Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

Corporate Finance Basics Compendium

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

Table of Contents
1. Role of Corporate Finance ..................................................................................................... 3
2. Capital Budgeting ................................................................................................................... 3
2.1 Introduction ........................................................................................................................... 3

2.2 Key Principles of Capital Budgeting: .................................................................................. 3

2.3 Decision Criterion ................................................................................................................. 3
2.3.1 Net Present Value (NPV) ................................................................................................ 3
2.3.2 Internal Rate of Return (IRR) ....................................................................................... 4
2.3.3 Payback Period ................................................................................................................ 5

2.3.4 Discounted Payback Method ......................................................................................... 6

2.3.5 Profitability Index (PI) ................................................................................................... 6
3. Cost of Capital ........................................................................................................................ 7
3.1 Introduction ........................................................................................................................... 7

3.2 The Optimal Capital Budget ................................................................................................ 8

3.3 Cost of Debt............................................................................................................................ 9
3.4 Cost of Preferred Stock......................................................................................................... 9
3.5 Cost of Equity ........................................................................................................................ 9
3.5.1 Capital Asset Pricing Model (CAPM) ........................................................................... 9
3.5.2 Dividend Discount Model Approach ........................................................................... 10
4. Measures of Leverage ........................................................................................................... 11
4.1 Introduction ......................................................................................................................... 11

4.2 Degree of Operating Leverage (DOL) ............................................................................... 11

4.3 Degree of Financial Leverage (DFL) ................................................................................. 12
4.4 Degree of Total Leverage (DTL) ........................................................................................ 12
4.5 Breakeven Quantity of Sales .............................................................................................. 12

5. Dividends ............................................................................................................................... 13
5.1 Dividend Policy .................................................................................................................... 13
5.2 Theories of Dividend Policy ................................................................................................ 13

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

5.3 Signaling Hypothesis ........................................................................................................... 13

5.4 Clientele Effect..................................................................................................................... 13

5.5 Residual Dividend Model.................................................................................................... 14

6. Stock Repurchases ................................................................................................................ 15
6.1 Reasons for Repurchases:................................................................................................... 15
6.2 Advantages of Share Repurchases ..................................................................................... 15

6.3 Disadvantages of Share Repurchases ................................................................................ 15

6.4 Stock Dividends vs. Stock Splits ........................................................................................ 15

6.5 Reasons for Stock Dividends or Stock Splits .................................................................... 16
6.6 Conclusion ............................................................................................................................ 16

7. Working Capital Management ............................................................................................ 17

7.1 Overview .............................................................................................................................. 17

7.2 Types of Working capital ................................................................................................... 17

7.3 Cash Conversion Cycle ....................................................................................................... 17
8. Financial Statement Analysis .............................................................................................. 18
8.1 Bookkeeping......................................................................................................................... 18

8.2 Accounting ........................................................................................................................... 18

8.3 Double Entry System .......................................................................................................... 18

8.4 Accounting Cycle ................................................................................................................. 18
8.5 Accounting Equation........................................................................................................... 19
8.6 Basic Accounting Ratios ..................................................................................................... 19
8.6.1 Activity Ratios ............................................................................................................... 19

8.6.2 Liquidity Ratios ............................................................................................................. 20

8.6.3 Solvency Ratios .............................................................................................................. 20

8.6.4 Profitability Ratios ........................................................................................................ 20

8.6.5 Valuation Ratios ............................................................................................................ 21

9. Pecking Order Theory.......................................................................................................... 21

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

1. Role of Corporate Finance:

The objective of Corporate Finance is to create shareholder value. It has 4 primary functions:

1. Planning for funds – This involves deciding on the Capital structure of the firm

2. Raising funds – The quantum and type of funds (debt/equity, etc.) is decided. This fund
is raised at a certain cost known as Weighted Average Cost of Capital (WACC)

3. Management of funds – This involves Capital Budgeting (long-term planning) and

Working capital management (Short-term planning)

4. Distribution of funds – This involves planning for dividends. It is important for a firm
to decide whether to reinvest the reserves & surplus or pay dividends.

