Accounting serves a crucial role in business through:
Checking transactions to ensure accuracy
Consistent recording of these transactions
Reporting that allows understanding of financial health
Contrary to some beliefs, the role of accountants is not to forecast the future or to value businesses or assets; rather, they are considered historians, recording past transactions.
The three fundamental questions any stakeholder should be able to answer from accounting statements are:
What do you own? (Assets)
What do you owe? (Liabilities)
How much money did you make? (Earnings/Cash Flow)
These questions can be addressed through three primary financial statements:
Balance Sheet
Income Statement
Statement of Cash Flows
The Balance Sheet provides a snapshot of a company’s financial position at a specific point in time and includes:
Assets: What the company owns
Fixed Assets: Long-term physical assets (e.g., land, buildings, machinery)
Current Assets: Short-term assets (e.g., cash, inventory, accounts receivable)
Financial Assets: Investments in other companies (stocks/bonds)
Intangible Assets: Non-physical assets (e.g., patents, brand names)
Liabilities: What the company owes
Current Liabilities: Debts due within one year (e.g., accounts payable, short-term debt)
Long-term Liabilities: Debts due after one year (e.g., bank loans, bonds)
Other Liabilities: Obligations (e.g., pension funds, healthcare obligations)
Equity: The residual interest in the assets after deducting liabilities
The basic equation governing the balance sheet can be represented as:
Assets = Liabilities + Equity
The Income Statement details the company’s financial performance over a specific period, focusing on:
Revenues: Total income from sales
Cost of Goods Sold (COGS): Direct costs attributable to production
Gross Profit: Calculated as:
Gross
Profit = Revenues − COGS
Operating Expenses: Indirect costs (e.g., marketing, administrative)
Operating Profit: Calculated as:
Operating Profit = Gross
Profit − Operating Expenses
Net Income: Final profit after taxes and other non-operating expenses
The Statement of Cash Flows explains the changes in cash balances due to operational, investing, and financing activities:
Cash Flows from Operations: Driven by net income, adjustments for non-cash expenses, and changes in working capital
Cash Flows from Investing: Cash spent on capital expenditures or investments in other businesses
Cash Flows from Financing: Cash received from issuing debt/equity and cash paid for dividends or debt repayments
The fundamental equation for change in cash balance can be simplified as:
ΔCash = Cash Flows from Operations + Cash Flows from Investing + Cash Flows from
Financing
The three financial statements are interconnected:
Depreciation and amortization from the income statement are added back in the cash flow statement.
Investments in fixed assets on the balance sheet reflect as capital expenditures in the cash flow statement.
Changes in the balance sheet components influence cash flow movements.
Accounting practices are governed by formalized rules to ensure consistency and comparability:
GAAP: Generally Accepted Accounting Principles used predominantly in the United States.
IFRS: International Financial Reporting Standards used in many other countries.
Understanding and applying these standards is crucial for accurate financial analysis.
As students of accounting, it is essential to interpret financial statements with an accounting mindset. Approach each statement analytically and remember that the evolving nature of accounting practices affects reporting and analysis.
In this session, we will cover the fundamental concepts of income statements, focusing on the differences between cash accounting and accrual accounting.
Revenue is recorded when cash is received.
Expenses are recorded when cash is paid.
Suitable for very small businesses (often called checkbook accounting).
Revenue is recorded when it is earned, regardless of when cash is received.
Expenses are recorded when they are incurred, not necessarily when they are paid.
This method follows the principle of recognizing transactions when they occur.
Example: Selling an item on December 30 does require recognizing revenue in the financials for that year, even without payment.
Expenses can be broadly categorized into three types:
Operating Expenses (OPEX):
Expenses tied directly to revenue generation.
Examples: Labor, materials.
Financing Expenses (FINEX):
Costs related to capital not derived from equity.
Examples: Interest on loans or debt.
Capital Expenses (CAPEX):
Long-term investments that provide benefits over years.
Examples: Buildings, machinery.
