9. CONCEPTS & MODES OF ANALYSIS

What is Simple Interest?

Simple Interest: Simple Interest is the interest paid only on the principal

amount borrowed. No interest is paid on the interest accrued during the

term of the loan.

There are three components to calculate simple interest: principal, interest

rate and time.

Formula for calculating simple interest:

I = Prt

Where,

I = interest

P = principal

r = interest rate (per year)

t = time (in years or fraction of a year)

Example:

Mr. X borrowed Rs. 10,000 from the bank to purchase a household item. He

agreed to repay the amount in 8 months, plus simple interest at an interest

rate of 10% per annum (year).

If he repays the full amount of Rs. 10,000 in eight months, the interest

would be:

P = Rs. 10,000 r = 0.10 (10% per year) t = 8/12 (this denotes fraction of a

year)

Applying the above formula, interest would be:

I = Rs. 10,000*(0.10)*(8/12) = Rs. 667.

This is the Simple Interest on the Rs. 10,000 loan taken by Mr. X for 8

months.

If he repays the amount of Rs. 10,000 in fifteen months, the only change is

with time.

Therefore, his interest would be:

I = Rs. 10,000*(0.10)*(15/12) = Rs. 1,250

65

What is Compound Interest?

Compound Interest: Compound interest means that, the interest will

include interest calculated on interest. The interest accrued on a principal

amount is added back to the principal sum, and the whole amount is then

treated as new principal, for the calculation of the interest for the next

period.

For example, if an amount of Rs. 5,000 is invested for two years and the

interest rate is 10%, compounded yearly:

• At the end of the first year the interest would be (Rs. 5,000 * 0.10)

or Rs. 500.

• In the second year the interest rate of 10% will applied not only to

Rs. 5,000 but also to the Rs. 500 interest of the first year. Thus, in

the second year the interest would be (0.10 * Rs. 5,500) or Rs. 550.

For any loan or borrowing unless simple interest is stated, one should

always assume interest is compounded. When compound interest is used we

must always know how often the interest rate is calculated each year.

Generally the interest rate is quoted annually. E.g. 10% per annum.

Compound interest may involve calculations for more than once a year, each

using a new principal, i.e. (interest + principal). The first term we must

understand in dealing with compound interest is conversion period.

Conversion period refers to how often the interest is calculated over the

term of the loan or investment. It must be determined for each year or

fraction of a year.

E.g.: If the interest rate is compounded semiannually, then the number of

conversion periods per year would be two. If the loan or deposit was for five

years, then the number of conversion periods would be ten.

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Formula for calculating Compound Interest:

C = P (1+i)n

Where

C = amount

P = principal

i = Interest rate per conversion period

n = total number of conversion periods

Example:

Mr. X invested Rs. 10,000 for five years at an interest rate of 7.5%

compounded quarterly

P = Rs. 10,000

i = 0.075 / 4, or 0.01875

n = 4 * 5, or 20, conversion periods over the five years

Therefore, the amount, C, is:

C = Rs. 10,000(1 + 0.01875)^20

= Rs 10,000 x 1.449948

= Rs 14,499.48

So at the end of five years Mr. X would earn Rs. 4,499.48 (Rs.14,499.48 –

Rs.10,000) as interest. This is also called as Compounding.

Compounding plays a very important role in investment since earning a

simple interest and earning an interest on interest makes the amount

received at the end of the period for the two cases significantly different.

If Mr. X had invested this amount for five years at the same interest rate

offering the simple interest option, then the amount that he would earn is

calculated by applying the following formula:

S = P (1 + rt),

P = 10,000

r = 0.075

t = 5

Thus, S = Rs. 10,000[1+0.075(5)]

= Rs. 13,750

Here, the simple interest earned is Rs. 3,750.

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A comparison of the interest amounts calculated under both the method

indicates that Mr. X would have earned Rs. 749.48 (Rs.4,499.48 – Rs.

3,750) or nearly 20% more under the compound interest method than

under the simple interest method.

