Income Statement Analysis

Income Statement Analysis :

Revenue :

Amount realized by a company through sales.

Net Sales :

Sales minus Sales Returns represents Net Sales.

Net Sales= Sales – Sales Returns

Cost of Goods Sold:

Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead.

In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours ("Cost of Services").

In the income statement, the cost of goods sold is subtracted from revenues to arrive at the gross margin of a business.

Cost Of Goods Sold =Beginning Inventory + Purchases - Ending Inventory.

COGS also include Direct Costs such as:

• Labor to produce the product, supplies used in manufacture or sale,
• Shipping costs, costs of containers, freight in, and
• Overhead costs directly related to the manufacture or production activity (like rent and utilities for the manufacturing facility).

The assumption is that the result, which represents costs no longer located in the warehouse, must be related to goods that were sold. Actually, this cost derivation also includes inventory that was scrapped, or declared obsolete and removed from stock, or inventory that was stolen. Thus, the calculation tends to assign too many expenses to goods that were sold.

Types of COGS:

There are two types of costs included in COGS:

• Direct and
• Indirect.

Direct Costs:

o        Cost to purchase the merchandise for resale.

o        Cost of raw materials.

o        Packaging costs.

o        Work in process.

o        Cost of inventory of finished products.

o        Supplies for production.

o        Direct overhead costs related to production (for example, utilities and rent for manufacturing facility).

Indirect Costs:

§         Manufacturing materials and supplies.

§         Labor (for workers who actually touch the product).

§         Costs to store/wholesale the products.

§         Salaries of administrators, managers overseeing production.

Factors Impacting COGS:

The cost of goods sold can also be impacted by the type of costing methodology used to derive the cost of ending inventory. Consider the impact of the following two inventory costing methods:

First In, First Out Method

Under this method, known as FIFO, the first unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in lower-cost goods being charged to the cost of goods sold.

Last In, First Out Method

Under this method, known as LIFO, the last unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in higher-cost goods being charged to the cost of goods sold.

Example:

Suppose  a company has $10,000 of inventory on hand at the beginning of the month, expends $25,000 on various inventory items during the month, and has $8,000 of inventory on hand at the end of the month. What was its cost of goods sold during the month? 
The answer is:

Beginning inventory	$10,000
+ Purchases	25,000
- Ending inventory	8,000
= Cost of goods sold	$27,000

The cost of goods sold can be fraudulently altered by a number of means in order to change reported profit levels, such as:

• Altering the bill of materials and/or labor routing records in a standard costing system
• Incorrectly counting the quantity of inventory on hand
• Performing an incorrect period-end cutoff 
• Allocating more overhead than actually exists to inventory

Gross Profit :

Gross Profit = Gross Sales – Cost of goods sold

The Gross profit must not be messed up with the operating income. In order to calculate operating income we require net income that is the different between the gross profit and operating expenses including taxes and interest payments. 

Operating Profit = Gross Profit – Total operating expenses

Net Profit :

Net Profit = Gross Profit – Operating Expense – Taxes – Interest Payments

Net Profit = Gross Profit – Indirect Expenses + Indirect Income

Source:Accountingtools.com

What is The Difference Between Cost and Expense

What is The Difference Between Cost and Expense:

Cost :

Cost is the price of an asset. Sometimes it is called "Cost Basis." The cost basis of an asset includes every cost to purchase, acquire, and set up the asset, and to train employees in its use.

Ex: 

If a manufacturing business buys a machine, the Cost includes shipping, set-up, and training.

Cost basis is used to establish the basis for depreciation and other tax. 

Expense:

An expense, is a cost that has expired or was necessary in order to earn revenues. An expense is an ongoing payment, like utilities, rent, payroll, and marketing. 

An expense is a cost of doing business. Expenses are used to produce revenue and they are deductible, reducing the business's income tax bill.

Ex:

The expense of rent is needed to have a location to sell from, to produce revenue.

The cost of a business phone is required to take calls from customers who want to buy the business's products and services. T

here is usually no asset associated with an expense. Although we use the term "Cost" with expenses, they are really just payments.

