Manipal Institute of Management

Financial Statement Analysis

Case Study Analysis

Salsa International

Report Submitted By

Michelle Imma Carvalho 191202004

Gyan Karkera 191202014
Dhanya Prabhu 191202056
Cypnie Dalmeida 191202078
Nitin Sudhakar Shetty 191202094

Report Submitted to
Dr. Nandan Prabhu K P
Questions answered by Dhanya Prabhu 191202056 (1-3)

1. Why is it that mere circulation of funds does not create wealth?

Mere circulation of funds does not create wealth. In this case, Salsa international has not
created any wealth by mere transfer of cash from shareholders to company, then to the
franchisees and all the way back to the company. There is no additional cash. Salsa
company has not earned a bona fide profit. Bona fide profit is revenue minus the cost. It
includes all genuine revenue earned and all relevant costs. After earning bona fide profit,
the owners of the company are wealthier than they were before as there is additional
cash generation. In this case it was mere showing of fees as revenue and further as
accounting profit. Accounting profit does not add anything to owner’s wealth. Once the
investors are aware of this circulation of funds, the company will lose its ability to
generate accounting profits by raising new funds in stock market. Further, the investors
can suffer hefty loss once the stock price fall to zero when it is brought to investor’s
knowledge that reported profits are not increasing wealth.

2. What is technical meaning of wealth creation? Can we equate value creation with
wealth creation?

Wealth is created by buying or investing in cash, land, property, gold, shares, bonds with
an expectation that the price will move higher. This rise is price over a period of time leads
to wealth creation. Wealth creation is different from value creation. Taking the example
of physical asset such as property, value is created or we can say income is earned in the
form of rent whereas wealth is created by appreciation on such property. When investors
invest in shares, value creation is income in the form of dividend and wealth creation is
by hike in stock price. Physical and financial assets can create value as well as wealth. NPV
is present value of future cash inflow- present value of cash outflow. Inflow won’t be more
than outflow and hence true creation of wealth does not happen.
 3. How do you link three imperatives of the calculation of present value of future cash
inflows with wealth creation?

Three imperatives are cn / (1+r)t for calculation of the present value of future cash inflow.
C is magnitude of cash flow.
R is minimum rate of return a firm must earn to ensure that expected ROR = Actual ROR.
T is time. The return should be received at the earliest.
The present value of cash flow is calculated to create value. However, the three
imperatives are not in consonance with the money circulation business such as Salsa
International.

Questions answered by Michelle Imma Carvalho 191202004 (4-6)

4. How is depreciation used to change the net profits? What should a financial analyst do
while calculating the net income of a company?
Depreciation which is charged to P&L is discretionary in nature. The depreciation amount
can be changed by either changing method of depreciation or the rate of depreciation. By
charging high depreciation, the net profits can be shown less or net loss. The financial
analyst must calculate net income by adding back depreciation to it to understand actual
or excess cash flow in the company.

5. Should depreciation be altogether ignored? What is the result? What is the theoretical
rationale behind charging depreciation?

Matching Principle is the theoretical rationale behind depreciation as the assets is used
by the company for a certain period and though the assets remains the same, but the
efficiency of the asset might reduce which is why depreciation is charged. Companies
charge high rate of depreciation as this results in increase in the expenses and decrease
 in the net income which would help them in paying less amount of tax to the government.
No, it should not be ignored as many companies try to value the true profits of the
organization by adding back the depreciation, but Real estate business ignore
depreciation.

6. What do Real estate owners do while they charge depreciation? Why do they urge to
disregard depreciation while calculating true net profits? How do real estate owners
create wealth and yet reduce their income tax?

The Real estate is considered to be one of the investments that have tax advantage and
this is because of real estate depreciation. The rental property owner pay tax for a very
small portion of their actual revenue generated. The real estate owners charge
depreciation on the building to reduce the book value of net profit or to show net loss in
the books of accounts and reduce the proportion of tax paid or to not pay tax at all. The
real estate owners make use of acceleration method of depreciation in which higher rate
of depreciation is charged initially and gradually the depreciation rate is reduced in later
years. The real estate owners buy land frequently and charge high rate of depreciation to
show more net loss and reduce the amount of tax. The property must be owned by the
real estate owner; they cannot lease a property and then charge depreciation on the
asset.

Questions answered by Nitin Sudhakar Shetty 191202094 (7-9)

7. Is depreciation, therefore, a tax saving expense?

Yes, as depreciation is a discretionary item it can be considered as tax saving expense.

Depreciation expense is the largest tax deduction available and can help improve cash
flow by reducing the tax liabilities.
 8. How do real estate owners sell properties at profits though they do not show profits in
their Profit and Loss A/c?

The real estate owners charge high rate of depreciation so that there are no profits as per
the books but there will be value for the property or land. The real estate owners buy land
frequently and charge high rate of depreciation to show more net loss and reduce the
amount of tax.

9. Does it imply that actual profits of a real estate firm should be calculated in a way other
than that of accounting profits?

