Department of Finance and Accounting: IBS, IFHE, Hyderabad

Program: MBA
Semester: III
Course: Syndicated Learning Program (SLP-3)
Academic Year: 2021-22
Department of Finance and Accounting

IBS, IFHE, Hyderabad
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Dr. D Satish
Area Head, Department of Finance & Accounting
Resource Persons:
Dr. M.V. Narasimha Chary (Course Coordinator)
Dr. D. Srinivasa Chary
Prof. C. Anita
Dr. Pramod Mantravadi
Dr. P. Bhanu Sireesha
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TABLE OF CONTENTS
Basics of AFM, FM1 and FM2 divided into 6 parts covered in 6 sessions.
S.No. Broader Topic Sub-Topics Pg. No.

1. Accounting Concepts and Conventions 4
2. Journal Entries and their reflection on
1 Financial Accounting 5
Financial Statements
3. Financial statements of different sectors (Corporates,
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Banks & Financial Services)
1. Cost concepts and behaviour 15
Cost and Management
2 2. Cost-Volume-Profit analysis 18
Accounting
3. Activity Based Costing 19
1. Time Value of Money - Concepts and Applications 21
3 Time Value of Money 2. Equity and Bond Valuation 22
3. Capital Budgeting Techniques 24
1. Identifying and Interpreting Key Financial Ratios for any
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Industry/Company
Corporate 2. Using concepts of Relative Valuation and
4 31
Performance Enterprise Value, in Valuation of Companies
3. Application of Balanced Scorecard Framework in
36
Strategy and Performance Management
1. Security Risk & Return (Ex-post and Ex-ante) 38
5 Risk and Return 2. Portfolio Risk & Return 40
3. Portfolio Diversification 42
1. Impact of leverage on capital structure: EBIT-EPS
Capital Structure, 46
analysis
6 Working Capital and 2. Estimation & funding of Working capital 48
Dividend Policy
3. Bonus shares, stock split and share buyback 51
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1. FAQs on Broader Topic: Financial Accounting
Sub-topic: 1. Accounting Concepts and Conventions
1. Definition of Accounting
Accounting is a systematic process of identifying, recording, measuring, classifying, verifying, summarizing,
interpreting and communicating financial information for use by the end users. It reveals profit or loss for a
given period and the value and nature of a firm’s assets, liabilities and owners’ equity.
Identify accounting information, record all relevant information, measure in monetary terms, similar
transactions classified into groups, verifying the correctness of the recording, find the net balances by
summarizing, analyse to arrive at results, interpret to understand the impact of the result and communicate to
the end users.
2. All concepts
Business entity concept
Every business gets a separate legal status as compared to its owners. All activities will be conducted on the
name of the business and not the persons who own / operate / or otherwise are associated with the entity.
Examples are: Gujarat Polymers Ltd., Infosys Ltd., HDFC Bank Ltd., Reddy & Associates.
Going concern concept

An entity is expected to continue to operate for an indefinitely long period in the future. Here, it is assumed
that the resources currently available to the entity will be used in its future operations. Owners may change but
the business continues to operate.
Cost concept
In accounting, all transactions are recorded at their cost only (not at the market value).
Money measurement concept

Money is expressed in terms of its value at the time of its record. So, this concept suggests recording the
transactions only in monetary terms. Thus, any subsequent changes in the purchasing power of money will not
affect the amount recorded.
Duality concept
Every transaction has 2 aspects and accounting involves recording both these aspects. Hence, it is called dual
aspect concept.
Economic resources of an entity are assets. Claims of various parties against these assets are equities. Equities
are of 2 types – liabilities (claims by outsiders) and owners’ equity (claims by owners).
This gives rise to an equality between the two, Assets = Liabilities + Equity.
Accrual concept
Whether the transactions are involving cash movement or not, accounting information needs to be recorded
for such transactions on the basis of the time of happening and its certainty of happening. In contrast to this
concept, there is cash method also available. Example: Goods purchased on credit will be recorded on the date
of purchase rather than the date of payment for it.
Accounting period concept

Instead of waiting till the end of the life of the entity to know the profits made, owners, management and other
interested parties are interested to know the income earned at frequent intervals. They also want to see how
things are going on. Hence, specific intervals are created, generally 1 year period called the accounting period,
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for reporting to outsiders. In India, the financial year (Apr to Mar) is taken as the accounting period by all
business entities.
Matching concept
Every sale has revenue attached with expenses. To measure the net effect of the sale, there is a need to
recognize both these aspects in the same accounting period. When an event affects both revenues and
expenses, the effect on each of these should be recognized in the same accounting period. First identify the
revenue realizable for the accounting period, then match the corresponding expenses incurred to generate such
revenue.
Consistency concept
In accounting, once an entity decides to follow one accounting method, it should use the same method for all
subsequent events of the same character unless it has a sound reason to change it. Frequent changes will make
it difficult to make comparisons across periods.
Realization concept
The realization concept indicates the amount (how much) of revenue that should be recognized from a given
sale. It says that the amount to be recognized as revenue should be the amount that is reasonably certain to be
realized, i.e., the amount that customers are reasonably certain to pay. For example, if there is a sale of goods
at a discount, then the revenue to be recorded should be the lower amount (after deduction of the discount),
and not the normal price.
Conservatism concept
This concept says, recognize revenues only when they are reasonably certain and recognize expenses as soon
as they are reasonably possible.
Materiality concept
According to this concept, trivial matters may not be considered. Accountants do not attempt to record events
so insignificant that the work of recording them is not justified by the usefulness of the results. So, insignificant
events may be disregarded from individual recording and probably can be clubbed into a category called
miscellaneous items and recorded.
Full disclosure
Unlike the materiality concept, all important information will have to be compulsorily be disclosed in the
accounts. According to this concept, all important information about the financial condition and activities of the
entity must be disclosed in the reports. In case the information is not possible to show in the financial
statements, the information must be presented separately under notes.
Sub-topic: 2. Journal Entries and their reflection on Financial Statements
1. Types of accounts:
Accounts are basically classified into three types:
Personal accounts: The accounts of those aspects of the transactions involving persons (natural, artificial or
representative)
Real accounts: The accounts of those aspects of the transactions involving possessions of the business (any
asset, owned and used for conducting the business, can be tangible or intangible)
Nominal accounts: The accounts of those aspects of the transactions involving incomes, revenues, expenses and
losses of the business.
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2. Golden rules of accounting:
For Personal accounts, the rule is: Debit the receiver, and Credit the giver
For Real accounts, the rule is: Debit what comes in, and Credit what goes out
For Nominal accounts, the tule is: Debit all expenses and losses, and Credit all incomes and gains
3. Journal entries for transactions:

a. Incurring huge expenditure for purchase of Plant, Property & Equipment (PPE):
A 5 floored building has been acquired and centrally air conditioned. Total cost incurred includes Rs.80
lakhs for the building and Rs.12 lakhs for the air conditioning. The journal entry for such transaction will
be:
PPE (Building) A/c …………………………. Dr. Rs.80,00,000

PPE (Air conditioners) A/c ……………….. Dr. Rs.12,00,000
To Bank A/c Rs.92,00,000
Description:
‘PPE’ (possession / asset) is Real account, ‘Bank’ (your money maintained in the bank account, is a
possession / asset) is Real account.
Effect on Financial Statements:

Increase in PPE (Assets side of BS) and decrease in bank balance (Assets side of BS).
b. Assets depreciated / amortized:

Apart from the Buildings of Rs.80 lakhs, air conditioners of Rs.12 lakhs, the company also has a patent
for the design of the products it manufactures, valued at Rs.10 lakhs. The patent and air conditioners
have a life of 5 years, and the building for 10 years. Depreciation and amortization need to be charged
on the assets at the end of the financial year. The journal entry for such transaction will be:
Depreciation on Buildings A/c …………………………… Dr. Rs.8,00,000

To PPE (Buildings) A/c Rs.8,00,000
Depreciation on Air conditioners A/c ………………… Dr. Rs.2,40,000

To PPE (Air conditioners) A/c Rs.2,40,000
Amortization on Patents A/c …………………………….. Dr. Rs.2,00,000

To Patents A/c Rs.2,00,000
Description:
‘Depreciation’ and ‘Amortization’ are treated as Nominal account (they are expenses for the business),
‘PPE’ (possession / asset) is Real account, ‘Patents’ (possession / asset) is Real account.

Decrease in PPE (Assets side of BS) and increase in expenses of the business (resulting in less profit,
decrease in Retained Earnings) (Liabilities side of BS).
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c. Payment of interest on loan and repayment of principal loan:
A loan of Rs.1 crore, taken from ICICI bank five years ago, is maturing this day. The loan carries an
interest @ 10% p.a. Today the company repays the principal along with the last year’s interest to the
bank. The journal entry for such transaction will be:
ICICI Bank Loan A/c …………. Dr. Rs.100,00,000

Interest on bank loan A/c …… Dr. Rs.1000,000
Description:
‘ICICI Bank Loan’ (Bank is the person who offered loan to the company, i.e., the company is having a
business activity with a bank) is Personal account, ‘Interest on bank loan’ (expense) is Nominal account,
‘Bank’ (possession / asset) is Real account.

Decrease in Bank balance (Assets side of BS), increase in expenses of the business (resulting in less
profit, decrease in Retained Earnings) (Liabilities side of BS) and decrease in bank loan (Liabilities side
of BS).
d. Payment of corporate tax:

The company made a profit before tax of Rs.2 crores for the financial year on which it pays income tax
@ 30%. The journal entry for such transaction will be:
Income Tax A/c ……………………. Dr. Rs.60,00,000

Description:
‘Income tax’ (expense) is Nominal account, ‘Bank’ (possession / asset) is Real account.

Decrease in Bank balance (Assets side of BS) and increase in expenses of the business (resulting in less
profit, decrease in Retained Earnings) (Liabilities side of BS).
e. Payment of salaries by corporates:

Generally given answer is: Salaries A/c debited and Cash or Bank A/c credited
But, when a company pays salary to its employees, generally there would be certain amounts deducted
from the gross salary to arrive at the salary payable to the employees. These deductions include the
employer’s and employee’s contribution to EPF, advance tax payable by the employee to the Income
tax department, professional tax payable by employees, etc. All these will have to be considered while
writing the journal entry.
The journal entry shall be:

Employees’ Salaries A/c is debited with the gross salary amount [This is an expense for the company,
and falls under the category ‘nominal account’]
Bank A/c is credited with actual amount paid to the employees [This is a possession of the company in
the form of balance in the account, and falls under the category ‘Personal account’]
Provident Fund A/c is credited with (employees’ contribution + employer’s contribution) (which is part
of gross salary) [This is a receipt of money from employees, which needs to be paid off to the PF
department later by the company, and falls under the category ‘nominal account’]
Income tax A/c is credited with the amount that is deducted from employees’ salary towards income
tax [This is a receipt of money from employees, which needs to be paid off to the tax department later
by the company, and falls under the category ‘nominal account’]
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Professional tax A/c is credited with the amount deducted from employees’ salary [This is a receipt of
money from employees, which needs to be paid off to the tax department later by the company, and
falls under the category ‘nominal account’]
For example, Rs.10000 has been paid as salary to the employee, after deducting Rs.1000 as income tax,
Rs.1500 as employees share of provident fund, but before employers’ share of provident fund Rs.1500.
The journal entry for such transaction will be:
Salaries A/c …… Dr. Rs.12500

Employer’s contribution due A/c ……. Dr. Rs.1500
To Bank A/c Rs.10000
To TDS payable A/c Rs.1000
To PF payable (employees’ contribution) A/c Rs.1500
To PF payable (employer’s contribution) A/c Rs.1500

Increase in expenses of the business (resulting in less profit, decrease in Retained Earnings) (Liabilities
side of BS) and decrease in bank balance (Assets side of BS) and temporary accounts created for
payments due for various purposes.
f. Bad debts incurred:

Mars International India Pvt. Ltd. sold goods worth Rs.1000,000, to one of its customers, Big Bazaar, a
retail outlet on 1 March, 2020. Big Bazaar was supposed to make the payment by 1 June, 2020, but did
not honor the same. Mars International has exhausted all the possible recovery measures, but could
not recover the amounts. On February 28, 2021, Big Bazaar paid only Rs.2 lakhs in full and final
settlement for the supply. Journalize in the books of Mars International India Pvt. Ltd. The journal entry
for such transaction will be:
On 1 March, 2020:
Big Bazaar A/c ……………………………. Dr. Rs.10,00,000
To Sales A/c Rs.10,00,000
On 28 October, 2020:
Bank A/c ……………………………………… Dr. Rs.2,00,000
Bad debts A/c ……………………………… Dr. Rs.8,00,000
To Big Bazaar A/c Rs.10,00,000
Description:
‘Big Bazaar’ is Personal account, ‘Sales’ (revenue generated) is Nominal account, ‘Bank’ is Real account,
‘Bad debts’ (loss faced due to non-payment) is Nominal account.

Increase in bank balance (Assets side of BS), increase in expenses of the business (resulting in less profit,
decrease in Retained Earnings) (Liabilities side of BS), decrease in trade receivables (Assets side of BS).
g. Provision for bad and doubtful debts created:

Since the past 5 years, it has been observed that the company has been facing bad debts @ 2% of its
annual sales every year. During the current financial year that ended recently, the company had annual
sales worth Rs.5 crores, and it wants to make a provision to the extent of 2% for the bad and doubtful
debts. The journal entry for such transaction will be:
Provision for bad and doubtful debts expenses A/c …… Dr. Rs.10,00,000
To Provision for bad and doubtful debts A/c Rs.10,00,000
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Description:
‘PBDD Expenses’ is Nominal account, PBDD is exceptional account created to reduce asset.

Increase in expenses of the business (resulting in less profit, decrease in Retained Earnings) (Liabilities
side of BS) and decrease in trade receivables (Assets side of BS).
h. Issue of share capital, incurring expenses for raising the capital:

Issue of 100,000 equity shares of the company of face value Rs.500 each at Rs.1000. For this issue, the
company incurs Rs.20,00,000 as expenses on the public issue, which includes professional consultation,
underwriting commission, legal expenses, printing expenses, listing expenses, etc. The journal entry for
such transaction will be:
Bank A/c …………………. Dr. Rs.9,80,00,000

Expenses on Public Issue A/c ……. Dr. Rs. 20,00,000
To Equity Share Capital A/c Rs.5,00,00,000
To Securities Premium A/c Rs.5,00,00,000
Description:
‘Bank’ is Real account, ‘Expenses on Public Issue’ (capital expenses) (Nominal account), ‘Equity Share
Capital’ (represents the creation of liability to owners) (Personal account), ‘Securities Premium’ (capital
receipt, it is the extra amount contributed by the owners) (Nominal account).

Increase in bank balance (Assets side of BS) and increase in share capital account (Equity – Liabilities
side of BS) after adjusting the exceptional expenses incurred.
i. Creation of general reserve:

From the profit before tax of Rs.2 crores, the company paid 30% as income tax, and from the balance
(PAT) the company decides to transfer 15% to general reserve. The journal entry for such transaction
will be:
Retained Earnings A/c …………………………. Dr. Rs.21,00,000

To General Reserve A/c Rs.21,00,000
Description:
‘Retained Earnings’ (balance of accumulated profits) is exceptional account, ‘General Reserve’
(accumulated profits set aside) is exceptional account. Both accounts involve the owners’ funds, where
balance from one account is transferred to another account.

