 In last class, we were talking about how we can use different ways to record the correct value of cost of goods sold in inventory and in that we found that there is an argument that can favor the first in first out and also a possible argument that can favor a last in first out, while both of them are correct methods to record cost of goods sold and inventory. Now, let us see what will be the argument that favors first in first out. First in first out, the assumption is the inventory that gets acquired first, gets used first and gets sold first. So, that is the first in first out logic. Now, why is that favored over the last in first out? One is for a purpose of accounting, it is more accounting than conceptual that this first in first out captures value of inventory that you see in your balance sheet. In your balance sheet, you see that there is some value against inventory and as somebody using the balance sheet, I would want the value of the inventory to be most recent and exact. Now, this first in first out will capture the inventory that is not used in its recent cost of acquisition, because what gets used is the inventory that was purchased sometime back, which does not sit in your balance sheet any longer, but because it gets consumed and it goes as cost of goods sold. So, what sits in your balance sheet need not be the most recent, but definitely not the first. So, it gives a fairer estimate more correct value of the inventory, because it is not the one that was purchased first. It is not I am not saying that it is the most recent, it will also include inventory that was purchased the most recent, but then the FIFO captures the correct value that is a correct estimate of the value of the inventory in your balance sheet, because always I am more interested in knowing what is the fair estimate of my asset items in the balance sheet, this is one accounting justification. Another thing is if I use first in first out, there is more likelihood that it maximizes why, because very unlikely that the cost of inventory reduces there are cases, but in the majority of the circumstances that we handle, we have always found that the cost of inventory, the cost of certain material, the cost of acquisition is always increase year on year at least to cover inflation. So, when the cost of inventory increases year after year, if you use the first in first out method, what sits in your cost of goods sold is that value that would have used the maximum inventory that was purchased first, because it is first in first out. And because the cost of inventory is rising over the accounting period, in all likelihood the cost of goods sold will be lesser than it would have been had you adopted last in first out, because in that case the cost of goods sold would have recorded the cost of acquisition at higher acquisition prices that by reducing your net income. So, these two broadly are arguments that favor the use of FIFO method. Likewise, there are also arguments that support that I should use last in first out. One relates to your principle of matching, principle of matching says revenue versus expenses. When you are recording revenues in this particular accounting period, you have to take into account the cost related cost to this particular accounting period. And if it is a revenue that is happened at this time instant x, you have to necessarily take into the inventory that was purchased in the vicinity time period x, fair enough. Another second thing is it reduces taxable income. Why? Because higher cost of goods sold though it reduces your net income, the profit before tax is also relatively less. And hence your taxable income tax that you need to pay is less, your taxable income is reduced. So, these are two things, two points that favor the use of LIFO over FIFO. But I have told you that the most popular method that is used is the first in first out, not that it is the only correct method that is the most popular method. Now, we have covered revenues, we have covered cost of goods sold. The third thing that I said I will be discussing in class is the principle of depreciation. And is there again different ways in which we can depreciate an asset? I have told you that depreciation is an expense which is non-cash because cash does not really flow out of the entity. And it is an expense because we have to charge the entity for using an equipment that gets depreciated. Typically assets are of two types, tangible and intangible assets. Your tangible assets are your land, building, equipment and all that. Your intangible could be your patents, goodwill, trademarks. So, such non-physical assets are your intangible assets. And we depreciate tangible assets. And the equivalent for intangible assets is what we call as amortization. When we depreciate an asset, I have told you in the previous classes that it is only the capital expenditure that creates an asset that gets depreciated, not the revenue expense because that gets written off in that particular year. So, when an asset is depreciated, it means that we are charging the entity some expense for using that particular asset for that particular accounting period. So, which means when you do depreciation, there is a depreciation expense. And how does that get charged? Suppose the cost of acquisition of the asset is x. And let us say the life of the asset is 10 years, then the annual depreciation expense is x by 10. So, every year in your income statement you would have a depreciation expense of x by 10. And in your balance sheet that corresponding x by 10 gets reduced in the value of the asset cost of x. So, you will have x accumulated depreciation x by 10. So, the final book value of the asset will be 9 by 10 of x. Then in the second year, it will be 2x by 10. So, it keeps on reducing year after year while the annual depreciation expense is x by 10. Now, what do you depreciate? You depreciate the cost of acquisition. At times you might even have residual value for the asset. Residual value means the residual value is suppose after the lifetime of the asset, it can be sold for a particular