Remaining Balance

1 1000 263.79 100 163.79 836.21
2 836.21 263.79 83.621 180.169 656.041
3 656.041 263.79 65.6041 198.1859 457.8551
4 457.8551 263.79 45.7855 218.00449 239.85061
5 239.85061 263.79 23.9851 239.804939 0.00
Therefore, the firm must pay the lender 263.79 (Approx) at the end of each of the next three years,
and the percentage cost to the borrower, which is also the rate of return to the lender, will be 10
percent. Each payment consists partly of interest and partly of repayment of principal. This breakdown
is given in the amortization schedule shown. The interest component is largest in the first year, and it
declines as the outstanding balance of the loan decreases. For tax purposes, a business borrower or
homeowner reports the interest component shown in Column 3 as a deductible cost each year, while
the lender reports this same amount as taxable income.
Interest Rates and Discount Factors
So, what interest rate should we use while discounting the future cash flows? Understanding what is
called as Opportunity cost is very important here.
Opportunity Cost
Opportunity cost is the cost of any activity measured in terms of the value of the other alternative that
is not chosen (that is foregone). Put another way, it is the benefit you could have received by taking an
alternative action; the difference in return between a chosen investment and one that is not taken.
Say you invest in a stock and it returns 6% over a year. In placing your money in the stock, you gave up
the opportunity of another investment - say, a fixed deposit yielding 8%. In this situation, your
opportunity costs are 2% (8% - 6%).
But do you expect only fixed deposit returns from stocks? Certainly not. You expect to earn more than
the return from fixed deposit when you invest in stocks. Otherwise you are better off with fixed
deposits. The reason you expect higher returns from stocks is because the stocks are much riskier as
compared to fixed deposits. This extra risk that you assume when you invest in stocks calls for
additional return that you assume over other risk-free (or near risk-free) return.
The discount rate of cost of capital to be used in case of discounting future cash flows to come up with
their present value is termed as Weighted Average Cost of Capital (WACC).
Where D = Debt portion of the Total Capital Employed by the firm
TC = Total Capital Employed by the frim (D+E+P)
Kd = Cost of Debt of the Company.

t = Effective tax rate of the firm
E = Equity portion of the Total Capital employed by the firm
P = Preferred Equity portion of the Total Capital employed by the firm
Kp = Cost of Preferred Equity of the firm
The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital Asset Pricing Model
(CAPM)
Or
Where Rf = Risk-free rate
β = Beta, the factor signifying risk of the firm
Rm = Implied required rate of return for the market
So what discount factors do we use in order to come up with the present value of the future cash flows
from a company’s stock?
Risk-free Rate
The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including
default risk. Default risk is the risk that an individual or company would be unable to pay its debt
obligations. The risk-free rate represents the interest an investor would expect from an absolutely risk-
free investment over a given period of time.
Though a truly risk-free asset exists only in theory, in practice most professionals and academics use
short-dated government bonds of the currency in question. For US Dollar investments, US Treasury
bills are used, while a common choice for EURO investments are the German government bonds or
Euribor rates. The risk-free interest rate for the Indian Rupee for Indian investors would be the yield on
Indian government bonds denominated in Indian Rupee of appropriate maturity. These securities are
considered to be risk-free because the likelihood of governments defaulting is extremely low and
because the short maturity of the bills protect investors from interest-rate risk that is present in all
fixed rate bonds (if interest rates go up soon after a bond is purchased, the investor misses out on the
this amount of interest, till the bond matures and the amount received on maturity can be reinvested
at the new interest rate).
Though Indian government bond is a riskless security per se, a foreign investor may look at the India’s
sovereign risk which would represent some risk. As India’s sovereign rating is not the highest (please
search the internet for sovereign ratings of India and other countries) a foreign investor may consider
investing in Indian government bonds as not a risk free investment.
For valuing Indian equities, we will take 10-Yr Government Bond as risk-free interest rate. (Roughly
7.8% - as of this writing).
Equity Risk Premium
The notion that risk matters and that riskier investments should have higher expected returns than
safer investments, to be considered good investments, is both central to modern finance. Thus, the

expected return on any investment can be written as the sum of the risk-free rate and a risk premium
to compensate for the risk. The equity risk premium reflects fundamental
judgments we make about how much risk we see in an economy/market and what price we attach to
that risk. In effect, the equity risk premium is the premium that investors demand for the average risk
investment and by extension, the discount that they apply to expected cash flows with average risk.
When equity risk premia rises, investors are charging a higher price for risk and will therefore pay
lower prices for the same set of risky expected cash flows.
Equity risk premia are a central component of every risk and return model in finance and is a key input
into estimating costs of equity and capital in both corporate finance and valuation.
The Beta
The Beta is a measure of the systematic risk of a security that cannot be avoided through
diversification. Therefore, Beta measures non-diversifiable risk. It is a relative measure of risk: the risk
of an individual stock relative to the market portfolio of all stocks. Beta is a statistical measurement
indicating the volatility of a stock’s price relative to the price movement of the overall market. Higher-
beta stocks mean greater volatility and are therefore considered to be riskier but are in turn supposed
to provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
The market itself has a beta value of 1; in other words, its movement is exactly equal to itself (a 1:1
ratio). Stocks may have a beta value of less than, equal to, or greater than one. An asset with a beta of
0 means that its price is not at all correlated with the market; that asset is independent. A positive
beta means that the asset generally tracks the market. A negative beta shows that the asset inversely
follows the market; the asset generally decreases in value if the market goes up.
Consider the stock of ABC Technologies Ltd. which has a beta of 0.8. This essentially points to the fact
that based on past trading data, ABC Technologies Ltd. as a whole has been relatively less volatile as
compared to the market as a whole. Its price moves less than the market movement. Suppose Nifty
index moves by 1% (up or down), ABC Technologies Ltd.’s price would move 0.80% (up or down). If
ABC Technologies Ltd. has a Beta of 1.2, it is theoretically 20% more volatile than the market.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher
returns. Lower-beta stocks pose less risk but generally offer lower returns. This idea has been
challenged by some, claiming that data shows little relation between beta and potential returns, or
even that lower-beta stocks are both less risky and more profitable.
Beta is an extremely useful tool to consider when building a portfolio. For example, if you are
concerned about the markets and want a more conservative portfolio of stocks to ride out the
expected market decline, you’ll want to focus on stocks with low betas. On the other hand, if you are
extremely bullish on the overall market, you’ll want to focus on high beta stocks in order to leverage
the expected strong market conditions. Beta can also considered to be an indicator of expected return
on investment. Given a risk-free rate of 2%, for example, if the market (with a beta of 1) has an
expected return of 8%, a stock with a beta of 1.5 should return 11% (= 2% + 1.5(8% - 2%)).
Problems with Beta
The Beta is just a tool and as is the case with any tool, is not infallible. While it may seem to be a good
measure of risk, there are some problems with relying on beta scores alone for determining the risk of
an investment. Beta is not a sure thing. For example, the view that a stock with a beta of less than 1
will • do better than the market during down periods may not always be true in reality. Beta scores
merely suggest how a stock, based on its historical price movements will behave relative to the
market. Beta looks backward and history is not always an accurate predictor of the future. Beta also
doesn’t account for changes that are in the works, such as new lines of • business or industry shifts.
Indeed, a stock’s beta may change over time though usually this happens gradually. As a fundamental
analyst, you should never rely exclusively on beta when picking stocks. Rather, beta is best used in
conjunction with other stock-picking tools.
Risk Adjusted Return (Sharpe Ratio)
The Sharpe ratio / Sharpe index / Sharpe measure / reward-to-variability ratio, is a measure of the
excess return (or risk premium) per unit of risk in an investment asset or a trading strategy. It is
defined as:
Where, R is the asset return, Rf is the return on a benchmark asset such as the risk free rate of return,
[R − Rf] is the expected value of the excess of the asset return over the benchmark return and σ is the
standard deviation of the asset.
The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the performance
of an asset or a portfolio. The ratio helps to make the performance of one portfolio comparable to that
of another portfolio by making an adjustment for risk. It is excess return generated for an asset or a
portfolio for every one unit of risk. For example, if stock A generates a return of 15% while stock B
generates a return of 12%, it would appear that stock A is a better performer. However, if stock A,
which produced the 15% return but has much larger risks than stock B (as reflected by standard
deviation of stock returns or beta), it may actually be the case that stock B has a better risk-adjusted
return. To continue with the example, say that the risk free-rate is 5%, and stock A has a standard
deviation (risk) of 8%, while stock B has a standard deviation of 5%. The Sharpe ratio for stock A would
be 1.25 while stock B’s ratio would be 1.4, which is better than stock A. Based on these calculations,
stock B was able to generate a higher return on a risk-adjusted basis. A ratio of 1 or better is
considered good, 2 and better is very good, and 3 and better is considered excellent.

Valuation of Stocks
9
Why Valuations are required
While purpose of carrying out valuation could vary from person to person, some of the reasons for
carrying out valuations of assets/businesses/liabilities are as follows:
 Buying a business as part of investment exercise

 Selling a business as part of investment exercise
 Mergers and Acquisitions
 General sense of value of business to owners
 Fair treatment to different set of stake holders in case of equity swap
 Accounting, taxation and other regulatory and legal requirements
Fundamental analysis is based on the premise that each share has an intrinsic worth or value which
depends upon the benefits that the holder of a share expects to receive in future from the share in the
form of dividends and capital appreciation.
Discounted Cash Flows Model (DCF) for Business Valuation
In discounted cash flow valuation, the value of an asset is the present value of the expected cash
flows on the asset. The cash flow could be either the dividend which is actually paid out to
shareholders or free cash flow which is accrued to the firm or to the shareholders. The basic principle
behind the DCF models is that every asset has an intrinsic value that can be estimated, based upon
its characteristics in terms of cash flows, growth and risk. The information required in order to find out
the intrinsic value of any asset using DCF is :
• to estimate the life of the asset

•to estimate the cash flows during the life of the asset
• to estimate the discount rate to apply to these cash flows to get present value
In case of a stock, the assumption of going concern entails that we use perpetuity as our estimated
life of a company (and hence stock) unless conditions require assumptions otherwise. The estimate of
cash flow could be divided as, Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE)
depending upon the exact method of DCF valuation we choose. The discount rate used to deduce the
present value should reflect the uncertainty (risk) of the cash flows and opportunity cost of capital.
(Please refer to earlier section on Opportunity cost)