Decrease in Retained Earnings (Liabilities side of BS) and increase in General Reserve (Liabilities side of
BS).
j. Announcement of dividends and later on payment of the dividends:

Ramco Cements Ltd. announced an annual dividend of Rs.10 lakhs on its equity share capital for the last
financial year. The payment was done within one month of the declaration. The journal entries for such
transactions will be:
(a) For declaration of annual dividend:

Retained Earnings A/c …………………… Dr. Rs.10,00,000
To Proposed Annual Dividend A/c Rs.10,00,000
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(b) For payment of annual dividend:
Proposed Annual Dividend A/c ………. Dr. Rs.10,00,000
Description:
‘Retained Earnings’ (balance of accumulated profits) is exceptional account, ‘Proposed annual dividend’
(accumulated profits set aside) is temporarily created account, ‘Bank’ is real account.

Decrease in Retained Earnings (Liabilities side of BS) and decrease in Bank balance (Assets side of BS).
Sub-topic: 3. Financial Statements of different sectors (Corporates, Banks & Financial Services)
1. Accounting equation
Assets = Owners Equity + Liabilities
Non-Current Assets + Current Assets = Owners Equity + Non-Current Liabilities + Current Liabilities
2. Profit equation of a company / bank

For Company: Revenues (Sale of goods or services provided) (-) All Expenses
For Banks: Spread [Interest on loans (-) Interest on deposits] (-) Burden [Expenses other than interest
on deposits (-) income other than interest income]
3. What is the difference between journal entry and ledger posting?

Individual transactions are stored in the form of a journal entry which is made on the chronological
order. Whereas the information from the journal is summarized in the form of a ledger posting into
separate accounts, so that the result of all transactions relating to each such account can be easily
identified.
4. What is Trial Balance? What does an accurate Trial Balance suggest?

Trial Balance is a summary of all the balances of various ledger accounts and Cash / Bank accounts of
an organization at any given date. An accurate Trial Balance is evidence that all the transactions are
recorded according to the accounting concepts and principles. It also ensures arithmetical accuracy of
the process of ledger postings.
5. What is the difference between profit and loss account and income & expenditure statement?
P&L account is prepared for the business organization whose aim is to earn profit by running business
whereas Income and Expenditure statement is prepared for non-profit organizations, like Trusts.
6. How is Profit & Loss account linked to BS?

Profit & Loss account summarizes the revenues, costs and expenses incurred during a specific period of
time. A balance sheet provides both investors and creditors with a snapshot as to how effectively a
company’s management uses its resources. Profit & Loss account is linked to the BS through another
account called the retained earnings account, where the current year profit is adjusted to the proposed
dividends and then the leftover balance is transferred to the BS to complete the total amount due to
the shareholders of the company. The result of the Profit & Loss account becomes part of the Net worth
in the BS.
7. Key line items on Profit & Loss account of companies / banks

For Company: Revenue from operations, operating expenses, non-operating expenses and tax expenses
[Revenue from operations, other incomes, expenses including material consumed, stock in trade
purchases and changes, employee benefit expenses, finance costs, depreciation and amortization
expense, SG&A expenses, exceptional and extraordinary items, tax expense etc.]
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For Banks: Interest income, interest expenses, non-interest income, provisions for credit losses, non-
interest expenses and income tax expenses
8. Key line items on BS of companies / banks

For Company: Under assets: non-current assets and current assets. Under liabilities: equity, non-current
liabilities and current liabilities.
For Banks: Under assets: property, trading assets, loans to customers, deposits with RBI. Under
liabilities: loans from RBI, deposits from customers, trading liabilities, miscellaneous debt, common and
preferred shares
9. What is authorised share capital? Retained earnings? EPS? Net worth?

Authorised share capital refers to every share the company would be able to issue if it wanted to, or if
it became necessary to. It is the maximum amount that the company raise in the form of capital for the
company through its whole life. It is set by the shareholders and can only be increased with their
approval.
Retained earnings represents that part of the total earnings that have been retained for use (reinvested)
in the business. It is that part of the profit that has been retained in the business for further use in the
operations of the business after the distribution of the dividends to the owners. Hence, it is the
difference between the total earnings of the entity from its inception to date and the total amount of
dividends paid out to its shareholders over its entire life.
[The owners’ equity increases through earnings, the results of profitable operations of the entity, and
decreases when earnings are paid out in the form of dividends.]
EPS ‘Earnings per Share’ (EPS) is the amount of earning attributable to each equity share, or it is the
portion of the company’s profit allocated to each outstanding share of common stock of the company.
Net worth Net worth is a synonym used for the term owners’ equity. It includes paid in capital and
retained earnings.
10. What are debentures?

Debenture is a certificate of agreement of loan given under the company’s stamp and carries an
undertaking that the debenture holder will get a fixed return and the principal amount whenever the
debenture matures.
11. What is preference capital?

The capital that a company raises through the issuance of preference shares, which have a fixed rate of
dividend to be paid and a preferential right to avail profits and claim assets during liquidation.
12. Why should company distribute dividends to its shareholders?

Regular dividend payments are signals that a company is healthy and profitable. Also, issuing dividends
can attract investors/shareholders. A company may also distribute earnings to shareholders if it lacks
profitable investment opportunities.
13. Who has the first right on the cash flows of the firm: a bondholder or shareholder?
A bond holder always has the first right. Shareholders including those who own preferred stock, must
wait until bondholders are paid during a bankruptcy before claiming company assets.
14. Who is more senior creditor: a bondholder or shareholder?

A bond holder is always more senior. Shareholders (including those who own preferred stock) must
wait until bondholders are paid during a bankruptcy before claiming company assets.
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15. What is EBITDA?
EBITDA denotes the gross operating margin of the entity. It stands for the earnings before interest,
taxes, depreciation and amortization.
16. When should a company buy back its shares?

The effect of a buyback is to reduce the number of outstanding shares on the market, which increases
the ownership stake of the shareholders. A company might buy back shares because it believes the
market has discounted its shares too steeply, to invest in itself, or to improve its financial ratios.
17. What is goodwill?

The good reputation a company has with its customers, the trade names developed by the company,
factors that contribute to the value of a company, like the knowledge and skills that are built up as the
business operates, the teamwork that exists within the organization, the importance of a favourable
location, etc. all constitute to the goodwill of the company.
18. What are the different activities in a business shown on the cash flow statement?
The Cash Flow Statement showcases the cash generated and used during a period. It involves (a)
Operating activities (where business activities accounting to cash are considered); (b) Investing activities
(involving sale and purchase of assets of the company); and (c) financing activities (involving generation
and redemption of equities and other liabilities).
19. Walk me through the cash flow statement

Start with net income, go line by line through major adjustments (depreciation, changes in working
capital and deferred taxes) to arrive at cash flows from operating activities.
Mention capital expenditures, asset sales, purchase of intangible assets, and purchase / sale of
investment securities to arrive at cash flow from investing activities.
Mention repurchase / issuance of debt and equity and paying out dividends to arrive at cash flow from
financing activities.
The total of cash flows from operations, cash flows from investments and cash flows from financing
gives the total change of cash.
Beginning of the period cash balance plus the change in cash allows you to arrive at the end of the
period cash balance.
20. What do you understand by (a) procure to pay; (b) order to cash; (c) manufacturing execution
process?
(a) Procure to pay is the process of integrating purchasing and payables systems to create greater
efficiencies. It exists within the larger procurement management process and involves four key
stages: selecting goods and services; enforcing compliance and order; receiving and reconciliation;
and invoicing and payment.
(b) Order to cash process refers to a company’s business process for the entire order processing
system. This is a set of business processes to manage from sales order right through to customer
payments. It helps define the company’s success and its relationships with customers.
(c) Manufacturing execution process is an information system that monitors and tracks the process of
producing manufactured goods on the factory. Its overall goal is to make certain that manufacturing
operations are effectively executed to improve production output.
21. Can the profit of a company decrease though its revenue increases? Explain.
Profit of the company is the net of its revenues after deducting the expenses for the period. It is the
residual of all revenues and gains over all expenses and losses for the period. When revenues increase,
there could be increase in COGS, increase in expenses, decrease in allocated asset / resource value,
increase in borrowing interest, increase in tax, etc., thus resulting in a drop in the net income of the
company.
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22. Is it possible for a company to show positive cash flows but be in grave trouble?
Yes, it is possible, if a company sells off inventory but delays payables it is in such a position.
23. How is it possible for a company to show positive net income but go bankrupt?
A case of deteriorating working capital is an example of this situation. Here the trade receivables are
increasing and trade payables are lowering, for the company to go bankrupt.
24. Why are increases in trade receivables a cash reduction on the cash flow statement?
Since our cash flow statement starts with net income, an increase in trade receivables is an adjustment
to net income to reflect the fact that the company never actually received those funds.
25. I buy a piece of equipment. Walk me through the impact on the 3 financial statements.
Initially, when the equipment is purchased, there is no impact in the Profit and Loss account, the cash
goes down, and PP&E goes up in the Balance Sheet (BS), and the purchase of PP&E is a cash outflow in
the Cash Flow Statement (CFS).
Over the life of the asset: depreciation reduces the net income in the Profit and Loss account, PP&E
goes down by the depreciation, retained earnings go down in the BS, and depreciation is added back in
the cash from operations section as it is a non-cash expense that reduced the net income in the CFS.
26. What is a deferred tax liability and why might one be created?
Deferred tax liability is a tax expense amount reported on a company’s income statement that is not
actually paid in that time period, but is expected to be paid in the future. It arises when a company
actually pays lesser amount of taxes than they show as an expense on their P&L account for the period.
Differences in depreciation expense between Indian GAAP and Ind AS can lead to differences in income
between the two, which ultimately leads to differences in tax expense reported in the financial
statements and taxes payable.
27. How do you categorize interest and dividend in a Cash Flow Statement?
According to para 30, AS-3, In the case of a financial enterprise, the interest paid and the interest and
dividend received will be classified as cash flows arising from operating activities. Whereas, in the case
of other enterprises, cash flows arising from interest paid should be classified as cash flows from
financing activities while the interest and dividends received should be classified as cash flows from
investing activities. Dividends paid should be classified as cash flows from financing activities only.
28. How would you deal with the following while preparing final accounts?
a. Outstanding and prepaid expenses
b. Bad debts and provision for doubtful debts
Outstanding expenses are recognized as expenses in the Profit and Loss account and are also a current
liability in the Balance Sheet.
Prepaid expenses are expenses for a period beyond the current accounting period, hence are reduced
from the total expenses paid in the Profit and Loss account and are a current asset in the Balance Sheet.
Bad debts are the actual loss of revenue and provision for doubtful debts are an expected loss of
revenue. These are reduced from the trade receivables in the current assets of the balance sheet and
are to be reduced from the total revenue receivable in the Profit and Loss account.
29. What is a deferred tax asset and why might one be created?
Deferred tax asset arises when a company actually pays more in taxes to the Income Tax department
than they show as an expense on their income statement for the period.
Differences in revenue recognition, expense recognition and net operating losses can create deferred
tax assets.
30. Distinguish between Expenditure and Expense?

An expense is an item of cost applicable to the current accounting period. Expenditures take place when
an entity acquires goods or services. When expenditure is incurred, the related cost is either an asset
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or an expense. If the cost benefits future periods, it is an increase in an asset. If not, it is an expense
resulting in a reduction in the retained earnings of the current period.
31. Treatment of advertising expenses in financial statements.

Advertising is considered an expense item, as part of operating expenses recorded in profit and loss
statement. It is the amount a company incurs to promote its products, brands and image via television,
radio, magazines, internet, billboards, fliers, etc.
32. Can cash flow statement be negative?

Negative cash flow is not necessarily a sign of financial weakness. It occurs when the business has more
outgoing than incoming money. A company with negative free cash flow indicates an inability to
generate enough cash to support the business. Free cash flow tracks the cash a company has left over
after meeting its operating expenses. For example: growing companies will have negative cash flow
from investing activities.
33. Effect of depreciation on cash flow statement.

Depreciation is a non-cash item, so virtually it has no impact on the cash movement and therefore does
not impact cash flow statement. It is added back to the net profit in order to find the actual amount
involving cash movement in the operating activities.
34. How is finance different from accounting?

Finance focuses on planning and directing the financial transactions for an organization, while
accounting focuses on recording and reporting on those transactions.
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2. FAQs on Broader Topic: Cost & Management Accounting
Sub-topic: 1. Cost Concepts and Behavior
1. Classification of costs:
a. Nature of elements: Costs are divided into three categories, material cost, labor cost and
expenses. This type of classification is useful in determining the total cost.
b. Functions: Costs are divided according to the function for which they have been incurred, like
production cost, selling cost, distribution cost, administrative cost, research cost, development
cost, pre-production cost, conversion cost, etc.
c. Traceability: Costs are divided as direct costs and indirect costs. Direct costs are the costs that can
be identified with or attributed to the end product. Costs that cannot be identified or attributed
to the final product in particular are called Indirect costs.
d. Variability: Costs are classified into three categories, fixed cost, variable cost and semi-variable
(behavior-wise) cost. Fixed cost is that cost which remains constant at all levels of production, and
is incurred irrespective of the volume of output. Variable cost tends to vary with the volume of
output and is directly in proportion with every increase or decrease in the volume. Semi-variable
cost is partly fixed and partly variable in relation to output, and does not vary proportionately, but
does not remain stationary at all times.
e. Controllability: Costs are classified as controllable and uncontrollable costs. Controllable costs are
those costs that can be influenced by specific actions, whereas the costs that cannot be influenced
by any actions are Uncontrollable costs.
f. Normality: Costs are classified as normal and abnormal costs. Normal cost is the cost normally
incurred at a given level of output under the conditions at which that level of output is normally
attained. The cost that is not normally incurred at a given situation and conditions is called
Abnormal cost.
2. What is Prime Cost?

Prime cost includes all the costs that are directly attributed to the production of each product. It
includes the costs of direct materials and direct labor involved in manufacturing an item. Prime cost is
an important measure to aid the company in fixing prices for its products, help make improvements in
controlling inventory, minimizing waste, optimizing labor costs through smart scheduling, etc.
3. What are direct costs? Give examples.

Direct cost is a cost that can be directly tied / attributed to the production of specific goods or services.
It can be traced to the cost object, like service, product or department. Examples include cost of raw
material used for each unit of production, wages paid to the laborer for working on the conversion of
the materials, etc. All direct costs are variable by definition, since they can be directly traced to the cost
object and vary with volume of output.
4. What are indirect costs? Give examples.