value x, then that x is the residual value. In this case for the sake of easy understanding, let us say it can be sold for y, then y is the residual value. Then what has to be depreciated is x minus y. If residual value is y, the depreciation x minus y has to be depreciated or depreciationable. I do not know whether that is a term that is only used let us say for understanding s. So, the value to be depreciated it is this that gets depreciated over a 10 year period. The question is are there just as we saw cost of goods sold different ways, are there different ways in which assets can be depreciated? Yes, there are and I am just going to deal with two such methods. One is your straight line method which is just a linear depreciation and another method that is called the years digit method. A straight line years, so these two are the depreciation methods that we will be seeing. For let us say for an illustration that I purchase an equipment that is worth 1000 rupees and the estimated life of the equipment is 10 years and it has no residual value. The residual value is 0. So, what do we do? So, we are in year 5, 6, 7, 8, 9, 10. Let us say I have a straight line method of depreciation here. So, in a straight line method what is my annual depreciation? It is 100. So, every year it is 100. Why? Because the cost of acquisition is 1000 and residual value is 0 and it is a 10 year lifetime. So, the annual depreciation is 100. What is the net book value? At year 0, we just purchased it. I mean, we just purchased the net book value is 1000 and finally, it drops by 100 every year and the net book value at the end of last year is 0. This is a very straight forward case. This is a straight line method of depreciation. The next thing is called the year's digit. Now, in a year's digit, the depreciation rate is no longer linear. We are not adopting a straight line method. We are not hence taking a linear rate of depreciation. In this case, it is 10 percent every year. Then, what is the rate that is adopted? The depreciation rate is a fraction that is calculated by one particular method. In this case, it is 10 years. So, let us say we call it the sum of the year's digits. 10 years means n into n plus 1 by 2 is 55. How did we get this? This I call the sum of the year's digit, S y d and this forms the denominator and the rate, depreciating rate is calculated this way. So, the denominator is the sum of the digits, 55 that is constant. In the numerator, it is n that is the total life of the asset. So, the rate of depreciation for the first year is n by 55. For the second year, it is n minus 1 by 55. For the third year, it is n minus 2 by 55 and likewise keeps drop. So, the rate of depreciation keeps changing in this particular fashion and so on till you get 1 by 55 here. Now, what will be your annual depreciation in this case? 10 by 55 of 1181.82. Then, what is your net book value? At year 0 to 1000, now it becomes 818.18 and in the second year, your annual depreciation becomes 163.64, 9 by 55 times 1000. So, your net book value is this minus this. So, third year, your annual depreciation 145.45, your net book value is 509.09. Likewise, this also keeps on dropping and you will see in the ninth year, you will have the annual depreciation as 36.36, 18.18 and here the depreciation is 18.18 and the net book value is 0. In both these cases, the net book value at the end of the life of the asset is 0. Now, what makes the difference? The difference is that the annual depreciation in the case of a straight line method is 100, in the case of the year's digit method keeps changing. Now, why is this relevant for our discussion? Now, if you try to plot a graph between the year and the method that you actually adopt to calculate the annual depreciation. Now, the annual depreciation if I use the linear method, let us say it was 180 here, continues to be 100. Suppose, it is sum of the year's digit. Now, you would find that somewhere between suppose, I fill all these details 127.27, here it is 109.09, then 90.91, 72.73, 54.1, 55. You find that between the 5th and 6th year that the annual depreciation expense, which was higher till the 5th year in the sum of your digit method gets below 100 during the 5th year and 6th year period. So, somewhere here it crosses somewhere here, why is this important? It is important because from a reporting point of view, I might decide to get advantages of a reduced taxable income because of an increased depreciation expense for the first 5 years. If you look at this, the first 5 years I have the depreciation expense more than 100 here. Now, here are two options that is available, one annual depreciation expense of 100. In the other case, the first 5 years the annual depreciation expense is more than 100 and I decided to choose this. Why? Because I receive accelerated benefits of higher depreciation expense, which reduces my taxable income. What will I do after 5 years? I switch over to straight line method, it is allowed because remember when we discuss the principle of consistency. Though it says that you follow the same method that you are adopting, if at all you are making a change, you just have to be reasonable in explaining why you are making this change. In this case, it is reasonable to say that 5 years I have followed some of your digits so that I get the benefit of the reduced taxable income ahead of time and then after the 6th year whatever is the remaining depreciable amount, I depreciate it over a straight line method and just I have to while I file my income statement and balance sheet, I just have to explain that I am shifting my sum of years digit method to a straight line method and then for the remaining 5 years, you can continue to follow the straight line method of depreciation. So, these are the 3 special cases that I thought you should be knowing and of course, as I told you before there are other special cases that can add more complexity to this subject, but we are not going to dwell on those special cases. I am sure all of you you will feel little comfortable when it comes to understanding and