The typical income statement follows this structure:
Net
Income = Revenue − Cost
of Goods Sold (COGS) − Operating Expenses − Financing Expenses − Taxes
1. Revenues: Total sales minus returns and discounts. 2. Cost of Goods Sold
(COGS): Direct costs associated with producing the products/services. 3. Gross
Profit:
Gross Profit = Revenue − COGS
4. Operating
Profit:
Operating Profit = Gross Profit − Operating Expenses
5.
Taxable Income:
Taxable Income = Operating Profit − Financing
Expenses
6. Net Income:
Net Income = Taxable
Income − Taxes
Long-term Contracts : Revenue from contracts spanning multiple years is often recognized proportionately to the service provided.
Example: A three-year software contract requires splitting revenue over the contract duration.
Geographical Breakdown : Companies need to report revenue sources by geographical location.
Segment Reporting : Companies may need to separate revenue based on different business segments.
Cost of Goods Sold (COGS): Directly linked to product/service creation.
Other Operating Expenses: Include selling, general, and administrative costs (SG&A), which cannot be directly traced to specific products.
Depreciation is a way to allocate capital expenses over time.
Economic Depreciation: Reflects actual loss of asset value over time.
Accounting Depreciation: - Straight-Line Depreciation:
$$\text{Annual Depreciation} = \frac{\text{Asset Value}}{\text{Useful
Life}}$$
Tax Depreciation: Focuses on minimizing taxable income rather than reflecting true asset value.
Interest Expense : Typically charged on loans or bonds.
Can also include implicit financing charges from leases treated as debt.
Income from non-operating activities is listed below operating income and can include:
Interest income and minority investment income.
Defined as non-recurring income or expenses that should be separated from typical income to avoid skewing financial results.
Caution is advised if extraordinary items appear regularly, as they may not be truly extraordinary.
Companies may provide pro forma income statements, which adjust accounting expenses for more favorable interpretations.
Important for investors to scrutinize these adjustments for validity.
The final goal of an income statement is to provide a clear picture of a company’s earnings through various classifications of income and expenses, adhering to generally accepted accounting principles (GAAP). Understanding these classifications and their impact on reported net income is crucial for informed financial analysis.
This document aims to provide detailed notes on income statements, highlighting differences and commonalities across companies at various stages in their life cycles. The discussion focuses on how income statements reflect the growth and maturity of companies and includes case studies of specific companies.
Companies, much like living organisms, undergo a life cycle consisting of the following phases:
Birth – Initial formation and establishment.
Growth – Rapidly increasing revenues, often experiencing high revenue growth rates.
Maturity – Stabilization of revenues and profit margins.
Decline – Decreasing revenues and potential losses, leading to possible dissolution or transformation.
The main components of an income statement typically include:
Revenues (Sales)
Cost of Goods Sold (COGS)
Gross Profit (GP)
Operating Expenses (including R&D, Selling, General and Administrative costs)
Operating Income
Net Income
Gross Profit:
GP = Revenues − COGS
Operating Income:
Operating Income = Gross Profit − Operating Expenses
Net Income:
Net Income = Operating Income − Interest Expenses − Taxes
Overview: Peloton is a young company focused on high-end exercise bikes and subscription services.
Income Statement Highlights:
Rapid revenue growth from $XX in 2017 to $YY in 2019 (doubling each year).
High gross profits due to the nature of the product.
Net Income: Negative due to high operating expenses.
R&D expenses are significant but may not be treated as operating expenses.
Overview: Netflix is a more mature growth company with a larger revenue base.
Income Statement Highlights:
Revenue growth at a slower rate than Peloton, yet impressive given the base.
Technology and development treated as operating expenses.
Net Income: Positive as the company is beyond the youthful phase of high primary expenses.
Basic vs. Diluted net income explained as:
$$\text{Basic Net Income} =
\frac{\text{Net Income}}{\text{Shares Outstanding}}$$
$$\text{Diluted Net Income} = \frac{\text{Net Income}}{\text{Shares Outstanding +
Potential Shares}}$$
Overview: Coca-Cola has transitioned from a growth company to a mature company.