Consider a bond on offering which generates 9% as interest per annum and gets redeemed at the end
of 10th year on its face value of Rs. 100,000. Current prevailing interest rates (or expected return by
investors) in the economy are also 9% for this maturity and credit quality. What would be the value of
this bond today?
The value of the bond is the present value of all the future cash flows discounted at prevailing interest
rates of 9%. As both coupon and expected rate (discount rate) are same, it would turn out to be face
value viz Rs. 100,000. If expected rate of return by investors is higher (lower) than 9%, then bond
would have value less (more) than Rs. 100,000. It is simple mathematics based on present and future
value computations*.ples).
This is an example of discounted cash flows model for bond valuation. Actually, every asset or liability
is priced the same way. Assets are acquired at a cost and the expectation is for these assets to
generate a combination of earnings and/or capital gains (on sale of assets). If the bond is replaced
with equity, the coupons will be replaced with dividends and redemption value by expected sales
proceeds from sale of equity. However, in case of bonds, both quantum of cash flows and their timings
were known with certainty, in case of equity quantum of cash flows (dividends or sales price) and their
timings are unknown and uncertain.
The concept of valuing an asset based on its cash flows can be extended to valuing businesses based
on their earnings (profits or to be more precise cash flows) and terminal value (one time sales
proceeds from assets). While, the discounted cash flows models are used to value businesses, these
valuations come with significant error of judgment because of the inability to measure quantum and
timings of future cash flows with certainty. These models could also be very sensitive to some input
factors. Conceptually, discounted cash flow (DCF) approach to valuation is the most appropriate
approach for valuations when three things are known with certainty:
 Stream of future cash flows

 Timings of these cash flows, and
 Expected rate of return by the investors (called discount rate).
Once these three pieces of information are available, it is simple mathematics to find the present
value of these cash flows which a potential investor in that instrument would be willing to pay today to
receive the expected cash flow stream over a period of time.
In valuing a business, the cash flows (outflows and inflows) at various stages over its expected life is
considered. A rational way to find the value of a business may be to first find the inflows over outflows
(called Free Cash Flows – FCFs) at different points in time and then bringing them to today (find
present Value – PV) at an appropriate rate of return (Discount Rate - DR). This is called Discounted
Cash Flow (DCF) method to value a project or a business/firm. The two principal factors that drive the
valuation of a firm using DCF are estimating the expected cash flows and the second is the
determination of the rate used to discount these cash flows. The value estimated using the DCF can
vary across analysts if there are differences in estimating these two factors.
There are two ways to look at the cash flows from a business. One is the free cash flows to the firm
(FCFF), where the cash flows before any payments are made on the debt outstanding are taken into
consideration. This is the cash flow available to all capital contributors-both equity and debt. The
second way is to estimate the cash flows that accrue to the equity investors alone. Interest payments
on debt is deducted from the FCFF and net borrowings added to it to arrive at the free cash flows for
equity (FCFE). It is to be noted that the cash flows to the equity investors is not taken to be the
dividends alone. It is extended to include the residual cash flows after meeting the obligations to the
debt holders and dividends to preference shareholders. FCFF may be used for valuation if FCFE is
likely to be negative or if the capital structure of the firm is likely to change significantly in the future.
FCFF is computed as:

Earnings Before Interest & Tax (EBIT) less Tax plus Depreciation & Non-cash charges less Increase
(Decrease) in working capital less Capital Expenditure Incurred (Sale of assets)
FCFE is computed as
FCFF Less Interest plus Net borrowing
Apart from depreciation, other non-cash charges include amortization of capital expenses and loss on
sale of assets, which are added back. Gains on the sale of assets are deducted from the FCFF and
FCFE calculations.
Valuation requires a forecast of the cash flows expected in the future. This can be done by applying
the historical growth rate exhibited by company or a rate estimated by the analysts based on their
information and analysis. A more robust way is to look at the internal determinants of growth, namely,
the proportion of earnings ploughed back into the business and the return on equity that it is expected
to earn. The growth rate can be calculated as the product of the retention rate and the return on
equity. A firm may have a period of high growth in revenues, profitability, capex and other performance
parameters and then stabilize to a steady growth.
Since equity is for perpetuity and it is not possible to forecast the cash flows forever, the practice is to
calculate a terminal value for the firm once the high growth period is over. The terminal value may be
calculated using the perpetuity growth method where the cash flow is expected to grow forever at a
steady though modest rate once the high growth period is over. The average long term GDP growth
rate or inflation rate is a good proxy for this rate. The terminal value is calculated by multiplying the
cash flow for the last year of the high growth period by (1+ Growth rate) and dividing the resultant
value by (Discounting rate- Growth rate).The other method is to calculate the terminal value by
applying a multiple to a parameter such as the EBITDA at the end of the high growth period. The
multiple is decided based on that of comparable firms. The terminal value is added to the cash flows
for the growth or projection period, and then discounted to the present value.
The discount rate used in the DCF valuation should reflect the risks involved in the cash flows and
therefore the expectations of the investors. To calculate the value of the firm, the FCFF is discounted
by the weighted average cost of capital (WACC) that considers both debt and equity.
To calculate the value of equity, FCFE is discounted using the cost of equity.
FCFE is the cash available to stock holders after all expense, investments and interest payments to
debt-holders on an after tax basis.
FCFF = NI + NCC + 1(1-T) -FC - WC
NCC = non-cash charges such as depreciation and amortization

NI = Net income.
I (1-t) = After-tax interest expense.
FC = Change in fixed capital investments.
WC = Change in working capital investments.
CFO = cash flow from operations
Net income is post the interest paid to the company’s bondholders, but the definition of FCFF is the
cash available to the firm’s bondholders and equity holders. So it is the money before paying the
interest, thus, we need to add back the after tax expense of interest.
FCFF = EBIT (1-T) + NCC – FC - WC
FCFF is on an after tax basis and EBIT is before taxes, so we need to multiply by the firm’s after tax
rate which is (1-T). EBIT is pre interest charges, so we do not need to add back I (1-T).
FCFF = CFO – FC + 1(1-T)
CFO adds back depreciation and takes account of change in WC, so the only thing left that is not
accounted for is the interest expense and change in Fixed Capital Investments.
Free cash flow to equity (FCFE) is the cash flow available to the firm’s common equity holders after all
operating expenses, interest and principal payments have been paid, and necessary investments in
working and fixed capital have been made. FCFE is the cash flow from operations minus capital
expenditures minus payments to (and plus receipts from) debt holders.
FCFE = FCFF + NET BORROWING -1 (1-T)
We need to subtract the interest expense now because FCFE is all the cash available to stock holders.
FCFE = NI + NCC –FC – WC + NET BORROWING

This formula again doesn’t include the addition of I (1-T) back because NI already deducted it out.
FCFE = CFO + NET BORROWING - FC
Notice FCFF adds back I (1-T) but FCFE doesn’t.
The value of equity can be found by discounting FCFE at the required rate of return on equity r:
Since FCFE is the cash flow remaining for equity holders after all other claims have been satisfied,
discounting FCFE by r (the required rate of return on equity) gives the value of the firm’s equity.
Dividing the total value of equity by the number of outstanding shares gives the value per share.
Computing FCFF and FCFE based upon historical accounting data is straightforward. Often times, this
data is then used directly in a single-stage DCF valuation model.
Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow
for the company based on assumptions regarding the company’s revenue growth rate, net operating
profit margin, income tax rate, fixed investment requirement, and incremental working capital
requirement. We describe these variables and how to estimate them in other screens.
Step 2—Estimate the Discount Rate: the next order of business is to estimate the company’s weighted
average cost of capital (WACC), which is the discount rate that’s used in the valuation process. We
describe how to do this using easily observable inputs in other screens.
Step 3—Calculate the Value of the Corporation: the company’s WACC is then used to discount the
expected cash flows during the Excess Return Period to get the corporation’s Cash Flow from
Operations. We also use the WACC to calculate the company’s Residual Value. To that we add the
value of Short-Term Assets on hand to get the Corporate Value.
Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company’s liabilities—debt,
preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by
the amount of stock outstanding to get the per share intrinsic stock value.
Dividend Discount Model (DDM)

In the strictest sense, the only cash flow you receive from a firm when you buy publicly traded stock is
the dividend. The simplest model for valuing equity is the dividend discount model -- the value of a
stock is the present value of expected dividends on it. While many analysts have turned away from the
dividend discount model and viewed it as outmoded, much of the intuition that drives discounted cash
flow valuation is embedded in the model. In fact, there are specific companies where the dividend
discount model remains a useful tool for estimating value.
The General Model

When an investor buys stock, she generally expects to get two types of cash-flows - dividends during
the period she holds the stock and an expected price at the end of the holding period. Since this
expected price is itself determined by future dividends, the value of a stock is the present value of
dividends through infinity.

Where DPSt = Expected dividends per share Ke = Cost of equity
The rationale for the model lies in the present value rule - the value of any asset is the present value
of expected future cash flows discounted at a rate appropriate to the riskiness of the cash flows.
There are two basic inputs to the model - expected dividends and the cost on equity. To obtain the
expected dividends, we make assumptions about expected future growth rates in earnings and pay-
out ratios. The required rate of return on a stock is determined by its riskiness, measured differently in
different models - the market beta in the CAPM and the factor betas in the arbitrage and multi-factor
models. The model is flexible enough to allow for time-varying discount rates, where the time variation
is caused by expected changes in interest rates or risk across time.
Gordon Growth Model

The Gordon growth model can be used to value a firm that is in ‘steady state’ with dividends growing
at a rate that can be sustained forever. The Gordon growth model relates the value of a stock to its
expected dividends in the next time period, the cost of equity and the expected growth rate in
dividends.
Where, DPS1 = Expected Dividends one year from now (next period) Ke= Required rate of return for
equity investors g = Growth rate in dividends forever
What is a stable growth rate?

While the Gordon growth model is a simple and powerful approach to valuing equity, its use is limited
to firms that are growing at a stable rate. There are two insights worth keeping in mind when
estimating a ‘stable’ growth rate. First, since the growth rate in the firm’s dividends is expected to last
forever, the firm’s other measures of performance (including earnings) can also be expected to grow
at the same rate. To see why, consider the consequences in the long term of a firm whose earnings
grow 6% a year forever, while its dividends grow at 8%. Over time, the dividends will exceed earnings.
On the other hand, if a firm’s earnings grow at a faster rate than dividends in the long term, the pay-
out ratio, in the long term, will converge towards zero, which is also not a steady state. Thus, though
the model’s requirement is for the expected growth rate in dividends, analysts should be able to
substitute in the expected growth rate in earnings and get precisely the same result, if the firm is truly
in steady state
The second issue relates to what growth rate is reasonable as a ‘stable’ growth rate. This growth rate
has to be less than or equal to the growth rate of the economy in which the firm operates. This does
not, however, imply that analysts will always agree about what this rate should be even if they agree
that a firm is a stable growth firm for three reasons.
 Given the uncertainty associated with estimates of expected inflation and real growth in the
economy, there can be differences in the benchmark growth rate used by different analysts,
i.e., analysts with higher expectations of inflation in the long term may project a nominal
growth rate in the economy that is higher.
 The growth rate of a company may not be greater than that of the economy but it can be less.
Firms can becomes smaller over time relative to the economy.
 There is another instance in which an analyst may stray from a strict limit imposed 3. on the
‘stable growth rate’. If a firm is likely to maintain a few years of ‘above-stable’ growth rates, an
approximate value for the firm can be obtained by adding a premium to the stable growth rate,
to reflect the above-average growth in the initial years. Even in this case, the flexibility that the
analyst has is limited. The sensitivity of the model to growth implies that the stable growth rate
cannot be more than 1% or 2% above the growth rate in the economy. If the deviation
becomes larger, the analyst will be better served using a two-stage or a three-stage model to
capture the ‘super-normal’ or ‘above-average’ growth and restricting the Gordon growth model
to when the firm becomes truly stable.
Limitations of the model