Simply put, compounding refers to the re-investment of income at the same

rate of return to constantly grow the principal amount, year after year.

Should one care too much whether the rate of return is 5% or 15%? The

fact is that with compounding, the higher the rate of return, more is the

income which keeps getting added back to the principal regularly generating

higher rates of return year after year.

The table below shows you how a single investment of Rs 10,000 will grow

at various rates of return with compounding. 5% is what you might get by

leaving your money in a savings bank account, 10% is typically the rate of

return you could expect from a one-year company fixed deposit, 15% - 20%

or more is what you might get if you prudently invest in mutual funds or

equity shares.

The Impact of Power of Compounding:

The impact of the power of compounding with different rates of return and

different time periods:

At end of Year 5% 10% 15% 20%

1 Rs 10500 Rs 11000 Rs 11500 Rs 12000

5 Rs 12800 Rs 16100 Rs 20100 Rs 24900

10 Rs 16300 Rs 25900 Rs 40500 Rs 61900

15 Rs 20800 Rs 41800 Rs 81400 Rs 154100

25 Rs 33900 Rs 1,08300 Rs 3,29200 Rs 9,54,000

What is meant by the Time Value of Money?

Money has time value. The idea behind time value of money is that a rupee

now is worth more than rupee in the future. The relationship between value

of a rupee today and value of a rupee in future is known as ‘Time Value of

Money’. A rupee received now can earn interest in future. An amount

invested today has more value than the same amount invested at a later

date because it can utilize the power of compounding. Compounding is the

process by which interest is earned on interest. When a principal amount is

invested, interest is earned on the principal during the first period or year.

In the second period or year, interest is earned on the original principal plus

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the interest earned in the first period. Over time, this reinvestment process

can help an amount to grow significantly.

Let us take an example:

Suppose you are given two options:

(A) Receive Rs. 10,000 now OR

(B) Receive Rs.10,000 after three years.

Which of the options would you choose?

Rationally, you would choose to receive the Rs. 10,000 now instead of

waiting for three years to get the same amount. So, the time value of

money demonstrates that, all things being equal, it is better to have money

now rather than later.

Back to our example: by receiving Rs.10,000 today, you are poised to

increase the future value of your money by investing and gaining interest

over a period of time. For option B, you don't have time on your side, and

the payment received in three years would be your future value. To

illustrate, we have provided a timeline:

If you are choosing option A, your future value will be Rs. 10,000 plus any

interest acquired over the three years. The future value for option B, on the

other hand, would only be Rs. 10,000. This clearly illustrates that value of

money received today is worth more than the same amount received in

future since the amount can be invested today and generate returns.

Present Value Future Value

Option A: Rs. 10,000

Option B: Rs. 10,000 - Interest

Rs. 10,000 + Interest

Rs. 10,000

0 1 2 3 Years

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Let us take an another example:

If you choose option A and invest the total amount at a simple annual rate

of 5%, the future value of your investment at the end of the first year is Rs.

10,500, which is calculated by multiplying the principal amount of Rs.

10,000 by the interest rate of 5% and then adding the interest gained to the

principal amount.

Thus, Future value of investment at end of first year:

= ((Rs. 10,000 X (5/100)) + Rs. 10,000

= (Rs.10,000 x 0.050) + Rs. 10,000

= Rs.10,500

You can also calculate the total amount of a one-year investment with a

simple modification of the above equation:

Original equation: (Rs.10,000 x 0.050) + Rs.10,000 = Rs.10,500

Modified formula: Rs.10,000 x [(1 x 0.050) + 1] = Rs.10,500

Final equation: Rs. 10,000 x (0.050 + 1) = Rs. 10,500

Which can also be written as:

S = P (r+ 1)

Where,

S = amount received at the end of period

P = principal amount

r = interest rate (per year)

This formula denotes the future value (S) of an amount invested (P) at a

simple interest of (r) for a period of 1 year.

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How is time value of money computed?