Example : Cost Vs. Expense Explain:

A company has a cost of $6,000 for property insurance covering the next six months. Initially the cost of $6,000 is reported as the current asset Prepaid Insurance. However, in each of the following six months, the company will report Insurance Expense of $1,000—the amount that is expiring each month. The unexpired portion of the cost will continue to be reported as the asset Prepaid Insurance.

The cost of equipment used in manufacturing is initially reported as the long lived asset Equipment. However, in each accounting period the company will report part of the asset’s cost as Depreciation Expense.

A retailer’s purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.

The matching principle guides accountants as to when a cost will be reported as an expense.

Sources:

Accountingcoach ,Biztaxlaw

Basic EPS and Diluted EPS

Basic EPS Vs. Diluted EPS

The Basic EPS  is the EPS which accrues to the shareholders of the company. This is derived by dividing the net profit (after deducting dividend on preference shares) of a company by the total number of shares outstanding.

Eg:

Suppose  if the net profit of a company = Rs 100,000

The shares outstanding are = 2,000

EPS =Rs 100,000 / 2,000 = Rs 50

Diluted EPS which is a little more complicated than basic EPS.

Assuming a company needs to raise debt and it realizes that it would be able to get cheaper debt by issuing convertible bonds rather than plain vanilla bond or it decides to reward its employees with stock options instead of bonuses.

In these cases, when the convertible bond is converted or stock option is purchased, it will result in increase in number of shares for the company. For existing shareholders this will result in a lower EPS accruing to them.

So a diluted EPS gives what the EPS of a company would be if all convertible bonds, convertible warrants, convertible preference shares and stock options outstanding on the company’s books are converted into shares. This will give the equity share holder the correct picture when investing in the company.

Hence

Diluted EPS = net profit ÷ number of shares adjusted for future dilutions.

Notes:
However, there are certain points to be noted when calculating diluted EPS.

Firstly, when accounting for convertible bonds, after tax interest expense is not considered an interest expense for diluted EPS. Hence interest adjusted for tax should be added back to the net profit.

Secondly, in case of convertible preference shares, the dividend has to be added back to the net profit.

So the next time you are trying to figure out if a stock is cheap by calculating its price to earnings ratio (PE ratio) make sure that the denominator is diluted EPS.

Sources:

Thefinanceconcept.com

Equitymaster.com

Diluted EPS

Basic EPS  :

The Basic EPS is the EPS which accrues to the shareholders of the company. This is derived by dividing the net profit (after deducting dividend on preference shares) of a company by the total number of shares outstanding.

Diluted EPS:

Diluted EPS is derived by dividing the total earnings by the number of shares that would be outstanding if the holders of equity warrants, convertible bonds, convertible preferred shares and stock options, exercise their options to obtain common shares. It is known as diluted EPS because of the proportional reduction in the ownership interest because of the issuance of new common shares.

For example, if the holder of convertible bond exercises his options to obtain common shares, than it will affect both the numerator and denominator of the EPS formula.

EPS = Total earnings / Weighted average number of outstanding shares

So when the holder exercise the option, the company is now not liable to pay interest to the holder, which will increase the total earnings (numerator) and the company will issue number of common shares to bond holders, which will increase the denominator. But the investor does have to calculate basic or diluted EPS. The companies report these figures along with the details of EPS computation in the footnotes of financial statements.

A big difference in basic and diluted EPS can indicate the presence of high potential of dilutive  securities. The diluted EPS is lesser than the basic EPS since the number of share increases while calculating diluted EPS. 

Due to this, the trailing P/E calculated on the basis of diluted EPS is higher than the trailing P/E calculated on the basis of basic EPS and the stock looks overvalued or expensive. But investors should prefer to use diluted EPS for calculating trailing P/E ratio as it makes the comparison among companies with difference amount of dilutive securities easier and relevant.

Second major benefit of using diluted EPS is that it shows the worst case scenario. If dilutive securities holder exercise their option due to any reason, than the common investor will be on safe side. Third reason why an investor should use diluted EPS is because major well known experts, research analyst and brokers use diluted EPS for calculating trailing P/E.

