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What is Shareholder’s Equity? – Calculation & Formula

Are you aware that shareholders are the actual owners of a company? They contribute to the capital by buying the shares of the company. Most companies raise funds by issuing shares to the public. When individuals purchase these shares, they become owners, i.e., the equity shareholders of the company. Notably, the shareholder’s equity is one of the financial attributes that reflects the company’s financial health.

Want to know more about shareholder’s equity? Let’s get started!

What is Shareholder’s Equity?

Shareholder’s equity is the actual value of the business, representing the amount invested by the owners of the company. We also know it as equity, owner’s equity, or stockholder’s equity. The equity amount includes share capital, retained earnings, and other assets entitled to the company’s owners.

In the accounting sphere, shareholder’s equity implies the total company’s assets minus total liabilities, i.e., reflecting a company’s net worth after paying all of its debts. Sometimes, it is also referred to as book value equity. That means, if a company gets liquidated and paid all its debts, the entitled ownership of the remaining equity is with the shareholders of the company.

Essential Components of Shareholder’s Equity

In the balance sheet, shareholder’s equity includes various components that help investors to know the vital financial aspects and equity sources. These items are present in the balance sheet, providing an alternative approach to computing the owner’s equity. Let’s check out the major components of Shareholder’s Equity:

Outstanding Share Capital

It is the capital raised for the company by issuing the shares to the public. Outstanding share capital constitutes both equity and preference shares. While assessing these shares, we need to consider the book value of the stocks, not the market price. This is because market prices are volatile in nature.

Suppose a company issues 2 lakh shares in the market at ₹10 per share, then the outstanding share capital would be ₹20 lakhs.

Additional Paid-in Capital

Additional Paid-in Capital denotes the difference of value for the shares subscribed above par level, i.e., at a premium. It is calculated by subtracting the book value of the common or preferred shares from the cost at which they are sold.

For example, if a company issues 1 lakh shares at ₹12 per share, and the book value of each share is ₹10. This means the additional paid-in capital would be ₹2 lakhs.

Retained Earnings

It is the part of profits that the company reinvests for the expansion and development of the business. After earning profits in the financial year, the company chooses to retain a portion as retained earnings, and the rest is distributed among the shareholders as dividends.

Here is an example. Suppose, if a company earns a profit of ₹40 lakhs in a financial year and distributes ₹ 30 lakhs among the shareholders as dividends. The company keeps the remaining ₹10 lakhs as retained earnings. While calculating shareholder’s equity, this amount is added to the share capital and makes up a part of the shareholders’ fund.

Treasury Stock

Sometimes companies repurchase previously issued stocks from their shareholders. These reacquired shares are known as treasury stocks. In the balance sheet, we deduct treasury stock from shareholder’s equity and record it as a negative amount under the equity section.

The primary purpose of holding treasury stock is to secure the company’s future, such as raising capital to tackle any uncertainties.

Calculation of Shareholder’s Equity

There are two major ways to calculate shareholder’s equity. Let’s understand:

Shareholder’s Equity Formula 1

Shareholders’ Equity = Total assets – Total liabilities

It is the simplest and basic accounting equation to calculate owner’s equity – the difference between total assets and total liabilities.

Total assets – It comprises all the long-term and current assets present in the balance sheet, including investments, land & building, equipment, cash equivalents, accounts receivable, and more.

Total Liabilities- It includes all current and long-term liabilities such as debts, accounts payables, taxes, and others.

Shareholder’s Equity Formula 2

Shareholders’ Equity = Share capital + retained earnings – treasury stock

This equation is also known as the investor’s formula. Here, we use major components of shareholder’s equity to find the real value. Investors mainly use this formula to assess the company’s financial viability.

As per the formula, we add outstanding share capital and retained earnings, whereas the share buybacks are reduced to get shareholder’s equity.

Now we will calculate shareholder’s equity using above -mentioned formulas. Here’s a balance sheet of ABC company:

Liabilities	Amount (₹)	Assets	Amount (₹)
Share Capital	6,00,000	Land and building	3,50,000
Retained Earnings	1,00,000	Plant and machinery	2,00,000
Long-term debts	1,00,000	Stock	1,00,000
Outstanding payments	50,000	Debtors	1,50,000
Creditors	30,000	Cash	80,000
Total	8,80,000	Total	8,80,000

As per balance sheet ABC, the calculation of shareholder’s equity is as follows:

Using Formula 1

Shareholders’ Equity = Total assets – Total liabilities = (₹ 8,80,000 – ₹ 1,80,000) = ₹ 7,00,000

Using Formula 2

Shareholders’ Equity = Share capital + retained earnings – treasury stock

= ₹ 6,00,000 + ₹ 1,00,000 – 0

= ₹ 7,00,000

Relevance of Shareholder’s Equity

Shareholder’s equity is a vital indicator of the company’s investment and its financial strength. It can be positive or negative, reflecting the various aspects of the company. The shareholder’s equity will be positive if total assets exceed the total liabilities. It denotes the company’s financial sustainability and has required surplus assets to pay back to its shareholders.

At the same time, if total liabilities are more than total assets, then shareholder’s equity will be negative. It hints that the company’s financial health is unpleasant; the business is not performing well and has no reserves to safeguard shareholders. If the situation continues for an extended period, the company stands at the risk of bankruptcy. Such an event can be a caution light for the intended investors.

Well, shareholder’s equity is one aspect of weighing a company’s financial health. It is not the definite or only one. For example, negative equity can be seen in startup companies, especially in the early phase of their journey. However, investors look for stability and good returns; that’s why they majorly invest in companies with positive owner’s equity.

The Bottom Line

Shareholder’s equity is a significant financial metric for analyzing a company’s financial outlook. It gives rightful direction to investors about the improvement option. They assess the company’s balance sheet to know the fundamentals so that they can invest in sustainable business.

Shareholder’s equity also helps in determining the ROE (Return on Equity) ratios, indicating how effectively a company generates returns with its share capital. So, it is an indispensable factor present in the balance sheet that gives a comprehensive idea of a company’s financial well-being.