The time value of money may be computed in the following circumstances:

1. Future value of a single cash flow

2. Future value of an annuity

3. Present value of a single cash flow

4. Present value of an annuity

(1) Future Value of a Single Cash Flow

For a given present value (PV) of money, future value of money (FV) after a

period ‘t’ for which compounding is done at an interest rate of ‘r’, is given

by the equation

FV = PV (1+r)t

This assumes that compounding is done at discrete intervals. However, in

case of continuous compounding, the future value is determined using the

formula

FV = PV * ert

Where ‘e’ is a mathematical function called ‘exponential’ the value of

exponential (e) = 2.7183. The compounding factor is calculated by taking

natural logarithm (log to the base of 2.7183).

Example 1: Calculate the value of a deposit of Rs.2,000 made today, 3

years hence if the interest rate is 10%.

By discrete compounding:

FV = 2,000 * (1+0.10)3 = 2,000 * (1.1)3 = 2,000 * 1.331 = Rs. 2,662

By continuous compounding:

FV = 2,000 * e (0.10 *3) =2,000 * 1.349862 = Rs.2699.72

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2. Future Value of an Annuity

An annuity is a stream of equal annual cash flows. The future value (FVA) of

a uniform cash flow (CF) made at the end of each period till the time of

maturity ‘t’ for which compounding is done at the rate ‘r’ is calculated as

follows:

FVA = CF*(1+r)t-1 + CF*(1+r)t-2 + ... + CF*(1+r)1+CF

= CF ÷ ÷

ø

ö

ç çè

æ + -

r

(1 r) t 1

The term ÷ ÷

ø

ö

ç çè

æ + -

r

(1 r) t 1

is referred as the Future Value Interest factor for an

annuity (FVIFA). The same can be applied in a variety of contexts. For e.g.

to know accumulated amount after a certain period, to know how much to

save annually to reach the targeted amount, to know the interest rate etc.

Example 1: Suppose, you deposit Rs.3,000 annually in a bank for 5 years

and your deposits earn a compound interest rate of 10 per cent, what will be

value of this series of deposits (an annuity) at the end of 5 years? Assume

that each deposit occurs at the end of the year.

Future value of this annuity is:

=Rs.3000*(1.10)4 + Rs.3000*(1.10)3 + Rs.3000*(1.10)2 + Rs.3000*(1.10)

+ Rs.3000

=Rs.3000*(1.4641)+Rs.3000*(1.3310)+Rs.3000*(1.2100)+Rs.3000*(1.10)

+ Rs.3000

= Rs. 18315.30

3. Present Value of a Single Cash Flow

Present value of (PV) of the future sum (FV) to be received after a period ‘t’

for which discounting is done at an interest rate of ‘r’, is given by the

equation

In case of discrete discounting: PV = FV / (1+r)t

Example 1: What is the present value of Rs.5,000 payable 3 years hence, if

the interest rate is 10 % p.a.

PV = 5000 / (1.10)3 i.e. = Rs.3756.57

In case of continuous discounting: PV = FV * e-rt

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Example 2: What is the present value of Rs. 10,000 receivable after 2 years

at a discount rate of 10% under continuous discounting?

Present Value = 10,000/(exp^(0.1*2)) = Rs. 8187.297

4. Present Value of an Annuity

The present value of annuity is the sum of the present values of all the cash

inflows of this annuity.

Present value of an annuity (in case of discrete discounting)

PVA = FV [{(1+r)t - 1 }/ {r * (1+r)t}]

The term [(1+r)t - 1/ r*(1+r)t] is referred as the Present Value Interest

factor for an annuity (PVIFA).

Present value of an annuity (in case of continuous discounting) is calculated

as:

PVa = FVa * (1-e-rt)/r

Example 1: What is the present value of Rs. 2000/- received at the end of

each year for 3 continuous years

= 2000*[1/1.10]+2000*[1/1.10]^2+2000*[1/1.10]^3

= 2000*0.9091+2000*0.8264+2000*0.7513

= 1818.181818+1652.892562+1502.629602

= Rs. 4973.704

What is Effective Annual return?

