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  • Inflationary Gap – Overview, Requirements, and Economics

    Inflationary Gap – Overview, Requirements, and Economics

    Full employment has always been a concept and assumption for many micro and macroeconomic concepts. It is a base for many theories and impacts one of the most crucial economy related factors–inflation. When a nation’s employment level rises, it increases the money supply in the market, and that results in inflation. This is the basic understanding of the equation between employment and inflation. 

    This equation sometimes leads to an inflationary gap, which is the concept we will discuss in this article. We will cover what an inflationary gap is, its components, how it impacts businesses and nations, and how to manage it; so, let’s get started.  

    What is an inflationary gap?

    An inflationary gap is a difference between the real GDP (Gross Domestic Product) and the expected GDP if there is full employment in the country. In simple words, when employment rises beyond the full employment level, inflation rises, and the difference is called the inflationary gap. 

    For example, under normal employment conditions, citizens of country A require 1000 tons of yarn. If the employment level rises beyond full employment, citizens of country A will have more money to spend, and thus, their demand for yarn will increase to 2000 tons. This will create a higher demand in the country to procure raw materials, manufacture them and sell them. 

    Because demand increases, prices of yarn will also increase. The same notion applies to other goods and services as citizens’ purchasing power increases; the end result is inflation. Thus, we can define the inflationary gap as the difference between yarn price when the requirement was 1000 tons and when the demand was 2000 tons. 

    In addition to higher demand and employment, the inflationary gap increases when the government increases its expenditure and the overall trade activities rises. The inflationary gap also impacts the business lifecycle, which we will cover soon. 

    Calculating the real Gross Domestic Product

    In order to find the inflationary gap, calculating GDP is necessary as it helps find real GDP.

    As per its definition, “GDP measures the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time”. While GDP is an important factor in knowing the economic condition of a nation, it accounts for the current time only and does not include inflation. To account for inflation in GDP, we require Real GDP. 

    Below are the formulas needed to calculate GDP and Real GDP. 

    GDP = Y = C + I + G + NX

    Whereas:

    • Y = Nominal GDP
    • C = Consumption expenditure
    • I = Investment
    • G = Government expenditure
    • NX = Net exports

    Once we receive GDP, we can calculate Real GDP as:

    Real GDP = Nominal GDP (Y) / D

    Whereas D = GDP deflator (changes in prices of goods and services)

    The difference between GDP and Real GDP is the fact that real GDP also considers inflation to reflect the changes in the price levels to provide a more realistic picture of the economic condition of a country. 

    Impact of the inflationary gap on business life cycle  

    As promised, here is how the inflationary gap impacts an economy’s business life cycle.

     

    A business cycle represents the periods of expansion and contraction in an economy. It has six phases: Expansion, peak, recession, contraction, depression, trough, and recovery. Each of these phases has a different impact on economic factors such as income, employment, profits, demand and supply, investments, and overall economic output. 

    Coming back to the inflationary gap, in the business cycle, it occurs when the expansion phase is taking place. When Real GDP goes higher than the expected GDP, it leads to more people having jobs with better pay scales. 

    As the purchasing power of people increases, their demands for goods and services accelerate, and that increases inflation, leading to an inflationary gap. The outcome is that the business cycle reaches its peak with the maximum possible growth and price levels. To combat soaring prices of goods and services, the government intervenes with measures which result in a period of recession followed by contraction, which has higher unemployment rates and lower economic output. 

    Thus, it can be said that the inflationary gap and the business cycle of an economy are highly related. 

    What does the inflationary gap mean in economics?

    Till now, we discussed the inflationary gap in layman’s terms. Let’s understand it now as a concept of economy. 

    Whereas, 

    LRAS: Long-run Aggregate Supply

    SRAS: Short-run Aggregate Supply

    AG: Aggregate Demand

    -> As seen in the chart, in the short period, the aggregate supply increases as the inflationary gap rises because businesses try to maximise their profit by providing more goods and services to benefit from the price hike. Thus, the SLRS line has an upward slope. However, this situation does not persist in the long run. 

    -> In the long run, the supply becomes dependent on the available resources in the country, which is limited. As a result, LRAS is a vertical line. 

    -> We can see that the Real GDP is the intersection of AG and SRAS. The difference between that intersection and potential GDP shown in the graph is the inflationary gap. 

    This is also related to the business cycle discussed above. Once an inflationary gap rises and reaches a peak, it results in contraction. 

    Measures to control the inflationary gap

    While the inflationary gap is associated with full employment, a persistent situation results only in higher prices and worsens the economic condition of people. In order to control it, the government generally implements measures via monetary and fiscal policies. 

    • Monetary policy: Typically, central banks make decisions on monetary policy and increase the interest rate to control the supply of money in the market. As interest rates increase, banks raise their interest for lending money, too. This results in people having less money to spend, and inflation eventually comes under control. 
    • Fiscal policy: Governments make decisions on fiscal policy. The aim of this policy is also to control the supply of money. However, this is done by increasing taxes and reducing government expenditure. 

    These measures help the government to have control over their money supply and control the levels of inflation. In India, the Reserve Bank of India is responsible for undertaking tasks related to monetary policy and deciding on interest rates. 

    The bottom line

    The inflationary gap is the difference between Real GDP and potential GDP. It increases employment in a country leading to higher purchasing power. The inflationary gap has a direct impact on the economic condition of a nation as it affects how businesses perform and people spend their money. While in the short run, the inflationary gap increases the prices of goods and services, the situation loses its momentum in the long run when the government intervenes with measures such as a fiscal and monetary policy to control the money supply.

  • What is merchant banking – Services and Examples

    What is merchant banking – Services and Examples

    There are three types of banking services based on the individuals or institutions they serve. It includes investment banking, commercial or retail banking, and merchant banking. While investment banking serves financial institutions and companies to raise capital and facilitate services on a similar line, and retail banking serves individual consumers, merchant banking provides services related to the capital requirement and cross-border trade to large financial corporations and high net worth individuals (HNIs). 

    This article will focus on what merchant banking is with examples, how it functions, its services, and how it is different from investment banking. 

    Merchant banking in India

    The concept of merchant banking emerged in the 17th-18th century in France and Italy. However, in India, this term was brought by National Grindlays Bank in 1967 when they launched a new merchant banking division. Following in the same footsteps, Citibank established its merchant banking division in 1970, and the State Bank of India did the same in 1972. Today, after more than 50 years of merchant banking in India, most public and private sector banks and many institutions have evolved to provide merchant banking services. 

    Meaning of merchant banking

    Merchant banking refers to the specific branch of banking services that serves only large multinational companies/corporations and HNIs for their financial needs. They do not cater to the requirements of the general public. Merchant banks are experts in international trade and trade finance, leading to providing high-quality and concentrated services to their large clients. A few examples of merchant banks are Goldman Sachs, Citigroup, J.P. Morgan Chase, etc.