Yes, in order to know the actual profits of a real estate firm, the type of calculation is
different than that of accounting profits. Earnings Before Interest, Depreciation and
Amortization (EBIDA) method of measuring the earnings must be applied here. This is so
because the Gross Profit method only takes into account the direct costs and not the
indirect costs of the business. EBIDA shows the earnings by adding back the debt capital
cost, depreciation and amortization. Thus, it takes into account the non-cash expenses
such as depreciation which can make a big difference in knowing the real earnings of a
real estate firm.

Questions answered by Cypnie Dalmeida 191202078 (10-12)

10. In income tax calculations, does the government allow the businesses to charge
depreciation at a rate higher than the rate of depreciation charged for accounting
purposes? If so, why?

Yes, the Income Tax Act specifies the percentage of depreciation for various assets of any
business and this percentage is higher than the life of those assets. Taxes are based on
 the amount of earnings of a business. Depreciation is an expense that reduces the
earnings of the company. The depreciation is set high so that the taxes charged on the
earnings are reduced. This is done by the government in order to attract businessmen
and encourage them to conduct business activities without making them feel like paying
the taxes is a burden for their company.

11. Do you perceive the power of lobbying exercised by real estate Moghuls in the tax
code’s relaxation on the rate of depreciation rates?

The high rate of depreciation in the real estate business can also be attributed to the
power of lobbying. Those who are real estate developers have gone on making
extraordinary wealth, thus becoming Moghuls. This has given them the power or
influence of exercising lobbying. These instances can be seen all around the world. Most
prominent example would be Mr Donald Trump, a real estate businessman who went on
to become the president of the United States of America.

12. Can businesses show permanent losses though they create huge wealth? How does
broadcasting business is a case of typical example for this phenomenon?

Businesses can indeed show permanent losses even though they are able to create huge
wealth. In the broadcasting business, a huge amount is spent on buying the broadcasting
equipment such as the spectrums to communicate. Although they spend less on building
by opting for a small or medium sized building, they have to invest hugely on the
necessary digital products. These assets also show high depreciation and thus high losses.
But over the years, the value of these assets only tends to increase like the value of land
in the real estate business. Hence there is an advantage to make big profits by selling the
equipment at huge prices.
Questions answered by Gyan Karkera 191202014 (13-16)

13. What represents true profits? Accounting profits? EBIT? EBITDA? What do these
represent? What is your rationale?

The main indicator of the performance of a business is its profits. Generally, the
calculation of profits consists of deducting the expenses of the business from its revenues.
Businesses can calculate their accounting profit by using the accounting profit formula
given below.
Accounting profit = Revenues – Explicit Expenses
In the above formula, revenues consist of all income that a business generates from its
operations. It is also known as income or sales of the business. On the other hand, explicit
expenses consist of all the expenses of the business from its accounting system.
EBIT represents earnings that have interest and taxes added back to them whereas
EBITDA stands for Earnings before interest, taxes, depreciation and amortization. The
adding back of depreciation and amortization is the only key difference between EBIT and
EBITD.
The bonafide profits are the true profits whereas accounting profits which are obtained
in lieu of GAAP principles can be easily manipulated as it doesn’t give the actual profit as
seen in salsa international case where the circulation of money was shown as revenue.
EBIT doesn’t show the actual profit as it includes the depreciation and tax.
The actual profits of a company are obtained by adding back depreciation, amortization
and the interest (EBITDA). Therefore, EBITDA is the correct description of actual profit.

14. How do you represent the value creation in the form of a formula from the economic
point of view?

Value creation can be defined as giving something valuable to receive something else
that’s more valuable to you. The definition is broad and captures both costs and benefits.
 In accounting we use economic value added (EVA) or economic profit which is a measure
based on residual income technique that serves as an indicator of the profitability of the
projects undertaken.

The underlying premise of this concept consists of the idea that real profitability occurs
when additional wealth is created for shareholders and the projects should create returns
above their cost of capital.

EVA= NOPAT – (WACC*capital invested)

Where,

NOPAT= net operating profits after tax

WACC= weighted average cost of capital

Capital invested = Equity+ long-term debt at the beginning of the period.

15. How best to represent the true profits from an accounting point of view?

The best way to represent the true profits is to use EBITDA as it excludes the impact of
accounting and financing decisions related to capital expenditure, it allows for more
accurate comparisons between similar firms. EBITDA can be used to analyse and compare
profitability among companies and industries, as it eliminates the effects of financing and
capital expenditures. EBITDA is often used in valuation ratios and can be compared to
enterprise value and revenue. It is considered a more reliable indicator of a company’s
operational efficiency and financial soundness because it enables investor to focus on
company’s baseline profitability without capital expenses factored into assessment.
16. What is the difference in profits from an accounting point of view and the economic
point of view?

Accounting profits are the net income for a company which is revenue minus expense. It
includes explicit cost such as raw materials and wages.
Economic profit includes explicit and implicit cost, which are implied or imputed costs. It
also includes the opportunity cost which is determined by economic principles and not by
accounting principles.
The key difference between these 2 are that economic profit is based on more of
theoretical calculations on alternative actions which could be taken whereas accounting
profit calculates what actually occurred and the measurable results for the specified
period.