interpreting a financial statement and then you will know what has happened behind the screens that create this financial statement and that is where you will begin to appreciate the entire concept of accounting, the principles of accounting, the principle of duality, T accounts, generalized, why did I do this, why was expenses recorded this way, why not this way, how sales is recognized, how cost of goods sold is being calculated. So, all these conceptual understanding is what that I gave you in the last 14, 15 classes and with that conceptual understanding, you will be able to prepare a balance sheet and income statement and a cash flow statement. You will be able to identify relevant activities and measure those activities in monetary terms and communicate in monetary terms by adopting a uniformly followed practice and in the process you would have created a balance sheet and income statement and a cash flow statement. Now, the exercise does not stop there after you have created a balance sheet and income statement and cash flow and of course, I told you why we do this. Financial accounting is little different from management accounting because the users of the information that comes out of financial accounting is not only those inside the organization, but also those outside the organization, it could be your bankers, it could be a shareholders or whoever they are. So, that is one main reason why financial accounting gains importance. So, it is not just that you prepare this and then your job is over. After I prepare, what am I going to do to these financial statements? Can I understand what these financial statements mean? I will be able to understand them and add more sense to these financial statements. If I start analyzing these statements by calculating certain set of ratios and these ratios can explain whether my firm is liquid enough. If I calculate the liquidity ratios, whether there has been efficiency in terms of the activities that the firms engaged, I can calculate some ratios based on activity to understand the leverage of the capital structure of the firm by calculating the debt equity ratios. To understand the profitability of the firm, I have some profitability ratios. Now, let us see how these ratios are important as a way to analyze these financial statements. Now, these ratios are important because looking at a financial statement, looking at balance sheet and income statement, it just tells me that cash is this much, inventory is this much, income is this much and all that. Now, if I am able to relate all those entries, these balance sheet figures and income statement figures and try to see whether there is some relationship between these or I am able to calculate some ratios based on these entries. I can make some fair judgment on the performance of the entity and if I am able to do this for the previous year, the year before that, then I can also see how there has been a progress in the firm or if I am able to do this and compare this with my competitive firms ratio, then I can know how I perform against competition. So, it is this performance of an entity based on these ratios becomes very important when it comes to using these financial statements to analyze them. Suppose, I want to compare one ratio with the previous year's ratio, let us say current assets to current liabilities, that is 1.1.92. So, previously it was 1.1, now it is 0.92, what does it mean? It means that last year I had more current assets as a relative to current liabilities and this year I do not have enough current assets to cover my current liabilities. Have I done better? Looking at this ratio I can say no, I have not done better because I do not have enough current assets to cover my current liabilities. Likewise, I calculate different ratios. Why? Because as I told you, it is not somebody inside the firm that is interested in doing this analysis, since this becomes a public document, your annual report has this income statement balance sheet, anybody can do this ratio analysis. As a shareholder, I will do the ratio analysis. As an investor, as a banker, as a member of the leadership team, as government, as anybody who can use this information, who thinks that this information is necessary can do this ratio analysis. Now, let us begin with the liquidity ratio. Liquidity means how cash rich or cash poor the firm is. It refers to the solvency of an entity and also it means that how quickly can assets be converted and realized to cash with very minimum or in fact no loss in the value of the asset. If an asset can be converted with no loss, then it is the most liquid form of asset. The most liquid form of asset is cash by itself. So, liquidity measures the solvency of the firm. There are two ratios that actually explains the extent of liquidity of an entity. One is its current ratio, the other is the quick ratio. Current ratio is your current assets by current liabilities. By the way, current assets minus current liabilities is a net working capital. I have not explained to the class what working capital is because I do not think that the subject matter for this course. I will be talking more about this in the next course, but it is enough for you to know that working capital is that finance that is required to meet your short term day to day requirement and its purpose of easy calculation assumed to be net working capital is assumed to be current assets minus current liabilities. Now, current ratio is just current assets minus current liabilities. What does this mean? It just tells you the firm is solvent enough or is not solvent enough to cover its current liabilities. If the ratio is more than 1, which means you have enough current assets to meet your current liabilities. If it had been 2.1 last year, 1.3 this year, it means that from the solvency perspective, I view that the extent of liquidity has reduced as against last year. Because my current assets which could cover 2.2 times the current liabilities now able to cover only 1.3 or 1.4 times the current liabilities. But your current assets includes your cash, your accounts