The Gordon growth model is a simple and convenient way of valuing stocks but it is extremely
sensitive to the inputs for the growth rate. Used incorrectly, it can yield misleading or even absurd
results, since, as the growth rate converges on the discount rate, the value goes to infinity. Consider a
stock, with an expected dividend per share next period of Rs. 2.50, a cost of equity of 15%, and an
expected growth rate of 5% forever. The value of this stock should be:
Note, however, the sensitivity of this value to estimates of the growth rate in the Figure:
As the growth rate approaches the cost of equity, the value per share approaches infinity. If the growth
rate exceeds the cost of equity, the value per share becomes negative. This issue is tied to the
question of what comprises a stable growth rate. For instance, an analyst who uses a 14% growth rate
and obtains a Rs. 250 value would have been violating a basic rule on what comprises stable growth.
In summary, the Gordon growth model is best suited for firms growing at a rate comparable to or lower
than the nominal growth in the economy and which have well established dividend pay-out policies
that they intend to continue into the future. The dividend pay-out of the firm has to be consistent with
the assumption of stability, since stable firms generally pay substantial dividends. In particular, this
model will under estimate the value of the stock in firms that consistently pay out less than they can
afford and accumulate cash in the process.
Two-stage Dividend Discount Model

The two-stage growth model allows for two stages of growth - an initial phase where the growth rate is
not a stable growth rate and a subsequent steady state where the growth rate is stable and is
expected to remain so for the long term. While, in most cases, the growth rate during the initial phase
is higher than the stable growth rate, the model can be adapted to value companies that are expected
to post low or even negative growth rates for a few years and then revert back to stable growth. The
model is based upon two stages of growth, an extraordinary growth phase that lasts n years and a

stable growth phase that lasts forever afterwards. Extraordinary growth rate: g% each year for n years
Stable growth rate: gn forever
DPSt = Expected dividends per share in year t Ke = Cost of Equity (hg: High Growth period; st: Stable
growth period) Pn = Price (terminal value) at the end of year n g = Extraordinary growth rate for the
first n years gn = Steady state growth rate forever after year n
The same constraint that applies to the growth rate for the Gordon Growth Rate model, i.e., that the
growth rate in the firm is comparable to the nominal growth rate in the economy, applies for the
terminal growth rate (gn) in this model as well. In addition, the pay-out ratio has to be consistent with
the estimated growth rate. If the growth rate is expected to drop significantly after the initial growth
phase, the pay-out ratio should be higher in the stable phase than in the growth phase. A stable firm
can pay out more of its earnings in dividends than a growing firm.
Thus, a firm with a 5% growth rate and a return on equity of 15% will have a stable period pay-out ratio
of 33.33%.
Limitations of the model

There are three problems with the two-stage dividend discount model – the first two would apply to
any two-stage model and the third is specific to the dividend discount model.
 The first practical problem is in defining the length of the extraordinary growth period. Since
the growth rate is expected to decline to a stable level after this period, the value of an
investment will increase as this period is made longer. It is difficult in practice to convert these
qualitative considerations into a specific time period.
 The second problem with this model lies in the assumption that the growth rate is high during
the initial period and is transformed overnight to a lower stable rate at the end of the period.
While these sudden transformations in growth can happen, it is much more realistic to
assume that the shift from high growth to stable growth happens gradually over time.
 The focus on dividends in this model can lead to skewed estimates of value for firms that are
not paying out what they can afford in dividends. In particular, we will under estimate the value
of firms that accumulate cash and pay out too little in dividends.
Since the two-stage dividend discount model is based upon two clearly delineated growth stages, high
growth and stable growth, it is best suited for firms which are in high growth and expect to maintain
that growth rate for a specific time period, after which the sources of the high growth are expected to
disappear. One scenario, for instance, where this may apply is when a company has patent rights to a
very profitable product for the next few years and is expected to enjoy super-normal growth during this
period. Once the patent expires, it is expected to settle back into stable growth. Another scenario
where it may be reasonable to make this assumption about growth is when a firm is in an industry
which is enjoying supernormal growth because there are significant barriers to entry (either legal or as
a consequence of infra-structure requirements), which can be expected to keep new entrants out for
several years. The assumption that the growth rate drops precipitously from its level in the initial
phase to a stable rate also implies that this model is more appropriate for firms with modest growth
rates in the initial phase. For instance, it is more reasonable to assume that a firm growing at 12% in
the high growth period will see its growth rate drops to 6% afterwards than it is for a firm growing at
40% in the high growth period.
Finally, the model works best for firms that maintain a policy of paying out most of residual cash flows
– i.e, cash flows left over after debt payments and reinvestment needs have been met – as dividends.
The two-stage model can also be extended to a multi-stage model that takes into consideration the
gradual transition in the growth rates, etc. However, in reality, forecasting the growth rates in distant
future is a task involving so many uncertainties that it’s not worthwhile doing so in realistic valuation
exercise.
Gordon Growth Model

The Gordon growth model can be used to value a firm that is in ‘steady state’ with dividends growing
at a rate that can be sustained forever. The Gordon growth model relates the value of a stock to its
expected dividends in the next time period, the cost of equity and the expected growth rate in
dividends.
Market Risk (Beta)

Beta is a measure of the systematic risk of a security or a by comparing the volatility in the investment
relative to the market, as represented by a market index. It measures the risk of an investment that
cannot be diversified away.
Beta of 1 indicates that the security's price will move with the market. Beta of less than 1 means that
the security will be less volatile than the market. And, beta of greater than 1 indicates that the
security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's
theoretically 20% more volatile than the market both on up and down moves.
Cost of equity is generally computed with help of Capital Asset Pricing Model (CAPM), which defines
cost of Equity as follows:
Ke = Rf + β * (Rm – Rf)
Where:
Rf = Risk Free Rate,
(Rm – Rf) = Market risk premium (MRP), and
β = Beta
The Weighted Average Cost of Capital of the firm (WACC) is then calculated as under:
WACC = [Ke * Equity / (Equity+ Debt)] + [Kd * (1-Tax)* Debt / (Equity+ Debt)]
= [Ke * We] + [Kd * (1-Tx)*Wd]
Where Kd = Cost of Debt, Wd = Weight of Debt, Ke = Cost of Equity, We = Weight of Equity
The free cash flows are then discounted at the appropriate discount rate to arrive at the
Enterprise Value (EV) of the firm or the value of equity, as the case may be. DCF valuations may result
in erroneous output if sufficient rigor does not go into estimating the cash flows and discount rate.
Price / Earnings Ratio

The P/E ratio (price-to-earnings ratio) of a stock (also called its “P/E”, or simply “multiple”) is a
measure of the price paid for a share relative to the annual net income or profit earned by the firm per
share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more
for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. The
P/E ratio has units of years, which can be interpreted as “number of years of earnings to pay back
purchase price”, ignoring the time value of money. In other words, P/E ratio shows current investor
demand for a company share. The reciprocal of the PE ratio is known as the earnings yield. The
earnings yield is an estimate of expected return to be earned from holding the stock.
Price-to-earnings ratio is popular in the investment community. Earnings power is the primary
determinant of investment value.
PE = Market Price per Share / Earnings Per Share
There are a number of variants on the basic PE ratio in use. They are based upon how the price and
the earnings are defined.
Price: is usually the current price is sometimes the average price for the year Earnings Per Share
(EPS):
 Earnings per share in most recent financial year
 Earnings per share in trailing 12 months (Trailing PE)
 Forecasted earnings per share next year (Forward PE)
 Forecasted earnings per share in future year
Trailing P/E or P/E TTM

Earnings per share is the net income of the company for the most recent 12 month period, divided by
number of shares outstanding. This is the most common meaning of PE ratio if no other qualifier is
specified. Monthly earning data for individual companies are not available, so the previous four
quarterly earnings reports are used and EPS is updated quarterly. Note, companies individually
choose their financial year so the schedule of updates will vary.
Forward P/E or Estimated P/E
Instead of net income, uses estimated net earnings over next 12 months. Estimates are typically
derived as the mean of a select group of analysts (note, selection criteria is rarely cited). In times of
rapid economic dislocation, such estimates become less relevant as “the situation changes” (e.g. new
economic data is published and/or the basis of their forecasts become obsolete) more quickly than
analysts adjust their forecasts.
Based on XYZ’S EPS of Rs. 101 for the year FY10, the trailing 12 month PE of XYZ at a price of Rs.
2200 per share works out to be 22X. If we come up with an estimated EPS of Rs. 120 for FY11 based
on our analysis and assume the same PE multiple of 22X (Forward P/E) for the next year, then the
target price works out to be (22 * 120) Rs. 2640.
Other Valuation Parameters in New Age Economy and Businesses Sometimes, people wonder on
valuations of the new age businesses such as Ecommerce companies or tech companies such as
Whatsapp, Zomato, Linkedin, Facebook etc. Honestly speaking, it is difficult to put the numbers
together to arrive at the valuations at which these transactions are happening. We may call it our own
limitation to understand the value proposition. Without attempting to do this impossible task, let us
state that in new age economy, people use absolutely new parameters/language such as eyeballs,
page reviews, footfall, ARPU, no. of users etc. to justify exorbitant valuations. Honestly speaking, as
Buffett would state, all of these should ultimately translate into profits for owners at some point in
time. If there is no visibility of that happening, most of these valuations would sustain till there is a
story line, people believe in those stories and next buyer is available for the same. And, would fall like
a pack of cards in absence of those. We have seen that during the .com boom in 2000 – 2001.
Price / Book Value Ratio
A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the
current closing price of the stock by the latest quarter’s book value per share. It is also known as the
“price-equity ratio”.
A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that
something is fundamentally wrong with the company. As with most ratios, be aware that this varies by
industry.
Price to book value ratio is a widely used ratio. It is necessary to estimate the end-year-book value per
share for the next period. This can be derived from the historical growth rate by the sustainable growth
formula (g=ROE*retention rate).
Enterprise Value/EBITDA Ratio
The enterprise value to EBITDA multiple is obtained by netting cash out against debt to arrive at
enterprise value and dividing by EBITDA.
Price/Sales Ratio
The Internet boom of the late 1990s was a classic example of hundreds of companies coming to the
market with no history of earning – some of them didn’t even have products yet. Their stock prices
soared only to come crashing down later. Fortunately, that’s behind us.
However, we still have the problem of needing some measure of young companies with no earnings,
yet worthy of consideration. After all, Microsoft had no earnings at one point in its corporate life.
One ratio you can use is Price to Sales or P/S ratio. This metric looks at the current stock price relative
to the total sales per share. You calculate the P/S by dividing the market cap of the stock by the total
revenues of the company. You can also calculate the P/S by dividing the current stock price by the
sales per share.

Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S,
the better the value, at least that’s the conventional wisdom. However, this is definitely not a number
you want to use in isolation. When dealing with a young company, there are many questions to answer
and the P/S supplies just one answer.
Price to sales ratio is relatively volatile in comparison to other ratios. This ratio is suitable for growth
companies. A requirement for a growth company is strong consistent sales growth.
Special cases of Valuation
IPOs
Most firms conducting initial public offerings (IPOs) are young companies for which it is difficult to
forecast future cash flows. Most of them are in pioneering stage or expansion stage and their
revenues are highly volatile with very high growth rates which are unsustainable in the future. To value
these companies, discounted cash flow analysis is very imprecise, and the use of accounting
numbers, in conjunction with comparable firm multiples, is widely recommended.
The data about the firm is also not widely available and the Draft Red Herring Prospectus (DRHP) is
the only source of information of finances of the company. Relative valuation using multiples such as
P/E (adjusted for leverage, growth rates) and EV/EBITDA are most commonly used for valuing IPOs.
Here, we start with an already listed company and take its trading multiple as base. Then, we make
adjustments for information availability (We generally reduce the multiple for non-availability of
information about the company in the public domain due to its privately held nature), phase in the
product development, size and growth rates.
Analysts face problems when companies which are pioneers in their industries and having new
innovative but never-before-tested business models come to capital markets for raising capital. Due to
their new business models, there are no comparable companies in the listed space. The dot com
bubble and subsequent bust was an example of the market paying humungous multiples to new and
innovative business models due to lack of complete understanding of the business. Valuing IPOs is
thus a different ball-game altogether due to lack of information and comparable companies at times.
Financial Services firms
Unlike any other manufacturing or service company, a bank’s accounts are presented in a different
manner (as per banking regulations). The analysis of a bank account differs significantly from any
other company. The key operating and financial ratios, which one would normally evaluate before
investing in company, may not hold true for a bank (like say operating margins).

The primary business of a bank is to accept deposits and give out loans. So in case of a bank, capital
(read money) is a raw material as well as the final product. Bank accepts deposits and pays the
depositor an interest on those deposits. The bank then uses these deposits to give out loans for which
it charges interest from the borrower.
Of the cash reserve, a bank is mandated to maintain a certain percentage of deposits with the
Reserve Bank of India (RBI) as CRR (cash reserve ratio), on which it earns lower interest. Whenever
there is a reduction in CRR announced in the monetary policy, the amount available with a bank, to
advance as loans, increases which acts as a positive for Banks in healthy credit off-take scenario. The
second part of regulatory requirement is to invest in Government Securities that is a part of its
statutory liquidity ratio (SLR). The bank’s revenues are basically derived from the interest it earns from
the loans it gives out as well as from the fixed income investments it makes. If credit demand is lower,
the bank increases the quantum of investments in Government Securities.
Apart from this, a bank also derives revenues in the form of fees that it charges for the various
services it provides (like processing fees for loans and forex transactions). In developed economies,
banks derive nearly 50% of revenues from this stream. This stream of revenues contributes a
relatively lower 15% in the Indian context.
Having looked at the profile of the sector in brief, let us consider some key factors that influence a
bank’s operations. One of the key parameters used to analyse a bank is the Net Interest Income (NII).
NII is essentially the difference between the bank’s interest revenues and its interest expenses. This
parameter indicates how effectively the bank conducts its lending and borrowing operations (in short,
how to generate more from advances and spend less on deposits).
Interest revenues

Interest revenues = Interest earned on loans + Interest earned on investments + Interest on deposits
with RBI.
Interest on loans:
Since banking operations basically deal with ‘interest’, interest rates prevailing in the economy have a
big role to play. So, in a high interest rate scenario, while banks earn more on loans, it must be noted
that it has to pay higher on deposits also. But if interest rates are high, both corporates and retail
classes will hesitate to borrow. But when interest rates are low, banks find it difficult to generate
revenues from advances. While deposit rates also fall, it has been observed that there is a squeeze on
a bank when bank rate is soft. A bank cannot reduce interest rates on deposits significantly, so as to
maintain its customer base, because there are other avenues of investments available to them (like
mutual funds, equities, public savings scheme).
Since a bank lends to both retail as well as corporate clients, interest revenues on advances also
depend upon factors that influence demand for money. Firstly, the business is heavily dependent on
the economy. Obviously, government policies (say reforms) cannot be ignored when it comes to
economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail
spending (especially for new capacities). This means that they will borrow lesser. Companies also
become more efficient and so they tend to borrow lesser even for their day-to-day operations (working
capital needs). In periods of good economic growth, credit off-take picks up as corporates invest in
anticipation of higher demand going forward.
Similarly, growth drivers for the retail segment are more or less similar to the corporate borrowers.
However, the elasticity to a fall in interest rate is higher in the retail market as compared to
corporates. Income levels and cost of financing also play a vital role. Availability of credit and
increased awareness are other key growth stimulants, as demand will not be met if the distribution
channel is inadequate.
Interest on Investments and deposits with the RBI
The bank’s interest income from investments depends upon some key factors like government
policies (CRR and SLR limits) and credit demand. If a bank had invested in Government Securities in a
high interest rate scenario, the book value of the investment would have appreciated significantly
when interest rates fall from those high levels or vice versa.
Interest expenses
A bank’s main expense is in the form of interest outgo on deposits and borrowings. This in turn is
dependent on the factors that drive cost of deposits. If a bank has high savings and current deposits,
cost of deposits will be lower. The propensity of the public to save also plays a crucial role in this
process. If the spending power for the populace increases, the need to save reduces and this in turn
reduces the quantum of savings.
Key parameters to keep in mind while analysing a banking stock
As we had mentioned earlier, cash is the raw material for a bank. The ability to grow in the long-term
therefore, depends upon the capital with a bank (i.e. capital adequacy ratio). Capital comes primarily
from net worth. This is the reason why price to book value is important. As a result, price to book value

is important while analysing a banking stock rather than P/E. But deduct the net non-performing asset
from net worth to get a true feel of the available capital for growth.
Before jumping to the ratio analysis, let’s get some basic knowledge about the sector. The Banking
Regulation Act of India, 1949, governs the Indian banking industry. The banking system in India can
broadly be classified into public sector, private sector (old and new) and foreign banks.
The government holds a majority stake in public sector banks. This segment comprises of SBI and its
subsidiaries, other nationalized banks and Regional Rural Banks (RRB). The public sector banks
comprise more than 70% of the total bank branch network in the country.
Old private sector banks have a largely regional focus and they are relatively smaller in size. These
banks existed prior to the promulgation of Banking Nationalization Act but were not nationalized due
to their smaller size and regional focus.
Private Banks entered into the sector when the Banking Regulation Act was amended in 1993
permitting the entry of new private sector banks. Foreign banks have confined their operations to
mostly metropolitan cities, as the regulations restricted their operations. However, off late, the RBI has
granted approvals for expansions as well as entry of new foreign banks in order to liberalize the
system.
Now let’s look at some of the key ratios that determine a bank’s performance.
Net interest margin (NIM):
For banks, interest expenses are their main costs (similar to manufacturing cost for companies) and
interest income is their main revenue source. The difference between interest income and expense is
known as net interest income. It is the income, which the bank earns from its core business of
lending. Net interest margin is the net interest income earned by the bank on its average earning
assets. These assets comprises of advances, investments, balance with the RBI and money at call.
Operating profit margins (OPM)
Banks operating profit is calculated after deducting administrative expenses, which mainly include
salary cost and network expansion cost. Operating margins are profits earned by the bank on its total
interest income. For some private sector banks the ratio is negative on account of their large IT and
network expansion spending.
Cost to income ratio
Controlling overheads are critical for enhancing the bank’s return on equity. Branch rationalization and
technology upgrade account for a major part of operating expenses for new generation banks. Even
though, these expenses result in higher cost to income ratio, in long term they help the bank in

improving its return on equity. The ratio is calculated as a proportion of operating profit including non-
interest income (fee based income).
Other income to total income
Fee based income account for a major portion of the bank’s other income. The bank generates higher
fee income through innovative products and adapting the technology for sustained service levels. This
stream of revenues is not depended on the bank’s capital adequacy and consequently, potential to
generate the income is immense. The higher ratio indicates increasing proportion of fee-based
income. The ratio is also influenced by gains on government securities, which fluctuates depending on
interest rate movement in the economy.
Credit to deposit ratio (CD ratio)
The ratio is indicative of the percentage of funds lent by the bank out of the total amount raised
through deposits. Higher ratio reflects ability of the bank to make optimal use of the available
resources. The point to note here is that loans given by bank would also include its investments in
debentures, bonds and commercial papers of the companies (these are generally included as a part of
investments in the balance sheet).
Capital adequacy ratio (CAR)
A bank’s capital ratio is the ratio of qualifying capital to risk adjusted (or weighted) assets. The RBI has
set the minimum capital adequacy ratio at 10% as on March 2002 for all banks. A ratio below the
minimum indicates that the bank is not adequately capitalized to expand its operations. The ratio
ensures that the bank do not expand their business without having adequate capital.
NPA ratio: The ‘net non-performing assets to loans (advances) ratio’ is used as a measure of the
overall quality of the bank’s loan book. Net NPAs are calculated by reducing cumulative balance of
provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad quality of
loans.
Provision coverage ratio The key relationship in analysing asset quality of the bank is between the
cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that
indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A
high ratio suggests that additional provisions to be made by the bank in the coming years would be
relatively low (if gross non-performing assets do not rise at a faster clip).