2. Capital Budgeting

2.1 Introduction
The Capital Budgeting Process is the process of identifying and evaluating capital projects, i.e.,
projects where the cash flow to the firm will be received over a period longer than a year.
Capital budgeting usually involves the calculation of each project’s future accounting profit by
period, the cash flow by period, the present value of the cash flows after considering the time
value of money, the number of years it takes for a project’s cash flow to pay back the initial
cash investment, an assessment of risk, and other factors.

2.2 Key Principles of Capital Budgeting:

1) Decisions are based on cash flows, not accounting income (Incremental cash flows are to
be considered, not sunk costs)
2) Cash flows are based on opportunity costs
3) The timing of cash flows is important
4) Cash flows are analyzed on an after-tax basis
5) Financing costs are reflected in the project’s required rate of return

2.3 Decision Criterion

2.3.1 Net Present Value (NPV)
The NPV is the sum of present values of all expected incremental cash flows if a project is
undertaken. The discount rate used is the firm’s cost of capital, it is calculated based on the
next best alternative use of the money. For a normal project with an initial cash outflow,
flowed by a series of cash inflows (after tax), the NPV is given by:

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

For independent projects, the NPV decision rule is to accept projects with positive NPVs and to
reject projects with negative NPVs.

Simple Example

Year Project A Project B

(INR) (INR)
0 -2000 -2000
1 1000 200
2 800 600
3 600 800
4 200 1200

The Table shows the expected net after-tax cash flows of two projects, A and B. Discount Rate
(Required rate of Return) = 10%

NPV of A
-2000 + 1000/ (1.1) ^1 + 800/ (1.1) ^2 + 600/ (1.1) ^3 + 200/ (1.1) ^4 = INR 157.64

NPV of B
-2000 + 200/ (1.1) ^1 + 600/ (1.1) ^2 + 800/ (1.1) ^3 + 1200/ (1.1) ^4 = INR 98.36

Both projects A and B have positive NPVs, so both can be accepted. But, if only one project is
to be chosen and if other factors are kept constant, then Project A should be chosen because it
has a positive NPV.

Advantage of the NPV Method: It is a direct measure of the expected increase in the value
of the firm/project

Disadvantage of the NPV Method: The project size is not measured. For example, an NPV of
INR 100 for a project costing INR 10,000 is good, but the same NPV of INR 100 is not so good
for a project costing INR 10,000,000

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

2.3.2 Internal Rate of Return (IRR)

The IRR is the discount rate which makes the present values of a project’s estimated cash inflows
equal to the present value of the project’s estimated cash outflow. It is the discount rate at which
the NPV of a project is equal to 0.
If IRR > the required rate of return, accept the project
If IRR < the required rate of return, reject the project
Continuing with the above example used for NPV:-
Project A:
0 = -2000 + 1000/ (1 + IRRA) ^1 + 800/ (1 + IRRA) ^2 + 600/ (1 + IRRA) ^3 + 200/ (1 + IRRA) ^4
Project B:
0 = -2000 + 200/ (1 + IRRB) ^1 + 600/ (1 + IRRB) ^2 + 800/ (1 + IRRB) ^3 + 1200/ (1 + IRRB) ^4

Using trial-and-error methods, financial calculators or Excel, the IRR for Project A = 14.49%
and the IRR for Project B = 11.79%. Both can be accepted as the IRRs for both projects > 10%.