November 29, 2024

Profitability Index Definition, Formula and Calculation
Whenever you think of investing your money in a project, needless to say, you would want to get your profit back. However, most of the time, many project investments are based on mere guesswork.
Whether you are going to gain profits out of a project is regarded as a matter of intuition by several people. Since it is highly important that you evaluate the chances of profitability before investing in a project, you get a significant calculation to back you up. But what if you get a metric that helps you evaluate this specific aspect?
That is where Profitability Index comes into the picture. It provides an easily understandable ratio that can assist you in making various decisions. In this post, let’s talk about the definition of profitability index, its formulas and calculation.

What is the Profitability Index?

Also known as the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR), the Profitability Index (PI) helps represent the relation between the advantages and costs of a potential project.
This one is a simple ratio that designates whether an investment project will be profitable or not by showcasing the value created by every investment unit.
It is evaluated as the ratio between the initial amount invested in the project and the present value of future anticipated cash flows. The higher the PI, the more attractive will be the project.

Importance of Profitability Index

Companies generally use the profitability index as it lets them see the amount of money they may make. In simple words, it can assist in avoiding the selection of the wrong project. This could be from a decision over a specific period or concerning their investments. This also helps managers decide whether an investment will be a good one.
Apart from this, when it comes to comparing the performance of varying businesses, the profitability index lends a helping hand.
Suppose you have two organizations with the same operations and assets. The profitability index will help you figure out which company is making more and better profits. This may showcase that one organization has a more operative management structure than the other. Furthermore, this may also mean that one organization’s customers are ready to pay more than the other organization’s customers.

Formula of PI

The profitability index formula indicates the present value of future cash flows, which is divided by the initial project cost. Mathematically, it is presented in the following manner:
Profitability Index = Present Value of Future Cash Flows / Initial Investment
Moreover, there is one more representation of the PI formula, which is:
Profitability Index = (Net Present Value + Initial Investment) / Initial Investment
After putting numbers into the profitability index, you can determine whether to move forward with a project.
Let’s elaborate it further with an example. Suppose you are considering investing in a project that will cost you Rs.1000 in initial investment. The expected returns from this project will be Rs.1300. By putting these numbers into the equation, here is what you get:
Profitability Index = 1300 / 1000
Thus,
PI = 1.3
Since the value of PI is bigger than one, the project is going to be profitable for you.
Components of PI
There are two significant components of PI, such as:
The Numerator (Present Value of Future Cash Flows)
The PV of future cash flows need the application of time value of money calculations.
The correct number of periods is used to discount cash flows to compare future cash flows to current monetary levels.
Discounting accounts come from the notion that the value of $1 today will not be the same as the value of $1 in the next year as current money has more earning potential as compared to the money that is hitherto unobtainable.
Thus, cash flows received in the future are regarded to have a lower present value than money received in the present.
The Denominator (Investment Required)
The discounted predictable cash outflows showcase the initial capital outlay of a specific project. The required initial investment is the cash flow needed at the beginning of the project. All the other outlays might occur at any point in the project’s life.
Also, all of this is factored into the calculation via the discounting use in the numerator. Such extra capital outlays might factor in advantages pertaining to depreciation or taxation.
Interpreting the Profitability Index
As mentioned above, the higher the PI, the more striking the project will be. So, for example, if the value of PI is more than one, the project will be regarded as a good investment. If the PI is equal to one, the project represents a break-even point, and the company will be indifferent between moving forward and not proceeding with that project.
Usually, these values are positive and not negative. However, one disadvantage of PI is that the technique doesn’t consider the project size. For example, even if a project has significant cash inflows, it can still result in lower PI calculations since the profit margins may not be high.
Also, if the calculation is less than one, it simply says that the deficit of outflows is more than the discounted inflows. In such a situation, the project should not get accepted.

Conclusion

Irrespective of the business type you are operating or the industry you are working in, generating a profit is essential to expand or grow. As far as possible investments and projects are concerned, you must comprehend the benefits you can receive before making any decision.
With a profitability index, you can easily determine the benefits and costs of a potential investment or project. Once you know the PI value, you can then decide on what will be best for your business in the future. Keep in mind that the outcome can be an increase in possible profitability or a higher return on investment.
November 29, 2024

Accounting vs. Auditing

When it comes to accounting vs auditing, the terms are often used interchangeably, but the differences between these two disciplines can have a major impact on whether a company follows good financial practices.

Accounting and auditing are two fields of finance, but they differ in the way each one performs its operations.

Accounting and auditing work with the financial statements of a business and ensure compliance with regulatory standards and accuracy. While accountants prepare financial statements, including statements of cash flows, income statements, and balance sheets, an auditor is responsible for evaluating the correctness of it all.

Apart from this, an accountant and an auditor have to look into a gamut of more duties and responsibilities. In this post, let’s figure out the true meanings of accounting and auditing.

Beyond this, if you are confused between these two concepts, you will find a thorough differentiation between accounting and auditing.

What is Accounting?

Accounting is known as a process of recording, categorizing, summarizing, and understanding financial statements and transactions to comprehend a company’s financial position. It is also called the specialized language of business as it helps understand an entity’s economic activities.

Accounting is an act of methodically capturing daily money transactions and classifying them into various groups. And then, they are summarized in such a way that they can be referred to easily during an emergency.

One of the primary functions of accounting is to offer material information, specifically the one that is financial in nature, as it helps in decision-making. Accounting is further divided into various types, such as:

Cost accounting
Social responsibility accounting
Management accounting
Human resource accounting
Tax accounting
Financial accounting

Some of the fundamental objectives of accounting are:

To keep a proper record through trial balance, journals, ledgers, and subsidiary books
Determining results through maintained records
Providing required information pertaining to liquidity and solvency position
Displaying the company’s financial position through balance sheets

What is Auditing?

Auditing is the process of evaluating a company’s financial records, such as statements and transactions, to figure out discrepancies during the accounting process. Not just that, auditing also helps in verifying the correctness of records.

It is an unbiased, critical investigation of every part of the transaction, be it account books, receipts, vouchers, or anything relevant. Also, frauds and errors or purposeful manipulations in accounts can be discovered through detailed auditing.

The auditor is liable for inspecting the transparency and accuracy of the financial information. Also, they comply with accounting standards and figure out whether taxes have been paid adequately.