The banking sector plays a very vital role in the working of the economy and it is very important that
banks fulfil their roles with utmost integrity. Since banks deal with cash, there have been cases of
mismanagement and greed in the global markets. And hence, investors need to check up on the
quality of management.
Firms with negative cash flows
For firms with negative cash flows (generally during the capital expenditure mode), we can clearly not
use the DDM and the FCFE for discounting cash flows. Relative valuation methods such as PE and
EV/EBITDA also fail in the valuation of EBITDA negative companies. The most accepted methods of
valuation in such companies are FCFF and P/B methods. In case of certain companies, innovative
methods like P/Sales and P/Consumer, etc. are also used. Many a times loss making but asset heavy
businesses are valued by SOTP method based solely on valuing their assets (such as land banks for
some textile mills) on as-is basis.
Acquisition Valuation
At times different businesses bid for others in their own or other industries. Many a times, the motive
behind these acquisitions is to make use of possible synergies between the businesses to create
value. For example, an apparel manufacturing company may get into retailing in order to get vertically
integrated and make additional margins on its business as a whole. Similarly, a steel manufacturer
may acquire a coal mine in order to secure fuel supply for its operations. During such times,
acquisition of the target company may be strategically very important for the acquirer and thus the
acquirer may pay a premium over its intrinsic value. Sometimes the acquirer gets a control of the
target and uses its management and operational execution expertise to generate more value. In such
cases, the additional price paid by the acquirer to get control is termed as the control premium. Such
a premium is generally seen to be given to a majority shareholder of the target which currently has the
controlling stake in the target. Another such premium given is for non-compete clause. This clause
makes sure that the management and promoters of the target company do not start another such
similar businesses in direct competition with the acquirer for a specified amount of time.
Distressed Companies
Distressed securities are securities of companies or government entities that are either already in
default, under bankruptcy protection, or in distress and heading toward such a condition. When
companies enter a period of financial distress, the original holders often sell the debt or equity
securities of the issuer to a new set of buyers. In recent years, private investment partnerships such
as hedge funds have been the largest buyers of distressed securities. Other buyers include brokerage
firms, mutual funds, private equity firms, and specialized debt funds
(such as collateralized loan obligations) are also active buyers. Investors in distressed securities often
try to influence the process by which the issuer restructures its debt, narrows its focus, or implements
a plan to turn around its operations. The US has the most developed market for distressed securities.
Other international markets (especially in Europe) have become more active in recent years as the
amount of leveraged lending increased, capital standards for banks have become more stringent, the
accounting treatment of non-performing loans has been standardized and insolvency laws have been
modernized. Investors in distressed securities typically must make an assessment not only of the
issuer’s ability to improve its operations but also whether the restructuring process (which frequently
requires court supervision) might benefit one class of securities more than another.
During the recent crisis, we saw many Indian real estate companies trading at historic lows on account
of being highly leveraged and having lack of cash flows to support such leverage. These companies
then saw many rounds of equity infusion through QIP route and restructured/ refinanced or repaid
their debt. This, however, presented an opportunity for investors to invest in such companies at fairly
low levels and see the prices appreciate as these companies improved their cash flows and mended
their debt levels. Investing in distressed companies involves a fair amount of judgement about the
future path of the company, availability of sustained financing, improved business conditions and
residual value of assets, etc.

Valuation of Firms
10
Weighted Average Cost of Capital
Before doing the valuation of any company an analyst should know its weighted average cost of
capital i.e. discounting rate. Now the question arises here what is WACC?
Generally firms employ several types of capital, called capital components, with equity and preferred
stock, along with debt, being the three most frequently used types. All capital components have one
feature in common: The investors who provided the funds expect to receive a return on their
investment.
The required rate of return on each capital component is called its component cost, and the cost of
capital used to analyze capital budgeting decisions should be a weighted average of the various
components’ costs. We call this weighted average cost of capital, or WACC.
We can find out the weighted average cost of capital by applying the formula:
WACC = Ke*We + Kd*Wd(1-t)+Kpf*Wpf
Where,
Ke = Cost of Equity
We = Weight of Equity
Kd = Cost of Debt
Wd = Weight of Debt
Kpf = Cost of Preferred Stock
Wpf = Weight of Preferred Stock
t = Tax Rate
Cost of Debt Kd(1-t): Generally cost of debt is calculated by applying the formula i.e. Kd = Interest /
Debt
Suppose a company had issued debt in the past, and its bonds are publicly traded. The financial staff
could use the market price of the bonds to find their yield to maturity (or yield to call if the bonds sell
at a premium and are likely to be called). The YTM (or YTC) is the rate of return the existing

bondholders expect to receive, and it is also a good estimate of Kd, the rate of return that new
bondholders would require.
If a company had no publicly traded debt, its staff could look at yields on publicly traded debt of
similar firms. This too should provide a reasonable estimate of Kd.
The required return to debt holders, Kd, is not equal to the company’s cost of debt because, since
interest payments are deductible, the government in effect pays part of the total cost. As a result, the
cost of debt to the firm is less than the rate of return required by debt holders. The after-tax cost of
debt, Kd(1-t), is used to calculate the weighted average cost of capital, and it is the interest rate on
debt, Kd, less the tax savings that result because interest is deductible.
After-tax component cost of debt = Interest rate – Tax savings
= Kd – t*Kd
= Kd(1-t)
Therefore, if a company can borrow at an interest rate of 10 percent, and if it has a marginal tax rate
of 30 percent, then its after-tax cost of debt is 7 percent:
Kd (1-t) = 10 (1-.3) = 7%
Cost of Preferred Stock Kpf:: Generally cost of preferred stock is calculated by applying the formula i.e.
Kpf = Dpf / Pn
Where,
Dpf = Dividend on Preferred Stock
Pn = Net issuing price of Preferred Stock which is the price the firm receives after deducting
flotation costs
Suppose that a company has preferred stock that pays 10 Rs. dividend per share and sells for
Rs.100 per share. If the company issued new shares of preferred, it would incur a flotation
cost of 5 percent, or Rs.5.00 per share, so it would net Rs. 95.00 per share. Therefore, cost of
preferred stock is 10.52 percent:
Kpf = 10 / 95 = 10.52 %
Cost of Equity Ke: Companies can raise common equity in two ways: (1) directly by issuing new shares
and (2) indirectly by retaining earnings. In both the cases the required rate of return is equivalent to
cost of equity. There are generally three ways to find out the cost of equity. They are as follows:
a) The Capital Asset Pricing Model

b) The Discounted Cash Flow Method
c) The Bond-Yield Risk-Premium Approach
These methods are not mutually exclusive — no method dominates the others, and all are subject to
error when used in practice. Therefore, when faced with the task of estimating a company’s cost of

equity, we generally use all three methods and then choose among them on the basis of our
confidence in the data used for each in the specific case at hand.
CAPM Approach
To estimate the cost of equity using the Capital Asset Pricing Model (CAPM), we proceed as
follows:
a) Estimate the risk-free rate (Rf)

b) Estimate the current expected market risk premium (Rm – Rf)
c) Estimate the stock’s beta coefficient and use it as an index of the stock’s risk (βi)
d) Substitute the preceding values into the CAPM equation to estimate the required rate of return
on the stock in question
Ke = Rf + (Rm – Rf) βi
Suppose the beta of a company is 1.1. Take the risk-free rate as 10 year Treasury bill yield rate i.e.
7.43%. The return on market index is 15%. So the return on company’s stock is:
Ke = 7.43 + (15 – 7.43) 1.1 = 15.757 %
It should be noted that although the CAPM approach appears to yield an accurate, precise estimate of
Ke, it is hard to know the correct estimates of the inputs required to make it operational because (1) it
is hard to estimate the beta that investors expect the company to have in the future, and (2) it is
difficult to estimate the market risk premium. Despite these difficulties, surveys indicate that CAPM is
the preferred choice for the vast majority of companies.
Discounted Cash Flow Approach (DCF): In the previous chapter “Valuation of Stocks”, we saw that if
dividends are expected to grow at a constant rate, then the price of a stock is
D1
Po 
Ke  g
Here Po is the current price of the stock
D1 is the dividend expected to be paid at the end of Year 1
Ke is the required rate of return.
We can solve for Ke to obtain the required rate of return on common equity:
D1
Ke  g
P0
Thus, investors expect to receive a dividend yield, D 1/Po, plus a capital gain, g, for a total expected
return. In equilibrium this expected return is also equal to the required return, K e. This method of
estimating the cost of equity is called the discounted cash flow, or DCF, method. Three inputs are
required to use the DCF approach: the current stock price, the current dividend, and the expected
growth in dividends. Of these inputs, the growth rate is by far the most difficult to estimate.
We can use these approaches for estimating the growth rate: (1) historical growth rates, (2) the
retention growth model, and (3) analysts’ forecasts.
Historical Growth Rates If earnings and dividend growth rates have been relatively stable in the past,
and if investors expect these trends to continue, then the past realized growth rate may be used as an
estimate of the expected future growth rate.
Retention Growth Model Most firms payout some of their net income as dividends and reinvest, or
retain, the rest. The payout ratio is the percent of net income that the firm pays out as a dividend,
defined as total dividends divided by net income; the retention ratio is the complement of the payout
ratio: Retention ratio= (1 - Payout ratio). ROE is the return on equity, defined as net income available
for common stockholders divided by common equity. The growth rate of a firm will depend on the
amount of net income that it retains and the rate it earns on the retentions. Using this logic, we can
write the retention growth model:
g = ROE (Retention ratio)
Analysts’ Forecasts Analysts publish growth rate estimates for most of the larger publicly owned
companies. For example, Value Line provides such forecasts on more than 1000 companies. Further,
several companies compile analysts’ forecasts on a regular basis and provide summary information
such as the median and range of forecasts on widely followed companies. However, these forecasts
often involve non-constant growth.
Suppose a company stock sells for Rs. 35; its next expected dividend is Rs. 3.00; and its expected
growth rate is 7 percent. The expected and required rate of return, hence its cost of common stock,
would then be 15.57 percent:
Ke = 3.00/35.00 +7 = 15.57 %
Bond-Yield-plus-Risk-Premium Approach
Here Analysts use the formula i.e. Ke = Bond Yield + Risk Premium
Suppose the 10 year bond yield in the market is 7.43% and risk premium is 3%.
Ke = 7.43% + 3% = 10.43%
Because the 3 percent risk premium is a judgmental estimate, the estimated value of Ke is
also judgmental.
Weighted Average Cost of Capital (WACC)
Suppose the capital structure of the company is as follows:

Common Equity: 200000 Rs.
Preferred Stock: 100000 Rs.
Debt: 200000 Rs.
Cost of Equity = 10%
Cost of Preferred Stock = 20%
Cost of Debt = 15%
Tax Rate = 30%
We = 200000/500000 = 0.4
Wpf = 100000/500000 = 0.2
Wd = 200000/500000 = 0.4
WACC = 0.4 * 10% + 0.2 * 20% + 0.4 * 15% (1-0.3) = 12.2 %

Discounted Cash Flow Corporate Valuation Model
The corporate valuation model is the present value of expected future free cash flows, discounted at
the weighted average cost of capital. In a sense, the corporate valuation model is the culmination of
all the material covered so far like analysis of financial statements, cash flows, financial projections,
time value of money, risk & return, and the cost of capital.
Corporate assets are of two types: operating and non-operating. Operating assets, in turn, take two
forms: assets-in-place and growth options. Assets-in-place include such tangible assets as land,
buildings, machines, and inventory, plus intangible assets such as patents, customer lists, reputation,
and general know-how. Growth options refer to opportunities the firm has to increase sales. They
include opportunities arising from R&D expenditures, customer relationships, and the like.
Most companies also own some non-operating assets. Financial, or non-operating, assets are
distinguished from operating assets and include items such as investments in marketable securities
and non-controlling interests in the stock of other companies. For most companies operating assets
are far more important than non-operating assets. Moreover, companies can influence the values of
their operating assets but the values of non-operating assets are largely out of their direct control.
There are five steps in estimating the value of a firm under discounted cash flow model. They are as
follows:
1. Estimating the free cash flow for the explicit forecast period
2. Estimating the growth in earnings
3. Computing the weighted average cost of capital
4. Computing the terminal or continuing value
5. Determination of value of the firm
We have already discussed about how to compute WACC and growth in earnings. Now we will discuss
the rest processes.
Estimating the Value of Operations: Free cash flow (FCF) is the cash from operations that is actually
available for distribution to investors, including stockholders, bondholders, and preferred
stockholders. It represents the cash that a company is able to generate after laying out the money
required to maintain or expand its asset base. It is important because it allows a company to pursue
opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make
acquisitions, pay dividends and reduce debt. FCF is calculated as:
If you carefully observe first three lines of the above mentioned equation, you will find that it is actually
the cash flow from operating activities. So it measures the financial performance of the company
which is calculated as operating cash flow minus capital expenditures.
The value of operations is the present value of all the future free cash flows expected from operations
when discounted at the weighted average cost of capital:

Value of operations = Vop = PV of expected future free cash flow
FCF1 FCF2 FCF

  .......
(1  WACC ) (1  WACC )
1 2
(1  WACC ) 

FCFt

t 1 (1  WACC)t
To find the value of operations as a going concern, we use an approach similar to the non-constant
dividend growth model, proceeding as follows:
a) Assume that the firm will experience non-constant growth for N years, after which it will grow at
some constant rate.
b) Calculate the expected free cash flow for each of the N non-constant growth years.
c) Recognize that after Year N growth will be constant, so we can use the constant growth formula
to find the firm’s value at Year N. This is the sum of the PVs for year N +1 and all subsequent
years, discounted back to Year N.
d) Find the PV of the free cash flows for each of the N non-constant growth years. Also find the PV
of the firm’s value at Year N.
e) Now sum all the PVs, those of the annual free cash flows during the non-constant period plus
the PV of the Year N value, to find the firm’s value of operations.
The terminal or horizon value is the value of operations at the end of the explicit forecast period. It is
also called the continuing value, and it is equal to the present value of all free cash flows beyond the
forecast period, discounted back to the end of the forecast period at the weighted average cost of
capital:
Terminal Value = Vop (at time N)
FCFN 1 FCFN (1  g )
 
WACC  g WACC  g
Suppose the weighted cost of capital is 20% with FCF at the end of period 1 = 200, FCF at the end of
period 2 = 500, FCF at the end of period 3 = 400. After that FCF is growing at a constant growth rate
of 5% each year up to infinity. The valuation of operation is as follows:
5% Growth up
Time: 0 1 2 3 4 to infinity ∞
20%
PV = ? 200 500 400 400 * 1.05
First we need to find out the terminal value at the end of period 3 by using the above mentioned
formula i.e.
TV3 = 400 (1+0.05) / (20% - 5%) = 2800 Rs.
Now our time line has been reduced to:

Time: 0 20% 1 2 3
PV = ? 200 500 400 + 2800

=3200
166.67
347.22
1851.85
2365.74
In this way we can find out the value of operations. The value of non-operating assets is usually close
to the figure reported on the balance sheet. The corporate valuation model can be used to calculate
the total value of a company by finding the value of operations plus the value of non-operating assets.
Relative Corporate Valuation Model
Comparable Company Approach: The objective in the discounted cash flow approach to valuation is to
value the assets based on their cash flows, growth and risk characteristics whereas the objective in
the comparable company approach is to value assets based on how similar assets are priced in the
market place. It is also termed as relative valuation.
Basis of Relative Valuation: The relative valuation or the comparable company approach to valuation
is based on the principle of substitution which states that "one will pay no more for an item than the
cost of acquiring an equally desirable substitute". In this approach, the value of a firm is derived from
the value of comparable firms, based on a set of common variables like earnings, sales, cash flows,
book value etc.
Advantages of Relative Valuation:
I. Valuation based on multiples and comparable firms can be done with fewer assumptions and at
a faster rate than the discounted cash flow valuation
II. The relative valuation is simple and easy to understand and present to clients than the
discoursed cash flow valuation.
III. The relative valuation measures the relative value of the asset rather than the intrinsic value
and hence it reflects the current atmosphere of the market.
Process of Relative Valuation
(i) Analysis of the Firm: The valuer should analyze the profitability position of the firm by looking
 Return on capital employed

 Return on Net worth
 Operating profit
 Net profit
He should also analyze the liquidity and solvency position of the firm by looking current & quick ratio
and interest coverage ratio & debt service coverage ratio. He can also check the efficiency of business

by analyzing the different turnover ratio like Asset turnover ratio, inventory turnover ratio etc. The
working capital requirements and capital structure of the firm should also be analyzed. He may
conduct the sensitivity analysis.
The qualitative analysis includes assessing the position of the firm in the industry, market share,
competitive advantage, managerial evaluation, the ownership pattern, technological performance etc.
(ii) Identification of Comparable Firms: A comparable firm is one with cash flows, growth potential and
risk similar to the firm being valued. The valuer has to carefully assess the general profile of the
industry, competitive structure, demand-supply position, installed capacities, pricing system,
availability of inputs, government policies and regulatory framework, etc.
The parameters for identification of comparable firms include product profile, scale of operations,
markets served, cost structures, geographical location, technology, etc.
(iii) Comparison and Analysis: The historical financial statements (balance sheet, profit & loss account
and cash flow/funds flow statement) of the firm being valued and the comparable firms are to be
analyzed, so as to identify the dissimilarities between them. The dissimilarities essentially arise
due to variations in accounting policies. Some of the common areas of dissimilarities are method
of inventory valuation, depreciation policies, valuation of intangible assets, treatment of off
balance sheet items, etc. Once such dissimilarities are identified appropriate adjustments are to
be made to make the firms comparable.
(iv) Selection of Valuation Multiples: The price of a stock is a function of both the value of the equity in
a company and the number of shares outstanding in the firm. Since stock prices are determined
by the number of units of equity in a firm, they cannot be compared across different firms. To
compare the values of "similar" firms in the market, you need to standardize the values in some
way. Values can be standardized relative to the earnings firms generate, to the book value or
replacement value of the firms, to the revenues that firms generate or to measures that are
specific to firms in a sector. Different Valuation Multiples are as follows:
1. Earnings Multiples: One of the more intuitive ways to think of the value of any asset is as a multiple
of the earnings that assets generate. When buying a stock, it is common to look at the price paid
as a multiple of the earnings per share generated by the company. This price/earnings ratio can be
estimated using current earnings per share, which is called a trailing PE, or an expected earnings
per share in the next year, called a forward PE. When buying a business, as opposed to just the
equity in the business, it is common to examine the value of the firm as a multiple of the operating
income or the earnings before interest, taxes, depreciation and amortization (EBITDA). While, as a
buyer of the equity or the firm, a lower multiple is better than a higher one, these multiples will be
affected by the growth potential and risk of the business being acquired.
2. Book Value or Replacement Value Multiples: While markets provide one estimate of the value of a
business, accountants often provide a very different estimate of the same business. The
accounting estimate of book value is determined by accounting rules and is heavily influenced by
the original price paid for assets and any accounting adjustments (such as depreciation) made
since. Investors often look at the relationship between the price they pay for a stock and the book
value of equity (or net worth) as a measure of how over- or undervalued a stock is; the price/book
value ratio that emerges can vary widely across industries, depending again upon the growth
potential and the quality of the investments in each. When valuing businesses, you estimate this
ratio using the value of the firm and the book value of all assets (rather than just the equity). For
those who believe that book value is not a good measure of the true value of the assets, an
alternative is to use the replacement cost of the assets; the ratio of the value of the firm to
replacement cost is called Tobin’s Q.
3. Revenue Multiples: Both earnings and book value are accounting measures and are determined by
accounting rules and principles. An alternative approach, which is far less affected by accounting
choices, is to use the ratio of the value of an asset to the revenues it generates. For equity
investors, this ratio is the price/sales ratio (PS), where the market value per share is divided by the
revenues generated per share. For firm value, this ratio can be modified as the value/sales ratio
(VS), where the numerator becomes the total value of the firm. This ratio, again, varies widely
across sectors, largely as a function of the profit margins in each. The advantage of using revenue
multiples, however, is that it becomes far easier to compare firms in different markets, with
different accounting systems at work, than it is to compare earnings or book value multiples.
4. Sector-Specific Multiples: While earnings, book value and revenue multiples are multiples that can
be computed for firms in any sector and across the entire market, there are some multiples that
are specific to a particular sector. While there are certain conditions under which sector-specific
multiples can be justified, they are dangerous for two reasons. First, since they cannot be
computed for other sectors or for the entire market, sector-specific multiples can result in
persistent over or under valuations of sectors relative to the rest of the market. Second, it is more
difficult to relate sector specific multiples to fundamentals, which is an essential ingredient to
using multiples well. The result will not only vary from company to company, but will also be difficult
to estimate.
The measurement of sector specific multiples varies from sector to sector though they share some
general characteristics. They are similar in the following characteristics. The numerator is usually
enterprise value - the market values of both debt and equity netted out against cash and
marketable securities. The denominator is defined in terms of the operating units that generate
revenues and profits for the firm.
For manufacturing firms that produce a homogeneous product (in terms of quality and units), the
market value can be standardized by dividing by the number of units of the product that the firm
produces or has the capacity to produce.
Value per unit product = (Market value of equity + Market value of debt) / Number of units
produced
For subscription-based firms such as cable companies, internet service providers and information
providers, revenues come from the number of subscribers to the base service provided. Here, the
value of a Firm can be stated in terms of the number of subscribers.
Value per subscriber = (Market value of equity + Market value of debt) / Number of subscribers
(v) Valuation of the Firm: The final step involves valuing the firm in relation to the comparable firm.
This requires applying the multiples identified to the firm being valued. This is a highly subjective
process. This process may provide several different values depending on the multiple applied. In
such possibility, average value may be computed based on the values depending on the multiple
applied. In case the valuer believes that a particular multiple(s) is/are more important, weighted
arithmetic average may be used by assigning appropriate weight ages that reflect the comparative
importance of each multiple.

Despite the fact that the use of multiples is simple, there are four steps in using them soundly. First,
the multiple consistently is defined and uniformly measured across the firms being compared.
Second, there should be a sense of how the multiple varies across firms in the market. In other words,
a high value, a low value and a typical value of the multiple in question should be identified. Third, the
fundamental variables that determine each multiple and how changes in these fundamentals affect
the value of the multiple is identified. Finally, the actual comparable firms are found out and adjusted
for differences between the firms on fundamental characteristics.
Example: Compute the value of ABC Ltd. with the help of the relative valuation approach using the
following information:
Sales Rs. 200 Cr
Profit after tax Rs. 30 Cr
Book value Rs. 120 Cr
The valuer feels that 50% weight age should be given to earnings in the valuation process. Sales and
book value may be given equal weight ages. The valuer has identified three firms which are
comparable to the operations of ABC Ltd.
(Rs. In Crore)
Particulars XYZ Ltd. ITC Ltd. ABB Ltd.