Usually while applying for a fixed deposit or a bond it is stated in the

application form, that the annual return (interest) of an investment is 10%,

but the effective annual return mentioned is something more, 10.38%. Why

the difference? Essentially, the effective annual return accounts for intrayear

compounding and the stated annual return does not. The difference

between these two measures is best illustrated with an example. Suppose

the stated annual interest rate on a savings account is 10%, and say you

put Rs 1,000 into this savings account. After one year, your money would

grow to Rs 1,100. But, if the account has a quarterly compounding feature,

your effective rate of return will be higher than 10%. After the first quarter,

or first three months, your savings would grow to Rs 1,025. Then, in the

second quarter, the effect of compounding would become apparent: you

would receive another Rs 25 in interest on the original Rs 1,000, but you

73

would also receive an additional Rs 0.63 from the Rs. 25 that was paid after

the first quarter. In other words, the interest earned in each quarter will

increase the interest earned in subsequent quarters. By the end of the year,

the power of quarterly compounding would give you a total of Rs 1,103.80.

So, although the stated annual interest rate is 10%, because of quarterly

compounding, the effective rate of return is 10.38%. The difference of

0.38% may appear insignificant, but it can be huge when you're dealing

with large numbers. 0.38% of Rs. 100,000 is Rs 380! Another thing to

consider is that compounding does not necessarily occur quarterly, or only

four times a year, as it does in the example above. There are accounts that

compound monthly, and even some that compound daily. And, as our

example showed, the frequency with which interest is paid (compounded)

will have an effect on effective rate of return.

How to go about systematically analyzing a company?

You must look for the following to make the right analysis:

Industry Analysis: Companies producing similar products are

subset (form a part) of an Industry/Sector. For example, National

Hydroelectric Power Company (NHPC) Ltd., National Thermal Power

Company (NTPC) Ltd., Tata Power Company (TPC) Ltd. etc. belong to

the Power Sector/Industry of India. It is very important to see how

the industry to which the company belongs is faring. Specifics like

effect of Government policy, future demand of its products etc. need

to be checked. At times prospects of an industry may change

drastically by any alterations in business environment. For instance,

devaluation of rupee may brighten prospects of all export oriented

companies. Investment analysts call this as Industry Analysis.

Corporate Analysis: How has the company been faring over the

past few years? Seek information on its current operations,

managerial capabilities, growth plans, its past performance vis-à-vis

its competitors etc. This is known as Corporate Analysis.

Financial Analysis: If performance of an industry as well as of the

company seems good, then check if at the current price, the share is

a good buy. For this look at the financial performance of the company

and certain key financial parameters like Earnings Per Share (EPS),

P/E ratio, current size of equity etc. for arriving at the estimated

future price. This is termed as Financial Analysis. For that you need

to understand financial statements of a company i.e. Balance Sheet

and Profit and Loss Account contained in the Annual Report of a

company.

74

What is an Annual Report?

An annual report is a formal financial statement issued yearly by a

corporate. The annual report shows assets, liabilities, revenues, expenses

and earnings - how the company stood at the close of the business year,

how it fared profit-wise during the year, as well as other information of

interest to shareholders. Companies publish annual reports and send

abridged versions to shareholders free of cost. A detailed annual report is

sent on request. Remember an annual report of a company is the best

source of information about the financial health of a company.

Which features of an Annual Report should one read carefully?

One must read an Annual Report with emphasis on the following:

§ Director’s Report and Chairman’s statement which are

related to the current and future operational

performance of a company.

§ Auditors’ Report (including Annexure to the Auditors

Report)

§ Profit and Loss Account.

§ Balance Sheet.

§ Notes to accounts attached to the Balance Sheet.

What is a Balance Sheet and a Profit and Loss Account

Statement? What is the difference between Balance Sheet and

Profit and Loss Account Statements of a company?

The Balance sheet of a company shows the financial position of the company

at a particular point of time. The balance sheet of a company/firm,

according to the Companies Act, 1956 should be either in the account form

or the report form.