receivable, your inventories and in the order of liquidity priority inventories is the one that probably takes more time to be converted into cash. So, I am not interested in actually having inventories as part of my current ratio because it is very difficult to convert inventories without reduction in value. So, I want to knock off inventories and then use another ratio that can explain the same solvency from a different perspective. So, if my current assets from a current assets remove inventory, current assets minus inventory divided by current liabilities that is called the quick ratio. Again, this is a liquidity measure, but then removes inventories and tells you the extent of solvency, how much of current assets minus the inventories that I have with me and how to what extent can it meet my current liabilities. So, this is the liquidity ratio. The next ratio is the activity ratio. The activity ratio is got to do more with the efficiency with which assets are being used and realized to generate sales and generate cash. So, this actually measures the speed at which assets are converted or utilized to generate sales and generate cash. And what are these types of ratios? First is the inventory turnover ratio, cost of goods sold divided by inventory. How quickly is your inventory being converted into a saleable good? Another inventory, I mean the activity ratio is your average collection period. Average collection period explains the receivables management efficiency of the entity. Suppose in a balance sheet you have average, I mean you have your accounts receivable say x, that x divided by the total annual sales by 360. This annual sales by 360 sales per day and your total accounts receivable divided by sales per day tells you on an average you have to wait for certain number of days before you get the real cash for the sale that you make. Now, how would that figure you want it to be? The longer is your collection period, it means that you are poor in your receivables management. So, as much as possible we need to have shorter collection periods. Strictly speaking that is why if you go to a restaurant business it is hot cash, you eat something you pay immediately. There is no collection period as against a manufacturing entity where you allow credit 30 days, 60 days credit. So, the collection period the longer or shorter explains how your receivables management as an activity is efficient. The longer it is it is not that efficient, the shorter it is it means that you have a better receivables management policy in place. Opposite to that is your average payment period which is got to do with your vendors. The total accounts payable divided by the annual purchases or you could also use cost of goods sold instead. The average purchases you make every day and your total accounts payable. So, if you use these two numbers you have a ratio expressed in days you have a number expressed in days. This tells you that let us say if this is 20 it means for every dollar every rupee that you purchase you take 20 days to pay your vendor for that. And within allowable principles if you are able to extend this 20 to 25 days, 30 days then it is good to the firm because you are elongating the cash outflow and this is opposite to the view that you take for receivables. The more and more you are able to stretch your payment period the more and more you have internal cash accruals that can be deployed for other activities. Sales by net fixed asset tells you how quickly your asset is been utilized. This is an asset turnover ratio how quickly you are able to utilize your asset to calculate sales. So, every one rupee of asset is generating some sales. The efficiency with which assets are being utilized to generate sales can be calculated using your fixed asset turnover ratio. If you include all the assets both your fixed and current assets it is just the total asset turnover but both of them in principle conveys the same meaning the extent to which assets are being productively used to generate sales. So, this measures the activity of the firm all these activity ratios. The next ratio I have not spent a lot of time on this but this we will be spending a lot of time and we actually do finance for engineers is to analyze the use of debt. Now, debt measures the extent of financial leverage. Every firm raises capital through different sources. The two most popular sources will be debt and equity and based on the characteristic of the firm the characteristic of the industry you will find different firms in different industries having different debt equity ratios. So, you can never say that a debt equity ratio of 40 percent is the best. It could be best for a given context you can never say that this is the right debt equity ratio because it changes from industry across companies. Now, two things that we would be interested in measuring to see the debt ratio is first the extent of leverage of the firm how much of debt it needs to be it needs to pay and whether the degree of indebtedness whether it is high or low considering the circumstances that the firm is operating. The second thing is whether this firm's ability is the firm's ability to meet its debt obligations whether it is able to service its debts. These I can calculate I can make an assessment by calculating these ratios. First thing is a simple debt ratio of the total assets that you have created total iabilities divided by total assets tells you the debt ratio of the total assets that you have created how much has come from the liability. Debt equity ratio is out of the total capital that you have from which you have created these assets how much is the debt component how much is the equity component 60 percent debt 40 percent equity 20 percent debt 80 percent equity. This we will use when we actually calculate the optimum capital structure of a firm when will you say that the firm is not optimally leveraged either it could be under levered or over levered. Now, this ratio we will use to find the optimum capital structure of a firm which tells you whether there is the right amount