Indirect cost is that cost which cannot be directly tied / attributed to the production of specific goods
or services. It benefits multiple products or projects. Examples include salaries paid to supervisors and
other employees, general administrative expenses, selling expenses, etc.
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5. What are overheads? Classify and give examples.
Overheads are costs that cannot be directly traced to the units of production. It refers to the ongoing
expense of operating a business and cannot be immediately associated with the products or services
being offered. However, overheads are still vital to business operations as they provide critical support
for the business to carry out profit making activities. Overheads are broadly classified as manufacturing
overheads, administrative overheads, selling and distribution overheads. Examples include production
facilities, depreciation of assets and equipment, rent of factory building, etc. under the manufacturing
overheads category. Under administrative overheads, we have employee salaries, office equipment and
supplies, legal and audit fees, etc. Under selling and distribution overheads we have salesmen’s salaries
and commission, travel expenses, entertainment costs, packaging and transportation costs, etc.
6. What is cost sheet / statement of cost? What is the need of preparing it?
Cost sheet is a statement prepared to show the various elements of cost, like prime cost, factory cost,
cost of production and total cost. It is prepared at regular intervals, so that assessment can be made
about the progress of the business. Cost sheet shows the cost per unit of any product at every level of
production which helps to know the stage of production and the price at which that particular
production stage has.
It helps the management in fixing selling prices; it acts as a guide to the management and helps in
formulating production policy; it enables to keep control over cost of production.
7. How many types of inventories can be maintained (for manufacturing / trading / services companies)?
There are three categories of inventories in a manufacturing sector: (a) raw materials (which are waiting
to be worked on), (b) work-in-progress (which are being worked on) and finished goods (which are ready
for shipping). For a firm carrying on trading activity, inventory will be restricted to finished goods and
supplies. In general, services sector does not involve in any tangible inventory; however, extensive
tangible inventory is required for wholesale and retail service providers as well as food service
providers.
8. What are step function costs? Give examples.

Step function costs are expenses that do not change steadily with changes in activity volume, and are
constant for a given level of activity, but change at discrete points, where the threshold is crossed. These
costs change disproportionately when there is a change in the production levels of a manufacturer, or
activity levels of any enterprise. Examples: the cost of starting a new production shift, which includes
utilities and the salaries of shift supervisors.
Examples of Direct costs

(a) Cost of raw materials or parts that go directly into producing the products
(b) Freight charges on raw materials purchased (also called as carriage inwards)
(c) Piece rate wages paid to laborers working on the conversion process
(d) Manufacturing supplies / consumable supplies
Examples of Indirect costs
(a) Production supervision salaries
(b) Quality control costs
(c) Insurance
(d) Depreciation
(e) Administrative and general expenses
(f) Selling, distribution, packing and marketing expenses
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Cost sheet format:
STATEMENT OF COST AND PROFIT
Particulars Rs. Rs. Rs.
Opening Raw Material Inventory
Add: Materials Purchased
Add: Freight on Material
Less: Purchases Returns
Less: Closing Raw Materials Inventory
Materials Consumed (A)
Direct Labor (B)
Other Direct Expenses (C)
PRIME COST (A+B+C)
Add: Factory Overheads:
All Items of indirect expenses incurred at factory level
Gross Works Cost
Add: Opening WIP Inventory
Less: Closing WIP Inventory
WORKS COST / FACTORY COST
Add: Administration Expenses:
All Items of indirect expenses incurred at office / administration level
COST OF PRODUCTION
Add: Opening Finished Goods Inventory
Less: Closing Finished Goods Inventory
COST OF GOODS SOLD
Add: Selling & Distribution Expenses:
All Items of indirect expenses incurred at selling and distribution level
COST OF SALES
Add: Profit
TOTAL SALES REVENUE
Sub-topic: 2. Cost-Volume-Profit Analysis
1. What is CVP analysis? Where is it used?

It studies the relationship between selling price per unit and total sales amount with total cost and
analyses its impact on the amount of profits. CVP is a tool that expresses relationship among total sales,
total cost and profit. It furnishes the complete picture of the profit structure and helps in planning of
profits. It answers “what-if” type of questions by providing the volume required to produce. This
concept is relevant in all decision-making areas, particularly in the short run.
2. What is marginal costing?

The estimated cost of producing one more unit of a product output or serving one more customer is
the marginal cost. Marginal costing is a technique where the marginal cost is charged to units of cost,
while the fixed cost for the period is completely written off against the contribution.
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3. Draw and explain CVP interrelations through a graph.
4. What is contribution? Is it the same as profit of the company?

It is the difference between sales revenue and variable cost. Variable cost is the important cost in
deciding profitability. The situation generating higher contribution is treated as a profitable one.
Contribution can be expressed in two ways:
(a) Sales Revenue (-) Variable Cost
(b) Fixed Cost (+) Profit
Contribution is not the same as profit of the company as it is used to recover the fixed costs first and
only the balance would be the profits.
5. How does contribution help in targeting profit?

More the contribution, more will be the profit as fixed costs are generally constant. Analyzing the
contribution helps managers make several types of decisions, whether to add or subtract a product line,
how to price a product or service, how to structure their sales commissions, etc. Checking the
contribution is a critical view on profit, because it forces the company to understand its cost structure,
segregation into variable and fixed.
6. What is PV ratio? What does it imply? Formula?

Profit Volume Ratio is the ratio of contribution to sales which indicates the contribution earned with
respect to one rupee of sales. It measures the rate of change in profit due to a change in volume of
sales. A high P/V Ratio indicates that a slight increase in sales without increase in fixed costs will result
in higher profits. A low P/V Ratio which indicates low profitability can be improved by increasing selling
price, reducing marginal costs or selling products having high P/V Ratio. It is calculated with the formula:
Contribution / Sales * 100.
7. What is break-even point? How does it help in making business decisions?

Break Even Point (BEP) is a volume of sales where there is neither loss nor profit. It means contribution
is enough to cover the fixed costs. Any contribution generated after BEP results in profits for the
organization. Profit maximization is the motive of every organization. Every organization uses BEP as a
base to take various decisions with regard to its sales volume and tries to increase it so that total fixed
costs can be covered as early as possible and more profits can be earned. It is calculated with the
formula:
(a) In terms of quantity: Fixed costs / Contribution per unit
(b) In terms of amount: Fixed costs / PV Ratio
8. How does calculation of BEP help me in decision making? / Name a few applications of marginal
costing.
The concept of marginal costing is practically applied in the following situations:
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(a) Evaluation of Performance: The evaluation of the performance of various departments or products
can be evaluated with the help of marginal costing which is based on contribution generating
capacity.
(b) Profit Planning: This technique through the calculation of P/V Ratio helps the management to plan
the activities in such a way that the profit can be maximized.
(c) Fixation of Selling Price: This technique assists the management to fix the price in such a way so that
prices fixed can cover at least the variable cost.
(d) Make or Buy Decisions: It helps the management in taking decisions whether to continue producing
a product or to buy it from an outside source.
(e) Optimizing Product Mix: To maximize profits and increase sales volume, it is necessary to decide an
optimized mix or proportion in which various products of a company can be sold.
(f) Cost Control: It is a technique of cost classification and cost presentation which enable the
management to concentrate on the controllable costs.
(g) Flexible Budget preparation: As the marginal costing particularly classifies costs as fixed and variable
costs which facilitate the preparation of flexible budgets.
9. What is margin of safety? What does it imply? Formula?

It is the amount of sales which generates profit, i.e., sales beyond Break Even Point are known as Margin
of Safety. The size of margin of safety is an extremely important guide to the financial strength of a
business. If margin of safety is large, it indicates that the business is in a sound condition and any
reduction in sales will not affect the profit of the business. If margin of safety is low, any loss of sales
may be a serious matter, where efforts need to be made to reduce fixed costs, variable costs or increase
the selling price or sales volume to improve contribution and the overall P/V Ratio.
Sub-topic: 3. Activity Based Costing
1. What is activity-based costing? What are its uses?

Activity based costing is an accounting methodology that assigns costs to activities rather than products
or services. It is a systematic, cause-and-effect method of assigning the cost of activities of products,
services, customers or any cost object. It enables resources and overhead costs to be more accurately
assigned to the products and the services that consume them.
2. What is the purpose of activity-based costing?

Activity based costing system is needed by an organization for the purpose of accurate product costing.
It charges overhead cost to products according to activities involved in the product, leads to easy
traceability of cost according to activities cost drivers, helps in cost control by eliminating non-value-
added activities and result in more accurate cost calculation of a product or job.
3. Who uses activity-based costing? What type of businesses do activity-based costing?

Activity based costing is suitable for product costing in various situations like, the business
manufacturing more than one product; overhead forms a high proportion of total cost; products are
not similar using different activities and consume different resources; overheads are not depending
upon the output of the product but on the complexity and diversity of operations; etc.
4. What are the disadvantages of activity-based costing?

a. Activity based costing system is time consuming and expensive to develop and implement. It is
not suitable for small organizations.
b. Determination of most appropriate cost drivers is difficult.
c. In some cases, finding the activity that causes the cost is impractical. For example, in cases like
factory insurances, factory manager’s salary, rent, rates and taxes of the factory premises, etc.
it is better to allocate costs on the basis of arbitrary volume.
d. A limited number of cost drivers may not fully explain the cost behavior of different items.
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e. Implementation of activity-based costing in service industry is difficult as the tracing of costs to
service delivery may result in too many cost drivers.
5. What are cost drivers and their importance in activity-based costing?

The causes for incurrence of overhead costs are known as cost drivers. A cost driver is a factor the
change of which results in a consequential change in the total cost of a related object. If its level changes,
it brings a corresponding change in the level of total cost of the related cost object.
6. Advantages of activity-based costing over traditional costing for service / manufacturing sector.
a. In traditional costing system, overhead costs are assumed to be influenced by only the units
produced, whereas in Activity based costing the cost drivers are used to segregate the costs to
various products and / or services.
b. Activity based costing improves product costing procedure by recognizing different fixed overhead
costs at batch level and product level.
c. It also helps in ascertaining areas where cost reductions are possible.
d. It can lead to improved decision making such as fixing selling price and highlighting the area where
the cost reduction is possible.
e. It can be applied to budgeting as well.
7. What is target costing?

Target costing is part of a product development process. It starts with understanding the wants and
needs of customer segments across targeted competitive markets, and the prices they are willing to pay
for the products and its variants. It includes cost planning in the initial designing stage and also the cost
control that exists throughout the lifecycle of the product.
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3. FAQs on Broader Topic: Time Value of Money
Sub-topic: 1. Time Value of Money - Concepts and Applications
1. Why is the consideration of time important in financial decision-making?

Financial decision-making involves the comparison of cash outflows and inflows that usually occur at
different periods of time. To have a meaningful comparison these cash flows must be converted to one
particular point in time because money has a time value, the worth of Rs 1000 today is not the same as
Rs 1000 after a year.
2. State the relationship between effective rate of interest and the stated annual rate of interest.
EIR=[1+ stated annual interest rate/m]^ m -1
where m=frequency of compounding per year
3. Explain the term future value.

Future value is the amount that a sum of money invested today grows to in a given period of time at a
given rate of interest.
4. Explain the term present value.

The present worth of a lump sum amount or cash flow to be received in the future.
5. What is Compounding Technique?

The technique of finding a future value of a given present sum of money is called “compounding”
6. What is Discounting Technique?

Discounting is the technique of translating a future value or a set of future cash flows into a present
value.
7. What is Time Line Analysis?

It is one of the important tools used in the time value of money analysis. It is a graphical representation
used to show the timing and amount of cash inflows and outflows.
8. Explain Annuity?
Annuity represents a series of equal payments (or receipts) occurring over a specified number of
equidistant periods.
9. What is the difference between annuity due and ordinary annuity?

If payment is made at the end of each period, it is called an ordinary or deferred annuity. An annuity
whose payments are made at the beginning of each period is called an annuity due.
10. What is Perpetuity?

A Perpetuity is an annuity whose payments or receipts continue forever.
11. What is Growing Annuity?

The cash flow that grows at a constant rate for a specified period of time.
12. What is Growing Perpetuity?

A Perpetuity that grows at a constant rate.
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13. What is Intra-Year Compounding?
Here compounding is done more than once a year.
14. Can the real rate of return be larger than the nominal rate?
Yes, when the compounding is done more than once a year.
15. Which one you will prefer: an investment that pays 5 percent a year on which interest is compounded
(a) quarterly, (b) semi-annually, (c) annually? Why?
Quarterly –compounded because the effective interest is maximum for this alternative.
16. As you increase the length of time involved, what happens to future values?
Future value increases
17. As you increase the length of time involved, what happens to present values?
Present value decreases
18. What happens to a future value if you increase the interest rate keeping all other parameters
constant?
Future value increases
19. What happens to a present value if you increase the discount rate keeping all other parameters
constant?
Present value decreases
20. What all do you need to find out the present value of an investment?
Future value of the investment, interest rate, period of investment.
21. “A rational human being has a time preference for money.” Do you agree?
Yes. Because the value of Rs.1000 today is more than Rs.1000 after one year. Inflation, present
investment opportunities, preference for present consumption, risk and uncertainty in future are the
reasons for this.
Sub-topic: 2. Equity and Bond Valuation
1. How to arrive at value of a bond?

The intrinsic value or the present value of a bond should be the sum of present value of coupon amounts
and redemption amount
2. What is Face Value of a Bond?

It represents the amount of borrowing by the firm which it specifies to repay after a specific period of
time, i.e., the time of maturity. A bond is generally issued at face value or par value which is usually
Rs.100 and may sometimes be Rs.1,000.
3. What is Coupon Rate of fixed income security?

A bond carries a specific rate of interest which is also called the coupon rate. The interest rate payable
is simply the product of the par value of the bond and coupon rate.
4. What do you understand by Time to Maturity?

A bond is issued for a specific period of time. It is repaid on maturity.
5. What do understand by Bond Redemption Value?

The value which a bondholder gets on maturity is called redemption value. A bond may be redeemed
at par, at premium (more than par), or at discount (less than par value).
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6. What does Market Value of a Bond?
Market value is the price at which the bond is usually bought or sold. Market value may be different
from par value or redemption value.
7. What is Yield to Maturity (YTM)?

The rate of return earned by an investor who purchases a bond and holds it till maturity. The YTM is the
discount rate which equals the present value of promised cash flows to the current market
price/purchase price.
8. What is Yield to Call (YTC)?

The rate of return earned on a bond if it is called before its maturity date.
9. What does Current Yield represent?

Current yield measures the rate of return earned on a bond if it is purchased at its current market price
and if the coupon interest is received. The annual interest payment on a bond divided by the bond’s
current price.
10. When can current yield and coupon rate be same?

Coupon rate and current yield are two different measures. Coupon rate and current yield will be equal
if the bond’s market price equals its face value.
11. What are Convertible Debentures?

A financial instrument that can be converted into a different security of the same company under
specific conditions is referred to as convertible security.
12. What is Conversion Ratio?

Conversion ratio gives the number of shares of stock received for each convertible security.
13. What are bonds in perpetuity and bonds with maturity?

Bonds in perpetuity are irredeemable bonds. Bonds may be redeemable after a specified period (known
as bond with maturity period).
14. How are values of bonds affected when the market rate of interest changes?
There is an inverse relationship between the value of a bond and the market interest rate. The bond
value would decline when the market interest rate rises and vice-versa.
15. Define a yield curve.

Yield curve shows the relationship between the yields-to-maturity (YTM) of bonds and their maturities.
It is also called the term structure of interest rates.
16. What is EPS?

Company's profit divided by the outstanding shares of its common stock. The resulting number serves
as an indicator of a company's profitability.
17. What is dividend yield?

The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much
a company pays out in dividend each year relative to its stock price.
18. Various techniques used in stock market to minimise/avoid loss?