Source:

Thefinanceconcept.com

Discounted Cash Flow (DCF) Analysis

Discounted Cash Flow (DCF) is a cash flow summary adjusted so as to reflect the time value of money. With DCF, money to be received or paid at some time in the future is viewed as having less value, today, than than an equal amount that is received or paid today.

• Present value (PV) is what the future cash flow is worth today. Futue value (FV) is the value, in non discounted currency units that actually flows in or out at the future time. A $100 cash inflow that will arrive two years from now could, for example, have a present value today of about $94, while its future value is still considered $100. The present value is discounted below the future value. 
• The longer the time period before an actual cash flow event occurs, the more the present value of future money is discounted below its future value.
• The total discounted value (present value) for a series of cash flow events across a time period extending into the future is known as the net present value (NPV) of a cash flow stream. 

DCF can be an important factor when evaluating or comparing investments, proposed actions, or purchases. Other things being equal, the action or investment with the larger DCF is the better decision. When discounted cash flow events in a cash flow stream are added together, the result is called the net present value (NPV).

DCF and NPV and related time value of money concepts are more easily understood when explained together and illustrated, along with related concepts such as discount rate,future value (FV), and present value (PV), as shown in the sections below.

Time value of money in finance and business planning:

When business case or investment projections extend more than a year into the future, professionals trained in finance usually want to see cash flows in both discounted terms and non discounted terms. They want to see projections, that is, that consider the time value of money. In modern finance, time-value-of-money concepts play a central role in decision support and planning.

Time value of money analysis begins with the present value concept, the idea that money you have now is worth more, today, than an identical amount you would receive in the future Why? There are at least 3 reasons:

• Opportunity. The money you have now you could (in principle) invest now, and gain return or interest, between now and the future time. Money you will not have until a future time cannot be used now. 
• Risk. Money you have now is not at risk. Money predicted to arrive in the future is less certain.
• Inflation. A sum you have today will very likely buy more than an equal sum you will not have until years in future. Inflation over time reduces the buying power of money.

Present value, future value, and net present value:

What future money is worth today is called its present value (PV), and what it will be worth in the future when it finally arrives is called not surprisingly its future value (FV). The right to receive a payment one year from now for $100 (the future value) might be worth to us today$95 (its present value). Present value is discounted below future value.

When the analysis concerns a series of cash inflows or outflows coming at different future times, the series is called a cash flow stream. Each future cash flow has its own value today (its own present value). The sum of these present values is the net present value for the cash flow stream. 

Consider an investment today of $100, that brings net gains of $100 each year for 6 years. The future values and present values of these cash flow events might look like this:

 

All three sets of bars represent the same investment cash flow stream. The black bars stand for cash flow figures in the currency units when they actually appear in the future (future values). 

The lighter bars are values of those cash flows now, in present value terms. The net values in the legend show that after five years, the net cash flow expected is $500, but the Net present value today is discounted to something less.

The size of the discounting effect depends on two things: the amount of time between now and each future payment (the number of discounting periods)  and an interest rate called the discount rate. The example shows that:

• As the number of discounting periods between now and the cash arrival increases, the present value decreases.
• As the discount rate (interest rate) in the present value calculations increases, the present value decreases. 

Whether you will or will not calculate present values yourself, your ability to use and interpret NPV / DCF figures will benefit from a simple understanding of the way that interest rates and discounting periods work together in discounting. 

DCF and NPV: Mathematically speaking

DCF and NPV calculations are closely related tocalculations for interest growth and compounding, which are already familiar to most people. Remember briefly how these work. The formula at left looks into the future and might ask, for instance: What is the future value (FV) in one year, of $100 invested today (the PV), at an annual interest rate of 5%?

FV₁  = $100 ( 1 + 0.05)¹ = $105

When the FV is more than one period into the future, as most people know, interest compounding takes place. Interest earned in earlier periods begins to earn interest on itself, in addition to interest on the original PV. Compound interest growth is delivered by the exponent in the FV formula, showing the number of periods. What is the future value in five years of $100 invested today at an annual interest rate of 5%?