the right mix of debt and equity that this firm has been utilized as a result of which the value of the firm is maximized. So, this ratio becomes important from that perspective times interest earned ratio is your earnings before interest and taxes what is the earnings that you have before your interest and taxes divide that by your interest. It tells you the propensity of the firm to meet its current debt obligations whether it will be able to meet at least its interest obligations. So, this is a set of debt measures the ratios that used to calculate the debt profile the leverage the financial leverage of an entity. The next important ratio is the profitability ratio at the end of the day everybody needs to know the net income that the firm is making. The profitability ratios gross profit by sales your gross margin by sales gives you the gross profit again when we saw the income statement I told you what the operating margin is your operating profits are in this case the earnings earnings before interest and tax divided by sales gives you the operating profit margin. The net profit margin is your net income divided by sales that is the profitability measure net income divided by sales. Suppose I want to measure the return on assets for every dollar or every rupee of asset how much is the return that I generate then it just your net sales I mean net income divided by total asset. As a shareholder I want to know the return on equity it is just all the earnings that is available to the firm that needs to be dispersed with shareholders divided by the number of I mean the value of the total shareholders equity. So, that gives you the return on equity. So, the net income after taxes which is actually entirely the shareholders divided by the total value of the shareholders equity is the return on equity. The earnings per share again the net income that needs to be distributed to shareholder divided by the total number of shares outstanding in the firm. The P by E ratio is the price to earnings ratio is the market price of the common stock that is trading market price divided by the earnings per share that is the P by E ratio. So, these are all your profitability ratios. Another important ratio that you need to know is called the DuPont ratio which is more integrative and you will understand why I am saying this word integrative because it just dissects the financial performance into three identifiable ratios each of them important in their own way and then integrates all these three to arrive at a final ratio. Now, you see that the return on equity is a very very important profitability ratio because the understanding is that the purpose of any firm is to maximize shareholders value and one indicator that tells you yes shareholder value is getting maximizes the return on equity. Now, that return on equity as I told you before it is the net income divided by the total equity value that can be divided into three parts. One that explains the net profit margin in this case it is net income divided by sale and then another important measure is how efficiently assets are being used to generate the sale and that you can measure by calculating the sales divided by the assets because that gives you the efficiency of the use of asset and that is called the asset turnover. And then another thing is the extent of leverage and that you can measure by having a look at the total assets that you have created how much has been because of equity. So, asset by equity that measures the extent of financial leverage. Now, all these three looked at individually are very important ratios one net income by sales is a profitability ratio sales by asset it is a productivity activity ratio it tells you about asset turnover asset by equity it is a leverage ratio it tells you the extent to which debt and equity is being used. And each of them on their own are important ratios and all of them combined will explain the return on equity. So, if you are able to break the return on equity into these three parts and see the contribution of each of these ratios to the return on equity you will be able to understand this concept a little better because then you will be able to know whether profitability can be improved the asset turnover can be improved or the probably can change the capital structure. So, that the return on equity also improves we are just dissecting the return on equity into these three important ratios not that these three are the only important ratios because all these three put together also forms return on equity which is also a very very important integrator that speaks about shareholder value creation. So, dupe on ratio splits return on equity into these three parts to make an individual analysis integrating them to calculate the return on equity. So, what we have done during these classes is to understand financial accounting from the perspective of identifying activities within a firm that makes monetary sense and recording them in by following a set of principles that is uniformly accepted. And then communicating that information by way of creating an income statement balance sheet and cash flow and using these statements we are able to make a judgment we are able to make an analysis of the performance of the company. So, this is in a nutshell in a single sentence what we have done in these last 14 15 classes. And I am sure you will now begin to appreciate the financial statements that you see I am sure you will be able to identify activities within the firm and monetize them record them based on some accepted principles. And when you do all of this meticulously correctly you will definitely be able to create your own the firms balance sheet income statement and cash flow statement. So, next class we will be talking a little bit about management accounting because accounting I said I will be dealing with financial and management accounting. In the next class we will be spending little time on management accounting after which I will be concluding the chapters on accounting and then we will shift into strategy and economics. Thank you.