Advantage of the IRR Method: It measures profitability as a percentage, showing the return
in each Rupee invested. One can comment on how much below the IRR the actual project
return could fall (in percentage terms) before the project becomes economically unfeasible

Disadvantages of the IRR Method: The possibility of producing rankings of projects which
may differ from the NPV rankings (either due to cash flow timing differences or due to
differences in project size) and the possibility of Multiple IRRs for the same project or no IRR

2.3.3 Payback Period

The Payback Period is the number of years it takes to recover the initial cost of an investment.
Continuing with the same example:-
Year Project A (INR) Project B (INR)
Net Cash Cumulativ Net Cumulativ
Flow e NCF Cash e NCF
Flow
0 -2000 -2000 -2000 -2000
1 1000 -1000 200 -1800
2 800 -200 600 -1200
3 600 400 800 -400
4 200 600 1200 800

Payback Period = Full years until recovery + (Unrecovered Cost at the beginning of
last year/Cash flow during last year)

Payback Period (Project A) = 2 + (200/600) = 2.33 years

Payback Period (Project B) = 3 + (400/1200) = 3.33 years

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

Since the Payback Method does not take into account the time value of money and cash
flow Beyond the payback period, project decisions cannot be based solely on this method.
However, this method is a good measure of project liquidity.

here time value of money i.e discount rate

2.3.4 Discounted Payback Method
This method uses the present values of the projects’ estimated cash flows. It must be
greater than the Payback Period without discounting. Continuing with the same example:-

Year Project A (INR) Project B (INR)

Net Cash Discounte Cumulativ Net Cash Discounte Cumulative

Flow d e Flow d DCNF
NCF DCNF NCF
0 -2000 -2000 -2000 -2000 -2000 -2000
1 1000 910 -1090 200 182 -1818
2 800 661 -429 600 496 -1322
3 600 451 22 800 601 -721
4 200 137 159 1200 820 99

Discounted Payback Period (Project A) = 2 + (429/451) = 2.95 years

Discounted Payback Period (Project B) = 3 + (721/820) = 3.88 years

This method addresses the concern of discounting cash flows at the project’s required rate of
return, but it still does not consider cash flows beyond the discounted payback period.

2.3.5 Profitability Index (PI)

This is the Present Value of a project’s future cash flows divided by the initial cash outlay. It
is closely related to the NPV.

PI = (PV of future cash flows/Initial Investment) = 1 + (NPV/Initial Investment)

If PI > 1.0, accept the project, else, if PI < 1.0, reject the project.

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

3. Cost of Capital
3.1 Introduction
A firm must decide on how to raise capital for its various projects, to funds its business and for
growth, dividing it among common equity, debt and preferred stock. The optimum mix which
produces the minimum overall cost of capital will maximize the value of the firm. Debt,
preferred stock and common equity are referred to as the capital components of the firm. The
cost of each of these components is called the component cost if capital.

kd: Cost of Debt – The rate at which the firm can issue new debt. It can also be considered
as the yield to maturity on existing debt (pre-tax component)

kd(1 – t): After-tax cost of Debt. “t” is the firm’s marginal tax-rate
kp: Cost of preferred Stock
ke: Cost of Equity – The required rate of return on common stock. Normally, the Cost of Equity
is higher than the Cost of Debt

WACC: Weighted Average Cost of Capital – It is the cost of financing the firm’s assets.
WACC is the average of the costs of the above sources of financing, each of which is weighted
by its respective use in the given situation.

WACC = (wd) [kd(1 – t)] + (wp)(kp) + (we)(ke)

Where,
wd = percentage of debt in the capital structure, wp = percentage of preferred stock in the capital
structure, we = percentage of equity in the capital structure

Simple Example

Suppose Company A’s target capital structure is as follows: wd = 0.45, wp = 0.05, we =

0.50. Before-tax cost of debt = 8%, cost of equity = 12%, cost of preferred stock = 8.4%,
marginal tax rate = 40%
WACC = (wd) [kd (1 – t)] + (wp) (kp) + (we) (ke)

WACC = (0.45) (0.08) (1 – 0.40) + (0.05) (0.084) + (0.50) (0.12) = 0.0858 = 8.58%

The weights in the calculation of WACC should be based on the firm’s target capital structure
(The proportions the firm aims to achieve over time). The assumption here is that the
firm would stick to the same capital structure throughout the life of the project

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

3.2 The Optimal Capital Budget

In the figure below, the intersection of the investment opportunity schedule with the marginal
cost of capital curve identifies the amount of the optimal capital budget. The firm should
undertake projects, whose IRRs are greater than the cost of funds as this will maximize the value
created.