Once this thorough inspection of financial records and accounting books is completed, the auditor prepares a report with their opinion. There are basically two types of auditing reports:

Unmodified
Modified

Qualified
Disclaimer
Adverse

Auditing can be of two diverse types, such as:

Internal Auditing: It is conducted by an auditor hired in-house by the company’s management.
External auditing: It is conducted by auditors who work outside of the company, and the company’s shareholders hire the auditor.

Similarities Between Accounting and Auditing

If you look closely, you will find that many fundamental processes in these two fields are quite similar. Some of them are:

Both accounting and auditing require knowledge of accounting basics and principles.
These procedures are executed by people who hold an accounting degree.
They are important procedures and techniques of analysis, bookkeeping, and computation that help compile financial statements and reports.
Generally, the process for activities in auditing and accounting, like tax compliance, is the same.
They both have the same methods for bookkeeping, like accrual and cash basis.
Their goal is to make sure financial statements and records are prepared with utmost accuracy and that they offer a fair understanding of the company’s financial position.

Difference Between Accounting and Auditing

To understand the concepts of accounting vs auditing comprehensively, below mentioned is a thorough table of differentiation:

Factors of Comparison	Accounting	Auditing
Purpose	The objective of accounting is to display a company’s performance, profitability, and position.	The objective of auditing is to cross-check data put forth by accounting. The purpose here is to reveal the fairness to which financial records have been maintained.
Objective	To comprehend a company’s loss and profit for a period.	To comprehend the accuracy of all financial records, statements, and transactions.
Operational Mode	Accounting is carried out daily as transactions occur every day in a company.	Auditing is a periodic affair generally done monthly, quarterly or yearly.
Responsible Person	Accountants are the responsible person.	Auditing is done by auditors.
Sequence	Accounting begins at the end of bookkeeping.	Auditing begins at the end of accounting.
Concentration	It concentrates on current financial transactions and activities.	It concentrates on previous financial statements.
Included Information	It included everything related to financial transactions and records.	It includes financial statements and records on a sample basis.
Governing Standards	Accounting standards govern it.	Auditing standards govern it.
Executed By	Internal employees execute it.	It is either executed by external auditors or independent agencies.
Appointment & Remuneration	A company’s management appoints accountants on a salary basis.	A company’s shareholders appoint auditors on an auditing fee basis.

Wrapping Up

Undoubtedly, both accounting and auditing are specialized fields. However, the auditing scope is much wider than accounting as it requires a profound understanding of several tax rules, acts, accounting, and auditing standards along with fundamental communication skills.

Along with this, individuality, uprightness, honesty, and discretion are some of the basic requirements that must be maintained when performing the process of auditing. The reports that an auditor submits turn out to be helpful for varying end-users, including government, customers, debtors, suppliers, investors, shareholders, creditors, and more, for adequate decision-making.

As far as accounting is concerned, it is no less either, considering that it needs all-inclusive knowledge of assumptions, conventions, principles and standards, tax laws, and Companies Act rules. Moreover, since auditing is based on competence in accounting, it cannot be taken for granted either.

November 29, 2024

Calculate a Company’s Forward P/E in Excel

There are numerous ratios with unique characteristics to evaluate the performance of a company, i.e. leverage ratios, liquidity ratios, etc. One such ratio is the P/E ratio or Price to Earnings Ratio. It helps in calculating the growth of the company’s stock. However, there is one more elevated version of this ratio known as the forward P/E ratio. It helps in finding the future prospect of a company’s share price.
This article will cover this interesting ratio’s meaning and importance and calculate it in Excel.

What is the forward PE ratio? How is it different from normal PE?

Forward price-to-earnings (forward P/E) is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the share price calculation. Investors and analysts around the world use this ratio to gauge the value of a company by taking estimates of its future earnings.
Unlike the P/E ratio, which considers the available past data on earnings and the price of shares, forward P/E is based on the estimation of earnings of a company and provides insights on how the stock is likely to be a few years down the line. From the valuation standpoint, the forward P/E ratio is considered more relevant than the normal P/E.
For calculating forward P/E, we need to add future estimation of earnings in the denominator instead of current earnings. While the earnings used in the forward PE ratio are estimated numbers and may not be as reliable as current data, this ratio still benefits companies by getting a forecast of their future earnings and share price.

Why is it crucial for businesses and investors to calculate the forward PE ratio?

Forward PE is widely used for comparison across companies. Investors use this ratio along with others to check how a company stands relative to its competitors in the same industry. It is a part of the validation model cold relative valuation, wherein ratios are used to gauge the relative values of a company.
Forward P/E ratios not only help Investors to understand their growth prospects and where a company stands in the competition, but it also acts as a straightforward metric of valuation. On the other hand, for companies, it shows the future road and helps them stay on track with their goals. As Earnings reflect all the fundamentals of a business, companies evaluate future earnings for forward P/E as how successful they estimate themselves to be in the future.

What is the formula for forward P/E ratio?

The formula for forward P/E is almost analogous to the PE ratio. However, estimated (or forecasted) earnings per share are used instead of current or historical share price in forward PE. Projected earnings could be for the following year or years, depending on the requirement.
Forward P/E = Current Share Price / Estimated Future Earnings Per Share
For example, if a company has a current share price of Rs. 100, and next year’s earnings per share (EPS) is expected to be Rs. 5, then the company has a forward P/E ratio of 20.0x.
Here, the only challenge is to find out what the estimated future earnings of the company would be. Investors can use their own estimates. However, there are various databases like Bloomberg, Capital IQ, Yahoo Finance, Equity Research reports, etc., where an investor can find the estimated EPS based on business fundamentals.

How to Calculate the Forward PE ratio in Excel?

Let’s talk about the calculation part in Excel now. Once the future earnings are in handy, finding forward P/E becomes very easy. Here is an example of how this works in Excel.
Select a company or companies to calculate forward P/E and get the relevant data such as market price and earnings. All that is needed is to divide the market price by earnings to get forward P/E/. See the steps below.
-> Open an Excel sheet and enter the titles shown in the snapshot below. We will start by calculating forward P/E for ABC Ltd.

-> We can calculate the forward P/E with the help of the formula= Current Share Price / Estimated Future Earnings Per Share.
-> For that, place the cursor in cell B4 and press‘=’ sign (as all formulas in excel begin with that sign) and type the formula as B2/B3. After pressing enter we can get the forward PE for company ABC.