    The typical responsibilities of merchant banking include fundraising, underwriting, lending, and financial advisory. The organizational structure of these types of banks is not that subtle. The same can be said for their profit margin as they have a very thin margin to survive on. Merchant banks receive a fee for providing banking and consultancy services to their clients. Merchant banking plays a crucial role for large companies to grow their business and raise enough funds to undertake international expansion. 

    Characteristics of merchant banking

    • They cater to large or multinational companies and HNIs
    • The decision-making process is faster. 
    • Skilled decision makers make the most of the hired staff to serve clients
    • Its organizational structure is not that bound or subtle. 
    • The focus point is the short or medium-term requirements of clients. 
    • International trade is their specialty. 
    • The liquidity ratio is quite high. 
    • These banks focus on fees or commission to make money; however, their profit margins and distribution is low. 

    How does merchant banking function?

    Merchant banks function quite distinctly from commercial banks. That is because commercial banks allow customers to deposit and withdraw funds and give out loans for personal, educational, house needs, etc., but merchant banking is limited to business entities and large corporations; the general public does not have access to it. In India, banks like SBI, ICICI, CITIBANK, etc., provide merchant banking services.

    These banks serve specific needs of large institutions for financial consulting, fundraising, lending, broking, etc., and help them assess different key parameters to sustain in current financial and economic conditions. 

    Let’s understand how a merchant bank functions with an example. If a large institute in India requires funding to expand in South Africa, merchant banking will help the institute source the funding. After analyzing the project proposal and the risks and rewards involved, the merchant bank will guide the company to raise funds via private equity, venture capital money, or loan. It depends on the requirement of the client. In return, the bank will receive a fee. 

    What are the primary services that merchant banking offers?

    Here are some of the services that merchant banking provides to its clients.

    • Cross-border transactions: This is one of the most important functions of merchant banks. It helps MNCs and HNIs to manage their global business and look after currency exchange for cross-border transactions using different means such as a letter of credit. 
    • Loan Syndication: To assist in various projects, merchant banks provide several ways for clients to get loans and fulfill their working and capital requirements. 
    • Issue Management: Merchant banking consults corporations and HNIs on matters of issue of shares like preference shares, equity shares, debentures, etc. The bank helps in the transaction of capital between businesses and investors. 
    • Leasing: Merchant banking also helps businesses lease certain assets for use for a fixed period on a suitable rental fee. This can be the lease of a factory, office space, or event space. 
    • Portfolio Management: The merchant banks will assess the assets and liabilities of the company and then propose investments in suitable instruments that will help keep their capital supply steady and also diversify the extent of their operations. They help diversify and create profits from the existing resources available to companies by guiding them on where to invest and manage risks. 
    • Project Counselling: Merchant banks play a big role in assisting companies with their management of long-term and short-term projects. The bank helps set up a plan which aligns with their financial, entrepreneurial, and social goals and ensures that the company has the right resources to execute it. 

    Corporate consulting: This service plays a major role in the success of companies that are clients of merchant banks. Merchant banks help companies diversify their operations and keep track of long-term goals to ensure their success. These consulting services extend to the matters of marketing, legal, and financial aspects.

    What is the difference between merchant banking and investment banking?

    While the goal of both these banking services is to help their clients succeed in their financial and business goals, they both are quite different. Investment banks help clients with issuing securities, underwriting services, mergers & acquisitions, and more. On the other hand, merchant banks cater to large organizations and HNIs for cross-border trade, fundraising, consultancy, lending, and more. 

    Additionally, the fee structure of both these banks differs. While merchant banks receive a fee or commission on the services they provide, investment banks have a two-stage income structure which includes fees from the clients as well as from interest and leases. There are multiple services provided by both banking services, but the primary functions remain unique and essential for their respective customers. 

    Conclusion

    Merchant banking refers to banks that cater to capital requirements and management of large companies and HNIs, in addition to helping them secure international transactions. Merchant banks receive fees or commissions for providing fundraising and consultancy services to their clients. However, their profit margin is low. Other lines of services provided by merchant banks also include loan syndication, project, and corporate consultation, leasing or properties, issue management, and portfolio management.  



  • Finance Lease or Operating Lease What is the Difference

    Finance Lease or Operating Lease What is the Difference

    In business, the lease is quite a critical concept. Be it a new small business or a startup; they generally look out for leasing options as their resources are restricted. Another reason is that owners don’t wish to invest a huge amount in acquiring assets just to support their business in the initial stages. 

    Majorly, there are two different types of leasing: financial lease and operating lease. If you are new to this concept, this article is meant to highlight the difference between a finance lease and an operating lease. So, without further ado, let’s get started. 

    Defining the Concept of Leasing

    The lease is referred to as a finance agreement wherein the owner of the asset (lessor) buys the asset and allows the asset user (lessee) to use it for a specific period against timely payments, known as lease rentals. 

    The fundamental terms and conditions of such a lease are written in a document known as the lease deed. Simply put, a lease is an alternative to purchasing an asset with borrowed or owned funds. 

    Types of Leasing

    There are two prevalent types of leasing:

    • Finance or Capital Lease

    This is a type of lease wherein the rewards and risks are transferred to the lessee along with the asset’s transfer. 

    • Operating Lease

    Contrary to the finance lease, the rewards and risks are not transferred to the lessee under the operating lease. 

    Operating Lease

    With an operating lease, you can sign an agreement to finance equipment(s) for less than their usual life. And then, at the end of the period, you can return the equipment(s) without any additional obligations. 

    Since this lease type has a shorter term, you can upgrade the asset periodically. You can even do so even when the lease is in force. 

    • The lessee gets access to the equipment for a specific time period in return for regular payments. 
    • The lessee can use the equipment for the entire term of the agreement. The regular rental payments do not equal the equipment’s total value.
    • The lessor has to bear the risk, and the plan is to return the equipment to them at the term’s end.
    • At the agreement’s end, the equipment must maintain a residual value, which is generally predicted at the start of the lease. 
    • Equipment payments could be considered in the regular payments. 

    Finance Lease

    A finance lease is generally used to purchase equipment(s) for a significant part of their useful lie. Under this type, at the end of the lease term, you get the ownership of the equipment(s) by providing a viable offer to buy the asset. 

    Generally, this ‘offer’ is referred to as the balloon amount. With this lease, the lessee will not have to bear a high upfront cost when buying the asset outright. Also:

    • The lessee will be liable for every risk, and the asset will be put on the balance sheet. 
    • The lessor gets to keep the ownership. However, the lessee gets to use the asset exclusively in regard to the agreement. 
    • During the lease period, the lessee pays the rental payments. They can pay a balloon payment at the end of the period (if required).
    • Usually, the agreement’s term is for the useful lifetime of the asset. 

    This lease type is non-cancellable in nature. However, it can only be cancelled if:

    • The lessor allows the cancellation
    • There is any contingent event happening
    • The lessee has entered into a lease agreement with the lessor for the similar asset

    In case the lessee cancels the agreement o this lease, the lessee will bear any type of losses that the lessor will have to incur. 