It is useful to view graphically how WACC alters as leverage changes. The classic figure below
shows how WACC is high at low levels of leverage (debt), it reaches an ‘optimum’ at the
idealized WACC before rising quickly into the territory where financial distress (risk of
bankruptcy) becomes a major factor.

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

3.3 Cost of Debt

The after-tax cost of debt is the interest rate at which firms can issue new debt net of the tax
savings from the tax deductibility of interest.

After-tax cost of debt = Interest Rate – Tax savings = kd – kd (t) = kd (1 – t)

3.4 Cost of Preferred Stock

If a company has preferred stock in its capital structure, the cost of preferred stock (kp) is:
kp = Preferred Dividends (Dps) / Market Price of Preferred Stock (P)

3.5 Cost of Equity

The cost of equity is the return a firm theoretically pays to its equity investors, i.e.,
shareholders, to compensate for the risk they undertake by investing their capital. Two methods
have been discussed below to calculate the Cost of Equity: the Capital Asset Pricing Model
(CAPM) and the Dividend Discount Model.

3.5.1 Capital Asset Pricing Model (CAPM)

The most commonly accepted method for calculating cost of equity comes from the Capital
Asset Pricing Model (CAPM): The cost of equity is expressed formulaically below:-

ke or re= rf + (rm – rf) * β

Where, ke or re = the cost of equity or the required rate of return on equity, rf = the risk free
rate, rm = expected return on the market portfolio, (rm – rf) = the equity market risk premium,
β
= beta coefficient = unsystematic risk of the firm
Risk Free Rate (rf): The amount obtained from investing in securities considered free from
credit risk, such as government bonds from developed countries

Beta (β): This measures how much a company's share price reacts against the market as a
whole. A beta of 1 indicates that the company moves in line with the market. If the beta is in
excess of 1, the share is exaggerating the market's movements; less than 1 means the share is
more stable. Occasionally, a company may have a negative beta, which means the share price
moves in the opposite direction to the broader market.

Equity Market Risk Premium (rm – rf): It represents the returns investors expect to
compensate them for taking extra risk by investing in the stock market over and above the risk-
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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

free rate

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

3.5.2 Dividend Discount Model Approach

If dividends are expected to grow at a constant rate, g, then the current value of the
company’s stock is given by this model.
P0 = D1/(ke – g)

Where: P0 = the current value of the company’s stock, D1 = next year’s dividend, ke = required
rate of return on equity or cost of equity, g = the firm’s expected constant growth rate (g =
(Retention
Rate)(Return on Equity ROE)). Re-arrange the terms to solve for k e

WACC Example

Question: Monetrix Inc. (a listed firm) is considering a project in the Financial Education
business. It has a D/E ratio of 2, a marginal tax rate of 40%, and its debt currently has a yield of
14%. The equity beta is 0.966. The risk-free rate is 5% and the expected return on the market
portfolio is 12%. Calculate the appropriate WACC to evaluate the project.

Solution

Project Cost of Equity = 5% + 0.966(12% - 5%) = 11.762%

Cost of Debt = 14%, Cost of Preferred Stock = 0%, Weight of preferred stock =

0 As D/E = 2, wd = 2/3, we = 1/3

Therefore, WACC = 1/3(11.762%) + 2/3(14%) (1 – 0.40) = 9.52%

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

4. Measures of Leverage
4.1 Introduction
Leverage, in general, refers to the amount of fixed costs a firm has. These fixed costs may be
fixed operating expenses (such as building or equipment leases) or fixed financing costs (such
as interest payments on debt. Greater leverage leads to greater variability of the firm’s after- tax
operating earnings and income. Leverage increases the risk and potential return of a firm’s
earnings and cash flows.

Business Risk:
Refers to the risk associated with the firm’s operating income and is the result of uncertainty
about a firm’s revenues and the expenditures necessary to produce those revenues. It is the
combination of the firm’s sales risk and operating risk (the additional uncertainty about
operating earnings caused by fixed operating costs).