-> Similarly, forward P/E for company XYZ Ltd. can be calculated. The result will look like this:

-> In the above illustration, ABC Ltd has a slightly higher forward P/E ratio compared to XYZ Ltd based on the price and forecast.
For the forward P/E ratio, results under 10- 25 are considered reasonably priced stocks. Stocks under 10 can be undervalued if their fundamentals are strong. If the ratio is above 50, the stock is overvalued and should be avoided. Both the stocks of ABC and XYZ are below 10. Investors should check other fundamental values before investing in them,

Conclusion

There are many ways and attributes to value the company. P/E and forward P/E are one of the most sought-after ratios in finance, but they should not be looked at in isolation. Forward P/E ratio accounts for estimated earnings, and thus this calculation holds utmost importance to ensure that the findings are reliable. Faulty estimations can distort the value of a company and thus needs careful consideration.

November 29, 2024
Distribution Channel – Definition, Types, Examples, and Function

A distribution channel is a route all goods and services must travel to reach their intended consumers. It can be defined as a chain of companies or intermediaries through which a product or service reaches the final buyer or end user. Contrariwise, it also describes the payment path from the final consumer to the original provider.

How does it function in a business?

Goods and services may reach consumers through multiple short-term and long-term channels. You can increase your sales by giving consumers more ways to find your product. Not all distribution channels work for all products, so businesses need to choose the right channel. Channels should align with the company’s overall mission and strategic vision, including sales goals.

3 methods for distribution and their differences

You essentially need a distribution channel to get the product to the end consumer. Choosing a distribution channel carefully is a proven way to help your business grow and is essential to achieving your goals. When choosing a distributor, analyze the prospective distributor. Will they have the characteristics to be effective distributors, and can they help you achieve your business development goals? These are some significant factors to consider.

Exclusive Distribution

Exclusive distribution is a concentrated selective distribution that appoints only one distributor in each region. Claiming an exclusive sales opportunity is not difficult, but there are steps to follow. This distributor maintains brand image, integrity, and often higher prices when channel control is important. An exclusive distributor means more control over the market, more active intermediaries, and higher brand loyalty.
When a manufacturing company sells its products through one or two major outlets that exclusively handle the market, it is said to employ a monopoly strategy. Exclusive distributors typically cover designer merchandise, major consumer electronics, and the most exclusive items and brands, such as Louis Vuitton and Burberry.

Intensive Distribution

This is a marketing strategy in which companies sell through the widest possible range of channels and cover as many outlets as possible so that customers can find their products practically wherever they go, such as drugstores, gas stations, and supermarkets. They help increase sales, build broader customer awareness, and drive impulse purchases.
This strategy is common for snacks, basic consumables & supplies, and magazines. Intensive distributors work with many manufacturers and typically sell large quantities of goods at low prices and low margins.

Subjective Distribution

This strategy is typically used for more specialized products distributed through specialized distributors covering specific geographic locations. The company selects several points of sale for product distribution. This option helps the manufacturer to focus its sales on select distributors rather than spreading them out over many exclusive distributors. Subjective distributors can save costs, increase marketing efficiency, and control marketing.
Product distribution always considers high-end items such as designer goods, e.g., Aldo, Titan, Sketchers, and H&M.

7 types of intermediaries in distribution channels (With examples)

Various sales intermediaries intervene as the products pass from the manufacturers to the final consumer or commercial user. These marketing intermediaries are also known as wholesalers, distributors, retailers, franchise dealers, brokers, authorized dealers, and agents. Such marketing intermediaries put distribution channels at risk. These distribution channels minimize the gap between places of production and consumption, thereby creating space, time, and ownership. Let’s further understand each intermediary in the distribution channels.
Wholesaler
Wholesale is an important part of the distribution channel. Wholesalers increase the range of a company’s products and increase the risk of selling to customers. Wholesalers can stock a range of different products, thus reducing company costs and customer time. They act as the ears and eyes for companies to understand their competitors and customers.
Retailers
Retailers are essentially shopkeepers. Retailers include everything from your neighborhood grocery store to the mall. The only difference between them is their size. Retailers will buy goods from wholesalers or distributors and sell them to end users. They will profitably sell these products to their customers.
Sales Team
A company may also have its own sales team selling goods or services. If the company has a diverse product line, it may be necessary to form more than one team to sell to different segments and audiences.
Brokers
Brokers are also employed to sell and earn a commission. The distinction between agents and brokers is that brokers have only a short-term relationship with the company. For example, real estate agents and insurance brokers.
Internet
One of the most important aspects of any business is getting your products or services in front of the right people and reaching the target audience. Numerous distribution channels available on the Internet could be used effectively to benefit your website. Using social networks like Instagram and YouTube as distribution channels allows you to reach out to more people and raise awareness of your products and services.
Resellers
A reseller is a channel partner who acts as a go-between for companies that manufacture, distribute, or provide IT products or services and end customers, who can be businesses or consumers. Working with a reseller can also help you find products faster. A company that needs to buy multiple technology components can do so through a single reseller rather than directly approaching multiple manufacturers or service providers. Some of the most popular resellers in India are Meesho & eBay.
Direct to Consumer- D2C
D2C is the process by which a company manufactures, markets, and distributes its products. There are no “middlemen” in producing and selling goods and services. A D2C brand typically ships to consumers, partners with retail locations, or operates pop-up shops to distribute products. By eliminating extra ‘parties’ from the sales journey, a brand can cut prices, communicate directly with the end customer, and provide a streamlined brand experience. It can establish a customer-first approach, direct communication channels through digital channels, and harness the power of influencers and word of mouth. For example, Pepperfry, Boat, and Lenskart, to name a few.
Distribution channels can be short or long, depending on the number of intermediaries required to deliver a product or service.