    Difference Between Finance Lease and Operating Lease

    To understand the difference between a finance lease and an operating lease thoroughly, refer to the table mentioned below:

    Factors
    Finance Lease
    Operating Lease
    Title
    At the end of the lease’s term, the asset’s ownership gets transferred to the lessee.
    Asset ownership stays with the lessor throughout the term and even after it.
    Residual / Balloon Amount
    There is a residual / balloon option that the lessee can take to buy the asset at a certain price.
    The lessee doesn’t have an option of residual / balloon amount.
    Administration & Running Costs
    Administration and running costs are not generally included in this lease type. This means there can be huge price and administration fluctuation for the lessee.
    All the running costs, such as insurance, registration, servicing, and more, get included in the agreement within the set term.
    Accounting Effect
    This is regarded as a loan. Since the lessee has the ownership, the asset gets a place on the balance sheet.
    This is regarded as rent. Thus, the lease payments are merely operating expenses; thus, the asset doesn’t get any place on the balance sheet.
    Lease Term
    The term of the lease is basically the significant economic life of the equipment that has been leased.
    The term of the lease can extend to less than 75% of the showcased useful life of the asset.
    Cancellation of the Lease
    It can be cancelled only on certain events.
    It can be done at any time.
    Tax Benefits
    The lessee gets a chance to claim the depreciation and interest.
    The lease payment is regarded as an expenditure; thus, the lessee cannot claim any depreciation.
    Example
    Office building, land, machinery, plan, and more.
    Coffee dispensers, laptops, computers, projectors, and more

    Conclusion

    And there you have it! The answer depends on your situation if you are considering which option would be the best, operating or finance lease. An operating lease agreement can decrease user administration and let them hand the asset back at the end while paying monthly repayment(s). 

    Such an option is generally beneficial for companies running short on funds. On the other hand, a finance lease has more administration requirements. Based on the type of asset, you may have to face resale risk as you will have to ensure that the balloon amount is met at the end of the lease term. 

  • Leverage Ratio: Definition, Formula & Calculation

    Leverage Ratio: Definition, Formula & Calculation

    Obtaining capital is a challenging task for any firm. When it comes to parting with their funds, every lender has its norms, hopes, and doubts.

    In the middle of that journey, a firm must understand several indicators and impediments, one of which is called leverage ratio.

    We will discuss the leverage ratio in this article, along with its meaning and how to compute it.

    What is Leverage Ratio?

    The Leverage ratio shows how much debt an organization has taken on to finance its assets and commercial operations.

    A firm that uses debt to finance its assets and operations will have a higher financial leverage ratio. This occurrence is usually a red flag for potential investors that the company might not be a safe investment.

    It could imply erratic earnings, a long wait before shareholders receive a significant return, or even the imminent insolvency of the company.

    Creditors also use these measures to decide whether to grant credit to firms. A corporation with a high leverage ratio is more likely to default on loans because most of its cash flow is toward debt repayment. 

    A company with a stable income stream and a lower financial leverage ratio is typically more financially prudent. On the other hand, a lower financial leverage ratio signals to potential investors and lenders that a business poses little danger and is probably not worth investing in.Now after understanding the leverage ratio meaning, let’s move on to understanding the ideal leverage ratios.

    What is the Ideal Leverage Ratio?

    Different levels of leverage are ideal depending on the ratio you’re discussing. Higher numbers are preferable for some ratios, like the interest coverage ratio. However, smaller ratios typically represent organizations that are functioning well.

    For instance, you want your debt-to-equity ratio, perhaps the most important financial leverage ratio, to be lower than 1. A ratio of 0.1 signifies that a company’s debt to equity is almost zero, and a ratio of 1 shows that a business’s debt and equity are equivalent. A highly good ratio will generally fall between 0.1 and 0.5.

    Types Of the Leverage Ratio

    There are three different types of leverage ratios. Each ratio belongs to one of the groups below. And each group serves a purpose and demonstrates different financial information about a business.

    Operating Leverage

    While examining operating leverage, you analyze a business’s variable and fixed costs. An organization with a high operating leverage ratio likely has a high fixed expense level. This typically denotes a capital-intensive business.

    High demand for a particular item might have a favorable effect on a capital-intensive business. Sales increase, as a result, of increasing earnings. The price the business may charge rises with demand, improving return on investment.

    If the reverse situation were to occur, it might be disastrous. Lower earnings might not meet the fixed costs if the demand for the item declines.

    Financial Leverage

    The amount of borrowing a company uses to finance its operations is compared to financial leverage ratios. A corporation can experience several benefits when it uses borrowed capital rather than equity stock.

    This only occurs if the company’s profit growth outpaces the loan cost as interest. A company may go bankrupt if it depends too heavily on external financing. 

    Combined Leverage

    As its name suggests, these ratios are created by combining operating and financial leverage. Looking at a company’s financial statements often reveals combined leverage.

    Operating leverage is disclosed in the income statement, and financial leverage is disclosed on the balance sheet. It is possible to evaluate combined leverage by looking at them together. 

    How do Businesses Create Leverage?

    There are several ways for a business to create leverage. The company’s sector determines how to create leverage in all of these situations. 

    The following are some ways a business can use to generate leverage:

    • When a company directly purchases assets without raising debt, it increases its capital without increasing debt, which increases leverage.
    • When a company purchases assets using debt, it increases its leverage.
    • When a credit is taken by the businesses on its reputation to pay the credit on time.
    • A company that borrows money to acquire another business increases its leverage. 

    Common Leverage Ratios

    Financial experts, traders, or creditors may take into account a variety of different leverage ratios. Here are some of the most popular leverage ratios:

    Debt to Equity Ratio

    A high debt-to-equity ratio often indicates that a company has used debt to fund the majority of its expansion. As a result, earnings may fluctuate depending on the industry. This is brought on by the increased interest costs incurred each month. If this isn’t controlled, it may cause a corporation to default.

    A debt-to-equity ratio of 2 or above is seen as dangerous. Nevertheless, this number fluctuates between industries and the nature of business. It’s anticipated that some companies would borrow more money to operate. For instance, Capital intensive corporations like infrastructure companies borrow huge sum of money for their operations as their returns grow in the long term.

                         Debt-to-Equity Ratio = Total Debt / Total Equity

    Debt to EBITDA Ratio

    EBITDA or Earnings Before Interest, Taxes, Depreciation, and Amortization, is a useful indicator for assessing a business’s financial success and capacity to provide cash flow for its shareholders.

    This leverage ratio examines the ability of a business to pay off its debt. It is frequently employed by banking or credit organizations. These institutions utilize it because it predicts the probability of loan default.

    Debt-to-EBITDA Ratio = Total Debt / EBITDA

    This ratio is expressed by figuring out how many years it will take EBITDA to pay off any debt. The majority of sectors prefer to keep this ratio below 3. If so, it might start to seem a little concerning.

    But there is another method to state this ratio. Costs associated with exploration may also be included. Companies do so to standardize various accounting methods for these expenses. This method may be employed, depending on the business.