Financial Risk: Refers to the additional risk that a firm’s common stockholders must bear
when a firm uses fixed cost (debt) financing. The fixed expenses, in this case, are in the form of
interest payments. The use of financial leverage increases the level of ROE and it also increases
the rate of change of ROE. The use of financial leverage increases the risk of default, but it also
increases the potential return for equity shareholders.

4.2 Degree of Operating Leverage (DOL)

It is defined as the percentage change in operating income (EBIT) that results from a given
percentage change in sales.

To calculate a firm’s DOL for a particular unit level of sales, Q:

Where: Q = quantity of units sold, P = price per unit, V = variable cost per unit, F = fixed costs

The DOL is highest at low levels of sales and declines at higher levels of sales.

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

4.3 Degree of Financial Leverage (DFL)

It is interpreted as the ratio of the percentage change in Net Income (or EPS) to the
percentage change in EBIT. For a particular level of operating earnings, DFL is calculated
as

DFL = EBIT/ (EBIT – Interest)

4.4 Degree of Total Leverage (DTL)

It combines the Degree of Operating Leverage and Financial Leverage. DTL measures the
sensitivity of EPS to the change in sales.

4.5 Breakeven Quantity of Sales

The level of sales that a firm must generate to cover all its fixed and variable costs is called the
breakeven quantity. At this quantity, revenues = total costs, implying that net income is 0.

The Contribution Margin, which is the difference between the price and the variable cost per
Breakeven Quantity of Sales = (Fixed Operating Costs + Fixed Financing Costs)
(Price – Variable Costper unit)

unit, is used to cover the fixed cost

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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

5. Dividends
A dividend is a pro rata distribution to shareholders that is declared by the company’s board of
directors and may or may not require approval by shareholders.

5.1 Dividend Policy

The decision to pay out earnings versus retaining and reinvesting them. Dividend

policy issues include:

a. High or low dividend payout?

b. Stable or irregular dividends?

c. How frequently to pay dividends?

d. Announce the dividend policy?

5.2 Theories of Dividend Policy

The 3 theories of dividend policy:

1. Dividend irrelevance: Investors don’t care about dividend payout.

2. Bird-in-the-hand: Investors prefer a high payout.

3. Tax preference: Investors prefer a low payout.

5.3 Signaling Hypothesis

Investors view dividend increases as signals of management’s view of the future.

Since managers hate to cut dividends, they won’t raise dividends unless they think the raise is
sustainable.

However, a stock price increase at time of a dividend increase could reflect higher expectations
for future EPS, not a desire for dividends.

5.4 Clientele Effect

1. Different groups of investors, or clienteles, prefer different dividend policies

2. Firm’s past dividend policy determines its current clientele of investors

3. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt
investors who have to switch companies
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Monetrix Corporate Finance and Investment Banking Basics Module MDI Gurgaon

5.5 Residual Dividend Model

Find the retained earnings needed for the capital budget. Pay
out any leftover earnings (the residual) as dividends.

Target Dividends  Net Income

- ⎞  Total ⎞
    
 equity ⎝ ⎝ ratio   capital 

 budget  
⎠
⎠ ⎝
Simple Example:
Capital budget = $800,000
Target capital structure = 40% debt, 60% equity
Forecasted net income = $600,000
How much of the forecasted net income should be paid out as dividends?
 Calculate portion of capital budget to be funded by equity
Of the $800,000 capital budget, 60% ie. $480,000 will be equity financed
 Calculate the excess or need for equity capital?
There will be $600,000 - $480,000 = $120,000 left over to be paid as dividends.
 Calculate the dividend payout ratio (DIV/PAT)?
$120,000 / $600,000 = 0.2 or 20%

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6. Stock Repurchases
A repurchase of stock is a distribution in the form of the company buying back its
stock from shareholders.