1. Stop losses 2. Check fundamental prior to investment 3. Discount short-term noises (Ex: Nestle India
-issue with Maggi later bounced back)
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19. Difference between market value and enterprise value
Market cap is the total value of all outstanding shares of the company's stock. It is calculated by
multiplying the stock's current share price and the number of shares outstanding. is a more accurate
measure of a company's real worth because it takes into consideration its debt obligations.
20. What is intrinsic value of a stock?

Intrinsic value is the value of a stock which is justified by assets, earnings, dividends, definite prospects
and the factor of the management of the issuing company.
21. What are characteristics of bull market?

Bull markets are characterized by optimism, investor confidence, and expectations that strong results
should continue for an extended period of time
22. Why would an investor buy preferred stock?

Most shareholders are attracted to preferred stocks because they offer more consistent dividends than
common shares and higher payments than bonds. preferred stock offers maximum flexibility to the
company without the fear of missing a debt payment.
23. What is P/E Ratio?

The E(P/E) ratio is formed by dividing the present value of the share by the expected earnings per share
denoted by E(EPS).
24. What is relative valuation?

RV also referred to as comparable valuation in valuing an asset and involves the use of similar, assets in
valuing another asset.
25. What is dividend capitalization approach?

According to the dividend capitalization approach, which is a conceptually sound approach, the value
of an equity share is the discounted present value of dividends received plus the present value of the
resale price expected when the equity share is sold.
Sub-topic: 3. Capital Budgeting Techniques
1. What is meant by capital budgeting decision?

A long-term Investment decision is called capital budgeting decision.
2. Why Capital budgeting decisions are more important?

The long-term Investment decision is called capital budgeting. It is more important due to the following reasons-
a) Long-term growth and affects: As capital budgeting decisions involve investment in long term fixed
assets, it affects the long-term growth.
b) Large amount of funds involved: As huge amount of fund is blocked for a long period; the decision
should be taken rationally.
c) Risk involved: As such a decision affects the returns of the firm as a whole, it involves more risk.
d) Irreversible decisions: These long-term decisions taken once cannot be reversed back, without incurring
heavy losses. It will lead to waste of fund, if reversed.
Thus, capital budgeting decisions should be taken after careful study and deep analysis.
3.Explain the concept of risk in capital budgeting?

Risk can be defined as variability of returns of an investment. Risk arises in investment evaluation because we
cannot make any correct prediction about the cash flow sequence since the future events on which they depend
are uncertain.
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4. What is Risk-Adjusted Discount Rate?
The discount rate that applies to a particular risky stream of income; the riskier the project’s income stream,
the higher the discount rate.
5.What is the major problem in using this approach to handle risk in capital budgeting?
The constant risk-adjusted discount rate is not valid over the life span of project. It is also quite difficult to specify
risk-adjusted discount rate properly to measure the degree of increasing risk.
6.What are the limitations of payback method as a risk handling technique?

The payback period method ignores the time value of money, ignores the cash flows occurring after the payback
period, and also does not measure the profitability of the project.
7.Why is the DCF analysis important in risk analysis in capital budgeting?

DCF analysis is important in risk analysis since it indicates the sensitivity of the project NPV to changes in
variables. It helps to identify variables which are critical to the project NPV.
8.How can you conduct the DCF break even analysis?

DCF break-even means a situation where NPV is zero. The NPV of a project depends on cash outlay, volume,
price, variable costs, fixed costs, depreciation rate, tax rate, life of the project etc. For calculating DCF break-
even point, one can take one variable and determine its minimum value at which NPV is zero.
9. What is sensitivity analysis?

Sensitivity analysis is a way of analysing change in the project’s NPV (or IRR) for a given change in one of the
variables, e.g., sales volume, unit selling price, unit variable costs, etc. It indicates how sensitive a project’s NPV
(or IRR) is to changes in particular variables. The more sensitive the NPV, the more critical is the variable. A risk
analysis technique in which key variables are changed one at a time and the resulting changes in the NPV are
observed.
10. What is Scenario Analysis?

A risk analysis technique in which “bad” and “good” sets of financial circumstances are compared with a most
likely, or base-case, situation.
11.What is Base Case?

An analysis in which all of the input variables are set at their most likely values.
12.What is Worst-Case Scenario?

An analysis in which all of the input variables are set at their worst reasonably forecasted values.
13.What is Best-Case Scenario?

An analysis in which all of the input variables are set at their best reasonably forecasted values.
14.What is Monte Carlo Simulation?

A risk analysis technique in which probable future events are simulated on a computer, generating estimated
rates of return and risk indexes.
15.What do you mean by Capital Rationing?

A situation in which a constraint is placed on the total size of the firm’s capital budget.
16. What is the difference between NPV and IRR?

The present value of all cash flows of a project or investment is called NPV. IRR is the rate at which the cash
inflows are equal to cash outflows.
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4. FAQs on Broader Topic: Corporate Performance
Sub-topic: 1. Identifying and Interpreting Key Financial Ratios for any Industry / Company
A sustainable business performance by a firm requires effective planning and financial management. Ratio
analysis is a tool that throws light on financial results and trends over time, and provide key indicators of
organizational performance. Managers can use ratio analysis to pinpoint strengths and weaknesses, from which
necessary strategies and initiatives can be formulated.
Investors / Funders may use ratio analysis to compare results against other organizations or make judgments
concerning management effectiveness
For ratios to be useful and meaningful, they must be:
• Calculated using reliable, accurate financial information
• Calculated consistently from period to period
• Used in comparison to internal benchmarks and goals
• Used in comparison to other companies in the same industry
• Viewed both at a single point in time and as an indication of broad trends and issues over time
• Carefully interpreted in the proper context, considering there are many other important factors and
indicators involved in assessing performance
How to use Ratios

• There are a number of financial ratios that can be reviewed to gauge a company's overall financial
health and to judge the likelihood that the company will continue as a viable business.
• Standalone numbers such as total debt or net profit are less meaningful than financial ratios that
connect and compare the various numbers on a company's balance sheet or income statement.
• The general trend of financial ratios, whether they are improving over time, is also an important
consideration.
• To accurately evaluate the financial health and long-term sustainability of a company, several
financial metrics must be considered in tandem.
• The four main areas of financial health that should be examined are Liquidity, Solvency, Profitability,
and Operating Efficiency
Liquidity
• Liquidity is a key factor in assessing a company's basic financial health. Liquidity is the amount of
cash and easily-convertible-to-cash assets a company owns to manage its short-term debt
obligations. Before a company can prosper in the long term, it must first be able to survive in the
short term
• The two most common metrics used to measure liquidity are the current ratio and the quick ratio
• The Current Ratio is equal to current assets divided by current liabilities; This directly measures the
ability of the company to pay back short-term debts and payables with its liquid assets
• The Quick Ratio, also known as the Acid Test, is a conservative measure of liquidity. This is because
it excludes inventory from assets and also excludes the current part of long-term debt from
liabilities. Thus, it provides a more realistic or practical indication of a company's ability to manage
short-term obligations with cash and assets on hand. A quick ratio lower than 1.0 is often a warning
sign, as it indicates current liabilities exceed current assets.
Solvency
• Related to liquidity is the concept of solvency—a company's ability to meet its debt obligations on an
ongoing basis, not just over the short term. Solvency ratios calculate a company's long-term debt in
relation to its assets or equity
• Debt ratio measures the relative amount of a company’s assets that are provided from debt:
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• Debt ratio = Total liabilities / Total assets
• Debt to Equity ratio (D/E) calculates the weight of total debt and financial liabilities against shareholders’
equity:
• Debt to Equity ratio = Total liabilities / Shareholder’s equity
• Interest coverage ratio shows how easily a company can pay its interest expenses:
• Interest coverage ratio = Operating income / Interest expenses
• Debt service coverage ratio reveals how easily a company can pay its debt obligations:
• Debt service coverage ratio = Operating income / Total debt service
• Debt-to-equity (D/E) ratio is generally a solid indicator of a company's long-term sustainability because it
provides a measurement of debt against stockholders' equity, and is, therefore, also a measure of investor
interest and confidence in a company.
• A lower D/E ratio means more of a company's operations are being financed by shareholders rather than by
creditors
• A high D/E ratio can indicate aggressive usage of Debt to take benefit from tax-deductibility of interest costs,
but at the same time can increase the firm’s potential financial risk
• D/E ratios vary widely between industries; Highly capital-intensive industries usually tend to have high D/E
ratios
Operating Efficiency
• A company's operating efficiency is key to its financial success. Efficiency ratios, also known as activity financial
ratios, are used to measure how well a company is utilizing its assets and resources. Some Common efficiency
ratios are:
• Asset Turnover Ratio measures a company’s ability to generate sales from assets:
• Asset turnover ratio = Net sales / Average total assets
• Inventory Turnover Ratio measures how many times a company’s inventory is sold and replaced over a given
period:
• Inventory turnover ratio = Cost of goods sold / Average inventory
• Accounts Receivable Turnover Ratio measures how many times a company can turn receivables into cash
over a given period:
• Receivables turnover ratio = Net credit sales / Average accounts receivable
• Days’ Sales in Inventory measures the average number of days that a company holds on to inventory before
selling it to customers:
• Days’ Sales in Inventory = 365 days / Inventory turnover ratio
Profitability
• Companies can survive for some years without being profitable, operating on the goodwill of creditors and
investors. But to survive in the long run, a company must eventually attain and maintain profitability.
• Metrics for evaluating profitability are Operating Profit Margin (OPM) and Net Profit Margin (NPM)
• OPM allows investors to see the amount of profit a company makes from its core operations, before the
deduction of interest and taxes. This indicates a company's basic operational profit margin, after deducting
the costs of producing and marketing the company's products or services. It indicates how well the company's
management is able to control costs.
• OPM is key to determining a company's potential earnings, and therefore in evaluating its growth potential.
• It is also considered to be the best profitability ratio to assess how well-managed a company is since the
management of basic overhead costs and other operating expenses is critical to the bottom-line profitability
of any company.
• Operating margins vary widely between industries and should be compared between similar companies
• Operating margin is one of the best indicators of efficiency.
• NPM is the ratio of net profits to total revenues. It is crucial to consider the net margin ratio because a simple
rupee figure of profit is inadequate to assess the company's financial health.
• A company might show a net profit figure of several hundred crores, but if the profit represents a NPM of 2%
or 3%, then even the slightest increase in operating costs or marketplace competition could plunge the
company into the red
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• A larger net margin, especially compared to industry peers, means a greater margin of financial safety, and
also indicates a company is in a better financial position to commit capital to growth and expansion.
Industry Sector and Financial Ratios

• When evaluating companies for investments, it's important to look at them in the context of their own sector.
• Each sector has different attributes that vary from other sectors. For example, capital intensive sectors, like
airline and manufacturing companies, have high levels of debt, while IT companies typically have low levels
of debt. Comparing them would not be an apples-to-apples comparison. As such, different ratios are better
suited to analysing certain sectors than others.
Considerations for identifying relevant financial ratios for an Industry Sector:

• Understand the Key Revenue Drivers, Cost Drivers and Profitability Drivers for the Industry Sector, based on
the nature of business / business models adopted by firms in the sector
• Correlate the financial ratios with how firms can expand their profitability and returns (enhancing sales
revenues vs. cost/expense control, operating and financial leveraging etc.)
Illustration: Which are the important Financial Ratios to study in Banking Industry?
• Banks operate and generate profit in a different way than most other businesses
• Net interest margin is an important indicator in evaluating banks because it reveals a bank’s net profit on
interest-earning assets, such as loans or investment securities
• Banks with a higher loan-to-assets ratio derive more of their income from loans and investments
• Banks with lower levels of loan-to-asset ratios derive a relatively larger portion of their total incomes from
more-diversified, non-interest-earning sources, such as asset management or trading
Some commonly used Financial Ratios for Banking Sector

Net Interest Margin
Net interest margin is an especially important indicator in evaluating banks because it reveals a bank’s net profit
on interest-earning assets, such as loans or investment securities. Since the interest earned on such assets is a
primary source of revenue for a bank, this metric is a good indicator of a bank's overall profitability, and higher
margins generally indicate a more profitable bank. A number of factors can significantly impact net interest
margin, including interest rates charged by the bank and the source of the bank's assets. Net interest margin is
calculated as the sum of interest and investment returns minus related expenses; this amount is then divided
by the average total of earning assets.
Loan-to-Assets Ratio
The loan-to-assets ratio is another industry-specific metric that can help investors obtain a complete analysis of
a bank's operations. Banks that have a relatively higher loan-to-assets ratio derive more of their income from
loans and investments, while banks with lower levels of loans-to-assets ratios derive a relatively larger portion
of their total incomes from more-diversified, noninterest-earning sources, such as asset management or
trading. Banks with lower loan-to-assets ratios may fare better when interest rates are low or credit is tight.
They may also fare better during economic downturns.
Return-on-Assets Ratio
The return-on-assets (ROA) ratio is frequently applied to banks because the cash flow analysis is more difficult
to accurately construct. The ratio is considered an important profitability ratio, indicating the profit per rupee a
company earns on its assets. Since bank assets largely consist of money the bank loans, the per-rupee return is
an important metric of bank management. The ROA ratio is a company's net, after-tax income divided by its
total assets. Since banks are highly leveraged, even a relatively low ROA of 1 to 2% may represent substantial
revenues and profit for a bank
Credit to Deposit Ratio
A credit to deposit ratio is the ratio of how much a bank lends out of the deposit it has mobilized. It helps in
assessing a bank’s liquidity and indicates its health. Ideal Credit to Deposit Ratio is between 80%-90%. This
means that the Bank is lending this percent of funds from the Total deposits that it has.
Lending is the main business of the bank so this ratio should be high. If the ratio is too low, it means the bank
may not be earning as much as they should be. If the ratio is too high, it means that the bank might not have
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enough liquidity to cover any unforeseen fund requirements, which may affect capital adequacy and asset-
liability mismatch.
Capital Adequacy Ratio:

Capital Adequacy Ratio is the ratio of a bank’s Total capital (tier 1 + tier 2) in relation to its risk-weighted assets.
It is decided by the central banks and bank regulators to prevent commercial banks from taking excess leverage
and becoming insolvent in the process. Minimum capital adequacy ratio ensures that the bank has enough
cushion to absorb a reasonable level of losses before they become insolvent and consequently lose
Shareholders’/Depositors’ Funds. A high CAR means that the bank is safe.
Other Important Ratios for Banks are
CASA Ratio; Gross NPAs; Net NPAs
FAQs
1. What is the Difference between ROI and ROE?

Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation
to their investment cost. It is most commonly measured as net income divided by the original capital cost of the
investment. The higher the ratio, the greater the benefit earned
There are several versions of the ROI formula. The two most commonly used are shown below:
ROI = Net Income / Cost of Investment
or
ROI = Investment Gain / Investment Base
Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its
total shareholders’ equity, expressed as a percentage.
ROE = Net Income / Shareholders’ Equity
ROE provides a simple metric for evaluating investment returns. By comparing a company’s ROE to the
industry’s average, something may be pinpointed about the company’s competitive advantage. ROE may also
provide insight into how the company management is using financing from equity to grow the business.
A sustainable and increasing ROE over time can mean a company is good at generating shareholder value
because it knows how to reinvest its earnings wisely, so as to increase productivity and profits. In contrast, a
declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive
assets.
2. Explain the current ratio. What is the ideal current ratio?