Sales 160 240 300
Profit After Tax 24 36 50
Book Value 80 180 200
Market Value 240 300 480
Solution: The Valuation multiples of the comparable firms are as follows:
Particulars XYZ Ltd. ITC Ltd. ABB Ltd. Average

Price/Sales Ratio 1.50 1.25 1.60 1.45
Price/Earnings Ratio 10.00 8.33 9.60 9.31
Price/Book Value Ratio 3.00 1.67 2.40 2.36
The Value of ABC Ltd. is as follows:
Particulars Multiple Parameters Value

Price/Sales Ratio 1.45 200.00 290.00
Price/Earnings Ratio 9.31 30.00 279.33
Price/Book Value Ratio 2.36 120.00 282.67

The weight age to P/S ratio, P/E Ratio and the P/BV ratio are 1, 2 and 1 respectively, thus the
weighted average value will be:
DISADVANTAGES OF RELATIVE VALUATION: Though relative valuation has its own strengths compared
to the discounted cash flow valuation, these strengths might sometimes prove to be weaknesses:
I. Relative valuation sometimes leads to inconsistent estimates of value because key variables
like risk, growth and cash flows are ignored.
II. The fact that multiples reflect the market mood also implies that using relative valuation to
estimate the value of an asset can result in values that are too high, when the market is over
valuing comparable firms, or too low, when it is under valuing these firms.
III. The lack of transparency regarding the underlying assumptions in relative valuation makes
them particularly vulnerable to manipulation.
Relative and Discounted Cash Flow Valuations: Discounted cash flow valuation and relative valuation
generally yield different estimates of value for the same firm. Even within relative valuation, different
estimates of value are obtained depending upon which multiple is used and on what firms the
valuation is based on.
The reason for the differences in value between discounted cash flow valuation and relative valuation
is the different views of market efficiency, or in particular, market inefficiency. In discounted cash flow
valuation, it is assumed that the markets make mistakes and that these mistakes are corrected over
time. These mistakes can often occur across entire sectors or even the entire market. In relative
valuation, it is assumed that while markets make mistakes on individual stocks, they are corrected on
average. Thus, a stock may be overvalued on a discounted cash flow basis but undervalued on a
relative basis, if the firms used in the relative valuation are all overpriced by the market. The reverse
would occur, if an entire sector or market were under-priced.
Sum Of The parts (SOTP)
An approach to valuing a company in which each business unit / operation is valued based on either
discounted free cash flows (DCF) or peer multiples. The sum of these parts makes up the total
enterprise value (EV) of the company (value of operations).
SOTP is regarded as the best tool to value companies with diversified business interests. It evaluates
each business or division of the company separately and assigns a value to its contribution. This
valuation also captures future potential of the new ventures which are not generating revenues right
now. At the end, the values of all the parts (including core business) are added up to arrive at an
approximate value of the company as a whole. SOTP valuation indicates if the company’s value would
be increased if it was split into separate business units.
Consider a company that has three business divisions – a power generation plant, a sugar
manufacturing business and a confectionery business. The approach that we take here is that we
treat each of these businesses as a different strategic business unit (SBU) having its own Balance
Sheet and P&L. In turn we assume that each of these businesses has a different risk, sources and

uses of funds, different RoEs and different growth rates which is a fairly logical thing to do considering
the nature of three businesses. We then use either DCF or price multiples to come up with value of
each business and thus come up with the EV and subsequently value of equity of the firm.
Relative Valuation
In relative valuation, the value of an asset is compared to the values assessed by the market for
similar or comparable assets. To do relative valuation then
 We need to identify comparable assets and obtain market values for these assets.
 Convert these market values into standardized values, since the absolute prices cannot be
compared. This process of standardizing creates price multiples.
 Compare the standardized value or multiple for the asset being analyzed to the standardized
values for comparable asset, controlling for any differences between the firms that might
affect the multiple, to judge whether the asset is under or overvalued.
 Most valuations in the markets are relative valuations
 Almost 85% of equity research reports are based upon a multiple and comparables.
 More than 50% of all acquisition valuations are based upon multiples
 Rules of thumb based on multiples are not only common but are often the basis for final
valuation judgments.
While there are more discounted cash flow valuations in consulting and corporate finance, they are
often relative valuations masquerading as discounted cash flow valuations.
 The objective in many discounted cash flow valuations is to back into a number that has been
obtained by using a multiple.
 The terminal value in a significant number of discounted cash flow valuations is estimated
using a multiple.
Relative valuation is much more likely to reflect market perceptions and moods than discounted cash
flow valuation. This can be an advantage when it is important that the price reflect these perceptions
as is the case when, the objective is to sell a security at that price today (as in the case of an IPO)
investing on “momentum” based strategies with relative valuation, there will always be a significant
proportion of securities that are undervalued and overvalued. Since portfolio managers are judged
based upon how they perform on a relative basis (to the market and other money managers), relative
valuation is more tailored to their needs. Relative valuation generally requires less information than
discounted cash flow valuation (especially when multiples are used as screens).
Even if you are a true believer in discounted cash flow valuation, presenting your findings on a relative
valuation basis will make it more likely that your findings/recommendations will reach a receptive
audience. In some cases, relative valuation can help find weak spots in discounted cash flow
valuations and fix them. The problem with multiples is not in their use but in their abuse. If we can find
ways to frame multiples right, we should be able to use them better.

Case Study
11
CASE STUDY: Valuation of Firms”
On July 5, 2001, Amit, a portfolio manager at Amit group, a mutual fund management firm, pored over
analyst write-ups of ABC Ltd., the athletic shoe manufacturer. ABC’s share price had declined
significantly from the start of the year. Amit was considering buying some shares for the fund he
managed, the Amit Large–Cap Fund, which invested mostly in fortune 500 companies with an
emphasis on value investing. Its top holdings included Exxon Mobile, General Motors, McDonald’s, 3M
and others large cop, generally old-economy stocks. While the stock market decline over the last 18
months, Amit Large-Cap had performed extremely well. In 2000, the fund earned a return of 20.7
percent even as the S&P 500 fell 10.1 percent. The fund’s year-to-date return at the end of June,
2001 stood at 6.4 percent versus the S&P 500’s minus 7.3 percent.
Only a week ago, on June 28, 2001, ABC held an analysts’ meeting to disclose its fiscal year 2001
results. However, the meeting had another purpose. ABC management wanted to communicate a
strategy for revitalizing the company. Since 1997, ABC’s revenues had plateaued at around Rs. 9
billion, while net income had fallen from almost Rs. 800 million to Rs. 580 million (see Exhibit 1).
ABC’s market share in athletic shoes had fallen from 48 percent in 1997 to 42 percent in 2000 in
addition; recent supply-chain issues and the adverse effect of a strong dollar had negatively affective
revenue.
At the meeting, management revealed plans to address both top-line growth and operating
performance. To boost revenue, the company would develop more athletic shoe products in the mid
priced segment - a segment that it had overlooked in recent years. ABC also planned to push its
apparel line, which, under the recent leadership of industry veteran Narayan had performed extremely
well. On the cost side, ABC would exert more effort on expense control. Finally, company executives
reiterated their long-term revenue growth target of 8-10 percent, and earnings growth target of above
15 percent.
Analyst reactions were mixed. Some thought the financial targets to be aggressive, other significant
growth opportunities in apparel and ABC’s international businesses.
Amit read all the analyst reports that he could find about the June 28 meeting but the reports gave
him no clear guidance: a Lehman Brother report recommended a ‘Strong Buy’ while UBS Warburg and
CSFB analysts expressed misgiving about the company and recommended a ‘Hold’. Amit decided
instead to develop his own discounted-cash flow forecast to come to a Clearer conclusion.
His forecast showed that at a discount rate of 12 percent. ABC was overvalued at its current share
price of Rs. 42.09 (see Exhibit 2). However, he had done a quick sensitivity analysis that revealed ABC
was undervalued at discount rates below 11.2 percent. Since he was about to go into a meeting, he
requested his new assistant, Jyoti, to estimate ABC’s cost of capital.

Jyoti immediately gathered all the data she thought she might need (Exhibits 1 through 4) and set out
to work on her analysis.
Exhibit 1
ABC LTD.: COST OF CAPITAL
Consolidated Income Statements
Year Ended May 31 1995 1996 1997 1998 1999 2000 2001
(In millions except per share data)
Revenues 4760.80 6470.60 9186.50 9553.10 8776.90 8995.10 9488.80
Cost of goods sold 2865.30 3906.70 5503.00 6065.50 5493.50 5403.80 5784.90
Gross Profit 1895.50 2563.90 3683.50 3487.60 3283.40 3591.30 3703.90
Selling and administrative 1209.80 1588.60 2303.70 2623.80 2426.60 2606.40 2689.70
Operating Income 685.70 975.30 1379.80 863.80 856.80 984.90 1014.20
Interest Expense 24.20 39.50 52.30 60.00 44.10 45.00 58.70
Other Expense, net 11.70 36.70 32.30 20.90 21.50 23.20 34.10
Restructuring Charge, net 0.00 0.00 0.00 129.90 45.10 (2.50) 0.00
Income before income taxes 649.80 899.10 1295.20 653.00 746.10 919.20 921.40
Income Taxes 250.20 345.90 499.40 253.40 294.70 340.10 331.70
Net Income 399.60 553.20 795.80 399.60 451.40 579.10 589.70
Diluted Earnings per common share 1.36 1.88 2.68 1.35 1.57 2.07 2.16
Average shares outstanding (diluted) 294.00 293.60 297.00 296.00 287.50 279.80 273.30
Growth (%)
Revenue 35.9 42.0 4.0 (8.1) 2.5 5.5
Operating Income 42.2 41.5 (37.4) (0.8) 15.0 3.0
Net Income 38.4 43.9 (49.8) 13.0 28.3 1.8
Margin(%)
Gross Margin 39.6 40.1 36.5 37.4 39.9 39.0
Operating Margin 15.1 15.0 9.0 9.8 10.9 10.7
Net Margin 8.5 8.7 4.2 5.1 6.4 6.2
Effective tax rate (%) * 38.5% 38.6% 38.8% 39.5% 37.0% 36.0%
* The Statutory tax rate was 35%. The state tax varied yearly from 2.5% to 3.5%.