Income Statement Highlights:
Revenue growth is very low, indicating maturity.
Major expenses include Selling, General and Administrative (SG&A).
Comparison of expenses reveals that SG&A is nearly equivalent to COGS.
Equity Income: Reflects contributions from subsidiary holdings.
Overview: Traditional automobile companies like Toyota face decline due to market shifts.
Income Statement Highlights:
Declining revenues in 2020 compared to 2019.
Financing operation revenues and expenses are part of the income statement mapping the integrated bank function.
Foreign exchange losses impact the income statement significantly.
Accounting principles are generally consistent but unique line items may appear depending on the company sector:
Commodity Companies: E.g., Total (French oil company)
Subtraction of excise taxes from revenues.
Exploration costs treated as operating expenses.
Non-controlling interest items are similar to equity income in cross-holdings.
Financial Services: E.g., HSBC
Interest income and expenses dominate the income statement.
Operating income is less relevant compared to net profit.
Provisions for bad debts are key.
Pharmaceuticals: E.g., Dr. Reddy’s Lab
Significant R&D costs often treated as operating expenses, which misrepresents true profit levels.
R&D should ideally be treated as a capital asset and amortized over time.
Understanding income statements requires consideration of the lifecycle stage of a company and the sector in which it operates. Each sector features unique line items that reflect operational realities. Evaluating financial performance necessitates adjusting for these variations as companies evolve.
In this session, we explore the concept of balance sheets in accounting, outlining two primary perspectives on their purpose:
Record of capital invested in assets (historical cost)
Reflection of current market value or liquidation value of assets
These dual perspectives illustrate the complexity and the potential discrepancies in balance sheet accounting.
The balance sheet categorizes assets into several types:
Fixed Assets: Physical assets with long lives.
Current Assets: Assets with a life of less than one year.
Financial Assets: Investments in securities or other companies.
Intangible Assets: Non-physical assets like brand names.
Old Method vs. Fair Value Accounting:
Old Method: Record fixed assets at the purchase price less accumulated depreciation.
Net Book Value = Purchase Price − Accumulated Depreciation
Fair Value Accounting: Record fixed assets based on their current market value.
The accounting treatment depends on the type of securities:
Publicly Traded Securities: Reflect market value.
Holdings in Other Companies: - Minority stakes: Use the equity method, report proportionate income/loss. - Majority stakes: Consolidate financial statements with 100% revenue/reporting.
Significant intangible assets include brand equity and technological advantages.
Goodwill: The primary intangible asset recorded is goodwill, which arises from acquisitions and reflects the premium paid over the book value.
Goodwill is problematic as it often does not reflect true underlying value and can lead to distortions.
In this session, we will explore how balance sheets evolve through the different stages of a company’s corporate life cycle. This analysis will demonstrate how balance sheets reflect the financial position and history of companies at various maturity levels.
The corporate life cycle includes the following stages:
Asset Base: Small but growing rapidly.
Debt: Very little or no debt, as it is often viewed as a last resort.
Shareholders’ Equity: Can be negative due to accumulated losses.
Asset Base: Still small but continuing to grow quickly.
Debt: Remains low or non-existent.
Shareholders’ Equity: Likely to become positive due to new equity inflows (e.g., from venture capital).
Asset Base: Stabilizes as growth slows.
Debt: May begin to increase as the company finances growth.
Shareholders’ Equity: Increases due to retained earnings.
Asset Base: Stabilizes and may be large.
Debt: Often high and growing, used to finance dividends or share buybacks.
Shareholders’ Equity: May shrink if the company returns substantial cash to shareholders.
Asset Base: Begins to decline.
Debt: Should decline in line with assets to avoid financial distress.
Shareholders’ Equity: Declines as a result of losses.
To illustrate these concepts, we will analyze the balance sheets of four companies at different stages of their life cycle.
Total Assets: Grew from $271 million to $865 million.