6.1 Reasons for Repurchases:

1. As an alternative to distributing cash as dividends.
2. To dispose of one-time cash from an asset sale.
3. To make a large capital structure change.

6.2 Advantages of Share Repurchases

1. Stockholders can tender (sell) or not.
2. Helps avoid setting a high dividend that cannot be maintained.
3. Repurchased stock can be used in takeovers or resold to raise cash as needed.
4. Income received is capital gains rather than higher-taxed dividends (sometimes).
5. Stockholders may take as a positive signal--management thinks stock is undervalued.

6.3 Disadvantages of Share Repurchases

1. May be viewed as a negative signal (firm has poor investment opportunities).
2. IRS could impose penalties if repurchases were primarily to avoid taxes on dividends.
3. Selling stockholders may not be well informed, hence be treated unfairly.
4. Firm may have to bid up price to complete purchase, thus paying too much for its own
stock.

6.4 Stock Dividends vs. Stock Splits

Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If stock dividend
is 10%, shareholders get 10 shares for each 100 shares owned.

Stock split: Firm increases the number of shares outstanding, say 2:1. Shareholders get extra
shares in the ratio of stock split.

Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is
divided into smaller pieces.”

Unless the stock dividend or split conveys information, or is accompanied by another event
like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged.

But splits/stock dividends may get us to an “optimal price range.”

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6.5 Reasons for Stock Dividends or Stock Splits
There’s a widespread belief that the optimal price range for stocks is $20 to $80.
Stock splits can be used to keep the price in this optimal range.
Stock splits generally occur when management is confident, so are interpreted as
positive signals. On average, stocks tend to outperform the market in the year
following a split.

6.6 Conclusion
1. Share repurchases have a positive effect on share prices.
2. Dividend initiations have a positive effect on share prices.
3. Dividend increases have a positive effect on share prices.

Interesting Read:
The Pizza Theory of Business Valuation

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7. Working Capital Management
7.1 Overview
Working Capital:-

 Assets/liabilities required to operate business on day-to-

day basis
 Cash
 Accounts Receivable
 Inventory
 Accounts Payable
 Accruals

Short-term in nature—turn over regularly

7.2 Types of Working capital

1. Gross working capital = Current assets
Gross Working Capital (GWC) represents investment in current assets
2. Net working capital = Current assets – Current liabilities

7.3 Cash Conversion Cycle

The length of time between a company’s payments and cash inflows.

Cash Inventory Receivables Payables

Conversion  Conversion  Collection 
Deferral Cycle Period Period
Period

Inventory Conversion Period – the average time required to convert materials

into finished goods and then to sell the finished goods.

Inventory Conversion Period = Inventory

Sales per day
Receivables Collection Period – (a.k.a. Days Sales Outstanding) the average
length of time required to convert the firm’s receivables into cash post sale.

Days Sales Outstanding Receivables = Receivables

Average Sales Per Day Annual Sales/365

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 Payables Deferral Period – the average length of time between the purchase
of materials and labor and the payment of cash for the materials and labor.

Payables Deferral Period Payables

Purchases per day

8. Financial Statement Analysis

8.1 Bookkeeping
Bookkeeping is the process of recording the daily
transactions of a business entity in a chronological order.

8.2 Accounting
Accounting is the process of recording, classifying,
reporting, analysing, interpreting and communicating of
financial information to the stake holders. Accounting is
the combination of all the 6 fields while bookkeeping is
only a part of the accounting process.

8.3 Double Entry System

According to this system, every business transaction has a two-fold effect and
that it affects two accounts in opposite directions. One of the two aspects is the
benefit receiving aspect or “incoming aspect” (termed as Debit) and the other is
the benefit giving aspect or “outgoing aspect” (termed as Credit). For every
transaction, one account is to be debited and another account is to be credited in
order to have a complete record of the transaction.
The basic principle under this system is that for every debit, there must be a
corresponding and equal credit and for every credit there must be a
corresponding and equal debit. Following this principle, the arithmetical
accuracy of the accounts can be checked by preparing a Trial Balance, where
the total of Debits and Credits should tally.
It is a scientific system maintaining a complete record of transactions which
helps in the ascertainment of profit/loss and financial position of the business
while maintaining the accuracy of accounts.