Exhibit 2
Discounted Cash Flow Analysis
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Assumptions
Revenue Growth (%) 7.0 6.5 6.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0
COGS/Sales (%) 60.0 60.0 59.5 59.5 59.0 59.0 58.5 58.5 58.0 58.0
S&A/Sales (%) 28.0 27.5 27.0 26.5 26.0 25.5 25.0 25.0 25.0 25.0
Tax Rate (%) 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
Current Assets/Sales (%) 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0 38.0
Current Liabilities/Sales (%) 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5 11.5
Yearly Depreciation and Capex equal each other
Cost of Capital (%) 12.0
Terminal Value Growth Rate (%) 3.0
Discounted Cash Flow Periods 1 2 3 4 5 6 7 8 9 10

Operating Income 1218.4 1351.6 1554.6 1717.0 1950.0 2135.9 2410.2 2554.8 2790.1 2957.6
Taxes 463.0 513.6 590.8 652.5 741.0 811.7 915.9 970.8 1060.2 1123.9
NOPAT 755.4 838.0 963.8 1064.5 1209.0 1324.2 1494.3 1584.0 1729.9 1833.7
Capex net of depreciation 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Change in NWC 8.8 (174.9) (186.3) (198.4) (195.0) (206.7) (219.1) (232.3) (246.2) (261.0)
Free Cash Flow 764.2 663.1 777.5 866.1 1014.0 1117.5 1275.2 1351.7 1483.7 1572.7
Terminal Value 17998.7
Total Flows 764.2 663.1 777.5 866.1 1014.0 1117.5 1275.2 1351.7 1483.7 19571.4
Present Value of Flows 682.3 528.6 553.4 550.4 575.4 566.2 576.8 545.9 535.0 6301.5
Enterprise value 11415.6

Less: current outstanding debt 1296.6
Equity Value 10119.0
Current Shares Outstanding 271.5
Equity Value per share at 12% 37.27 Current Share Price 42.09
Sensitivity of equity value to discount rate:

Discount Rate Equity Value Note: Terminal value is estimated using the
8.00% 75.8 constant growth model
8.50% 67.85 FCFt * (1  Ter min alValueGrowthRate)
9.00% 61.25 TV 
WACC  g
9.50% 55.68
10.00% 50.92
1572.7 * (1  0.03)
10.50% 46.81 TV 
12%  3%
11.00% 43.22
11.17% 42.09
11.50% 40.07
12.00% 37.27

Exhibit 3
Consolidated Balance Sheets
May 31
As of 2000 2001
(In Millions)
Assets
Current Assets
Cash and Equivalents 254.3 304.0
Accounts receivable 1569.4 1621.4
Inventories 1446.0 1424.1
Deferred Income taxes 111.5 113.3
Prepaid Expenses 215.2 162.5
Total Current Assets 3596.4 3625.3
Property, plant and equipment, net 1583.4 1618.8
Identifiable intangible assets and goodwill, net 410.9 397.3
Deferred income taxes and other assets 266.2 178.2
Total Assets 5856.9 5819.6
Liabilities and Shareholders' equity
Current Liabilities
Current portion of long term debt 50.1 5.4
Notes Payable 924.2 855.3
Accounts Payable 543.8 432.0
Accrued Liabilities 621.9 472.1
Income Taxes Payable 0.0 21.9
Total Current Liabilities 2140.0 1786.7
Long Term Debt 470.3 435.9
Deferred income taxes and other liabilities 110.3 102.2
Redeemable Preferred Stock 0.3 0.3
Shareholders' equity
Common Stock, par 2.8 2.8
Capital in excess of stated value 369.0 459.4
Unearned Stock Compensation (11.7) (9.9)
Accumulated other comprehensive income (111.1) (152.1)
Retained Earnings 2887.0 3194.3
Total Shareholders' equity 3136.0 3494.5

Total liabilities and Shareholders' Equity 5856.9 5819.6

Exhibit 4
Capital Market and Financial Information
On or around July 5, 2001
Current yields on Treasuries
3-month 3.59%
6-month 3.59%
1-year 3.59%
5-year 4.88%
10-year 5.39%
20-year 5.74%
Historical Equity Risk Premiums (1926-1999)
Geometric Mean 5.90%
Airthmetic Mean 7.50%
Current yield on publicly traded ABC Debt
Coupon 6.75% paid semi annually
Issued 7/15/1996
Maturity 7/15/2021
Current price 95.60
ABC Historic Betas
1996 0.98
1997 0.84
1998 0.84
1999 0.63
2000 0.83
Average 0.8
Consensus EPS Estimates
FY2002 FY2003
2.32 2.67
ABC Share Price on July 5, 2001 42.09
Dividend History and Forecasts
Payment dates 31-Mar 30-Jun 30-Sep 31-Dec Total
1997 0.10 0.10 0.10 0.10 0.40
1998 0.12 0.12 0.12 0.12 0.48
1999 0.12 0.12 0.12 0.12 0.48
2000 0.12 0.12 0.12 0.12 0.48
2001 0.12 0.12
Dividend Growth Forecast from 98-00 to 04-06 5.50%

How to Prepare a
Research Report? 12
Every Analyst makes a research report at the end of his/her analysis work. Research report is a
summary of the analysis work where the analysts make a recommendation (In the case of equity
research report: Buy or Sell the particular equity?). Preparation of research report is dependent on two
aspects: 1) Analysts’ Nature of Analysis 2) Types of Research Report (We are concerned here only
about equity research report).
Some Analysts follow Top to Bottom Approach whereas some analysts follow Bottom to Top approach.
ECONOMY ASPECTS COMPANY ANALYSIS
INDUSTRY ANALYSIS INDUSTRY ANALYSIS
COMPANY ANALYSIS ECONOMY ASPECTS
TOP TO BOTTOM BOTTOM TO TOP

APPROACH APPROACH
You can prepare a research report by segregating the research report into three parts 1) Business
Analysis 2) Financial Analysis 3) Summary
The format should be as follows:
o Company Description
 General description of group activity (brief)
 History (brief)
 Strategy – Main objectives
 Recent Events & Outlook
 Business Development
 Shareholder Structure Pattern
 others
o Economics of business
 Sales
 Split (+ growth rates) by
 Activity / Product
 Geography
 Currency Exposure

 Sensitivity (key drivers & risks)

 Market outlook / trends by activity/product/geography
 Margins
 Levels & Trends by division / activity
 Key drivers & Risks
 Sensitivity Matrix
 Historical (3yrs) + Volatility
 Seasonality
 EPS
 Sensitivity Matrix by sales/margins
o Debt & Liquidity analysis
 Structure
 Maturity Schedule
 Covenants
 Type
 Rating (Consensus)
 Dupont Analysis
o Risk Analysis
 Liabilities
 Off-balance Sheet items
 Litigations
 Main on-going Lawsuits (Positives & Negatives)
o Shareholding structure
 Free float & Main/Reference Shareholders
 Shareholder's Pacts / Agreements
 Hidden Interests
 Special Rights / Shares Class
o Group Structure
 Investments / Holdings
 Consolidation Structure
o Management
 Main figures (CEO, Chairman, CFO, COO)
 Career History (Main Management Positions)
 Highlights of Successful/Unsuccessful Events
 Board Members
 Company Affiliation
 Other Boards Positions
o Valuation (based on Consensus Estimates)
 Absolute Ratios
 Ratios chosen according to Sector
 Actual Levels (based on consensus)
 Historical Ratios (3 yrs and 5 yrs average)
 Relative Ratios vs Peers & Sector
 Definition of Peers
 Sum of the Parts
 By Activity
 LBO Model
 Inverted DCF + Sensitivity Matrix
o Market Sentiment
o Investment Summary

But in general the equity research report consists of:
1. SYNOPSIS
2. COMPANY DESCRIPTION
 BUSINESS MODEL
 REVENUE MODEL
 MANAGEMENT PART DISCUSSION
 FINANCIAL ANALYSIS
3. FOREWARD / OUTLOOK DISCUSSION
4. RISK MANAGEMENT
5. VALUATION
6. FINANCIAL STATEMENTS
 BALANCE SHEET
 INCOME STATEMENT
 CASH FLOW STATEMENT
 RATIO ANALYSIS
7. DISCLAIMER
So the preparation of research report depends on analysts’ nature and types of research report. We
are giving you one example of a research report based on infrastructure Industry prepared by BLB Ltd.
Please read it and you will get some ideas about How to Prepare a Research Report.
Presents an investment idea - Provides market perspective - Detailed company analysis.
All the research analysts have access to, more or less, the same information i.e. annual reports,
quarterly reports etc., In-fact, all good analysts and experts of a sector have similar things to say. So
how does one stand out and be the best?
Research analysts, make a difference by the way in which they present their views, conclusions and
recommendations. The communication aspect of an analyst’s job is as important as analysis, of which
writing research report is one.
Writing research reports, to an extent, is a creative process. Creativity in the sense of how one
structures the report and communicates the message. What an analyst does is to take in is a lot of
financial information and give out is an understandable version of what that financial information
mean. The process of converting numbers to views does demand for the certain qualities. As with
many other creative processes, there is no single answer to this question but there are certain ground
rules which one can follow to make a good report.
 Clarity of Idea
 Simplicity of delivery
 Presenting the argument clearly
 Narrative structure
 Create customized reports according to the reader type
Writing a good research report - Planning, Drafting and Editing:
Like any other writing projects, compiling research reports also have three important steps - Planning,
Drafting and Editing. The major sections of a research report include:
Company business, peer group analysis, shareholding pattern, key strengths, key concerns, industry
overview, company fundamentals, key financial indicators and financials.
Fact-based sections in research report:
Peer group analysis, shareholding pattern, company fundamentals, key financial indicators and
financials.
View-based section in research report:
Company Business, Key Strengths, Key concerns, Industry Overview.
Things to watch-out:
There are thousands of reports prepared after every results season and only a few of them get the
attention. What makes the other reports fail? After observation of many years, the following are a few
reasons that are listed out for failure of a research report:
 Unnecessary details
 Long sentences
 No proper structure
 Inconsistent views
 Complex language

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01. Fundamental Analysis Introduction 4

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Can I be a fundamental analyst?

1. Understanding the basic financial statements

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Investible grade attributes? What does that mean?

1. Management’s background – Who is they, their background, experience, education, do they

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Quantitative aspects include many things, to name few:

1. Profitability and its growth

Why is fundamental analysis relevant for investing?

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Efficient Market Hypothesis (EMH)

Weak form EMH

Semi-strong form EMH

Strong form EMH

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Arguments against EMH

The Behavioural Aspect

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Steps in Fundamental Analysis

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Indicator Favourable impact Unfavourable impact

WHAT IS AN ECONOMIC INDICATOR?

DIFFERENT ECONOMIC INDICATORS AND THEIR IMPACTS

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For different rates, please visit the RBI website.

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LIFE CYCLE OF AN INDUSTRY

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Chart 1: Life cycle of an industry and investment approach

Let us discuss each stage of the Industry Life Cycle:

Maturity The new ‘S’ curve

Invest Discontinuity Phase

Chart 2: The ‘S’ Curve

Evaluation of an industry should encompass four critical areas:

1. What are the strengths of the industry?

KEY CHARACTERISTICS OF INDUSTRY ANALYSIS

Absolute Imperfect Perfect

Chart 3: Market structure of an industry

 Product differentiation advantages through patents, brand-value, technology, market-access,

MICHAEL PORTER FIVE FORCES’ MODEL

Chart-4: The Five Competitive Forces

Company Analysis – Non

 How are things changing around (consumer tastes and preferences)?

The different issues regarding a company that should be examined are:

THE MANAGEMENT – Non Financial Aspect

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General Analysis of Companies