November 29, 2024
CAGR vs. IRR: What is the Difference?
Everyone is looking for attractive investments in this finance world. However, finding out the feasibility of the investment or business project is a monumental challenge for investors. Want to learn how to find the attractiveness of your investments?
Today, we learn about the two most reliable financial metrics and their differences – CAGR and IRR. Both are popular financial metrics and are widely used in financial models. In addition, these metrics help investors to:
Forecast the investment returns
Compare different investment or business models
Analysis of past performances
You may have come across some popular phrases such as what is CAGR in mutual fund, what is CAGR in stock market, what is the IRR of this investment scheme, and more. So, let’s delve deep to learn about the meaning of IRR and CAGR, their differences, how they work, which is the better option for evaluation and in which scheme, and so on!

What is Compound Annual Growth Rate?

The compound Annual Growth Rate (CAGR) is a financial metric to measure the annual growth of investment over time. It evaluates the returns on investment you have earned or going to earn during a specific period, with the impact of compounding taken into consideration.
CAGR is a reliable method for calculating the rise and fall of your ROI. It is also incredibly effective in measuring the expected future returns or comparing past performance.
Investment or investment portfolio witnesses standard fluctuation over the period due to market volatility. For example, your investment might see a smaller gain in one year, a huge gain in the next year, and a slim loss in the following year. This cycle continues with different rates of returns throughout the period.

How To Calculate CAGR?

The calculation of CAGR is simple. It principally considers the initial and final investment made during the period. The compound annual growth rate formula is as follows:
CAGR = (Final Value/ Initial Value)^1/n – 1
Here,
Final value = The ultimate Value at the end of the investment.
Initial Value = Original value at the beginning of the investment
N = It represents the number of years of investment
Let us understand the CAGR calculation more clearly with an example,
Suppose X invests ₹20,000 in the shares of a company for five years. After maturity, X cashed out the investments for ₹30,000. The CAGR of your investment is:
CAGR = {(30,000/20,000)^ 1/5 – 1} = 8.45%
It means the original investment of X ₹20,000 generated returns of 8.45% over a five-year period, which is equal to ₹30,000 at maturity.

What is IRR?

IRR full form is Internal Rate of Return. It is a financial metric used to measure the profitability of a project, business, or investment. In other words, IRR is a discount rate at which the NPV (Net Present Value) of a project or investment is zero.
IRR excludes all the external factors such as capital costs, inflation, tax, financial risks, and other inputs; that’s why it is called the internal rate of return. That means the net cash flows, i.e., cash inflows and cash outflows, would be equal to 0.
The internal rate of return method is a great way to assess the attractiveness of a project or investment. It gives estimates of the future value of an investment, allowing investors to analyze investment risks and make prudent decisions.
With the help of IRR, business owners or investors can estimate which projects or investments have the better potential cash outflow. Higher the IRR, the better the investment opportunity.

How to Calculate IRR?

Before we figure out the IRR formula, it is interesting that no one spends time calculating IRR manually. Calculating IRR by hand is a hectic process and time-consuming. Instead, most people use computing software, Spreadsheet or MS Excel, to calculate IRR within seconds. To calculate IRR, we need to derive NPV (Net Present Value).
NPV is the net difference between cash inflows and cash outflows in a specific period.
NPV Formula,
NPV = Cash flow/ (1 + i)t – initial investment
Where,
i = discount rate or required rate
t = time period
Cash flow = net cash flow during a specific investment period
Initial investment = original or the first investment of the project
Now, let’s understand the Internal Rate of Return Formula:

IRR Formula

Where,
CF0 = Original/ Initial investment
CF1, CF2, CF3, CF4, …. CFn = Cash flows
n = each single period
N = Investment period
NPV = Net Present Value (here NPV is equal to zero)
IRR = Internal Rate of Return
Here is a numerical example,
Suppose X invested ₹20,000 and for three years, she received returns of ₹5,000, ₹8000, and ₹10,000, respectively. The expanded IRR computation as follows:
NPV = CF0 + CF1/ (1 + IRR)1 + CF2/(1 + IRR)2 + CF3/ (1+IRR)3
0= (₹20,000) + ₹5,000/ (1 + IRR)1 + ₹8000/ (1 + IRR)2 + ₹10,000/(1+IRR)3
As we see, it is nearly impossible to calculate the IRR manually. We could try solving it through a hit-and-trial method, which will consume a lot of time. For ease, saving time, and getting accurate results, most investors use Excel or Spreadsheet to calculate the IRR of the intended investment. Let’s calculate the IRR of the following investment using Excel:

Step 1

Step2

The process is simple. Just scribble down net cash flows year-wise and run the IRR equation. The IRR of this investment is 7%. So, the higher the IRR, the better the investment.

CAGR vs. IRR: What’s the Difference?

CAGR and IRR are standard financial metrics to measure expected return on investment. Each metric has its own relevance, depending on the investment structures.
Let’s check out some fundamental differences between IRR vs CAGR:

Ease of Calculation

The method of CAGR is relatively much easier to calculate and understand than IRR. It needs only a few essential inputs to derive the rate of return, such as initial investment, final value, and investment period.
IRR is a complex metric involving many inputs and complicated methods. As a result, it isn’t easy to calculate manually. Mostly, IRR is calculated using software, Excel, or a Spreadsheet to save time and get better results.

Diverse Investment Avenues

CAGR is beneficial, where no cash inflows and outflows are involved. In such types of investments, it is a perfect metric that will help investors to decide where to invest and which will be better options.
When there are variations in returns or the investment depends on market volatility, the IRR is an excellent option. It considers net cash flows during the period, offering a better picture of investment over a specific period.

Usage and Purpose

CAGR is primarily used for analyzing past performances of investments, i.e., stocks and mutual funds. It gives a single compound rate of growth of an investment. CAGR is best for calculating lump sum investment.
On the other hand, the IRR is used to make a fair comparison between different investment schemes. Its primary purpose is to forecast investment returns rather than analyze and evaluate historic returns. IRR is good for taking capital budgeting decisions.

Time Value of Money

The time value of money plays a pivotal role in any business segment, project, and other investments. It provides a better overview of capital expenditure.
CAGR ignores the movement of cash and the time value of money during the investment period. So, it doesn’t present an accurate investment worth.
IRR is a preferable option for forecasting investment returns, considering the time value of money. It gives a realistic outlook and helps investors to make prudent decisions, comparing the different projects.