The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those
due within one year. It tells investors and analysts how a company can maximize the current assets on its
balance sheet to satisfy its current debt and other payables
3. How do you estimate return on capital employed?

ROCE is a metric for analysing profitability, and potentially comparing profitability levels across companies in
terms of capital.
ROCE = Earnings Before Interest and Tax / Capital Employed
EBIT, also known as operating income, shows how much a company earns from its operations alone without
regard to interest or taxes = Revenues - Cost of Goods Sold
Capital Employed = Total Assets - Current Liabilities
= Shareholders’ Equity + Long-Term Debt
4. What is capital adequacy ratio?

Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital in relation to its risk weighted assets and current
liabilities. It is decided by central banks and bank regulators to prevent commercial banks from taking excess
leverage and becoming insolvent in the process.
Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets
The risk weighted assets take into account credit risk, market risk and operational risk.
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The Basel III norms stipulated a capital to risk weighted assets of 8%. However, as per RBI norms, Indian
scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are
emphasized to maintain a CAR of 12%.
5. What is the difference between Solvency Ratios and Liquidity Ratios?

• Solvency and liquidity are both terms that refer to an enterprise’s state of financial health.
• Solvency refers to a firm’s capacity to meet its long-term financial commitments.
• Liquidity refers to an enterprise’s ability to pay short-term obligations; it also refers to its capability to sell
assets quickly to raise cash.
• Solvency and liquidity are equally important, and healthy companies are both solvent and possess adequate
liquidity
6. What is a Liquidity Ratio?

A liquidity ratio is a financial ratio that indicates whether a company's current assets will be sufficient to meet
the company's obligations when they become due. Examples of Liquidity Ratios are current ratio and quick ratio
or acid test ratio
7. How do you use the Inventory Turnover Ratio in practice?

Inventory turnover is a ratio showing how many times a company has sold and replaced inventory during a given
period. It is used to evaluate the efficiency of a company in handling the goods it manufactures or buys to resell.
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory
for that period
8. What does the Du Pont analysis tell you?

The DuPont analysis also called the DuPont model is a financial ratio based on the return on equity ratio that is
used to analyse a company's ability to increase its return on equity. The DuPont analysis looks at three main
components of the ROE ratio
9.What are the limitations of using ratio analysis in Business Decisions?

Information used in the analysis is based on real past results that are released by the company. Therefore, ratio
analysis metrics do not necessarily represent future company performance or be a good predictor in all
situations
10. How do you interpret a high accounts payable turnover?

The accounts payable turnover ratio indicates how many times a company pays off its suppliers during an
accounting period. A higher ratio indicates a generally favorable financial situation, as payables are being paid
more quickly
11.What is working capital turnover ratio?

The working capital turnover ratio is calculated as net annual sales divided by the average amount of working
capital during the same year. The working capital turnover ratio indicates a company's effectiveness in using its
working capital.
12.Can you show the break -up of ROE estimation as per Du Pont Formula?
ROE = Profit Margin * Asset Turnover * Leverage Factor
= (Net Profit/Sales) * (Sales/Total Assets) * (Sales/Total Assets Equity)
13.How do you calculate Return on total assets (ROA)?

It is estimated as the ratio of after-tax profit divided by total assets of the firm
14. Why is it complicated to compare a given ratio of two companies operating in different sectors/industries?
It is complicated to compare a given ratio of two companies operating in different sectors/industries because
the different nature of operations across industries makes the ratios vary from industry to industry
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15.What are three key financial ratios that Banks consider, while evaluating a loan proposal?
Leverage Ratio, Loan to Value Ratio and Debt Service Coverage Ratio
16. What does a high receivables turnover ratio indicate?

A High Accounts Receivable Turnover Ratio. A high receivables turnover ratio can indicate that a company's
collection of accounts receivable is efficient and that the company has a high proportion of quality customers
that pay their debts quickly
17. What is the difference between the current ratio and the acid test ratio?
The current ratio uses all of the current assets and divides their total by the total amount of current liabilities.
The acid test ratio uses only the following current assets (which are considered to be the "quick assets” and
divides their total by the total amount of current liabilities
18. What is the Accounts Receivable Turnover Ratio?

The financial ratio accounts receivable turnover is a company's annual sales divided by the company's average
balance in its Accounts Receivable account during the same period of time
Sub-topic: 2. Using concepts of Relative Valuation and Enterprise Value in Valuation of Companies
Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative
to equity market capitalization. EV includes in its calculation the market capitalization of a company but also
short-term and long-term debt as well as any cash on the company's balance sheet.
• Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative
to equity market capitalization.
• Enterprise value includes in its calculation the market capitalization of a company but also short-term and
long-term debt as well as any cash on the company's balance sheet.
• Market Capitalization does not fully represent a firm's value, as it leaves out factors, such as a company's debt
on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap,
as it incorporates debt and cash for determining a company's valuation
• Enterprise value is used as the basis for many financial ratios that measure the performance of a company
Formula and Calculation for EV

EV = MC + Total Debt + MP + MI − C
where:
MC=Market capitalization = current stock price multiplied by no. of outstanding stock shares
MP = Market Value of Preference Shares
MI = Minority Interest
Total debt=Equal to the sum of short-term and long-term debt
C=Cash and cash equivalents; the liquid assets of a company, but may not include marketable securities
Using Enterprise Value as a Valuation Multiple:

• Enterprise value is used as the basis for many financial ratios that measure the performance of a company.
An enterprise multiple that contains enterprise value relates the total value of a company as reflected in the
market value of its capital from all sources to a measure of operating earnings generated, such as earnings
before interest, taxes, depreciation, and amortization (EBITDA).
• Enterprise Value/EBITDA metric is used as a valuation tool to compare the value of a company, debt included,
to the company’s cash earnings less non-cash expenses. It's ideal for analysts and investors looking to compare
companies within the same industry
• EBITDA is a measure of a company's ability to generate revenue and is used as an alternative to simple
earnings or net income in some circumstances. EBITDA, however, can be misleading because it strips out the
cost of capital investments like property, plant, and equipment. Another figure, EBIT, can be used as a similar
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financial metric without the drawback of removing depreciation and amortization expenses related to
property, plant and equipment.
Advantages of using EV/EBITDA multiple:

• The ratio may be more useful than the P/E ratio when comparing firms with different degrees of financial
leverage (DFL)
• EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization
• EBITDA is usually positive even while earnings per share (EPS) is not
Limitations of Using EV
EV includes total debt, but it is important to consider how the debt is being utilized by the company's
management. For example, capital intensive industries such as the oil and gas industry typically carry significant
amounts of debt, which is used to foster growth. The debt could be used to purchase plant and equipment. As
a result, the EV would be skewed for companies with a large amount of debt as compared to industries with
little or no debt.
Different Types of Enterprise Value (EV) multiples

When decisions are about Mergers & Acquisitions, enterprise value multiples are the appropriate multiples to
use.
Commonly used Enterprise Value Multiples used in valuation analyses
• EV/Revenue: slightly affected by differences in accounting; computed as the proportion of Enterprise Value
to Sales or Revenue.
• EV/EBITDAR: most used in industries in the hotel and transport sectors; computed as the proportion of
Enterprise Value to Earnings before Interest, Tax, Depreciation & Amortization, and Rental Costs
• EV/EBITDA: EBITDA can be used as a substitute of free cash flows; most used enterprise value multiple;
computed as the proportion of Enterprise Value to Earnings before Interest, Tax, Depreciation & Amortization
• EV/Invested Capital – used for capital-intensive industries; computed as the proportion of Enterprise Value to
Invested Capital
It is best to compare companies within the same industry to get a better sense of how the company is valued
relative to its peers
Relative Valuation (Comparable Company Approach to Valuation)

• Relative Valuation (Comparable Company Analysis) is a process used to evaluate the value of a company using
the metrics of other businesses of similar size/nature in the same industry. Comparable company analysis
operates under the assumption that similar companies will have similar valuation multiples. Relative Valuation
technique is used to value a company by comparing that company’s valuation multiples to those of its peers.
• Typically, the multiples are a ratio of some valuation metric (such as equity Market Capitalization or Enterprise
Value) to some financial performance metric (such as Earnings/Earnings Per Share (EPS), Sales, or EBITDA).
The belief is that companies with similar characteristics should trade at similar multiples, all other things being
equal. Underlying assumption is that the market is efficiently pricing the securities of other companies
Steps in Performing Relative Valuation

• Select a Peer Universe: Pick a group of competitor/similar companies with comparable industries and
fundamental characteristics
• Validate key fundamental metrics
• Select appropriate multiple for valuation
• Calculate Market Capitalization: It is equal to Share price × Number of Shares Outstanding
• Calculate Enterprise Value = Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash & Cash
Equivalents
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• Using Market Capitalization, Enterprise Value and historical/projected financials, calculate) EV/EBITDA and
P/E multiples
• Value Target Company: Pick the appropriate benchmark valuation multiple for the peer group, and value the
target company based on that multiple. Typically, an average or median is used
There are various types of multiples that can be used in a Comps analysis. In general, multiples can be classified
in two broad categories: Operating multiples and Equity multiples. Operating multiples refer to the operating
results of the business as a whole while Equity multiples refer to the value created from the company that is
available to equity/shareholders.
Typical multiples used for Relative Valuation include:

• EV/Sales: The Enterprise value of the company divided by Sales/Revenue (Operating multiple)
• EV/EBITDA: The Enterprise value of the company divided by EBITDA (Operating multiple)
• P/E: Price/Earnings ratio for a company (Equity multiple)
• P/B: Price/Book ratio for a company (Equity multiple)
For Operating Multiples, we use Enterprise Value as the numerator of the calculation, while for Equity Multiples,
we use Market Capitalization as the numerator. You should generally not use EV for equity-related performance
metrics, nor should you use Market Capitalization for enterprise-related performance metrics
Finding the right comparable companies

Screening Criteria that can be used, include:
• Industry classification & Geography
• Size (revenue, assets, employees) & Growth rate
• Margins and profitability
Advantages of Relative Valuation approach

• Easy to calculate using widely available data of other public companies
• Easy to communicate across a variety of market participants
• Determine a benchmark value for multiples used in valuation
• Provide a useful way to assess market assumptions of fundamental characteristics baked into valuations
Disadvantages of Relative Valuation approach

• Influenced by temporary market conditions or non-fundamental factors
• Not useful when there are few or no comparable companies
• Can be difficult to find appropriate comparable companies for various reasons
• Less reliable when comparable companies are thinly traded
FAQs
1. What is Enterprise Value?

Enterprise value is a popular measurement of the total value of a company. It can be seen as the theoretical
price that would need to be paid in order to fully acquire a company in a going-private transaction. Unlike market
capitalization, which reflects only the value of the company’s equity, enterprise value reflects the size of the
company’s debts as well as its cash reserves. It is a popular figure among investors and analysts and is often
used in financial ratios.
2. Why is cash deducted from Enterprise Value?

To understand why cash is deducted from enterprise value, suppose that you are a private investor wishing to
purchase 100% of a publicly traded company. When planning your purchase, you note that the company’s
market capitalization is Rs.100 crore, meaning you will need Rs.100 crore to buy all the shares from its existing
shareholders. But what if the company also has Rs.20 crore in cash? In that scenario, your real “cost” for
purchasing the company would only be Rs.80 crore, since buying the company would immediately give you
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access to its Rs.20 crore in cash. All else being equal, a higher cash balance leads to a lower enterprise value,
and vice-versa.
3. Why is debt added to enterprise value?

Higher debt leads to a higher enterprise value because it represents an added cost that must be paid by any
would-be acquirer, to extinguish the claims of existing Debt Providers.
4. What is the difference between Market Value and Enterprise Value?

Market capitalization is the market value of a company’s stock; Sum total of all the outstanding shares of a
company. This financial metric assesses the value of a business based solely on the stock
Enterprise Value, on the other side, is a more comprehensive and alternative approach to measuring a
company’s total value. It takes into account various financial metrics such as market capitalization, debt,
minority interest, preferred shares, and total cash and cash equivalents to arrive at the total value of a company.
Although the minority interest and preferred shares are most of the time kept on zero effectively, this may not
be the case for some companies.
Formula to calculate EV:

Enterprise Value = Market Capitalisation + Market value of Preferred Shares + Total Debt (including long and
short-term debt) + Minority Interest – Total cash and cash equivalents
5. How is EV/EBITDA different from P/E ratio?

• PE ratio measures the money that investors are willing to pay for every rupee a company earns. It is a metric
used for valuing the firm’s equity as it takes into account the residual earning available to equity shareholders.
• Though widely used, PE ratio has its limitations as it cannot be used for valuing loss-making company
• PE ratio gives the Equity multiple, whereas EV/EBITDA gives the Firm multiple.
• Hence, EV/EBITDA ratio is a better measure as it values the worth of the entire company
6. Why is cash deducted in the enterprise value calculation?

Cash is subtracted out of Enterprise Value because excess Cash is considered a non-operating asset, and could
be used to pay down part of the company’s debt immediately, which would reduce the Enterprise Value of the
Company
7. What is Minority Interest (Non-Controlling Interest)?

Minority interest, or non-controlling interest (NCI), represents an ownership stake of less than 50% in a company
(hence the term minority, or non-controlling). For accounting purposes, minority interest is classified as a non-
current liability and shows up on the balance sheet of the company that owns a majority interest in the company
8. Why is Minority Interest included in Enterprise Value calculation?

• Enterprise Value is primarily used in Valuation Ratios such as EV/Total Sales, EV/EBIT, and EV/EBITDA.
• Suppose a company X owns 80% of company ABC. Due to accounting regulations, the consolidated financial
statements of X will reflect 100% of the Total Sales, EBIT, and EBITDA, etc. of the subsidiary ABC even though
X only owns 80% of ABC.
• For these ratios to be meaningful, the numerator must be adjusted to allow for a “like to like” comparison
between EV and Total Sales, EBIT, and EBITDA, etc. This is done by adding to Enterprise Value the equity value
of the subsidiary that the parent company does not own (Minority Interest). This results in both the numerator
and denominator of the various valuation ratios accounting for 100% of the subsidiary company in terms of
Equity, Total Sales, EBIT, and EBITDA
Explanation: Summary of Minority Interest in Enterprise Value

• The aim of adding minority interest to EV is to facilitate an “apples to apples” comparison between EV and
figures such as Total Sales, EBIT, and EBITDA.
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• The equity value shown in the consolidated financial statement will always show the value of the parent
company’s stake in its subsidiaries. Thus, if the parent company owns 80% of its subsidiary and its subsidiary
is worth Rs. 1,000, then the equity value reflects 80% of Rs.1,000, or Rs.800.
• A problem arises because, according to accounting regulations, the parent company must show 100% of all
other figures related to its subsidiaries if it owns more than 50% of its subsidiary.
• Parent company doesn’t reflect 80% of figures such as Total Sales, EBIT, and EBITDA. This creates a problem
regarding the calculation of various valuation ratios such as EV/Total Sales, EV/EBIT, and EV/EBITDA because
the numerator only reflects 80% of the subsidiary, whereas the denominator reflects 100% of the subsidiary.
• It is usually not possible or practical to adjust the denominator because companies don’t disclose enough
information. Therefore, we adjust the numerator to reflect 100% of the subsidiary
9. What are Relative Valuation Models?