    Debt to Capital Ratio

    Being one of the more useful leverage ratios, it concentrates on a company’s debt obligations and contrasts them with the entire capital base of the business. This percentage includes all short-term and long-term debts. Both debt and shareholder’s equity are considered to be capital.   

                     Debt-to-Capital Ratio = Total Debt / (Total Equity + Total Debt)

    It is one of the most popular methods of analyzing a company’s financial structure, as it examines the company’s financial strategy as well. It would be best to examine a company’s peers while examining the debt-to-capital ratio. 

    Companies with larger debt-to-capital ratios run more risks. This is due to the potential effect debt may have on their business. A lower ratio denotes more monetary stability.

    Coverage ratios and their uses with Leverage ratios

    Leverage ratios are helpful but can also be used with other ratios. You may get a more realistic image of a firm by combining them with coverage ratios. Measures of a company’s capacity to meet its financial obligations are called coverage ratios. Let’s look at a couple of them.

    Interest Coverage Ratio

    This ratio is focused on a company’s capacity to pay interest. Debt interest is one of the biggest problems when taking on debt. You are obligated to repay charges in addition to the principal loan amount. 

    A typical leverage ratio, however, says little about the company’s capacity to pay back debts. The interest coverage ratio helps to know about that.

    It demonstrates the business’s capacity to repay debts and interest. The ratio should be at least 3, while the exact value varies by industry. 

          Interest Coverage Ratio = Operating Income / Interest Expense

    Fixed Charge Coverage Ratio

    The Fixed charge coverage ratio examines a business’s cash flow about the interest in its long-term commitments.

    Pre-tax income is utilized since taxes are deducted. This indicates that the absolute number of profits may be applied to the interest payment at some future date. Similar to the interest coverage ratio, the better the ratio, the higher the number.

    Fixed-Charge Coverage Ratio = (Earnings Before Interest and Taxes + Fixed Charges Before Tax) / (Fixed Charges Before Tax + Interest)

    Asset coverage Ratio

    The asset coverage ratio determines how well a business can pay off its debt by liquidating its assets. 

    It deals with all the aggregated assets of the business, not only the liquid ones. It is the most effective technique for stakeholders to assess a company’s solvency.

    Asset Coverage Ratio = ((Assets – Intangible Assets) – (Current Liabilities – Short-term Debt)) / Total Debt

    Things like goodwill are regarded as intangible assets. Obligations that are due within a year are categorized as current liabilities. The same period is used for short-term debt as well. 

    The better a corporation can pay off its debt, the higher the ratio. As a result, a corporation will find it harder to pay off its debt if the ratio is smaller.

    The Risks of High Leverage

    Recognizing the dangers associated with excessive leverage relies on the kind of leverage being examined. Earnings tend to be multiplied through leverage, but the peril also increases. Though companies aim for a high financial and operating leverage, possessing both may be a little riskier for a company.

    A corporation with high operating leverage is likely not making as many sales as it should. Additionally, it indicates that despite low sales volume, businesses face substantial costs. As a result, less money is available to pay for other expenses. Additionally, it causes negative earnings, which no corporation wants.

    When ROI is insufficient to pay the interest on loans, there is high financial leverage. This lowers a company’s earnings per share as well as its competitiveness. The coexistence of these two ratios indicates impending default. 

    Few businesses are equipped to handle both. They aren’t inherently harmful on their own. They are a formula for disaster when combined.

    Reference

  • Here’s All You Need to Know about Current Ratio

    Here’s All You Need to Know about Current Ratio

    Liquidity ratios measure a company’s ability to settle its short-term obligations. The current ratio is one such ratio. This article explores the current ratio and its practicality.

    While determining a company’s solvency, you can use many liquidity ratios. The current ratio is one of them. The current ratio evaluates the all-around financial health of a company. Here is how to calculate and use it.

    Current ratio

    One of the liquidity ratios, the current ratio, measures the ability of a company to pay its short-term obligations (obligations to be paid within one year). It helps investors and analysts determine ways to maximize its current assets on its balance sheet to suffice its current debt and other short-term obligations.

    A current ratio that conforms to the industry average or is somewhat higher than the industry average is usually considered acceptable. But, a current ratio lower than the industry average indicates a higher risk of default in most cases.

    The current ratio is called current because it takes all current assets and current liabilities into account. It is also denoted as the working capital ratio because when a company has more current assets than its current liabilities, it also suggests that it has sufficient working capital for its day-to-day operations.

    Calculating the current ratio of a company

    While calculating the current ratio, a company’s current assets are compared to its current liabilities.

    Current assets are to be consumed or converted to cash within 1 year. These assets may include cash, bank deposit, marketable securities, accounts receivable, inventory, prepaid expenses, short-term loans & advances, and other current assets (OCA). On the other hand, current liabilities will be paid in 1 year. These liabilities may include accounts payable, short-term loans, cash credit, overdraft, advance from the customer, outstanding expenses (rent, salary, wages, etc.), and long-term loan instalments.

    Current Ratio = Current liabilities/Current assets

    Current ratio analysis of a company

    Current ratio analysis is conducted to determine the liquidity of a company. Subsequently, the current ratio analysis results can be considered to give loans or make investment decisions. Also, the current ratio can decide if a company should be shut down. 

    A company having a current ratio lower than 1.33 lacks capital on hand to meet its short-term obligations if all have to be paid at once. In other words, it is likely to face problems in paying its short-term loans and obligations. A current ratio greater than 1.33 suggests that the company has sufficient financial resources to maintain its solvency in the short term. In short, it can settle its debt and other short-term obligations comfortably.

    A current ratio under 1.33 suggests that the company’s debts to be paid in a year or less are much more than its current assets.

    The ideal ratio of current assets and current liabilities

    A decent current ratio depends on the company’s industry and its historical performance. As a thumb rule, a current ratio of more than 1.33 is considered an ideal current ratio as it indicates ample liquidity. All industries in India reported a median current ratio of 1.94 in 2020.

    Here we can take an example of Tata Consultancy Services.



    Tata Consultancy Services carries a current ratio of 2.92. This means that it has ₹ 2.92 of current assets for every ₹ 1.00 of current liabilities. So, Tata Consultancy Services is substantially capable of paying its obligations as it has a larger proportion of short-term assets compared to its short-term liabilities.

    Effects of an imbalanced current ratio of a company

    If current liabilities exceed current assets, the current ratio will be less than 1.33. A current ratio of less than 1.33 indicates that the company may have problems meeting its short-term obligations. In other words, the company has less than 1.00₹ of current assets for every 1.00₹ of current liabilities. 

    This can be understood with the help of an example. 

     

    Vodafone Idea has a current ratio of 0.29. This means that it has ₹ 0.29 of current assets for every 1.00₹ of current liabilities. So, Vodafone Idea may not be capable of meeting its obligations as it has a much smaller proportion of short-term assets compared to its short-term liabilities.