Shareholders’ Equity: Initially negative due to sustained losses.
Largest Asset: Cash and marketable securities.
Value Reflection: Future growth not accurately reflected in assets.
Largest Asset: Non-current content cost, reflecting owned media content.
Deferred Revenue: Represents subscriptions collected, showing future services owed.
Common Stock: Par value indicated but largely obsolete in relevance.
Total Assets: Substantial but growing slowly, indicating maturity.
Equity Method Investments: Valuations in other companies, requiring caution in interpretation.
Goodwill: Arises from acquisitions but lacks intrinsic value.
Treasury Stock: Reflects share repurchase impacting equity.
Total Assets: Nearly stable; reflective of established operations.
Finance Receivables: Company finances purchases via loans, impacting cash flows.
Accrued Pension Costs: Show obligations that vary by country.
Inventory Pricing: Significant fluctuations; oil prices can heavily affect asset values.
Financial Assets: Easier to value, more transparency in asset valuation.
Non-controlling Interests: Book value of minority interests in consolidated companies.
Intangible Assets: R&D and patents often not represented in balance sheet.
Historical Reflection: Balance sheets reflect a company’s past, indicating its maturity and growth stage.
Fair Value Accounting Controversies: Balances neither reflect historical cost nor current market value effectively.
Investor Awareness: It’s essential to scrutinize financial statements for discrepancies in values presented.
Having discussed Income Statements and Balance Sheets, we now turn to the third essential financial statement: the Statement of Cash Flows (SCF). The SCF provides critical insight into how cash flows are generated and used in a company.
The primary objectives of the SCF are:
To explain how much the cash balance of a company changed during a certain period.
To provide insights into:
Cash flows from operations
Cash flows from investing
Cash flows from financing
The SCF is typically divided into three sections:
Cash Flows from Operations (CFO)
Cash Flows from Investing (CFI)
Cash Flows from Financing (CFF)
Cash flows from operations typically start with Net Income:
CFO = Net Income + Non-Cash Charges − Change in Non-Cash Working Capital
To convert Net Income into Cash Flows from Operations:
Add back non-cash expenses:
Depreciation
Amortization
Subtract changes in non-cash working capital:
Increase in Accounts Receivable: Decrease in Cash Flow
Increase in Inventory: Decrease in Cash Flow
Increase in Accounts Payable: Increase in Cash Flow
Non-Cash Working Capital is the difference between current assets and liabilities, excluding
cash and cash equivalents. It affects cash flow as follows:
Change in Non-Cash
Working Capital = ΔAccounts Receivable + ΔInventory − ΔAccounts
Payable
Cash flows from investing reflect the investments made by the company. This section can include:
Cash spent on capital expenditures (CAPEX):
Net Investment in Operating
Assets = CAPEX − Cash Proceeds from Sale of Assets
Cash spent on non-operating investments (e.g., marketable securities, other companies).
Cash flows from financing arise from activities that fund the business. This section is broken down into:
Cash Flows to/from Debt:
$$\begin{aligned}
\text{Net Cash Flow from Debt} &= \text{Cash Inflow from New Debt} - \text{Cash Outflow from Debt
Repayment}
\end{aligned}$$
Cash Flows to/from Equity:
$$\begin{aligned}
\text{Net Cash Flow from Equity} &= \text{Cash Inflow from Issuance} - (\text{Cash Outflow for
Dividends
+ Cash Outflow for Buybacks})
\end{aligned}$$
When analyzing cash flows, compare the following:
Depreciation (CFO) vs. Capital Expenditures (CFI): Companies with growth should show CAPEX greater than depreciation.
Keep in mind that certain acquisitions may not reflect in cash flows if paid with equity, limiting the visibility of cash transactions.
The free cash flow available for dividends or stock buybacks can be calculated as follows:
Free Cash Flow to Equity = CFO − Capital Expenditures + Cash Inflows − Debt
Payments
The Statement of Cash Flows distinguishes itself by emphasizing cash movements rather than accrual accounting. It is essential for understanding the real cash position of a company and potential returns to investors.