Relative valuation models are used to value companies by comparing them to other businesses based on certain
metrics such as EV/Revenue, EV/EBITDA, and P/E ratios. The logic is that if similar companies are worth 10x
earnings, then the company that’s being valued should also be worth 10x its earnings. This guide will provide
detailed examples of how to perform relative valuation analysis.
10. When are Price/Sales multiples used?

Price/Sales multiples are typically used for companies with negative, highly volatile, or abnormally high/low EPS.
For example, fast-growing companies that have no earnings yet or negative earnings (because they are spending
a lot of money to grow or have not yet reached critical mass for sales) may be valued based upon multiples of
Sales. A common advantage of using Price/Sales is the general stability and lower accounting distortion afforded
by sales numbers. However, sales numbers can be manipulated through revenue recognition practices and
growth companies can be given high valuations regardless of having no earnings or cash flow. Additionally, using
Sales as a basis for valuation does not take into account the profitability of those Sales figures. Some companies,
for example, may be able to turn a large profit margin on incremental sales, while others might have very narrow
profit margins.
11. When are Price/Book multiples used?

Price/Book multiples are often used to value financial services companies since their balance sheets are
primarily composed of liquid assets that often approximate market values. These multiples can also be used for
companies with no earnings, highly variable earnings or companies not expected to continue as a going concern.
Unfortunately, for most companies in most industries the Price/Book ratio is highly idiosyncratic, because the
Book Value is a function of all past business activities (literally since the company’s founding or most recent
recapitalization). Therefore Price/Book ratios can swing wildly depending on each company’s circumstances
12. How is EV/EBITDA different from P/E ratio?

• PE ratio gives the equity multiple, whereas EV/EBITDA gives the firm multiple. Hence, EV/EBITDA ratio is a
better measure as it values the worth of the entire company.
• The PE ratio measures the money that investors are willing to pay for every rupee a company earns. It is a
metric used for valuing the firm’s equity as it takes into account the residual earning available to equity
shareholders.
• Though widely used, PE ratio has its limitations as it cannot be used for valuing loss-making companies and
fails to overcome the distortions caused by different accounting policies and capital structures
13. How does Relative Valuation differ from Intrinsic Value Models?
• While relative valuation models seek to value a business by companies to other companies, intrinsic valuation
models see to value a business by looking only at the company on its own.
• The most common intrinsic valuation method is Discounted Cash Flow (DCF) analysis, which calculates the
Net Present Value (NPV) of a company’s future cash flow.
• The benefits of a DCF model are that it includes lots of detail about the company’s business and isn’t
concerned with how other companies are performing. The drawbacks are that many assumptions are
required, and the company’s value is very sensitive to changes in some of those key assumptions
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14. What are the most common multiples used to value a company?
EV/EBITDA; EV/EBIT; P/E; and P/B
15. Can a company have a high EV/EBITDA multiple but a low PE multiple? When does it happen?
This relationship implies a significant difference between the firm’s enterprise value and its equity value. The
difference between the two is “net debt”. As a result, a company with a significant amount of net debt will likely
have a higher EV/EBITDA multiple.
Sub-topic: 3. Application of Balanced Scorecard Framework in Strategy and Performance Management
The Balanced Scorecard (BSC), proposed by Robert Kaplan, provides executives with a comprehensive
framework that translates a company’s strategic objectives into a coherent set of performance measures. The
Balanced Scorecard is a management system that can motivate breakthrough improvements in such critical
areas as product, process, customer, and market development.
The BSC presents managers with four different perspectives from which to choose measures. It complements
traditional financial indicators with measures of performance for customers, internal processes, and innovation
and improvement activities. The Scorecard’s measures are grounded in an organization’s strategic objectives
and competitive demands. And, by requiring managers to select a limited number of critical indicators within
each of the four perspectives, the Scorecard helps focus this strategic vision. A balanced Scorecard is a
framework that organizations can use to align business activities to the organization’s strategy and vision
BSC combines both financial and non-financial performance measures to give a ‘balanced’ view of the
organization. Performance measures are established and monitored within each of the following four
perspectives:
• Financial
• Customer
• Internal business processes
• Learning and growth
The Balanced Scorecard Links Performance Measures

• How do customers see us? (Customer Perspective)
• What must we excel at? (Internal Perspective)
• Can we continue to improve and create value? (Innovation and Learning Perspective)
• How do we look to shareholders? (Financial Perspective)
The Scorecard brings together, in a single management report, many of the seemingly disparate elements of a
company’s competitive agenda: becoming customer oriented, shortening response time, improving quality,
emphasizing teamwork, reducing new product launch times, and managing for the long term
Unlike conventional metrics, the information from the four perspectives provides balance between external
measures like operating income and internal measures like new product development. This balanced set of
measures both reveals the trade-offs that managers have already made among performance measures and
encourages them to achieve their goals in the future without making trade-offs among key success factors. The
balanced Scorecard can serve as the focal point for the organization’s efforts, defining and communicating
priorities to managers, employees, investors, even customers. Although often viewed as a strategic tool, the
balanced Scorecard works equally well at the operational level.
BSC can enable companies to track financial results while simultaneously monitoring progress in building the
capabilities and acquiring the intangible assets they would need for future growth. The Scorecard wasn’t a
replacement for financial measures; it was their complement.
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FAQs
1. What is the Balanced Scorecard?

A Balanced Scorecard is a framework that organizations can use to align business activities to the organization’s
strategy and vision. The framework focuses on shareholder/financial, customer, internal processes and learning
requirements of a business in order to create a system of linked objectives, measures, targets and initiatives
which collectively describe the strategy of an organization and how that strategy can be achieved
2. What are the benefits of the Balanced Scorecard?

• Organisations benefit from using the Balanced Scorecard in the following ways:
• Clearly communicates the vision and strategy across the organization
• Enables tracking of strategy implementation, with monthly/periodic reporting
• Streamlines initiatives and aligns them with major objectives
• Provides focus for the executive teams, clarifies roles and breaks down functional silos
• Streamlines and simplifies the strategic planning process
• Drives resources allocation and budgeting process
• Improves rewards system by linking measures to compensation
3. What are the applications of Balanced Scorecard?

There are several applications to use the Balanced Scorecard to improve performance:
• Strategy implementation at the Corporate Level
• Alignment of units / departments strategy with the Corporate Strategy
• HR Strategy, and rewards alignment
• Budgeting and resources allocation
4. How does the Balanced Scorecard help in improving performance?

Balanced Scorecard works on the premise that measurement drives performance. Historically, organizations
measured performance based purely on financial parameters. The Balanced Scorecard approach lays strong
emphasis on measuring key strategic parameters not only financial, but also non-financial parameters. By
identifying the top 4-5 strategic objectives within each of the 4 perspectives, the Balanced Scorecard presents
a comprehensive picture of a company's strategy
5. What type of Organizations can implement the Balanced Scorecard?

The Balanced Scorecard is a flexible tool, and can be implemented by any kind of organization:
• Large, medium and small businesses to ensure achievement of revenue / profit objective for its shareholders
• Non-profit organizations, to enable delivery of its social objectives, based on the availability of limited
resources
• Government organizations / departments to enable delivery to the public / community
6. What are the Key Principles in designing of the Balanced Scorecard?

• Cause-and-effect relationship between objectives
• Showing how customer value is created and how it is linked to the organization’s goals
• Aligning measures and initiatives with objectives
37
5. FAQs on Broader Topic: Risk and Return
Sub-topic: 1. Security Risk and Return (Ex-post and Ex-ante)
1. What is ‘average mean return’? How do you calculate it?

Average mean return (AMR) is the return on investment calculated by simply adding the returns for all sub-
periods and then dividing it by total number of periods. It overstates the true return and is only appropriate for
shorter time periods.
∑𝑛𝑖=1 𝑅𝑖
𝑅̅𝑖 =
𝑛
Alternatively, when we are concerned about ex-ante returns the following method is used.
𝑛
𝑅̅𝑖 = ∑ 𝑃𝑖 𝑅𝑖
𝑖=1
2. When and how do you have to annualize the ‘security returns’?

We have to annualize the returns if we have returns frequency of less than one year. For example, daily, weekly
or monthly returns.
To annualize the returns means to convert a short-term calculation or rate of return into an annual rate. It helps
to annualize a rate of return to better compare the performance of one security versus another.
Let’s say we have 0.1% daily returns. Since there are 365 days in a year, the annual returns will be calculated as:
Annual returns = (1+0.001)365 – 1 = 44.02%.
3. How do you calculate ‘geometric mean return’?

Geometric mean return (GMR) is primarily used for investments that are compounded. It is used to calculate
average rate per period on investments that are compounded over multiple periods.
𝐺𝑀𝑅 = √(1 + 𝑅1 )(1 + 𝑅2 )(1 + 𝑅3 ) … … … … . (1 + 𝑅4 ) − 1
4. What is security’s variance?

The variance of security returns is the measure of risk inherent in investing in a single asset.
𝑛
2
∑𝑖=1(𝑅𝑖 − 𝑅̅𝑖 )2
𝜎𝑖 =
𝑛−1
(or)
𝑛
𝜎𝑖2 = ∑ 𝑃𝑖 (𝑅𝑖 − 𝑅̅𝑖 )2

𝑖=1
5. What is security’s standard deviation?

A standard deviation of a security is the measure of risk involved in the security in terms of variability in the
returns. It is the square root of variance of security returns.
38
𝜎𝑖 = √𝜎𝑖2
6. What does a small/high standard deviation of a security indicate?

The smaller the standard deviation the lower the riskiness of the stock and higher the standard deviation higher
is the risk. For a smaller standard deviation, the probability distribution will be tighter.
7. When and how do you have to annualize the ‘standard deviation’?

We have to annualize the standard deviation if we have returns frequency of less than one year. For example,
daily, weekly or monthly returns.
To annualize volatility, it's necessary to measure standard deviation over a shorter period of time and
extrapolate it over the course of a year. In order to figure out what the standard deviation of returns is, the daily
returns must first be calculated.
Let’s say we have daily returns, then Annualized Standard Deviation = Standard Deviation of Daily Returns *
√365
8. What is ‘coefficient of variation’? What does it indicate?

The coefficient of variation (CV) is the ratio of the standard deviation to the mean. The higher the coefficient of
variation, the greater the level of dispersion around the mean. It is generally expressed as a percentage.
𝜎𝑖
𝑅̅𝑖
9. What is systematic risk of a security?

Systematic risk is that part of a security’s total risk that cannot be eliminated by diversification. It is measured
by the beta coefficient.
10. How do you calculate security beta?

Security beta is arrived by dividing security’s covariance with market variance.
𝜎𝑖𝑀
𝛽𝑖 = 2
𝜎𝑀
11. What is unsystematic risk of a security?

It is a company specific risk which is a diversifiable risk. It is that part of a security’s total risk associated with
random events not affecting the market as a whole. This risk can be eliminated by proper diversification.
12. What is a ‘relevant risk’ of a security?

The relevant risk of a stock is its contribution to the riskiness of a well-diversified portfolio.
13. What is ‘beta’ of a security?

The beta coefficient is a measure of a stock’s market risk, or the extent to which the returns on a given stock
move with the stock market. It measures the stock’s return sensitivity to the market returns as a whole.
14. What is ‘beta’ of an index?

The market beta shall be 1.
15. How does beta measure volatility in relation to market changes?
39
A beta of 1.0 means the stock’s return moves on average just as much as the market’s return. Beta above 1.0
implies the stock moves more than the market. Beta below 1.0 means the stock tends to move with the market
but less. Beta less than ‘0’ means the stock tends to move against the market, that is, in the opposite direction.
Zero Beta might indicate indifference.
16. How can beta help in investment strategy?

The idea of beta immediately suggests an investment strategy. When the market is moving up, hold high-beta
stocks because they move up more. When the market is moving down, switch to low-beta stocks because they
move down less.
17. What is ‘security alpha’?

Alpha represents that rate of returns a stock would generate irrespective of market conditions.
However, as per the modern portfolio theory, it is the difference between the actual rate of return and expected
rate of return. The expected return is calculated using CAPM-SML approach.
18. How do you calculate ‘security alpha’?

As per the modern portfolio theory, it is the difference between the actual rate of return and expected rate of
return. The expected return is calculated using CAPM-SML approach.
𝛼𝑖 = 𝑅𝑖 − [𝑅𝑓 + 𝛽𝑖 (𝑅𝑀 − 𝑅𝑓 )]
19. How do you decompose total risk into ‘systematic’ and ‘unsystematic’ components?
There are two ways of doing it.
Method-1: Systematic risk is a product of squared beta and market variance whereas unsystematic risk is the
error term.
𝜎𝑖2 = 𝛽𝑖2 𝜎𝑀
2 2
+ 𝜎𝑒𝑖
Method-2: Systematic risk is a product of squared correlation coefficient and security variance whereas
unsystematic risk is the error term.
𝜎𝑖2 = 𝜌𝑖𝑀
2
𝜎𝑖2 + 𝜎𝑒𝑖
2
Sub-topic: 2. Portfolio Risk and Return
1. What is ‘covariance’?
Covariance is a measure of the directional relationship between the variability of returns of two securities in the
context of portfolio management.
2. How do you calculate ‘covariance’?

Covariance can be calculated in two ways.
Method-1: It is calculated by analyzing the standard deviations from the expected return. Slightly different
based on ex-post or ex-ante returns.
For ex-post returns:
𝑛
∑ (𝑅𝑖 − 𝑅̅𝑖 ) (𝑅𝑗 − 𝑅̅𝑗 )
𝑖=1
𝜎𝑖𝑗 =
𝑛−1
For ex-ante returns:
40
𝑛
𝜎𝑖𝑗 = ∑ 𝑃𝑖 (𝑅𝑖 − 𝑅̅𝑖 ) (𝑅𝑗 − 𝑅̅𝑗 )

𝑖=1
Method-2: It is calculated by multiplying the correlation between the two variables by the standard deviation
of each variable.
𝜎𝑖𝑗 = 𝜌𝑖𝑗 𝜎𝑖 𝜎𝑗
3. What is a ‘scaled covariance’?

The scaled covariance is the coefficient of correlation.
4. How do you calculate ‘correlation coefficient’?

Correlation coefficient is used to measure how strong a relationship is between two securities. It is calculated
by dividing the covariance between two securities by the product of two securities standard deviations.
𝜎𝑖𝑗
𝜌𝑖𝑗 =
𝜎𝑖 ∗ 𝜎𝑗
5. What is the significance of correlation between two securities?

Correlation is the tendency of two securities to move together. A correlation coefficient (ρ) of +1.0 means that
the two securities move up and down in perfect synchronization. A correlation coefficient of -1.0 means that
the two securities always move in opposite directions. A correlation coefficient of zero suggests that the two
securities are not related to one another; that is, they are independent.
6. What is the need to create a portfolio?

An asset held in a portfolio is less risky than the same asset held in isolation. When more number of securities
are included in a portfolio, the individual risk(s) associated with few securities might offset individual risk(s)
associated with certain securities. Since the risk can be reduced by holding portfolios i.e., diversifying, most
financial assets are indeed held in portfolios.
7. How do you calculate risk of a ‘two-assets portfolio’?