The Bottom line

After understanding the concept and differences, a question arises – Which is better: CAGR vs. IRR? Depending on the investment prospects, each method has its own significance and purpose.
In the financial industry, IRR gives a more realistic picture than CAGR while assessing investments and business projects. Therefore, it has broader appeal among investors as the method takes account of the realities of the financial circles and market volatility. In some cases, CAGR serves the purpose in an optimum way..
November 29, 2024
Business Transactions – Definition and Examples
Every business comprises different activities, leading to revenue generation and sustaining the business’s existence. And a business transaction is the backbone of almost every business activity.
A business transaction is an economic event involving a third party that is documented in an organization’s accounting system. In this blog, we’ll go through the concept of business transactions and some examples in elaboration.

What is a Business Transaction?

Business transactions are defined as events occurring with any third party, measurable in monetary terms, and having a financial effect on the business. Getting insurance from an insurer, purchasing inventory from a supplier, selling items to a client in cash or on credit, paying employees’ salaries, getting a loan from a lender, and selling shares to an investor are some examples of business transactions.
For instance, a manufacturing company needs to buy raw materials to be used to produce finished goods. So, it will enter into a transaction with the vendor, which will have a monetary value. This will affect the company’s financials.
Moreover, business transactions are supported by the permitted, and genuine documents relating to the event or transaction entered. For example, in the case of a sale, the sale order and invoice will be regarded as legal documents for proving the deal.

Importance of Business Transaction

Business transactions are recurring and thus might occur once a year or more frequently in a company. If there isn’t a transaction in a company, the company is considered not functioning and will eventually shut down. Therefore, having business transactions suggests that an entity is active.
For example, if a company stops paying taxes, it can be interpreted as having no presence in the country, lacking ample resources to pay taxes, or having some other reasons.
Moreover, a small number of transactions indicates that a business is functioning, whereas a large number of transactions indicates that a business is expanding. These business transactions may be related to more competitive business practices and engagement with a business’s external and internal environments. So, active business transactions indicate the status of a company.
For example, if a company keeps buying fixed assets, such as large machinery, warehouses, office spaces, and so on, it suggests it is planning to expand. On the other hand, business transactions like salaries to staff, loan repayment, and rent payment suggest that the company is running smoothly, regardless of expansion.
Business transactions are usually documented. This way, anyone can assess the company’s ability to do business and generate profits throughout the relevant period. Moreover, recording business transactions aids in separating the income derived from business operations from other income sources, including capital gains, lottery winnings, salary income, etc.
Final accounts are generated through them at year’s end or for a specific period. So, business transactions enable the assessee to properly segment their income and expenses into the right heads and record and file his income tax returns in accordance with legal requirements.

What Are the Types of Business Transactions?

Cash Transaction: A cash transaction is one in which the money is made or received when the contract is made.
For instance, you pay ₹10,000 as your house rent in cash. Since a cash payment is made at the moment of the transaction, this is a cash transaction. On the same lines, if you spend ₹2,000 in cash to purchase stationery, it is also a cash transaction.
Credit Transaction: Unlike cash transactions, cash is not involved in credit transactions at the moment of the transaction. Instead, the amount is paid afterward (termed as credit period).
Suppose you sell art and craft supplies and an art school is one of your clients. At the beginning of a new academic session, the school asks for a 30-day credit period while buying art supplies in bulk from you on a credit basis. Therefore, there is no cash exchanged at the time of sale in this transaction. Rather, the consumer (the art school) will pay the amount after the 30-day credit period.
Internal Transaction: An internal transaction does not involve any outside parties. These transactions don’t include a value exchange with another party but have monetary terms or worth, such as fixed asset impairment.
Examples of internal transactions include:
Depreciation of a fixed asset.
The loss of property by fire.
The provision of products to other business units.
For example, as per the IT act, the depreciation rate for a laptop is 40% per year. Thus, the depreciation of every laptop is recorded in the books of accounts. (Note that depreciation is documented as an operating expense. And, every expense is a business transaction.)External Transaction: A transaction involving two or more parties is referred to as an external transaction. They are daily routine transactions, such as paying for purchases, sales, rent, utility costs, etc.

Examples of Business Transactions

A firm engages in several transactions each day that have an impact on its accounting. Typical commercial transactions include:
Taking out a loan from a bank: When a corporation enters into a loan agreement, it engages in a business transaction with the bank. The loan will impact the company’s asset and liabilities accounts.
Buying products from a vendor: When a business buys products from a vendor, the transaction is solely between the two parties. The business can record this transaction in a vendor account and a purchasing account. Additionally, purchases must be noted in the company’s inventory.
Rent and other utility payments: A business completes processes when it pays its rent, electric, water, or internet bills. The assets and spending accounts of the business will be updated with these payments.
Sales of goods: When a business makes a sale, it engages in commerce with the customer. The transaction will be noted in the records for assets and income. Sales agreements are typically used to formalize the deal.Interest payments: Making interest payments is a type of business transaction. This will impact a business’s assets account and expense account.

Conclusion

As business transactions offer an abstract perspective of the interactions between firms to attain a business objective, they are becoming more and more significant. A business can accurately portray its finances and thus assure the accuracy of its financial statements by recording business transactions, giving it a record of every business activity.
November 29, 2024
Discount Rate: Meaning, Calculation and Formula
Did you ever think of running your own business? For a while, let’s suppose you are the CEO of an ABC Corporation. It is a SaaS company that is growing exponentially. At this point, you are thinking of pitching to investors.
So, you will first have to make your company an attractive prospect for investors. How can you do that? The answer is – by finding your discount rate.
However, you must keep in mind that as a business, evaluating the discount rate could be a complicated task. The discount rate is essential for investors and companies assessing the future.
An accurate discount rate is integral to reporting, investing, and evaluating the financial viability of projects in the company. So, without further ado, let’s find out more about discount rate and their relevant information in this post.

What is Discount Rate?