Balance Sheet: Account Form

Liabilities Assets

Share Capital Fixed Assets

Reserves and Surplus Investments

Secured loans Current Assets, loans and advances

Unsecured loans Miscellaneous expenditure

Current liabilities and provisions

75

Balance Sheet: Report Form

I. Sources of Funds

1. Shareholders’ Funds

(a) Share Capital

(b) Reserves & surplus

2. Loan Funds

(a) Secured loans

(b) Unsecured loans

II. Application of Funds

(i) Fixed Assets

(ii) Investments

(iii) Current Assets, loans and advances

Less: Current liabilities and provisions

Net current assets

(iv) Miscellaneous expenditure and losses

The Profit and Loss account (Income Statement), on the other hand, shows

the financial performance of the company/firm over a period of time. It

indicates the revenues and expenses during particular period of time. The

period of time is an accounting period/year, April-March. The accounting

report summarizes the revenue items, the expense items, and the difference

between them (net income) for an accounting period.

How to interpret Balance Sheet and Profit and Loss Account of a

company?

Let’s start with Balance Sheet. The Box-1 gives the balance sheet of XYZ

Ltd. company as on 31s t March 2005. Let us understand the balance sheet

shown in the Box-1.

BOX-1

XYZ COMPANY LTD.,

Balance sheet as on 31st March, 2005

As at

31st

March,

2005

As at

31st

March,

2004

SOURCES OF FUNDS Schedule Page

Rs. Cr Rs. Cr Rs. Cr

1 SHAREHOLDERS' FUNDS

(a) Capital 1 19 103.87 104.44

76

(b) Reserves and Surplus 2 20 479.21 387.70

583.08 483.14

2 LOAN FUNDS

(a) Secured 3 21 353.34 387.76

(b) Unsecured 4 21 129.89 101.07

483.23 488.83

3 TOTAL FUNDS EMPLOYED 1066.31 971.97

APPLICATION OF FUNDS

4 FIXED ASSETS

(a) Gross Block 5 22 946.84 870.44

(b) Less: Depreciation 482.19 430.70

(c) Net Block 464.65 439.74

(d) Capital Work in Progress 62.10 44.44

526.75 484.18

5 INVESTMENTS 6 23 108.58 303.48

6

CURRENT ASSETS, LOANS AND

ADVANCES

(a) Inventories 7 24 446.34 350.25

(b) Sundry Debtors 8 24 458.47 300.32

(c) Cash and Bank Balances 9 25 66.03 5.67

(d) Loans and Advances 10 25 194.36 110.83

1165.20 767.07

7

Less: CURRENT LIABILITIES AND

PRIVISIONS

(a) Current Liabilities 11 26 595.22 500.19

(b) Provisions 12 26 139.00 82.57

734.22 582.76

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8

NET CURRENT ASSETS [(6) less

(7)] 430.98 184.31

9 TOTAL ASSETS (NET) 1066.31 971.97

10

NOTES TO BALANCE SHEET AND

CONTINGENT LIABILITIES 13 27

As per our report attached

For and on behalf of the

Board.

For A. SDF & CO. XXXXX AAAA

ASDFG

Chartered Accountants, Chairman BBBB LKJH

Q.W. TYUR CCCC TYUB

Partner. REFGH POIUY Directors

For HIJKL YYYY NSDF

Chartered Accountants ,

Vice-

Chairman

and QWER

WERT

Managing

Director MNBV

Partner. ZZZZZZ

Bombay 10th July, 2004 Secretary

Bombay, 28th June,

2004.

The balance sheet of a company is a record showing sources of funds and

their application for creating/building assets. However, since company’s fund

structure and asset position change everyday due to fund inflow and

outflow, balance sheets are drawn on a specific date, say 31s t March.

What do these sources of funds represent?

As shown in a sample balance sheet in Box-1, there are two sources of

funds:

(a) Shareholders’ Fund (also known as Net Worth) is the fund coming

from the owners of the company; and

(b) Loan Fund is the fund borrowed from outsiders.