    As the current ratio is the ratio of current liabilities to current assets, when a company’s current ratio is imbalanced, i.e., less than 1.33, this means the company has relatively more liabilities than its assets. Some possible effects could be:

    • The company may face problems in the short term for paying its short-term obligations, such as salary to workers, office rent, etc.
    • The company may have to raise additional financing, such as taking out a loan.
    • The company becomes more likely to face liquidity risk.
    • The company may have to take long-term funds in equity and/or long-term debt.

    The more current assets you have, the better the chances that the company will settle its current liabilities.

    The Bottomline

    If the current ratio is higher, the company is more capable of paying its obligations because it has a larger proportion of short-term assets than its short-term liabilities. The current ratio is a useful measure of a company’s short-term solvency. It also provides more valuable insight if calculated regularly over several periods.

  • Book Value Per Common Share – BVPS

    Book Value Per Common Share – BVPS

    What is the meaning of BVPS?

    Book Value Per Share (BVPS) is calculated by dividing the total equity by the total count of outstanding shares. The book value per share is the minimum invested capital per share that a corporation may have.

    Importance of BVPS:

    To calculate a company’s BVPS, we divide the total equity by the total number of shares in circulation.

    The company’s net value of a company is equal to its book value of equity per share (total assets less total liabilities). The stock is undervalued if its book value per share exceeds its market rate. The stock market investors will utilize book value per share to assess a firm’s share price.

    When calculating BVPS, it is essential to know the following:

    Analyzing the market rate of a company’s stock to its book value per share (BVPS) might help investors determine if the stock is underpriced. There is an undervaluation of stock in the market, whether its book value per share (BVPS) is greater than its current share price. When the company’s BVPS rises, investors will see their stocks as increasingly valuable and buy more.

    BVPS is the amount investors would get if the company was liquidated, sold all of those tangible items or assets, and all the obligations paid in full. A corporation’s book value is based on its assets’ previous costs. In contrast, the market value is a more appropriate floor rate.

    A proprietor might earn a risk-free profit by purchasing a firm and liquidating its assets if its share value dropped less than its BVPS. The financial statement is insolvent when obligations surpass assets, as with a negative book value.

    Formula:

    Following is the book value per share formula:

    BVPS: – Total Equity – Preferred Equity / Total Share Outstanding

    Illustration of Book Value per Share:

    For illustration purposes, let’s say that there are a million shares of Adani Ports’ common shares, and the company’s equity capital is $15 million. Or we can say the BVPS is $15 per share ($15 million divided by 1 million shares). Gains in Adani Ports’ common equity result from the company’s ability to grow its profit level and reinvest those funds in the form of either new assets or reduced debts.

    When a corporation earns $800,000 and invests $300,000 in new assets, then both common equity plus BVPS will rise. Equity in Adani would increase by $400,000, provided it used its profits to pay down debts.

    Further, buying back shares from investors is another strategy for boosting BVPS. Several businesses reinvest their profits in the form of share repurchase programs. In the Adani Ports scenario, it is assumed that 11,00,000 shares have been issued and that the company has repurchased 400,000 shares. At an equity capital level of $15 million, BVPS would rise per share. Consequently, by buying back their shares, companies may boost their BVPS by increasing their asset pile and decreasing their debt load.

    Outlining: What is Book Value Per Share (BVPS):

    BVPS is the amount that shareholders would get if the company was closed, all of its tangible assets were sold, and all its obligations were paid in full. However, its worth resides in the notion that stockholders use it to determine whether the stock value is low relative to the company’s value. The stock is undervalued if its book value of share is more than its current share price (MVPS).

    How can businesses boost their BVPS?

    In the case of boosting BVPS, a firm may utilize some of its profits to acquire assets that add to its common equity. Another option is to enhance common equity and BVPS by using profits to pay down debt. Many businesses utilize their profit to buy back shares of stock from their owners, which boosts the BVPS.

    Specific care required:

    The majority of publicly traded corporations meet their capital requirements using a mix of debt and stock market funding. Businesses buy debt via the issuance of interest-bearing corporate debt and the receipt of bank loans. An initial public offering is a standard method for raising equity money (IPO). 

    In some instances, businesses raise equity funding via means other than initial public offerings (IPOs), including follow-on issuance, rights offerings, and secondary market sales of shares. Interest must be paid on loans and bonds and repay the principal. 

    On the other hand, equity financing imposes no such duty on the business. Dividends and appreciation in stock value are the two significant goals of equity owners.

    Lenders who fund businesses are more concerned with how much value there is in the company’s assets. When it comes down to it, repayment is their first concern. In a nutshell, the amount of money a business may borrow from its creditors is established by looking at the book value of the firm’s assets.  The company’s capacity to repay a loan over a certain period might be gauged by looking at its book value.

    However, investors and traders care more about making a profit when purchasing or trading stock. Shareholders may better understand whether a company is overpriced, reasonably valued, or undervalued by comparing the market price to the book value.

    Difference between BVPS and MVPS

    The market value per share is a forward-looking indicator that takes into consideration a firm’s future earning capability. In contrast, the book value per share relies on past expenses. The market value of a firm’s stock ought to rise in tandem with the pace of its predicted profitability or development. 

    The market price per share is the current price of a particular share of a publicly listed company. Pricing per share in the market, in contrast to BVPS, varies according to the demand & supply in the economy.

    Conclusion

    Book value and market value are both valuable indicators of a company’s true worth. When evaluating a stock’s fair value in light of its liabilities, assets, including earnings potential, it might be helpful to compare it to its historical average. Understanding the benefits and drawbacks of the book, as well as market values, is essential for making sound financial decisions, as is the case with every monetary metric. It is up to the shareholder to decide whether to utilize book value, market value, or another metric when evaluating a firm.

    The market price per share is the current price of a particular share of a publicly listed company. Pricing per share in the market, in contrast to BVPS, varies according to the demand & supply in the economy.

    Reference

  • Internal Rate of Return: Definition, Formula, and Calculation

    Internal Rate of Return: Definition, Formula, and Calculation

    With uncertainty among investors thanks to market volatility, they are looking for bonds as safe investment options. Thus, Kotak Cherry discounted Kogta Financial India’s secured non-convertible debentures between 1 and 7 July at a 10% Internal Rate of Return (IRR). After the offer period, the rates dropped to 9.5%. These bonds are likely to offer higher returns than fixed deposits and lower risk than equities.

    Like these bonds, an investment can reward its investors, provided that just the right investment decision is made. Among the many factors to analyze an investment avenue is its Internal Rate Of Return (IRR). IRR estimates the profitability of potential investments. 

    What Is The Internal Rate Of Return?

    The internal rate of return (IRR) determines the profitability of potential investments. In a discounted cash flow analysis, IRR is a discount rate that makes all cash flows’ net present value (NPV) equal to zero.

    In general, the higher the IRR, the more favorable an investment is. IRR is consistent across investment avenues and may thus be used to rank different prospective investments or projects based on their profitability.

    When comparing investment choices with other similar traits, the investment with the highest IRR is likely to be regarded as the best.