The discount rate meaning is the interest rate used to discover the Net Present Value (NPV) of a project’s future cash flows. NPV assists in determining the profitability of a project or an investment. Thus, the interest rate helps comprehend whether the project is going to be viable or not.
Every investor or company anticipates specific future cash flows when agreeing to an investment or a project. But such future cash flows cannot be regarded as such to comprehend the project’s feasibility.
The reason is the decrease in the money’s value over time. Moreover, there is risk or uncertainty about the future, which must also be considered.
Hence, companies oversee a Discounted Cash Flow (DCF) analysis. Such an analysis uses discounting to evaluate the project’s current value based on its future cash flows. In simple words, it allows investors to comprehend the project’s NPV.
A positive NPV discount rate means that the present value of the cash flow is more than the initial investment cost. This means that returns are greater than the costs. Hence, it states that the project is viable. So, investing would be a correct decision.

How to Calculate Discount Rate?

The discount rate formula can be articulated as future cash flow divided by present value. And then, it is raised to the number of years’ reciprocal and minus one.
You can use the following steps to derive the formula for the discount rate:

Step 1: First and foremost, comprehend the value of your future cash flow that is under consideration.
Step 2: And then find out the present value of the future cash flows.
Step 3: Next, you will have to find the number of years between the present day and the time of the future cash flow. Denote this time by n
Step 4: Lastly, the discount rate formula can be taken by dividing Step 1 (future cash flow) by Step 2 (the present value) and raising to Step 3 (reciprocal of the number of years) and the minus one.
Mathematically speaking, it will be presented as:

Discount Rate = (Future Cash Flow / Present Value)^ 1/n – 1

Here,
n = number of years
If multiple compounding is involved during a year (t), the discount rate formula will be:
Discount Rate = T * [(Future Cash Flow / Present Value) 1/t*n – 1]
Types of Discount Rate
For companies, the future value of a specific investment doesn’t amount to anything. They can evaluate the worthiness of investment only based on its current value. Thus, the discount rate turns out to be a handy metric for assessing the present value.
Different companies choose different rates. For example, some may use the return rate they wish to get from investments based on the risks involved. Others may use the Weighted Average Cost of Capital (WACC) discount rate.
Thus, different rates apply to investments based on the purpose or the nature for which they are used. Jotted down below is more information about types of discount rates.
WACC
It is a significant rate of return that the investors of a company expect in return for the capital. It is helpful to evaluate the company’s equity value.
Risk-free Rate
It is the rate of return on a specific investment with no related risks. This rate helps in evaluating the time value of money.
Cost of Equity
The Cost of Equity is the return rate a company pays to the equity shareholders. It is generally used to evaluate the equity value of an organization.
Hurdle Rate
It is referred to as the minimum acceptable rate of return for investing somewhere. This rate helps assess investments in internal corporate projects.
Cost of Debt
The cost of Debt is the interest rate a company pays to the bondholders. It is used for the valuation of assets that produce fixed income.
Discount Rate Example
To understand the discount rate in more detail, let’s take an example here:
Suppose there is an organization called XYZ Corporations. It must receive a future cash flow worth Rs.5000 after five years. Now, let us calculate the discount rate if the present value of that future cash flow is Rs.2500.

Particulars
Value
Future Cash Flow
Rs.5000
Present Value
Rs.2500
Number of Years
5

The discount rate will be calculated with the help of this formula:
Discount Rate = (Future Cash Flow / Present Value) ^ 1/ n – 1
= (5000 / 2500) ^ 1/5 – 1
= 14.87%
Thus, in this situation, the discount rate used to compute the present value is 14.87%.

Conclusion

At last, understanding the future cash flows and their value by comprehending your discount rate is crucial. It is even more vital to determine the possible risk factors and value for new developments or projects. You would only wish to move ahead with such investments that offer more revenue than the initial costs.
Thus, being familiar with your discount rate is essential to know where your cash flow is standing in the forthcoming years. This will help you determine whether a specific investment or project is worthy of your attention and efforts.
November 29, 2024
What is Salvage Value: Meaning and Formula
We are aware that every piece of machinery and object has a useful life. After the usable term has passed, the equipment will no longer perform properly and must be sold.
This selling price is called salvage value. However, it might not be easy to figure out the salvage value. So, in this article, we will look at salvage value, formula, and how you can calculate it.

What is salvage value?

After an asset’s useful life is over, the asset’s salvage value means its selling price. It also shows how much it is worth getting rid of or selling. For example, if a company’s machinery has a 5-year life and is only worth Rs.5000 at the end of five years, the salvage value is Rs.5000.
Any asset that a firm will depreciate in its books over time might be given an estimated salvage value. Every organization will have its own array of criteria for determining salvage value. Because the salvage value of an asset is so low, some organizations may choose to depreciate it to zero at all times. The salvage value is significant in general because it represents the asset’s carrying value on a company’s books after depreciation has been taken into account. It is based on the amount of money a corporation expects to get when the asset is sold at the end of its useful life. Salvage value may simply be the amount of money a firm feels it can get by selling a depreciated, unusable asset for components.
This value is also known as scrap value

Example of Salvage Value

Let us assume that a company has spent Rs. 10 lakhs on equipment. The company estimates that the equipment’s usable life is ten years and that the equipment’s worth will be Rs.10,000 at the end of that time. As a result, the equipment’s scrap value is Rs.10,000.
Now that we have the salvage value, we can calculate the depreciation for the item. It will be Rs.10 lakhs – Rs.10,000 = Rs.9.90 lakhs.

Assumptions Regarding Depreciation & Salvage Value

When developing asset depreciation and salvage value estimations, companies consider the matching principle. The matching principle is a concept in accrual accounting that requires a corporation to record expenses in the same period that produces corresponding revenues. It will have a long, useful life if a corporation expects an asset to contribute to revenue for a long time.
Suppose a corporation is unsure of an asset’s usable life. In that case, it may predict fewer years and a greater salvage value to keep the asset on its books after total depreciation or sell it at salvage value. An accelerated depreciation technique, which deducts greater depreciation charges early, might be used by a corporation that wishes to front-load depreciation expenses. Because they think that an asset’s usage has fully matched its expenditure recognition of revenues during its useful life, many corporations adopt a salvage value of Rs.0.

Salvage Value’s Importance

It can be detrimental to a corporation if the salvage value is too high or low.
If the salvage value is too high:
Depreciation would be underestimated
The net income would be inflated
On the balance sheet, total fixed assets and retained earnings would be overstated.
If the salvage value is too low:
Higher depreciation
The amount of net income would be underestimated
On the balance sheet, total fixed assets and retained earnings would be reduced
The debt-to-equity ratio and loan collateral values would both be lower.