When a company/firm starts operations, its owners, called shareholders,

contribute funds called Share Capital. Note that in Box-1 XYZ COMPANY

LTD.’s capital in 2005 was Rs. 103.87 crore. The shareholders being the

owners, share part of the profit of the company, as dividend. Share capital

has been further divided into equity capital and preference capital.

Equity capital does not have fixed rate of dividend. The preference capital

78

represents contribution of preference shareholders and has fixed rate of

dividend.

After distributing dividends, a part of the profit is retained by the company

for meeting fund requirements in future. The retained profits accumulated

over the years are called reserves and surplus, which are shareholders’

property. In case of XYZ COMPANY LTD., note that the reserves and surplus

increased from Rs. 387.70 crore in 2004 to Rs. 479.21 crore in 2005.

What is the difference between Equity shareholders and

Preferential shareholders?

Equity Shareholders are supposed to be the owners of the company, who

therefore, have right to get dividend, as declared, and a right to vote in the

Annual General Meeting for passing any resolution.

The act defines a preference share as that part of share capital of the

Company which enjoys preferential right as to: (a) payment of dividend at a

fixed rate during the life time of the Company; and (b) the return of capital

on winding up of the Company.

But Preference shares cannot be traded, unlike equity shares, and are

redeemed after a pre-decided period. Also, Preferential Shareholders do

not have voting rights.

What do terms like authorized, issued, subscribed, called up and

paid up capital mean?

§ Authorized capital is the maximum capital that a company is

authorized to raise.

§ Issued capital is that part of the authorized capital which is offered

by the company for being subscribed by members of the public or

anybody.

§ Subscribed capital is that part of the issued capital which is

subscribed (accepted) by the public.

§ Called up capital is a part of subscribed capital which has been

called up by the company for payment. For example, if 10,000 shares

of Rs. 100 each have been subscribed by the public and of which Rs.

50 per share has been called up. Then the subscribed capital of the

79

Company works out to Rs. 1,00,000 of which the called up capital of

the Company is Rs. 50,0000.

§ Paid Up capital refers to that part of the called up capital which has

been actually paid by the shareholders. Some of the shareholders

might have defaulted in paying the called up money. Such defaulted

amount is called as arrears. From the called up capital, calls in

arrears is deducted to obtain the paid up capital.

What is the difference between secured and unsecured loans

under Loan Funds?

Secured loans are the borrowings against the security i.e. against

mortgaging some immovable property or hypothecating/pledging some

movable property of the company. This is known as creation of charge,

which safeguards creditors in the event of any default on the part of the

company. They are in the form of debentures, loans from financial

institutions and loans from commercial banks. Notice that in case of the XYZ

COMPANY LTD., it was Rs. 353.34 crore as on March 31, 2005. The

unsecured loans are other short term borrowings without a specific security.

They are fixed deposits, loans and advances from promoters, inter-corporate

borrowings, and unsecured loans from the banks. Such borrowings amount

to Rs. 129.89 crore in case of the XYZ COMPANY LTD.

What is meant by application of funds?

The funds collected by a company from the owners and outsiders are

employed to create following assets:

Fixed Assets: These assets are acquired for long-terms and are used

for business operation, but not meant for resale. The land and

buildings, plant, machinery, patents, and copyrights are the fixed

assets. In case of the XYZ COMPANY LTD., fixed assets are worth Rs.

526.75 crore.

Investments: The investments are the financial securities created by

investing surplus funds into any non-business related avenues for

getting income either for long-term or short-term. Thus incomes and

gains from the investments are not from the business operations.

Current Assets, Loans, and Advances: This consists of cash and other

resources which can be converted into cash during the business

operation. Current assets are held for a short-term period for

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meeting day-to day operational expenditure. The current assets are

in the form of raw materials, finished goods, cash, debtors,

inventories, loans and advances, and pre-paid expenses. For the XYZ

COMPANY LTD., current assets are worth Rs. 1165.20 crore.