    Impact Of IRR On Investment Decisions

    You can consider the IRR of your potential investments to make an informed decision. An IRR impacts investment decisions in the following ways:

    1. A common use of IRR is to analyze investment returns. In most situations, the advertised return assumes that any interest or dividend payments be reinvested back into the investment. 

    But what if you don’t reinvest dividends but take them as income when paid? 

    Are dividends not assumed to be reinvested and paid out? 

    What is the assumed return on the cash if dividends not reinvested are paid in cash?

    IRR particularly impacts investment decisions about instruments, especially having complicated cash flows.

    1. IRR can impact your financial decisions, such as during insurance policy evaluation. Insurance policies with the same premiums and a high IRR are widely seen as being more desirable. This way, you’re more likely to choose a policy with a higher IRR.
    2. One scenario for IRR in capital planning is to evaluate what is more profitable — a new operational setup or an existing operation expansion. For example, a beverage company may use IRR to decide whether to introduce a new flavor or enhance an existing drink. While both could bring profits to the beverage company, the more profitable decision as prescribed by IRR will be chosen.
    3. If a company spends significant resources repurchasing its own shares, a higher IRR can convince the company that its own stocks are a superior investment to creating new products or acquiring other small startups.

    Example of IRR

    Consider the following scenario: you contribute Rs.3 lakh to the EPF each year apart from the maximum Rs.2.5 lakh. Assume that the interest rate will be 8%, and your marginal tax rate will be 30%.

    So, each year, you will earn 8% of your accumulated amount and pay 30% of that amount in income tax.

    (For the sake of convenience, consider the complete annual inflow and tax as one event. Note that this does NOT happen in reality!)

    If Rs.3 lakh were deposited into the nontaxable EPF account each year for 20 years, it would have risen to Rs.1.48 crore. However, given the criteria, it will only accumulate to Rs.1.12 crore in the taxable account. The continuous taxation makes the true post-tax internal rate of return to be just 5.62%. So, it’s a deposit with a very long lock-in period and a return of 5.62% in a year. 

    A good deal? Quite possibly NO.

    Why? Because there are ample investment opportunities in the market better than the above.

    Rather than a taxable EPF account, why not invest in an equity fund?

    Consider another example of an equity fund. In this situation, the same inflow would result in Rs.1.39 crore rather than Rs.1.12 crore. Moreover, it will only be taxed once, at a rate of 10%, when it is withdrawn. So, the true internal rate of return here would be 7.48%. 

    Comparing both IRRs, it is clear that an equity fund is better than an EPF.

    What Is The Formula To Calculate IRR?

    Note that IRR estimates use the same formula as NPV calculations. IRR does not represent the worth of an investment. The annual return is what brings the NPV to zero.

    The formula of IRR is as follows:

    In the formula, Ct denotes net cash inflow during the period t, C0 denotes total initial investment cost, IRR denotes the internal rate of return, and t denotes the number of time periods.

    How To Calculate IRR?

    Let’s understand how to calculate IRR with the help of an example.

    Suppose that a company wants to proceed with either launching a new product or expanding a part of its business. Let the new product launch be Project A, and the business expansion be Project B.

    Project A

    Initial Investment = 2,50,000₹

    Year one = 85,000₹

    Year two = 95,000₹

    Year three = 80,000₹

    Year four = 70,000₹

    Project B

    Initial Investment = 1,00,000₹

    Year one = 50,000₹

    Year two = 35,000₹

    Year three = 25,000₹

    Year four = 20,000₹

    To assess the profitability, the company must calculate the IRR for each project.

    Keep the NPV to zero and solve for the IRRs using the formula. Furthermore, the initial investment is always negative because it represents an outflow.

    Project A

    0 = (−2,50,000) + 85,000 ÷ (1 + IRR)1 + 95,000 ÷ (1 + IRR)2 + 80,000 ÷ (1 + IRR)3 + 70,000 ÷ (1 + IRR)4

    Thus, IRR for Project A is 12.6%.

    Project B

    0 = (−1,00,000) + 500 ÷ (1 + IRR)1 + 35,000 ÷ (1 + IRR)2 + 25,000 ÷ (1 + IRR)3 + 20,000 ÷ (1 + IRR)4

    Thus, IRR for Project B is 13.72%.

    Thus, proceeding with the business expansion would be a more profitable option for the company.

    Financial Takeaways

    IRR is a popular statistic for assessing a project’s annual return or the annual growth rate of an investment. But, it is not sufficient to be used alone. If used with other metrics, it may lead to a more accurate prediction. Furthermore, if an investor can get a slightly lower IRR from an investment that is significantly less risky or consumes less time, they may gladly proceed with the lower-IRR project.

    FAQs

    What does IRR measure?

    IRR measures the expected growth rate of an investment.

    Can IRR be negative?

    Yes, when the total cash flow in investment is less than the initial investment, IRR is negative. In such cases, the investors receive negative returns on their investments.

    Why is IRR important?

    IRR is important because it evaluates the profitability of a potential project or investment.

  • Prudence Concept in Accounting

    Prudence Concept in Accounting

    Introduction

    In our daily life, prudence is essential to effective money management. We continually assess our financial choices to see if they are judicious and well-planned. 

    Similarly, the concept of “prudence” in accounting assists organizations in being cost-conscious and avoiding capital investments that might endanger their cash flow. 

    This guide will shed detailed insights on what is prudence,  its advantages, limitations, examples, etc. 

    Let’s check it out!  

    Explanation of Prudence in Accounting

    The “prudence” accounting practice encompasses more than being financially judicious. It ensures the company is not overvalued by preventing the income and assets from being exaggerated in its reporting.

    In contrast to conventional accounting, the prudence concept expects losses but does not account for them. There is a chance that the company is indeed undervalued as a result. This might not make the shareholders happy. 

    However, it provides a more accurate picture of the company’s financial health than more optimistic estimates and ensures that the company will always be able to pay its bills. 

    The prudence principle is incorporated into numerous accounting standards under Generally Accepted Accounting Principles, such as the necessity to write down fixed assets when their fair value is less than their book value but to refrain from doing so when the reverse condition applies.

    However, the International Financial Reporting Standards (IFRS) allow for the upward revaluation of fixed assets. Therefore, they don’t strictly adhere to the principle of prudence.  

    Applications of Prudence Concept in Accounting

    The prudence concept in accounting guarantees that the financial statements accurately and fairly reflect the company’s financial status.

    Recognized Revenues

    It is easy to feel overconfident about the financial stability of your firm if you focus too much on your top line and too little on your bottom line. Prudent accounting prevents this by distinguishing how revenues are recognized.

    Revenues are only acknowledged when certain, not when they are likely or anticipated. Businesses typically release their anticipated revenues from items like a recently closed contract and their actual revenue and expenses. 

    This accounting method only recognizes money that is present in the company’s bank account. This makes companies conscious that they only deal with real money, not fictional money. 

    Recognized expenses

    The Prudence concept also necessitates thorough and accurate cost reporting. They cannot ever be overstated to increase your revenue artificially. Additionally, good judgment requires that expenses be noted before funds are transferred from your account. When an expense is anticipated, it must be included in the company’s books immediately. This is referred to as an expense provision. 