The risk of a portfolio is measured using the standard deviation of the portfolio. However, it is not a simple
weighted average of the standard deviation of the two assets. We also need to consider the
covariance/correlation between the two assets.
𝑛
𝜎𝑝2 = ∑ 𝑊𝑖2 𝜎𝑖2 + 𝑊𝑗2 𝜎𝑗2 + 2𝑊𝑖 𝑊𝑗 𝜎𝑖𝑗

𝑖=1
(or)
𝑛
𝜎𝑝2 = ∑ 𝑊𝑖2 𝜎𝑖2 + 𝑊𝑗2 𝜎𝑗2 + 2𝑊𝑖 𝑊𝑗 𝜌𝑖𝑗 𝜎𝑖 𝜎𝑗

𝑖=1
8. What is the relationship between portfolio risk and number of stocks in the portfolio?
If the correlations of stocks were zero or negative, it might help to reduce/eliminate a major portion of the
portfolio risk. However, we may not be able to find stocks with zero or negative correlation all the time.
In that case, we tend to include stocks with smaller correlation coefficients. If we add more number of such
stocks in the portfolio, then the portfolio risk will be minimized.
So, the degree of correlation among the stocks plays an important role in deciding the number of stocks to be
added to a portfolio.
41
9. How is expected return on a portfolio calculated?
The expected return on a portfolio is simply the weighted-average expected return of the individual stocks in
the portfolio, with the weights being the fraction of total portfolio value invested in each stock.
𝑛
𝑅𝑝 = ∑ 𝑊𝑖 𝑅̅𝑖
𝑖=1
10. What is a ‘portfolio beta’? How is it calculated?

Beta for a portfolio of stocks is just the weighted average of the betas of the individual stocks where the weights
are the proportion of amount invested in each stock.
𝑛
𝛽𝑝 = ∑ 𝑊𝑖 𝛽̅𝑖
𝑖=1
11. What is a minimum variance portfolio?

A minimum variance portfolio indicates a well-diversified portfolio that consists of individually risky securities,
which are hedged when traded together, resulting in the lowest possible risk for an expected rate of return.
12. What do you understand by market risk premium?

A risk premium is the difference between the rate of return on a market and the return on a risk-free asset.
(𝑅𝑀 − 𝑅𝑓 )
Sub-topic: 3. Portfolio Diversification
1. What is ‘portfolio management’?

Portfolio management is the art and science of selecting and overseeing a group of investments that meet the
long-term financial objectives and risk tolerance of a client.
2. What is ‘investment analysis’?

Investment analysis involves researching and evaluating a security or an industry to predict its future
performance and determine its suitability to a specific investor. Investment analysis may also involve evaluating
or creating an overall financial strategy.
3. What are the random events that contribute to the diversifiable risk?
The part of a stock’s risk that can be eliminated is called diversifiable risk. Diversifiable risk is caused by such
random events as lawsuits, strikes, successful and unsuccessful marketing programs, winning or losing a major
contract, and other events that are unique to a particular firm. Because these events are random, their effects
on a portfolio can be eliminated by diversification – favorable events in one firm will offset the unfavorable
events in another.
4. What are the events that contribute to the non-diversifiable risk?

Non-diversifiable risk, also known as market or systematic risk, is that part of a security’s risk which cannot be
eliminated by diversification. It stems from factors that systematically affect most firms like war, inflation,
recessions and high interest rates. Because most stocks are negatively affected by these factors, market risk
cannot be eliminated by diversification.
5. What is the required rate of return as per CAPM-SML approach? How do you calculate?
42
As per CAPM-SML, any stock’s required rate of return is equal to the risk-free rate of return plus a beta-adjusted
market risk premium.
𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 (𝑅𝑀 − 𝑅𝑓 )
6. What is characteristic market line?

The characteristic line represents the average relationship between the stock’s return and the market’s return.
The slope tells us on the average how much of a change in stock return has come about with a given change in
market return. The slope is an indication of how much variation in the return on the stock goes along with
variation in the return on the market.
7. What is security market line (SML)?

SML, which is also a characteristic line, is a graphical representation which shows the relationship between the
risk of an asset as measured by its beta and the required rates of return for individual securities.
8. What is the measure of risk in security market line (SML)?

SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio.
9. What is capital market line (CML)? How do you calculate the expected returns by using CML?
The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels
of risk for a specific portfolio.
(𝑅𝑀 − 𝑅𝑓 )
𝐸(𝑅𝑝 ) = 𝑅𝑓 + 𝜎𝑝
𝜎𝑀
10. What is measure of risk in capital market line (CML)?

The CML measures the risk through standard deviation, or through a total risk factor.
11. What is Sharpe’s ratio?

The Sharpe ratio is a measure of risk-adjusted return. It describes how much excess return you receive for the
volatility of holding a riskier asset.
(𝑅𝑃 − 𝑅𝑓 )
𝜎𝑃
12. What is ‘efficient frontier’?

The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of
risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-
optimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of
the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.
43
13. What is a ‘Tangency Portfolio’?
Tangency portfolio, also known as market portfolio, is defined as the risky portfolio with the highest possible
Sharpe ratio. The steepest Capital Allocation Line (CAL), also known as Capital Market Line (CML), passes through
the Tangency portfolio.
14. What is ‘Tangency Point’ in the context of Capital Market Line (CML)?
The tangency point shows the optimal portfolio of risky assets which is known as the market portfolio.
15. What is a Global Minimum Variance Portfolio?

The global minimum variance portfolio lies to the far left of the efficient frontier and is made up of a portfolio
of risky assets that produces the minimum risk for an investor.
44
16. What is Minimum Variance Frontier?
The minimum variance frontier shows the minimum variance that can be achieved for a given level of expected
return.
17. What is a ‘separation theorem’ in portfolio management?

According to CAPM, the investors are allowed to lend and borrow at risk-free rate based upon their risk appetite.
It is based on Fischer’s separation theorem.
A separation property is a crucial element of modern portfolio theory that gives a portfolio manager the ability
to separate the process of satisfying investing clients' assets into two separate parts.
The first part is the determination of the "optimum risky portfolio". This portfolio is the same for all clients. It
has the highest Sharpe ratio.
The second part is tailoring the portfolio to the risk-averse needs of each individual client.
This is achieved through allocating the client's total investments partly to the risky assets and partly to the risk-
free assets.
45
6. FAQs on Broader Topic: Capital Structure, Working Capital and Dividend Policy
Sub-topic: 1. Impact of Leverage on Capital Structure: EBIT-EPS Analysis
01. What is capital structure? Name a few financial instruments used to raise capital?
Capital structure is a term which is referred to be the mix of sources from which the long-term funds are
raised. Financial instruments used to raise capital include, Ordinary Shares, Preference Shares, Bonds,
Warrants etc
02. What are the internal factors affecting capital structure?

i) Cost of capital. ii) Financial Risk. iii) Control Factor
iv) Stability of Earnings v) Attitude of the Management
03. What are the external factors affecting capital structure?

i) Economic Conditions ii) Interest Rates level
ii) Lending Policy iv) Taxation Policy
04. Explain Cost of capital and its importance?

Cost of the capital is the minimum rate of return which has to be earned on investments in order to satisfy
the investors of various types who are making investments in the company in the form of shares, debentures
and loans.
Cost of Capital is used to evaluate new project of company and allows the calculations to be easy so that it
has minimum return that investor expect for providing investment to the company.
05. How do you calculate the cost of equity using CAPM model?
46
The cost of equity is the return that an investor expects to receive from an investment in a business. This
cost represents the amount the market expects as compensation in exchange for owning the stock of the
business, with all the associated ownership risks.
Cost of equity = Risk free rate of return + [Beta × (market rate of return – risk free rate of return)]
06. How do you calculate Cost of Debt? Why is cost of debt considered only post tax?
To calculate the cost of debt, a company must determine the total amount of interest it is paying on each
of its debts for the year. Then it divides this number by the total of all of its debt. The result is the cost of
debt. The cost of debt formula is the effective interest rate multiplied by (1 - tax rate).
Cost of Debt = Interest rate * (1-Tax Rate)
Cost of debt is considered post-tax because the interest paid on debt provides tax advantage.
07. What would be cost of retained earnings?

Cost of retained earnings have the opportunity cost associated with it. It is same as cost of external equity,
only floatation cost need not to deducted here.
08. How do you calculate the cost of preference shares?

Cost of Irredeemable preference shares = Kp = Dp / NP
Cost of Redeemable preference shares = Kp = Dp+((RV-NP)/n)/ (RV+NP)/2
Where, Kp = Cost of Preference Share, Dp = Dividend on preference share
NP = Net proceeds from issue of preference share
Cost of Irredeemable Preference shares (KP) = Annual Preference Dividend in Rupees / Purchase price.
A 10% preference share with a face value of Rs 100000/- is purchased at 5% premium.
Cost of irredeemable Preference shares (KP) = 10000 / 105000 = 9.52%
09. How do you calculate the Cost of Debentures, using approximation method?
Cost of Debentures = Kd = [ I (1-t) + ((RV-NP)/n)] / (RV+NP)/2
10. How do you calculate the overall cost of capital of a firm?

Cost of capital is measured in terms of weighted average cost of capital.
First, determine the costs of the various sources of finance. We shall define the symbols ke, kr, kp and kd
to denote the costs of equity, retained earnings, preference capital and debt respectively.
Next determine the weights associated with the various sources of finance.
There after substitute the values in the following formula, to get weighted average cost of capital
WACC = Weke + Wrkr + Wpkp + Wdkd
11. What is meant by leverage? Why is increasing leverage also indicative of increasing risk?
Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset
base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money
specifically, the use of various financial instruments or borrowed capital to increase the potential return of
an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.
The business borrows money with the promise to pay it back. Debt increases the company's risk of
bankruptcy. But if the leverage is used correctly, it can also increase the company's profits and returns
specifically its return on equity.
12. What is an unlevered firm?

A firm with no debt in its capital structure is called unlevered firm. Sometimes, it is also called an All-equity
firm.
13. What is financial leverage? How do you calculate it? What does high/ low financial leverage indicate?
Financial leverage refers to the use of debt in the capital structure, with a view to enhance earnings to
equity shareholders (since interest on debt is deductible as business expense, for estimating taxable profits.
Financial leverage = EBIT / (EBIT – Interest – pre-tax preference dividend)
47
High financial leverage indicates usage of more debt by company. Low financial leverage indicates usage of
less debt by company.
14. What is operating leverage? How do you calculate it?

Operating leverage examines the effect of the change in the sales on the EBIT of the company. The firm’s
ability to use fixed operating cost to magnify the effects of changes in sales on its earnings before interest
and taxes is called operating leverage.
Operating leverage = Total contribution / EBIT
15. What is combined leverage? How do you calculate it?

The product of operating leverage and financial leverage is called combined leverage.
Combined leverage = Contribution / (EBIT-Interest – pre-tax preference dividend)
16. What is EBIT-EPS analysis? What is indifference point in EBIT-EPS analysis?

EBIT - EPS analysis involves comparison of alternative methods of financing at a desired level of EBIT.
The EBIT level at which the EPS is the same for two alternative financial plans is referred to as the
indifference point.
17. What is Miller and Modigliani hypothesis? What is the underlying logic under MM hypothesis?
MM hypothesis tells that firm's value is independent of capital structure. The same return can be received
by shareholders with the same risk.
MM Approach uses the logic of arbitrage to prove that two firms with similar risk (business risk) and return
cannot have value different from each other in long run.
18. What is net operating income theory (NOI)? What is the underlying logic under net operating income
theory (NOI)?
NOI, an approach in which both the value of the firm and the weighted average cost are independent of
capital structure.
NOI uses the logic that the advantage of using more of cheaper source of fund (debt) is completely offset
by the higher compensation demanded by equity owners. Equity owners demand higher return as they are
exposed to higher financial risk.
19. Explain a capital structure relevance theory. (Net income (NI) approach)
Net income (NI) approach is an approach in which both cost of debt, and equity are independent of capital
structure. Further the cost of debt is lower than cost of equity. Hence more the debt firm employs more will
be its value. In contrast to NOI approach, the overall cost of capital will come down with the infusion of
cheaper debt.
20. What do you mean by market capitalization?

Market capitalization is the aggregate valuation of the company based on its current share price and the
total number of outstanding shares. It is calculated by multiplying the current market price of the company's
share with the total outstanding shares of the company.
Sub-topic: 2. Estimation and Funding of Working Capital
01. What is working Capital? Explain the different types of working capital?
Working Capital: Capital required for day-to-day operational requirement of a business unit is called
working Capital.
Working capital is basically of two types i) Gross working capital and ii) Net working capital
i. Gross Working Capital: The total of current assets is called the Gross working capital
48
ii. Net Working Capital: The excess of current assets over the current liabilities is called net working
capital. (Current Assets – Current liabilities) It refers to the portion of working capital financed by long-
term sources of funds (which includes capital and reserves)
02. What is Negative Working Capital?

Negative Net working capital: The excess of current liabilities over the current assets. For example,
higher accounts payable of a company might result in negative working capital. Also the usage of current
liabilities to finance the non- current assets like fixed assets etc. It represents diversion of funds, which
may lead to liquidity crunch at a later stage.
03. Name the Current assets and Current liabilities.

Current Assets usually include cash, marketable securities, trade receivables, stocks / inventory, loans and
advances etc. Current liabilities normally include trade payables, cash credit / overdraft, loans and advances
etc.
04. Name the liquidity ratios and explain them.

A liquidity ratio is a financial ratio that indicates whether a company's current assets will be sufficient to
meet the company's obligations when they become due. Examples of Liquidity Ratios are current ratio, quick
ratio (acid test ratio) and cash ratio.
05. Current ratio is 0.85. What does it indicate?

A current ratio of less than 1 indicates that the company may have problems meeting its short-term
obligations. If inventory turns into cash much more rapidly than the trade payable become due, then the
firm's current ratio can comfortably remain less than one.
06. Calculate net- working capital in the following two cases and explain?
i.Current assets are Rs. 60 lakhs and current liabilities are Rs. 40 lakhs.
ii.Long term sources of funds including the Capital and reserves are Rs. 100 lakhs and non-current
liabilities are Rs 80 lakhs
Net working capital can be defined as two ways.
Amount in Lakhs of Amount in Lakhs of
LIABILITIES ASSETS
Rupees Rupees
Capital and Reserves 100 Fixed and Non-Current
80
& Assets
Long Term Liabilities
CURRENT ASSETS 60
CURRENT LIABILITIES 40
TOTAL 140 TOTAL 140
Net working capital can be arrived in two ways.

i.Current Assets (-) Current Liabilities = Rs 60 Lakhs – Rs 40 Lakhs = Rs 20 Lakhs
ii.Long term sources of funds including Capital and Reserves ( - ) Non- current assets including
the fixed assets = Rs 100 lakhs - Rs 80 lakhs = Rs 20 Lakhs.
07. How is working capital financed?