Miscellaneous Expenditures and Losses: The miscellaneous

expenditures represent certain outlays such as preliminary expenses

and pre-operative expenses not written off. Though loss indicates a

decrease in the owners’ equity, the share capital can not be reduced

with loss. Instead, share capital and losses are shown separately on

the liabilities side and assets side of the balance sheet, respectively.

What do the sub-headings under the Fixed Assets like ‘Gross

block’ ‘Depreciation’, ‘Net Block’ and Capital-Work in

Progress’ mean?

The total value of acquiring all fixed assets (even though at different points

of time) is called ‘Gross Block’ or ‘Gross Fixed Asset’.

As per accounting convention, all fixed assets except land have a fixed life.

It is assumed that every year the worth of an asset falls due to usage. This

reduction in value is called ‘Depreciation’. The Companies Act 1956

stipulates different rates of depreciation for different types of assets and

different methods calculating depreciation, namely, Straight Line Method

(constant annual method) and Written Down Value Method (depreciation

rate decreases over a period of time).

The worth of the fixed assets after providing for depreciation is called ‘Net

Block’. In case of the XYZ COMPANY LTD., Net Block was Rs. 464.65 crore

as on March 31, 2005.

Gross Block-Depreciation = Net Block

Rs. 946.84- Rs. 482.19 = Rs. 464.65

The capital/funds used for a new plant under erection, a machine yet to be

commissioned etc. are examples of ‘Capital Work in Progress’, which also

has to be taken into account while calculating the fixed assets as it will be

converted into gross block soon.

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What are Current Liabilities and Provisions and Net Current

Assets in the balance sheet?

A company may receive many of its daily services for which it does not have

to pay immediately like for raw materials, goods and services brought on

credit. A company may also accept advances from the customer. The

company thus has a liability to pay though the payment is deferred. These

are known as ‘Current Liabilities’. Similarly the company may have to

provide for certain other expenses (though not required to be paid

immediately) like dividend to shareholders, payment of tax etc. These are

called ‘Provisions’. In short, Current Liabilities and Provisions are amounts

due to the suppliers of goods and services brought on credit, advances

payments received, accrued expenses, unclaimed dividend, provisions for

taxes, dividends, gratuity, pensions, etc.

Current Liabilities and Provisions, therefore, reduce the burden of day-today

expenditure on current assets by deferring some of the payments. For

daily operations the company requires funds equal to the current assets less

the current liabilities. This amount is called ‘Net Current Assets’ or ‘Net

Working Capital’. In case of the XYZ COMPANY LTD., Net Current Asset

figure of Rs. 430.98 cr. has been arrived at by deducting Current Liabilities

(Rs. 595.22 cr.) and Provisions (Rs. 139 cr.) from Current Assets worth Rs.

1165.20 crore.

How is balance sheet summarized?

A balance sheet indicates matching of sources of funds with application of

funds. In case of the XYZ Company Ltd., ‘Total Funds Employed’ to the tune

of Rs. 1066.31 cr. are from the said two Sources of Funds-Shareholders

Funds and Loan Funds. These funds have been utilized to fund Total (Net)

Assets of Rs. 1066.31 cr. that consist of Fixed Assets (Rs. 526.75 cr.),

Investments (Rs. 108.58 cr.) and Net Current Assets (Rs. 430.98 cr.).

Thus in a balance sheet,

Total Capital Employed = Net Assets.

82

What does a Profit and Loss Account statement consists of?

A Profit and Loss Account shows how much profit or loss has been incurred

by a company from its income after providing for all its expenditure within a

financial year. One may also know how the profit available for appropriation

is arrived at by using profit after tax as well as portion of reserves. Further,

it shows the profit appropriation towards dividends, general reserve and

balance carried to the balance sheet.

The Box-2 exhibits Profit and Loss Account of XYZ Company Ltd. Item-1

represents income , Items from 2 to 6 show various expenditure items.

Items from 7 to 12 show the profits available for appropriation and items 13

(a), (b), and (c) indicate appropriation of profits.