A statement of cash flows summarizes the cash generated and used during a specific period. It divides cash flows into three main sections: Operating, Investing, and Financing. Understanding these cash flows helps in analyzing the financial health and trajectory of a company.
Companies typically undergo several stages in their lifecycle, which influences their statement of cash flows:
Operating Cash Flows: Negative
Investing Cash Flows: Negative (investment for future growth)
Financing Cash Flows: Positive (raising equity/debt)
Operating CF < 0, Investing CF < 0, Financing CF > 0
Operating Cash Flows: May turn positive
Investing Cash Flows: Continues to be negative
Financing Cash Flows: Neutral (stabilizes financing activities)
Operating CF ≥ 0, Investing CF < 0, Financing CF ≈ 0
Operating Cash Flows: Positive
Investing Cash Flows: Stabilizes with maintenance investments
Financing Cash Flows: Positive net inflows from debt and dividends
Operating CF > 0, Investing CF stable, Financing CF > 0
Operating Cash Flows: Decline
Investing Cash Flows: May turn positive (selling assets)
Financing Cash Flows: Debt repayments increase
Operating CF < 0, Investing CF > 0, Financing CF net
outflows
Operating Cash Flows: Negative due to early-stage business
Investing Cash Flows: Negative
Financing Cash Flows: Positive due to 539 million in new equity raised
Operating CF < 0, Investing CF < 0, Financing CF > 0
Operating Cash Flows: Negative due to high content expenses (13.9 billion)
Investing Cash Flows: Limited
Financing Cash Flows: Increased borrowing to fund operations
Operating CF < 0, Investing CF ≈ 0, Financing CF > 0
Operating Cash Flows: Strong positive due to net income (8.99 billion)
Investing Cash Flows: Consolidated additional spending
Financing Cash Flows: Borrowing and cash outflows from dividends (6.8 billion)
Operating CF > 0, Investing CF consolidated, Financing CF inflows and
outflows
Deferred Income Taxes: Negative cash flows indicate tax payments from prior years.
Financing Cash Flows: Cash flows indicating dividends paid to shareholders.
Deferred Taxes < 0, Dividends < 0
Depreciation/Amortization: Significant impact on cash flow despite net losses.
Investing Cash Flows: Regular disposals as part of operations.
Depreciation impacts cash, Investing CF regular disposals
R&D as Investing Cash Flow: Major investments are hidden within operating expenses.
Investing Activities: Lackluster due to R&D being accounted for in net income.
Investing CF not capturing R&D
The statement of cash flows is a crucial document that details a company’s cash inflows and outflows. Analyzing cash flows according to the lifecycle of the company can provide valuable insights into operational efficiency, investment strategies, and financing practices. Each section—Operating, Investing, and Financing—offers unique insights into the company’s financial health.
Accounting is a field that has evolved significantly, particularly as economies have shifted from manufacturing to technology and services. This session addresses the need to update our understanding of various accounting issues, especially for modern firms.
Three primary financial statements are critical for analysis:
Income Statement
Balance Sheet
Statement of Cash Flows
We will discuss four main areas:
Taxes and their reporting
Management compensation through stock and options
Commitments that resemble debt but are not classified as such
Capital expenditures treated as operating expenses
Understanding tax rates is crucial as companies deal with various rates:
Marginal Tax Rate:
Marginal Tax Rate = Federal
Rate + State
and Local Rates
For U.S. companies post-2017, the federal rate is 21% plus state/local
approximations bring it to 24% to 25%.
Effective Tax Rate:
$$\text{Effective Tax Rate} =
\frac{\text{Taxes Due}}{\text{Taxable Income}}$$
This reflects what the company reports.
Cash Tax Rate:
$$\text{Cash Tax Rate} = \frac{\text{Cash
Taxes Paid}}{\text{Income}}$$
The three tax rates may diverge due to:
International operations with different marginal tax rates.
Legal tax deferral and avoidance strategies.