FV₅  = $100 ( 1 + 0.05)⁵ = $128

The same formula can be rearranged to deliver a present value given a future value and interest rate for input, as shown at left. Now, the formula starts in the future and looks backwards in time, to today, and might ask: What is the value today of a $100 payment arriving in one year, using a discount rate of 5%?

PV₁ = ($100) / (1.0 + 0.05)¹     = $100 / (1.05)     = $95 

You should be able to see why PV will decrease if we either (a) increase the interest rate, or (b) increase the number of periods before the FV arrives. What is the present value of $100 we will receive in 5 years, using a 5% discount rate?

PV₅  = $100 / (1.0 +0.05)⁵      = $100 / (1.276)     = $75.13

When discounting is applied to a series of cash flow events, a cash flow stream, as illustrated in the graph example above, net present value for the stream is the sum of PVs for each FV:

Finally, note two commonly used variations on the examples shown thus far. The examples above and most textbooks show  "year end" discounting, with periods one year in length, and cash inflows and outflows discounted as though all cash flows in the year occur on day 365 of the year. However:

• Some financial analysts prefer to assume that cash flows are distributed more or less evenly throughout the period, and discounting should be applied when the cash actually flows.
• For calculating present values this way, it is mathematically equivalent to calculate as though all cash flow occurs at mid year.  This is so-called "mid period discounting." 
• Year end discounting is more severe (has a greater discount effect) than mid year (mid period) discounting, because the former discounts all cash flow in the period for the full period.
• When actual cash flow is known or estimated for months, quarters, or some other period, discounting may be performed for each of these periods rather than for one year periods. In such cases, the discount rate used for calculation is the annual rate divided by the fraction of a year covered by a period. Quarterly discounting, for example, would use the annual rate divided by 4.

The formulas at left show NPV calculations for mid-year discounting (upper formula) and for discounting with periods other than one year (lower formula).

In any case, the business analyst will want to find out which of the above discount methods is preferred by the organization's financial specialists, and why, and follow their practice (unless there is justification for doing otherwise).

Working examples of these formulas, along with guidance for spreadsheet implementation and good-practice usage are available in the spreadsheet-based toolFinancial Metrics Pro.

Choosing a discount rate for discounted cash flow analysis:

The analyst will also want to find out from the organization's financial specialists which discount rate the organization uses for discounted cash flow analysis. Financial officers who have been with an organization for some time, usually develop good reasons for choosing one rate or another as the most appropriate rate for the organization.

• In private industry, many companies use their own cost of capital (or weighted average cost of capital) as the preferred discount rate.
• Government organizations typically prescribe a discount rate for use in the organization's planning and decision support calculations. In the United States, for instance, the Office of Management and Budget (OMB) publishes a quarterly circular with prescribed discount rates for Federal Government use.
• Financial officers may use a higher discount rate for investments or decisions viewed as risky, and a lower discount rate when expected returns from a proposed action are seen as less risky.  The higher rate is viewed as a hedge against risk, because it puts relatively more emphasis (weight) on near-term returns compared to distant future returns.

Example: Comparing competing investments with NPV.

Consider two competing investments in computer equipment. Each calls for an initial cash outlay of $100, and each returns a total a $200 over the next 5 years making net gain of $100. But the timing of the returns is different, as shown in the table below (Case A and Case B), and therefore the present value of each year’s return is different. The sum of each investment’s present values is called the discounted cash flow (DCF) or net present value (NPV). Using a 10% discount  rate again, we find:

Timing	CASE A		CASE B
	Net Cash Flow	Present Value	Net Cash Flow	Present Value
Now	– $100.00	– $100.00	– $100.00	– $100.00
Year 1	$60.00	$54.54	$20.00	$18.18
Year 2	$60.00	$49.59	$20.00	$16.52
Year 3	$40.00	$30.05	$40.00	$30.05
Year 4	$20.00	$13.70	$60.00	$41.10
Year 5	$20.00	$12.42	$60.00	$37.27
Total	Net CFA =  $100.00	NPVA = $60.30	Net CFB = $100.00	NPVB = $43.12

Comparing the two investments, the larger early  returns in Case A lead to a better net present value (NPV) than the later large returns in Case B. Note especially the Total line for each present value column in the table. This total is the net present value (NPV) of each "cash flow stream." When choosing alternative investments or actions, other things being equal, the one with the higher NPV is the better investment.