8.4 Accounting Cycle

The entire accounting cycle is based on the double entry system. Once a
transaction occurs, it is recorded in the form of a journal which records the

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 debit and credit aspect of the transaction. These entries are then posted to
separate accounts known as Ledger. The balances in the ledger are carried over
to the Trial Balance where the total of Debits and Credits tally with each other.
Using the Trial Balance, the Profit and Loss Account (earlier, known as
Trading, Profit and Loss Account) and Balance Sheet can be prepared. In the
next year, new transactions plus the opening Balance Sheet is used to create the
corresponding Financial Statements.

8.5 Accounting Equation

Accounting equation is based on dual aspect concept (Debit and Credit). It
emphasizes on the fact that every transaction has a two sided effect i.e., on the
assets and claims on assets. Always the total claims (those of outsiders and of
the proprietors) will be equal to the total assets of the business concern. The
claims are also known as equities, are of two types: i) Owners equity (Capital);
ii) Outsiders’ equity (Liabilities).
Assets = Equities
Assets = Capital + Liabilities (A = C+L)

8.6 Basic Accounting Ratios

8.6.1 Activity Ratios

 Inventory Turnover = Cost of Goods Sold / Average Inventory
 Receivables Turnover = Sales / Average Receivables
 Fixed Asset Turnover = Sales / Average Fixed Assets

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  Asset Turnover = Sales / Average Total Assets
 Payables Turnover = Purchases / Average Payables
 [365/Turnover] is Days Outstanding
 More Turnover – is it always good / bad ?

8.6.2 Liquidity Ratios

Current Ratio: It is the relationship between the current assets and current liabilities
of a concern.

Current Ratio = Current Assets/Current Liabilities

If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and
Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000 /
Rs.2,00,000 = 2 : 1

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example :

Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000
Current Ratio => 3,00,000/1,00,000 =3:1
Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1

8.6.3 Solvency Ratios

 Debt = Short-term debt + Long-term debt
 Total capital = Debt + Equity
 Debt to Equity = Debt/Equity
 Interest coverage ratio = EBIT / Debt interest

8.6.4 Profitability Ratios

 Gross Profit Margin = Gross Profit / Net sales
 Net Profit Margin = Net Profit / Net sales

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  Return on Total Capital = EBIT/Total Capital

8.6.5 Valuation Ratios

 EPS = Net profit / No of Outstanding shares
 P/E Ratio = Market Price per share/ EPS
 PEG Multiple = PE / Growth Rate
 Dividend Payout Ratio = Dividend / Net Income
 Dividend Yield (%) = (Dividend amount per share *100) / Market price of
share

9. Pecking Order Theory:

Pecking Order theory states that for their financing needs, firms prefer Internal
financing to External financing (by using the current R&E), as external financing
comes with a cost (which can be substantial at times). Thereafter, in external financing
they prefer different external sources of financing in the following order:
Internal Financing >Secured Debt > Unsecured Debt > Preference
Shares > Equity

The pecking order theory explains the inverse relationship between profitability and
debt ratios:
1. Firms prefer internal financing.
2. They adapt their target dividend payout ratios to their investment
opportunities, while trying to avoid sudden changes in dividends.
3. Sticky dividend policies, plus unpredictable fluctuations in profits and
investment opportunities, mean that internally generated cash flow is
sometimes more than capital expenditures and at other times less. If it is more,
the firm pays off the debt or invests in marketable securities. If it is less, the
firm first draws down its cash balance or sells its marketable securities, rather
than reduce dividends.
4. If external financing is required, firms issue the safest security first. That is,
they start with debt, then possibly hybrid securities such as convertible bonds,
then perhaps equity as a last resort. In addition, issue costs are least for internal
funds, low for debt and highest for equity. There is also the negative signaling
to the stock market associated with issuing equity, positive signaling associated
with debt.

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