Working capital is defined as the total of current assets. It is finance by
i.Current liabilities, which mainly includes the Trade credit and Bank credit, and
ii.Net working Capital, which is the difference between current assets and current liabilities. It
represents owner’s contribution to finance current assets out of long-term sources of funds,
(including the capital and reserves)
To sum up, the working capital finance for a business entity (current assets) is met by trade credit, bank
credit and owner’s contribution.
49
08. What is working capital gap? What does it represent?
Working Capital Gap = Current assets – (Current liabilities excluding short term Bank Borrowings)
It represents Current assets over and above the trade credit. In other words, it indicates the amount to be
sourced from Bank credit and own sources to finance the current assets.
09. Explain the methods of working capital finance? [Tandon Committee method – I (MPBF method)
and method – II)
Once upon a time, when the bank credit was scarce, the Tandon committee norms were mandatory.
Now they are optional. But still Banks are using them for working capital assessment.
Step. I: In both the methods, first the working capital gap is to be calculated. Working Capital Gap =
Current assets – (Current liabilities excluding short term Bank Borrowings)
Step. II: Subtract MARGIN from the above. Margin for Method No I is 25% on Working Capital
Gap and for Method No II is 25% on Current assets.
10. Explain the method of financing working capital for MSME units?
Working Capital finance for MSME units is done as per Nayak Committee recommendations. It is called
Turnover method. Under this method, at first the projected turnover of the MSME unit shall be acceptable
to both the Bank and Customer. The working capital finance shall be 20% of the projected turnover,
provided the customer brings in a margin (own funds) to the extent of 5% of the projected turnover.
11. Explain the concept of EOQ?

The EOQ level is the point at which stocking costs are at their lowest point for a given item. Economic order
quantity (EOQ) is the ideal order quantity a company should purchase to minimize inventory costs such as
holding costs, shortage costs, and order costs. EOQ = √ (2AO / C), where A = Annual consumption, O =
Ordering cost per unit, and C = Carrying (Holding) cost per unit.
12. What is ABC analysis?

ABC Analysis, is an integral part of material management. It is an inventory categorization method, which
classifies the inventory primarily into three distinct categories A- Small volume of stock with highest value;
B- slightly higher volume of goods with moderate value; and C- large volume of stock with lower value. ABC
inventory management technique helps business entrepreneurs and stock owners identify the essential
products in the stock and prioritize their management based on the value. The inventory analysis is based
on the Pareto Principle, which states that 80% of the sales volume gets generated from the top 20% of the
items.
13. Define the term “Receivables”. Explain their importance in working capital management?
Receivables, also called as accounts receivable, are debts owed to a firm by its customers for goods or
services used or delivered but not yet paid for. Receivables are created by expanding the line of credit to
customers and are listed as current assets on the company's balance sheet.
Accounts receivable management incorporates in all about ensuring that customers pay their invoices.
Good receivables management helps prevent overdue payment or non-payment. It is therefore a quick and
effective way to strengthen the company's financial or liquidity position.
14. What does Debtor’s turnover indicate? How is it calculated? Should it be higher or lower?
Debtor’s turnover ratio is also known as Receivables Turnover Ratio, Debtor’s Velocity and Trade
Receivables Ratio. It is an activity ratio that finds out the relationship between net credit sales and average
trade receivables of a business. Debtor’s Turnover is arrived at by dividing the net credit sales by average
receivables. Higher turnover indicates, faster recovery and good demand and quality of goods. It also speaks
on quality of the debtors.
15. What does Creditor’s turnover indicate? How is it calculated? Should it be higher or lower?
50
Creditor’s turnover ratio is also known as Payables Turnover Ratio, Creditor’s Velocity and Trade Payables
Ratio. It is an activity ratio that finds out the relationship between net credit purchases and average trade
payables of a business.
It finds out how efficiently the assets are employed by a firm and indicates the average speed with which
the payments are made to the trade creditors.
Creditor’s turnover is calculated by dividing the Net Credit purchases by Average trade payables.
A high ratio may indicate Low credit period available to the business or early payments made by the
business.
16. What is Inventory turnover ratio? Explain its significance with suitable example.
Inventory turnover ratio (ITR) is an activity ratio and is a tool to evaluate the liquidity of company’s
inventory. It measures how many times a company has sold and replaced its inventory during a certain
period of time. Inventory turnover ratio is computed by dividing the cost of goods sold by average inventory
at cost.
A high ratio indicates fast moving inventories and a low ratio, on the other hand, indicates slow moving or
obsolete inventories in stock.
17. Explain the concept “Stock out position”

A stockout is an event in which inventory is currently unavailable, preventing an item from being purchased
or shipped. For online stores, a stockout can cause a lot of frustration for the customer especially if there is
no indication on when the item will be back in stock and available for purchase.
Stockouts happen for a variety of reasons. Factors such as underestimating customer demand, major
supplier delays, and a lack of funds to purchase new inventory can all lead to products being out of stock.
18. Explain the Cash Conversion Cycle / Working Capital Cycle / Operating Cycle?
The operating cycle is the time required for a company's cash to be put into its operations and then return
to the company's cash account.
19. Define “Net worth”
Net worth represents owners’ funds in the business. Net worth = Capital and reserves less Fictitious
assets.
20. Current assets are Rs 50 lakhs. It includes stock of Rs 20 lakhs. Current liabilities are Rs 30 lakhs. It
includes existing cash credit / Overdraft limit of Rs 10 lakhs. Calculate the following.
a) Current Ratio.
b) Quick / Acid Test Ratio
c) Gross Working Capital.
d) Net Working Capital
e) Working Capital Gap
f) Maximum Permissible Bank finance as per Tandon committee Method – I
g) Maximum Permissible Bank finance as per Tandon committee Method – II
a Current Ratio Current assets / Current Liabilities 50 / 30 1.6667

b Quick Ratio (Current assets – Stock) / Current (50-20) / 30 1
Liabilities
c Gross Working Total of Current assets Rs 50 Lakhs
Capital
d Net working Capital Current assets – Current liabilities 50 - 30 Rs 20 lakhs
e Working Capital Gap Current Assets – (Current 50 – (30 – 10) Rs 30 Lakhs
liabilities excluding short term
Bank borrowings)
f MPBF – Method I Working Capital Gap – 25% on 30 – (0.25 *30) Rs 22.5 Lakhs
Working Capital Gap
51
g MPBF – Method II Working Capital Gap – 25% on 30 – (0.25 *50) Rs 17.5 Lakhs
Current assets
Sub-topic: 3. Bonus shares, stock split and share buyback
01. What is dividend?

Dividend is the part of the profits (PAT) that is distributed to the shareholders.
02. What is Dividend per share?

Dividend per share is the amount of dividend being declared per share.
03. What is the difference between Dividend payout ratio and Dividend per share?
Dividend pay-out ratio is a percentage measuring the percent of profits declared as dividend. Whereas
Dividend per share is expressed in Rupees. It states the amount of dividend that each shareholder will get.
04. What is retention ratio?

It is the percentage of profits (PAT) that is retained back in the firm.
05. What is the relation between Dividend payout ratio and Retention ratio?
The summation of both ratios gives us one. i.e., they measure two different aspects of the same equation.
06. Is the dividend paid on common stock taxable to shareholders? What about Preferred stock? Is it tax
deductible for the company?
Earlier a company declaring dividends used to pay Dividend distribution tax (DDT). However, the Finance
Act, 2020 changed the method of dividend taxation. The DDT liability on companies and mutual funds stand
withdrawn. Similarly, the tax of 10% on dividend receipts of resident individuals, HUF and firms in excess of
Rs 10 lakh (Section 115BBDA) also stands withdrawn. Hence forth, all dividend received on or after 1 April
2020 are taxable in the hands of the investor/shareholder.
The Finance Act, 2020 also imposes a TDS on dividend distribution by companies and mutual funds on or
after 1 April 2020. The normal rate of TDS is 10% on dividend income paid in excess of Rs 5,000 from a
company or mutual fund. However, as a COVID-19 relief measure, the government reduced the TDS rate to
7.5% for distribution from 14 May 2020 until 31 March 2021
07. Does the dividend paid by the company appear in the Profit and Loss statement? Is it a revenue or an
expense?
Dividend paid by a company is not shown in profit and loss statement. Dividend is an appropriation of profits
made in retained earnings statement. Dividend is neither revenue nor an expense.
08. Is declaring dividends a good thing for the company?

There are two schools of thoughts. (1) The more dividend a company declares the less the company has
that can be used for growth of the firm. Since giving dividends is bad because it is hampering the future
growth prospectus of the firm. (2) If dividends are not declared, it might indicate that the firm is earning
enough but not paying for its shareholders. Shareholders may get de-motivated. Hence declaring dividends
is good.
09. Is dividend received by the shareholder taxable?

Dividend received from an Indian company was exempt until 31 March 2020 (FY 2019-20). That was
because the company declaring such dividend already paid dividend distribution tax (DDT) before making
payment.
However, the Finance Act, 2020 changed the method of dividend taxation. Henceforth, all dividend
received on or after 1 April 2020 is taxable in the hands of the investor/shareholder.
52
10. What are the different theories under Dividend policies?
Traditional theory, MM theory, Gordon Model, Walter model., etc
11. Explain the Miller and Modigliani theory on dividend payment

According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no effect on the price
of the shares and profitability of the firm. The theory believes that it is the investment policy that
increases the firm's share value.
12. Explain Walter Model on dividend payment

According to Walter Model, the dividend policy of a firm is based on the relationship between the internal
rate of return (r) earned by it and the cost of capital or required rate of return (Ke).As per this model, the
investment decisions and dividend decisions of a firm are interrelated.
A firm should retain its earnings if the return on investment exceeds the cost of capital. Such firms are
called Growth Firms (r > Ke). Such firms should have zero pay-out and should re-invest their entire earnings.
On the other hand, a firm should distribute its earnings to the shareholder if the internal rate of return is
less than the cost of capital (r < Ke). Such firms are called declining firms. Such firms should distribute the
entire profits i.e., 100 per cent pay-out ratio.
Firms with internal rate of return equal to the cost of capital (r = Ke) are called Normal Firms. In such firms,
the shareholders will be indifferent whether the firm pays dividends or retain the profits.
13. Explain Gordon Model on dividend payment

Gordon’s model explicitly relates the market value of the company to its dividend policy. The determinants
of the market value of the share are the perpetual stream of future dividends to be paid, the cost of
capital and the expected annual growth rate of the company.
The Gordon’s theory on dividend policy states that the company’s dividend pay-out policy and the
relationship between its rate of return (r) and the cost of capital (k) influence the market price per share of
the company.
When IRR is greater than the Cost of Capital, the price per share increases and the dividend pay-out
decreases. On the other hand, if IRR is lesser than the Cost of Capital, the price per share decreases and
dividend pay-out increases.
14. What are Bonus shares?

A bonus issue, also known as a scrip issue or a capitalization issue, is an offer of free additional shares to
existing shareholders. A company may decide to distribute further shares as an alternative to increasing the
dividend pay-out. For example, a company may give one bonus share for every five shares held.
15. How Bonus shares are issued? What is the source of funds for the issue of Bonus shares?
Bonus shares are issued to the existing shareholders, as fully paid shares, in proportion to their existing
holdings. Section 63 of Companies Act 2013, provides that a company may issue fully paid-up bonus
shares to its members, out of;
a) Its free reserves,
b) The securities premium account, or
c) The capital redemption reserve account.
16. What impact does Bonus issue has on the Balance sheet of a company?
A bonus issue is a simple reclassification of reserves, which causes an increase in the share capital of
the company on the one hand and an equal decrease in other reserves. The total equity of
the company therefore remains the same although its composition is changed.
17. What is stock split? Why is it done

A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost
the liquidity of the shares. Although the number of shares outstanding increases by a specific multiple, the
53
total value of the shares remains the same compared to pre-split amounts, because the split does not add
any real value.
18. What is the impact of Stock splits on the financial statements of a company?
A stock split will not change the general ledger account balances and therefore will not change the Rupee
value reported in the stockholders' equity section of the balance sheet. Although the number
of shares increase, the total Rupee value will not change.
However, a stock's price is affected by a stock split. After a split, the stock price will be reduced, since the
number of shares outstanding has increased. Thus, although the number of outstanding shares increases
and the price of each share changes, the company's market capitalization remains unchanged.
19. Why do companies buy back shares?

Buy-Back is a corporate action in which a company buys back its shares from the existing shareholders
usually at a price higher than market price. When it buys back, the number of shares outstanding in the
market reduces.
Companies’ buyback shares to consolidate the shareholdings, to improve earnings per share, return on
capital, return on net worth and to enhance the long-term shareholder value.
20. Under what circumstances companies are permitted to buy back their shares?
Sections 68 to 70 of the Companies Act, 2013 and Rule 17 of the Companies (Share Capital and
Debentures) Rules, 2014 deal with buy-back of shares. A company may purchase its shares out of:
• its free reserves;
• the securities premium account; or
• the proceeds of the issue of any shares or other specified securities.
However, no buy-back of any kind of shares can be made out of the proceeds of an earlier issue of the
same kind of shares.
Buyback of shares can be undertaken only when the company is solvent, and is permitted to do so as per
the Articles of association. A board resolution is required to be passed for buy back of shares and it should
be approved in AGM.
-x-x-x-
54

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Department of Finance and Accounting: IBS, IFHE, Hyderabad

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Program: MBA

Course: Syndicated Learning Program (SLP-3)

Academic Year: 2021-22

Department of Finance and Accounting

S.No. Broader Topic Sub-Topics Pg. No.

Sub-topic: 1. Accounting Concepts and Conventions

Going concern concept

Money measurement concept

Accounting period concept

Sub-topic: 2. Journal Entries and their reflection on Financial Statements

3. Journal entries for transactions:

PPE (Building) A/c …………………………. Dr. Rs.80,00,000

Effect on Financial Statements:

b. Assets depreciated / amortized:

Depreciation on Buildings A/c …………………………… Dr. Rs.8,00,000

Depreciation on Air conditioners A/c ………………… Dr. Rs.2,40,000

Amortization on Patents A/c …………………………….. Dr. Rs.2,00,000

Effect on Financial Statements:

ICICI Bank Loan A/c …………. Dr. Rs.100,00,000

Effect on Financial Statements:

d. Payment of corporate tax:

Income Tax A/c ……………………. Dr. Rs.60,00,000

Effect on Financial Statements:

e. Payment of salaries by corporates:

The journal entry shall be:

Salaries A/c …… Dr. Rs.12500

Effect on Financial Statements:

f. Bad debts incurred:

Effect on Financial Statements:

g. Provision for bad and doubtful debts created:

Effect on Financial Statements:

h. Issue of share capital, incurring expenses for raising the capital:

Bank A/c …………………. Dr. Rs.9,80,00,000

Effect on Financial Statements:

i. Creation of general reserve:

Retained Earnings A/c …………………………. Dr. Rs.21,00,000

Effect on Financial Statements:

j. Announcement of dividends and later on payment of the dividends:

(a) For declaration of annual dividend:

Effect on Financial Statements:

2. Profit equation of a company / bank

3. What is the difference between journal entry and ledger posting?

4. What is Trial Balance? What does an accurate Trial Balance suggest?

6. How is Profit & Loss account linked to BS?

7. Key line items on Profit & Loss account of companies / banks

8. Key line items on BS of companies / banks

9. What is authorised share capital? Retained earnings? EPS? Net worth?

10. What are debentures?

11. What is preference capital?

12. Why should company distribute dividends to its shareholders?

14. Who is more senior creditor: a bondholder or shareholder?

16. When should a company buy back its shares?

17. What is goodwill?

19. Walk me through the cash flow statement

30. Distinguish between Expenditure and Expense?

31. Treatment of advertising expenses in financial statements.

32. Can cash flow statement be negative?