When to use DCF and NPV in the business case:

In brief, an NPV / DCF view of the cash flow stream should probably appear with a business case summary when:

• The business case deals with an "investment" scenario of any kind, in which different uses for money are being compared.
• The business case covers long periods of time (two or more years).
• Inflows and outflows change differently over time (e.g., the largest inflows come at a different time from the largest outflows).
• Two or more alternative cases are being compared and they differ with respect to cash flow timing within the analysis period.

Source :solutionmatrix.com

Deferred Revenue Expenditure

Deferred Revenue Expenditure:

Simply an expenditure of revenue nature is a Deferred Revenue Expenditure and the  benefit of a revenue expenditure may be available for period of two or three or even more years. Such expenditure is then known as "Deferred Revenue Expenditure" and is written off over a period of a few years and not wholly in the year in which it is incurred. 

For example, a new firm may advertise very heavily in the beginning to capture a position in the market. The benefit of this advertising campaign will last quite a few years. It will be better to write off the expenditure in there or four and not in the first year.

Accounting Treatment: 

Deferred revenue expenditure is the expenditure which is originally revenue in nature but the amount spent is so large that the benefit is received for not a year but for many years. 

A proportionate amount is charged to profit and loss account of each year and balance is carried forward to subsequent years as deferred revenue expenditure. It is shown as an asset in the balance sheet, e.g., heavy expenditure incurred on advertisements.  

Heavy advertisement expenses , because this is for promotion of sale so, it is revenue expenses but because amount is too large so it is also capital expenditure. Now, it will include in deferred revenue expenditure. 

Example:

If we fix the target of getting benefit for this advertisement is 10 years and advertising cost $ 500000. Now $ 500000 is divided by10 years and we get $ 50000 and it will show as revenue expense which is debited to  profit and loss account and balance amount of $ 450000 will show in balance sheet as a fictitious asset.  i.e., although it is shown on the assets side if the balance sheet, it is not really an asset at all.

Every year one tenth part of Original and total advertising expenses will go to profit and loss account. This deferred revenue account will close in 10th year when there will not be any balance for showing as asset in balance sheet .

Meaning of "Holding Company” and “Subsidiary” as per Companies Act, 1956

Simple Definitions:

Holding Company:
A holding company is a parent company that owns enough voting stock(more than 50%) in a subsidiary to make management decisions , influence  and contorl the company's board of directors.
However, holding companies that control 80% or more of the subsidiary's voting stock gain the benefits of tax consolidation, which include tax-free dividends for the parent company and the ability to share operating losses.

Subsidiary Company :
A subsidiary is a company that is controlled by a holding company or parent; this means at least 50% of its stock is controlled by another company. This 50% or greater stake gives the parent company control.

Legal Definitions As per as per Companies Act,  1956 :

Indian Company :

Section 2(26)- “Indian company” means a company formed and registered under the Companies Act, 1956 (1 of 1956), and includes- 

(i)	a company formed and registered under any law relating to companies formerly in force in any part of India (other than the State of Jammu and Kashmir and the Union territories specified in sub-clause (iii) of this clause);
(ia)	a corporation established by or under a Central, State or Provincial Act;
(ib)	any institution, association or body which is declared by the Board to be a company under clause (17)   *** ;
(ii)	in the case of the State of Jammu and Kashmir, a company formed and registered under any law for the time being in force in that State;
(iii)	in the case of any of the Union territories of Dadra and Nagar Haveli, Goa, Daman and Diu, and Pondicherry, a company formed and registered under any law for the time being in force in that Union territory.