    Recognition of Assets

    Prudence avoids asset overvaluation. As a result, the asset’s value should be close to its realization cost.

    For instance, inventory may be valued at a lower cost or net realizable value, and provisions for bad and shaky debt are created and subtracted from the total amount of trade receivables. 

    Recognition of Liabilities

    A prudent person would not underestimate liabilities. As a result, liabilities will always be worth more than they should. For instance, workers are preparing to retire. The linked expense must be recognized along with the corresponding liability. 

    Examples of Prudence Concept in Accounting

    1. A company has a policy of paying cash to employees for unused vacation time at the end of the year. The company must forecast how many leaves will be there. Prudence ensures that the company recognizes the expenses and makes the required provisions.
    2. Working with a customer on a trade arrangement: The chance of the agreement coming into being is very high. Even if the agreement is ultimately reached, caution will ensure that the company doesn’t report income until it sells the items covered by the agreement. Additionally, revenue realization needs to be guaranteed.
    3. Trade receivables represent an organization’s anticipated annual revenue. But are all debtors prompt in making their payments? No, you can never predict which debtor will shortly declare bankruptcy. Therefore, being prudent ensures that the company allows for substandard and dubious loans.
    4. The Internal Accounting Standards mandate that inventory is valued at the lowest cost or net realization value. If the total cost up to this point is $20,000, it can be sold for $33,000 after incurring fees of $8,000 in the process. Therefore, the cost is $ 20000, while the net realizable value is $ 25000 (33000 -8000). The inventory of the two values is 20,000 dollars which are low enough. 
    5. A business has investments worth $120,000. (Cost). It is available for sale in the market for $150,000. However, they cannot display the investments at $150,000 by recognizing the $30,000 profit. One cannot overestimate the assets. Even still, just $120,000 will be offered for the investments. 

    So above are prudence concept examples that might help you give a better picture of the concept in your mind.

    Advantages and Disadvantages of Prudence Concept in Accounting

    1. Businesses benefit from prudent behavior since it keeps them from spending cash that hasn’t yet been received. By taking this action, you may avoid a potential cash flow disaster and halt a debt spiral. But this accounting approach also has some significant drawbacks.

      Let’s examine the benefits and drawbacks of the Prudence concept in Accounting:

    Advantages

    • It guarantees accurate cost measurement.
    • It assures accuracy in calculating the organization’s liabilities.
    • Prudential accounting is the foundation of accounting on which the financial statements are built.
    • It aids in providing a more accurate depiction of the financial statement’s costs, assets, liabilities, and revenue. 
    • It aids in the early identification of costs and liabilities, thus helping the organization foresee the future and prepare for it now.
    • Lower profits contribute to boosting cash reserves.
    • Income tax regulations permit deductions for business expenses, which lowers the tax obligation. 
    • It can be compared to other reporting techniques.   

    Disadvantages

    • The Prudence concept makes it difficult for a company to register the revenue due to doubt in the organization’s capacity to collect money.
    • Other accounting practices advise writing off the provision in a particular year when it is no longer necessary. This increases the income side and, in some years, the tax obligation.
    • Caution is recommended just on the liabilities and expenses side.
    • Provisions are a subject of management discretion. Hence they could show excess provisions even if they are not needed.

    Conclusion

    The principle of prudence makes sure that you pay off your debts in full before anything else, notwithstanding hopes for the revenue side. It, therefore, ensures businesses have enough money at the end of each year. 

    Moreover, prudence is essential when final accounts are completed since it can change the entire financial picture. Therefore, you see your best judgment when determining how and when to record an accounting transaction in the end. 

    Reference link :

  • The Meaning and Calculation of Return on Assets

    The Meaning and Calculation of Return on Assets

    We all have made investments in assets once in our lifetime, may it be gold or electronics. And once we made those investments, we would have also expected some return from them. 

    This return would be an increase in value, efficiency, or end-of-the-day happiness received through using the asset. But this is in our day-to-day lives. 

    So, what about the companies and industries that invest in assets?

    The industry term for the return received through the investment in assets is known as Return on Assets. In this blog, we’ll dive into Return on Assets and in detail understand different topics like the formula to calculate ROA, differences between ROA and ROE (Return on Equity), and much more.

    ROA is a financial ratio that reveals how profitable a company is, based on total assets. We can also know how efficiently a company utilizes its assets to generate profit through its ROA.  

    ROA – Key Points

    • ROA is a financial metric to analyze a company’s ability to use assets and generate profit.
    • Higher the ROA measure, the better the performance of a company.
    • Net income divided by the total assets of a company gives its ROA.
    • It is best to compare the ROA of a company in one industry to the ROA of another in the same industry as the metrics used to value the assets will remain the same.
    • It is said that ROA factors in the debt of a company, but ROE doesn’t.

    ROA as a comparative measure

    Efficiency is a core metric for analyzing the performance of any business. Comparing profits to revenue may give out the performances of companies, but comparing profits to assets used by the companies gives out the practicality of that company’s existence. 

    For any public company, ROA can differ substantially, and it can be dependent on the industry in which it operates. When using ROA as a comparative measure, it’s important to ensure the comparative figures are from the same industry. 

    ROA ratio provides the investors with a view of how effectively a company converts its investments on assets to net income. A company is said to be able to earn more income through its investments when the ROA ratio is high.

    Calculation of ROA

    ROA of a company is calculated by using the total assets in the company to divide the net income. It can be expressed as Net Income/Total Assets.

    For example, two companies, A and B, invest in assets like plant and machinery, equipment, and more in the automobile industry. A’s investment sums up to $1500, and B’s investment comes to $13500. End of the year, the net income earned by both companies is $180 and $150, respectively.

    ROA of the companies using the return on assets ratio formula:

    A = 180/1600 = 11%

    B = 1100/13500 = 8%

    We can say that B has a more valuable business through the return on total assets formula. Still, A has an efficient business because it’s not just about earning profit but also about a company’s long-term existence.

    Effective ROA Ratio

    Once we calculate the return on assets ratio, how do we know where the company stands in terms of efficiency?

    Industry experts say the ROA ratio of a company above 5% is considered good, and a ratio above 20% is considered excellent. But this is in general terms. When looking at ROA percentage, investors should also consider the company’s industry, market, customer base, and other factors that affect investment decisions in a company’s assets.

    ROA as a Financial Ratio

    A higher ROA may indicate a company is generating more profit against the total assets. On the contrary, a lower ROA means lower profits against the total assets. 

    Companies with higher ROAs tend to experience greater profits, while those with declining ROAs may struggle financially due to poor investment decisions. 

    As ROA also considers a company’s debt, a higher ROA in one year may say low debt, and a lower ROA in the next year may mean the company’s debt has increased.  

    Investing Decisions and ROA

    ROA is considered one of the very useful financial ratios to analyze a company’s performance. Investors can use the return of assets interpretation to find stock opportunities because the ROA shows a company’s efficiency in using its assets to generate profits. 