Deferred taxes arise when there’s a difference between what a company reports and what it actually pays:
Deferred Tax Assets (if paid more in taxes): expected reduction in future tax payments.
Deferred Tax Liabilities (if paid less in taxes): expected increase in future tax payments.
Net Operating Loss (NOL) can be carried forward (up to 20 years) or backward (up to 2 years) affecting future tax strategies.
Stock-based compensation links management and employee interests with shareholders. It includes:
Stock Options: the right to buy shares at a fixed price.
Restricted Stock: shares given but not tradable.
Post-2004, companies must value options at grant date:
Operating
Expense = Value
of Options Granted
Companies should not add back stock-based compensation when calculating cash
flows, as it represents a genuine dilution of shares.
Leases, especially long-term ones, should be viewed as debt. The distinction between capital leases (treated as debt) and operating leases (treated as expenses) was eliminated in 2019.
To convert lease commitments to debt:
Calculate the present value of future lease payments using the pre-tax cost of borrowing.
Record the present value as lease liability on the balance sheet.
Create a corresponding intangible asset category for the lease asset.
Operating income must be adjusted by removing lease expenses and adding depreciation.
R&D expenditures create long-term benefits and should be capitalized:
Determine amortization life for R&D costs.
Collect R&D expenses from prior years.
Adjust earnings by adding back R&D and deducting amortization.
This logic can extend to other contractual commitments like advertising, training, and customer acquisition costs.
Traditional accounting frameworks are based on outdated economic conditions. Analysts must adapt financial statements for relevance in today’s economy, ensuring accurate representation of a firm’s financial health.
This document presents detailed notes on key accounting inconsistencies, specifically focusing on tax rates, non-debt commitments, capital expenditures, and stockholder-based compensation. Each section discusses the implications of these inconsistencies on financial statements.
Given a set of companies, the effective tax rate can be calculated using:
$$\text{Effective Tax Rate} = \frac{\text{Taxes Paid}}{\text{Taxable
Income}}$$
Companies like Peloton (0%) and Netflix (9.5%) exhibit low or zero effective tax rates, typically seen in younger companies.
Coca-Cola pays 16.8%, while HSBC pays nearly 35%.
Notably, Dr. Reddy’s Labs reported a negative tax rate due to a tax credit resulting in a recovery of $1.6 billion.
To understand taxes paid in cash flow terms, reference the cash flow statement alongside the income statement. The actual taxes paid can differ significantly due to deferred taxes:
Total Cash Taxes Paid = Taxes from Income Statement + Deferred
Taxes
Even if contractual obligations (e.g., leases) are not labeled as debt, they represent future cash outflows that need to be accounted for.
Historically, lease obligations were treated as operating expenses. However, as of 2019, they are recognized as debt on balance sheets.
For instance, Nordstrom’s lease commitments in its financial statements were converted into a present value debt figure:
Assuming an interest rate of 4.7% for discounting future lease payments, the present value (PV) of commitments can be calculated by:
$$PV = \sum_{t=1}^{n} \frac{\text{Lease Payment}_t}{(1+r)^t}$$
This change increases the total debt and total assets on the balance sheet, while operating income will be influenced by depreciation of these lease assets.
Capital expenditures (CapEx) can include both physical (tangible) and non-physical (intangible) investments. Key observations include:
Research and Development (R&D) spending is typically treated as an operating expense rather than CapEx.
This accounting treatment results in significant underrepresentation of company assets and overstatement of operating expenses.
To transform R&D expenses from operating to capital expenses, follow this process:
Estimate the amortizable life of R&D (e.g., 10 years for pharmaceuticals).
Calculate the cumulative R&D expenses historically.
Calculate annual depreciation based on the estimated amortization.
For example, if \$3.03 billion is reported as R&D expense, and $1.69 billion would be recognized as amortization, then:
Effective Income = Reported Income + R&D
Expense − Amortization
Prior to 2004, stock options were often treated as zero value, leading to inconsistencies in reported earnings. Post-2004 standards require the valuation of stock options at issuance.