Provided that the registered or, as the case may be, principal office of the company, corporation, institution, association or body in all cases is in India; 

***      Section 2(17) “company” means-

(i)	any Indian company, or
(ii)	any body corporate incorporated by or under the law of a country outside India, or
(iii)	any institution, association or body which is or was assessable or was assessed as a company for any assessment year under the Indian Income-tax Act, 1922 (11 of 1922), or which is or was assessable or was assessed under this Act as a company for any assessment year commencing on or before the 1st day of April, 1970, or
(iv)	any institution, association or body, whether incorporated or not and whether Indian or non-Indian, which is declared by general or special order of the Board to be a company:

Provided that such institution, association or body shall be deemed to be a company only for such assessment year or assessment years (whether commencing before the 1^st day of April, 1971, or on or after that date) as may be specified in the declaration;

Foreign company :

Section 2(23A) -“foreign company” means a company which is not a domestic company 

Definitions as per Companies Act,  1956 :

Meaning of holding company” and “subsidiary”  

Section 4 – 

(1) For the purposes of this Act, a company shall, subject to the provisions of sub-section (3), be deemed to be a subsidiary of another if, but only if,- 

	(a)	that other controls the composition of its Board of directors; or
	(b)	that the other exercises or controls more than one-half of its total voting power in a case where it has issued securities and such securities have the same voting rights as equity shares;  or
	(c)	that the other holds more than one-half in value of its paid-up capital, in any other case;
(1A)	No company which is a subsidiary of another company shall, after the commencement of the Companies (Amendment) Act, 2003, become a holding company;
(2)	For the purposes of sub-section (1), the composition of a company’s Board of directors shall be deemed to be controlled by another company if, but only if, that other company by the exercise of some power exercisable by it at its discretion without the consent or concurrence of any other person, can appoint or remove the holders of all or a majority of the directorships; but for the purposes of this provision that other company shall be deemed to have power to appoint to a directorship with respect to which any of the following conditions is satisfied, that is to say-
	(a)	that a person cannot be appointed thereto without the exercise in his favour by that other company of such a power as aforesaid;
	(b)	that a person’s appointment thereto follows necessarily from his appointment as director or manager of, or to any other office or employment in, that other company, or
	(c)	that the directorship is held by an individual nominated by that other company or a subsidiary thereof.
(3)	In determining whether one company is a subsidiary of another-
	(a)	any shared held or power exercisable by that other company in a fiduciary capacity shall be treated as not held or exercisable   by it;
	(b)	subject to the provisions of clauses (c) and (d), any shares held or power exercisable –
		(i)	by any person as a nominee for that other company (except where that other is concerned only a fiduciary capacity); or
		(ii)	by, or by a nominee for, a subsidiary of that other company, not being a subsidiary which is concerned only in a fiduciary capacity;
		shall be treated as held or exercisable by that other company;
	(c)	any shares held or power exercisable by any person by virtue of the provisions of any debentures of the first-mentioned company or of a trust deed for securing any issue of such debentures shall be disregarded;
	(d)	any shares held or power exercisable by, or by a nominee for, that other or its subsidiary not being held or exercisable as mentioned in clause(c) shall be treated as not held or exercisable by that other, if the ordinary business of that other or its subsidiary, as the case may be, includes the lending of money and the shares are held or the power is exercisable as foresaid by way of security only for the purposes of a transaction entered into in the ordinary course of that business.
(4)	For the purposes of this Act, a company shall be deemed to be the holding company of another if, but only, if that other is its subsidiary.
(5)	In this section, the expression “company” includes any body corporate, and the expression “equity share capital” has the same meaning as in sub-section (2) of section 85.
(6)	In the case of a body corporate which is incorporated in a country outside India, a subsidiary or holding company of the body corporate under the law of such country shall be deemed to be a subsidiary or holding company of the body corporate within the meaning and for the purposes of this Act also, whether the requirements of this section are fulfilled or not.
(7)	A private company, being a subsidiary of a body corporate incorporated outside India, which, if incorporated in India, would be a public company within the meaning of this Act, shall be deemed for the purposes of this Act to be a subsidiary of a public company if not less than ninety-nine per cent. of the share capital   in that private company is not held by that body corporate whether alone or together with one or more other bodies corporate incorporated outside India.

Source : http://www.cbec.gov.in/aar/definitions.htm