How to determine an asset’s salvage value

The meaning of salvage value is the resale price of an object at the end of its useful life. To assess the salvage value, you can follow these procedures.
Calculate the asset’s remaining usable life.
The amount of years the company expects to maintain an asset in service is referred to as its useful life. It’s only an estimation since the company may be able to use an item beyond its usable life without issue.
Look for similar assets in the market.
Examine the market for similar assets once the asset’s useful life is determined.
Avoid comparing an asset’s asking price to a similar asset’s asking price since, in most used-asset markets, goods will sell for less than their asking price. Examine the pricing at which the assets were sold.
Through investigation, you could indeed discover that your asset will be worthless once it has served its purpose. If that’s the case, your salvage value is 0, which may be entirely okay.
Salvage Value Formula
Here’s the salvage value formula that can help you figure out salvage value:
Salvage Value (S) = P *(1 – i)^y
Here, P is the original price of the asset
i is the depreciation rate and
y is the number of years
So, before you can calculate the scrap value, you must first estimate the depreciation rate. You also need to know how long the item will last, i.e., the asset’s useful life.
When a corporation buys an asset, it first determines the item’s salvage value. After deducting this amount from the overall cost of the assets, depreciation applies to the outstanding amount.
Let us take an example where a firm has bought an asset for Rs. 10 lakhs with a useful life of 20 years. If the depreciation rate of the asset is 20%, then the salvage value of the asset will be:
= Rs.10 lakhs (1-.20)^20
=Rs. 11,529
You can easily calculate it on excel by using the above formula. You need to input the original cost of the asset, depreciation rate, and the number of years.

Conclusion:

Salvage value is very important to many types of business and activities across the world, but it’s not always precisely defined. You may ask yourself: “So what exactly does salvage value mean?” Well, in simple terms, it’s the “selling price” of a product or item after its first use or sale. It’s quite easy to see how this works for items such as consumables, but it can also apply to things like automobiles or company machinery.
November 29, 2024
Discounted Cash Flows: Meaning, Methods and Calculation

Discounted cash flow analysis, or DCF analysis, is a way of estimating the value of an asset by looking at all of its future cash flows and discounting them back to the present day using a given discount rate.
While it’s similar to other valuation methods in many ways, it has its own unique features that are worth understanding in detail before you use it on your own deals or start teaching others how to use it.

Why Do We Use Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is a method used in finance and accounting to discount future cash flows back to their current value. This process is important because it allows us to compare investment opportunities that have different risk profiles and expected returns.
The higher the cost of capital, the higher the required return on equity; this means equity investors will demand a larger share of profit from an enterprise. The lower the cost of capital, the lower the required return on equity; this means equity investors will demand less profit from an enterprise for their investment.

How to Use DCF Analysis

When you’re trying to value a company, one helpful tool is called a DCF analysis. This method can help you estimate the worth of a company’s stock. To do a DCF analysis, you’ll need to project the company’s future cash flows and then discount them back to the present. This may seem like a lot of work, but it can be helpful in making investment decisions.

Example of DCF

The examples listed below will help you understand the DCF more easily.
Example 1 – Simple Projections
Let’s say you are thinking about starting a new business. You believe the business will be profitable, but you want to be sure. To do a DCF analysis, project the future financial performance of the business. For a simple example, let’s say the business will generate $100 in cash flow each year for the next five years.
Example 2 – Multiple Revenue Streams & Expenses
In this example, we’ll use a company with multiple revenue streams and expenses to illustrate how DCF analysis can be used. The company has three main product lines: widgets, gizmos, and gadgets. They sell their widgets for $100 each, their gizmos for $80 each, and their gadgets for $60 each.
Example 3 – Adjusting the Tax Rate
The tax rate is one of the most important inputs in a DCF analysis because it directly affects the cash flows that are being discounted. A higher tax rate means less cash available to discount, and vice versa.
Methods of DCF
There are two different methods of discounted cash flow analysis that can be used to calculate the fair value of an asset, liability, or stock. While they both use the same inputs, they produce dramatically different results, let’s understand them in detail.
Net present value- The first method is called the net present value method. To calculate the net present value, you must first figure out how much money will be paid in the future.
This includes both positive and negative cash flows. Once you have determined the current value of all future cash flows, you must then discount those cash flows by a certain rate. Finally, you must subtract the initial investment from the sum of discounted cash flows. This will give you the net present value.
Internal rate of return- The internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of a project equal to zero. The higher the IRR, the more profitable the investment. There are two different methods that can be used to calculate IRR: the trial-and-error method and the iterative method.

How to Calculate DCF?

How do you calculate Discounted Cash Flow (DCF)? It’s not that easy! Follow the steps listed below to calculate easily.

Step 1: Identify the Current Market Value
In order to calculate the DCF, you need to first identify the current market value. This can be done by looking at the company’s financial statements and using a variety of valuation methods. Once you have determined the current market value, you can move on to step two.
Step 2: Determine the Terminal Value
The terminal value is the estimated value of a company’s equity at the end of a given period. The terminal value of a cash flow stream is the amount that you think it will be worth in the future. It’s typically based on a perpetuity growth model.
Step 3: Calculate the Current Cash Flows
The current cash flow of a company is the sum of all cash inflows and outflows within a given period. To figure out how much cash you have, you’ll need to consider all sources of cash and uses of cash like investing and financing activities
Step 4: Estimate Future Growth Rates
Estimating future growth rates is tricky, and there are a number of different ways to do it. The most important thing is to be honest with yourself and use the best information you have available. One common method is to look at the historical growth rate of the company and extrapolate that into the future. Another approach is to look at the industry average growth rate and use that as a starting point.
Step 5: Calculate the Cost of Capital
The cost of capital is the minimum return that a business must earn on its investments to satisfy its owners and creditors. The cost of equity is the return that shareholders expect from investing in a company, and the cost of debt is the interest rate that lenders charge a company for borrowing money.

Conclusion

By applying the concept of discounted cash flows, an investor can measure the present value of all future cash flows. The DCF technique thus serves a critical role in the corporate finance analysis of stocks, bonds, investment properties and other interest-bearing assets.

November 29, 2024