Consider a company like Netflix that reports stock-based compensation. The financial implications include:
Stock-based compensation is now an expense, affecting net income.
Accumulative options can dilute earnings per share (EPS).
Quantifying the impact on cash flows can be misleading since stock options result in actual share dilution rather than merely representing non-cash expenses.
In accounting, understanding these inconsistencies helps refine financial analysis. By approaching financial statements with this framework, investors can better assess company performance and value beyond conventional accounting practices.
Accounting ratios are crucial tools for comparing financial performance across companies and over time. Ratios help overcome the limitations of absolute numbers, which can often mislead due to differences in scale among firms.
Ratios provide a framework for comparing financial performance of different entities, thus normalizing for size.
They help reveal underlying trends in profitability, efficiency, and risk.
Profit margins scale profits to revenues. They can be classified according to the measure used in the numerator, as follows:
Contribution Margin:
$$\text{Contribution Margin} =
\frac{\text{Sales} - \text{Variable Costs}}{\text{Sales}}$$
Gross Margin:
$$\text{Gross Margin} = \frac{\text{Sales}
-
\text{Cost of Goods Sold}}{\text{Sales}}$$
Operating Margin:
$$\text{Operating Margin} =
\frac{\text{Operating Income}}{\text{Sales}}$$
After-tax Operating Margin:
$$\text{After-tax Operating
Margin} = \frac{\text{After-tax Operating Income}}{\text{Sales}}$$
Net Margin:
$$\text{Net Margin} = \frac{\text{Net
Income}}{\text{Sales}}$$
EBITDA Margin:
$$\text{EBITDA Margin} =
\frac{\text{EBITDA}}{\text{Sales}}$$
Each margin provides insights into different aspects of profitability:
Contribution and Gross Margins indicate profitability per additional unit sold.
Operating Margin reveals overall business profitability after accounting for fixed costs.
EBITDA Margin is crucial for understanding cash flow generation capacity.
Net Margin shows profitability to equity holders after all expenses and taxes.
Accounting returns measure profit relative to capital invested. They are classified mainly into:
Return on Equity (ROE):
$$\text{ROE} = \frac{\text{Net
Income}}{\text{Shareholders' Equity}}$$
Return on Invested Capital (ROIC):
$$\text{ROIC} =
\frac{\text{Operating Income} \times (1 - \text{Tax Rate})}{\text{Invested Capital}}$$
Where:
Invested Capital = Debt + Equity − Cash
Efficiency ratios assess how effectively a company utilizes its resources to generate revenue. Common ratios include:
Revenue to Working Capital: Focuses on how efficiently capital is managed.
Asset Turnover Ratio:
$$\text{Asset Turnover} =
\frac{\text{Sales}}{\text{Total Assets}}$$
Revenue to Invested Capital:
$$\text{Revenue to Invested
Capital} = \frac{\text{Sales}}{\text{Invested Capital}}$$
Financial leverage ratios depict the extent of a company’s borrowing. Key forms include:
Debt to Equity Ratio:
$$\text{Debt to Equity} =
\frac{\text{Total Debt}}{\text{Shareholders' Equity}}$$
Debt to Capital Ratio:
$$\text{Debt to Capital} =
\frac{\text{Total Debt}}{\text{Total Debt} + \text{Equity}}$$
Debt to EBITDA Ratio:
$$\text{Debt to EBITDA} =
\frac{\text{Total Debt}}{\text{EBITDA}}$$
Liquidity ratios help assess a company’s ability to meet short-term obligations. Frequently used types include:
Current Ratio:
$$\text{Current Ratio} =
\frac{\text{Current
Assets}}{\text{Current Liabilities}}$$
Quick Ratio:
$$\text{Quick Ratio} = \frac{\text{Current
Assets} - \text{Inventory}}{\text{Current Liabilities}}$$
In conclusion, understanding accounting ratios and their interpretations is fundamental to analyzing company performance. Ratios provide normalized measures for comparison across time and entities while revealing insights into profitability, efficiency, leverage, and liquidity.