    Comparing the ROAs of two companies can give the investor an idea of who will sustain longer in the advancing market.

    Though ROA is considered a vital metric to compare companies, investors should also consider various other factors that affect a company’s performance. ROA alone may not give the perfect analysis of a company’s performance.

    Different industries and their average ROA

    Industry
    Average ROA
    Healthcare
    7.97%
    Transporation
    6.91%
    Consulting Services
    51.43%
    Retail
    7.20%
    Grocery Stores
    33.50%
    Tobacco
    15.89%

    ROA vs. ROE

    Though ROE measures a company’s efficiency in utilizing its resources, a major difference between ROA and ROE is how a company’s debt affects the ratios.

    ROA considers total assets, including the Capital of the company. This Capital figure would include any debt the company borrows. So ROA factor provides a view of how leveraged a company is.

    ROE, on the other hand, considers a company’s equity, which excludes any liability. Thus, the company’s debt is out of the scene.

    For any company, debt plays a major role. To analyze a company’s efficiency, we have to consider its debt and how well it can manage the debt with the net income, it has earned.

    Issues with using ROA as an industry measure

    A major setback in using ROA as an industry measure to compare companies is that the ROA ratio cannot be used across industries. 

    The ratio is more or less very specific to one industry, and we cannot compare a company’s ROA in one industry to that of another company in another industry. 

    The reason for this is those different companies have different asset bases. For example, the asset base of the clothing industry is different from that of the automobile industry. Sometimes recording the assets in the company’s books at historical costs rather than market value may lead to inaccurate analysis.  

    The Bottomline

    ROA becomes an important financial metric for analyzing the efficiency and performance of a company in any industry. Though it illustrates a company’s net income as a percentage of total assets, it is not the only appropriate metric. 

    All investors should look at the overall picture when they compare different companies.

  • 3 Things You Must Know About Net Profit in Income Statement

    3 Things You Must Know About Net Profit in Income Statement

    All you need to know about the income statement!

    The income statement is one of the three significant financial statements for a business to know the revenue and expenditure aspects. It basically describes how healthy a company’s bottom line is and where the management needs to shift their focus. The typical time frame for a company to release an income statement is annually and quarterly. This article will cover in detail what an income statement is? What is a comparative income statement, and how a business uses it to know the financial well-being of the company with examples! 

    What is an income statement?

    Three financial statements – Income Statement, Balance Sheet, and Cash Flow Statement are essential for any business. They act as the encyclopedia of a company’s financial condition. The first and the foremost statement in this list is the income statement. It represents all the income inflows and outflows for a specific period of time. It is also referred to as the profit and loss statement, earnings statement, statement of operations, and statement of financial result. 

    An income statement is a valuable tool for internal and external stakeholders. The company management, directors, and employees are the internal stakeholders, while shareholders, investors, competitors, and creditors are the external stakeholders. 

    Because the profit and loss statement helps analyze where the company stands, the internal stakeholders get an idea of where the actions are needed. While for the external stakeholders, the statement yields information on whether their money is secured. As a result, it holds utmost importance. 

    Now that the base is clear, let us explore an enhanced version of the income statement, known as the comparative income statement. 

    What is a comparative income statement?

    A comparative income statement or comparative profit and loss statement is a typical income statement but showcases multiple accounting periods. This allows companies to analyze the difference in performance compared to a data point of the previous period. 

    The comparative statement of profit and loss includes all the particulars of an income statement side by side with the previous accounting entries. This makes it easier for companies to find a trend or anomaly and identify the reason for the same. The typical characteristics of a comparative profit and loss statement include representing the actual absolute numbers, changes if any in those numbers, and representing the increase or decrease over a certain period in terms of percentage. 

    The question is, what do these absolute numbers represent? What is included in an income statement? Let us understand that with an example. 

    Income statement format

    https://lh3.googleusercontent.com/43EArHt-89AbeRkNPQVib3mN_cEJ_v2c2Mbi3kmytOnPBajZ_heSNibJxlzf5KevJzeW_8WtRW4Q1UDceaLIeSpHWkM4N3ZLy6Uq_ykO4_mjrjY4F9-6_3askqs7kyUeHrRw7gAw

    Let’s now break down the comparative income statement line by line. 

    Income/Sales/Revenue:

    This is the top line item in the income statement. It represents income generated through the sales of goods and services. In India, a company gets input credit on Goods and Service Tax (GST) which is deducted from the income to derive the total income. Other income, such as interest income, income from sales of land, rental income, etc., are considered as Other Income. The Total Income is the aggregator of these particulars. 

    Cost of Goods Sold (COGS)

    Cost of Goods Sold includes all the expenses associated with selling goods and services. It is also known as Cost of Sales. Inventory expenses, depreciation, and amortization on tangible and intangible assets, advertising and marketing expenses, etc., are COGS. 

    Selling, General, and Administrative Expenses

    These expenses are also referred to as SG&A expenses. It is the cost that has to be incurred for running a company. Some of the examples are lease payments on rental offices, salary paid, insurance and travel expenditures, etc. 

    Depreciation and Amortization 

    Often companies create separate accounts to write down these expenses. They are non-cash in nature and typically are applied for Property, Plant, and Equipment, referred to as PP&E. 

    Gross Profit

    By deducting COGS from Total Sales or expenses, Gross Profit is derived. 

    EBITDA

    EBITDA is Earnings before Interest, Tax, Depreciation, and Amortization. Often companies prefer to deduct SG&A expenses (not depreciation or amortization) from the gross profit to derive this line item. 

    EBIT or Operating Income

    EBIT stands for Earnings before Interest and Tax. This ensures that no non-operating expenses and income are included. In simple words, it is the business income from regular operations.  

    EBT 

    Earnings before Tax or EBT is the pre-tax income for a business. It is derived by deducting interest expenses from EBIT or operating income. Interest expenses can be mentioned separately or under income expenses depending on the nature of debt taken.  

    Tax

    Tax is deducted from the EBT to derive the final income of the company. This includes any existing and upcoming tax expenses. Deferred tax is also included here, which is the surplus tax paid or any previous tax liabilities that need to be paid. 

    Net Income

    This is the total income a company generates over a period and is derived by deducting all the cash and non-cash expenses from the total sales or income. It is also the total profit or loss for a business in an accounting year. Net income is known as the bottom line of the company. The same amount is transferred to the balance sheet as retained earnings after deducting dividends. 

    Earnings per Share (EPS)

    EPS is the total earnings (Profit or Loss) that shareholders of the company receive. It is derived by dividing the total earnings by the number of shares outstanding. 

    Conclusion

    The income statement provides details on the profit and loss of a company, though, at a border scale, it is useful for cross-time and cross-business comparisons. For internal purposes, a company can choose to make a P&L statement on a monthly basis, but all the listed companies have to file their income statement every quarter and at the end of the year to the concerned authority (i.e. SEBI in India). An income statement allows companies to do a deep-down analysis of their operations, compare the same with their competitors, and take actions to make the bottom line healthier with time.