BOX – 2

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED

31ST MARCH, 2005

PARTICULARS RUPEES

(in crores)

RUPEES

(in crores)

RUPEES

(in crores)

As at

31st March,

2005

As at

31st March,

2004

INCOME

1. SALE OF PRODUCTS AND OTHER INCOME 2595.99 1969.10

EXPENDITURE

2. MANUFACTURING AND OTHER EXPENSES 2275.37 1742.54

3. DEPRECIATION 54.26 48.91

4. INTEREST 81.63 73.63

5. EXPENDITURE TRANSFERRED TO CAPITAL

ACCOUNTS 49.82 (44.27)

6. TOTAL EXPENDITURE 2316.44 1820.81

PROFIT BEFORE TAX 234.55 148.29

7. TAX FOR THE YEAR 92.5 45.75

PROFIT AFTER TAX 142.05 102.54

8. INVESTMENT ALLOWANCE RESERVE

ACCOUNT 4.66 3.55

9. INVESTMENT ALLOWANCE (UTILISED)

RESERVE WRITTEN BACK (15.2) (11.2)

10. DEBENTURE REDEMPTION RESERVE (0.57) (0.57)

11. CAPITAL REDEMPTION RESERVE

83

12. BALANCE BROUGHT FORWARD FROM

PREVIOUS YEAR 86.71 33.65

AMOUNT AVAILABLE FOR

APPROPRIATIONS 217.65 127.97

13. APPROPRIATIONS

(a) Proposed Dividends* 41.54 31.26

(b) General Reserve 100 10

(c) Balance credited to Balance Sheet 76.11 86.71

217.65 127.97

14. NOTES TO PROFIT AND LOSS ACCOUNT

* Details as per Directors Report

As per our report attached

to the Balance Sheet For and on behalf of the Board

For XYZ & co. PQR AAA

Chartered Accountants, Chairman BBB

ABC CCC

Partner DDD Directors

For LMN & co. GHI

Chartered Accountants,

Vice-

Chairman

and

DEF

Managing

Director

Partner STU

Mumbai, 10th July 2004 Secretary Mumbai, 28th June 2004

What should one look for in a Profit and Loss account?

For a company, the profit and loss statement is the most important

document presented to the shareholders. Therefore, each company tries to

give maximum stress on its representation/ misrepresentation. One should

consider the following:

§ Whether there is an overall improvement of sales as well as profits

(operating, gross and net) over the similar period (half-yearly or

annual) previous year. If so, the company’s operational management

is good.

§ Check for the other income carefully, for here companies have the

scope to manipulate. If the other income stems from dividend on the

investments or interest from the loans and advances, it is good,

because such income is steady. But if the other income is derived by

84

selling any assets or land, be cautious since such income is not an

annual occurrence.

§ Also check for the increase of all expenditure items viz. raw material

consumption, manpower cost and manufacturing, administrative and

selling expenses. See whether the increases in these costs are more

than the increase in sales. If so, it reveals the operating conditions

are not conducive to making profits. Similarly, check whether ratio of

these costs to sales could be contained over the previous year. If so,

then the company’s operations are efficient.

§ Evaluate whether the company could make profit from its operations

alone. For this you should calculate the profits of the company, after

ignoring all other income except sales. If the profit so obtained is

positive, the company is operationally profitable, which is a healthy

sign.

§ Scrutinize the depreciation as well as interest for any abnormal

increase. The increase in depreciation is attributed to higher addition

of fixed assets, which is good for long term operations of the

company. High depreciation may suppress the net profits, but it’s

good for the cash flow. So instead of looking out for the net profits,

check the cash profits and compare whether it has risen. High

interest cost is always a cause of concern because the increased debt

burden cannot be reduced in the short run.

§ Calculate the earnings per share and the various ratios. In case of

half yearly results, multiply half yearly earnings per share by 2 to get

approximately the annualized earnings per share.

## Thursday, December 25, 2008

### 9. CONCEPTS & MODES OF ANALYSIS

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