This session aims to apply financial ratios to real companies and examine how these metrics evolve throughout the corporate life cycle. The analysis encompasses:
Profitability Ratios
Accounting Returns
Debt Ratios
Efficiency Ratios
Coverage and Liquidity Ratios
Financial ratios change significantly as a company matures. Key observations include:
Younger companies typically exhibit:
Positive Gross Margins
Negative Operating Margins
Negative Net Margins
As companies grow:
Operating Margins become positive.
Net Margins eventually turn positive.
Younger companies can have negative accounting returns or returns that cannot be computed.
As they mature, they exhibit returning trends:
Accounting Returns increase and peak.
Mature companies see declining returns.
Young companies should avoid incurring debt; high debt ratios are risky.
As companies mature, debt ratios become more apparent:
Growth firms may carry moderate debt.
Mature firms can manage debt ratios effectively.
In this analysis, gross margin, operating margin, after-tax operating margin, net margin, and effective tax rate were computed for six selected companies: Peloton, Netflix, Coca-Cola, Toyota, Total, and Dr. Reddy’s.
Gross Margin :
Peloton: Low gross margin reflecting youth.
Dr. Reddy’s: High gross margin ( 80%).
Toyota and Total: Lower margins due to higher production costs.
Operating Margin and Net Margin :
Peloton: Positive gross margin but negative operating and net margins.
Coca-Cola and Dr. Reddy’s: Higher operating margins due to relatively lower production costs and market dynamics.
Accounting returns were analyzed using Return on Equity (ROE) and Return on Invested Capital (ROIC).
$$ROE = \frac{\text{Net Income}}{\text{Book Equity}}$$
$$ROIC = \frac{\text{After-Tax Operating Income}}{\text{Invested Capital}} =
\frac{\text{Operating Income} \times (1 - \text{Effective Tax Rate})}{\text{Book Equity} + \text{Debt} -
\text{Cash}}$$
Notable findings:
Dr. Reddy’s has minimal debt, thus showing high ROE.
Peloton’s ROE is notably negative due to losses.
Efficiency ratios were computed using:
$$\text{Sales to Invested Capital} =
\frac{\text{Revenues}}{\text{Invested Capital}}$$
$$\text{Asset
Turnover Ratio} = \frac{\text{Revenues}}{\text{Total Assets}}$$
Netflix : Most efficient with a revenue generation of $1.71 for every dollar of invested capital.
Growth Considerations : As Netflix scaled, efficiency improved, indicating operational leverage benefits as companies mature.
Debt ratios such as Debt to Equity and Debt to Capital ratios were analyzed:
$$\text{Debt to Equity Ratio} = \frac{\text{Total Debt}}{\text{Book Equity}} \quad
\text{or} \quad \frac{\text{Market Debt}}{\text{Market Equity}}$$
Notable observations on debt:
Netflix has a high Book Debt to Equity Ratio (195%), but a significantly lower Market Debt to Equity Ratio (7%).
Dr. Reddy’s demonstrates minimal debt across all measures.
Coverage ratios such as Interest Coverage and Fixed Charge Coverage were computed:
$$\text{Interest Coverage} = \frac{\text{Operating Income}}{\text{Interest
Expense}}$$
$$\text{Fixed Charge Coverage} =
\frac{\text{Operating
Income} + \text{Fixed Charges}}{\text{Fixed Charges} + \text{Interest}}$$
Dr. Reddy’s : High ratios indicating low risk.
Current Ratios and Quick Ratios : Given less utility in recent times, they may not accurately reflect a company’s short-term health.
Financial ratios are valuable tools but should be approached with caution. Key recommendations include:
Use a select few ratios that best represent the business’s performance.
Ensure ratios support your understanding of a company’s operational effectiveness and future potential.
Conduct an average-based analysis (normalization) for volatile companies to mitigate year-to-year fluctuations.
Remember, ratios are tools for analysis—not ends in themselves.