Depreciation & Amortization

Amortization, an accounting concept similar to depreciation, is the gradual reduction of the value of an asset or liability by some periodic amount (i.e., via installment payments). In the case of an asset, it involves expensing the item over the "life" of the item-the time period over which it can be used. For a liability, the amortization takes place over the time period that the item is repaid or earned. Amortization is essentially a means to allocate categories of assets and liabilities to their pertinent time period. The key difference between depreciation and amortization is the nature of the items to which the terms apply. The former is generally used in the context of tangible assets, such as buildings, machinery, and equipment. The latter is more commonly associated with intangible assets, such as copyrights, goodwill, patents, and capitalized costs (e.g. product development costs). On the liability side, amortization is commonly applied to deferred revenue items such as premium income or subscription revenue (wherein cash payments are often received in advance of delivery of goods or services), and therefore must be recognized as income distributed over some future period of time. Amortization is a means by which accountants apply the period concept in accrual-based financial statements: income and expenses are recorded in the periods affected, rather than when the cash actually changes hands. The importance of spreading transactions across several periods becomes more clear when considering long-lived assets of substantial cost. Just as it would be inappropriate to expense the entire cost of a new facility in the year of its acquisition since its life would extend over many years, it would be wrong to fully expense an intangible asset only in the first year. Intangible assets such as copyrights, patents, and goodwill can be of benefit to a business for many years, so the cost of accruing such assets should be spread over the entire time period the company that the company is likely to use the asset or generate revenue from it. The periods over which intangible assets are amortized vary widely, from a few years to as many as 40 years. (The costs incurred with establishing and protecting patent rights, for example, are generally amortized over 17 years.) The general rule is that the asset should be amortized over its useful life. Small business owners should realize, however, that not all assets are consumed by their use or by the

passage of time, and thus are not subject to amortization or depreciation. The value of land, for instance, is generally not degraded by time or use (indeed, the value of land assets often increases with time). This applies to intangible assets as well; trademarks can have indefinite lives and can increase in value over time, and thus are not subject to amortization.

Ratio Analysis Ratio Analysis can be defined as the study and interpretation of relationships between various financial variables, by investors or lenders. It is a quantitative investment technique used for comparing a company's financial performance to the market in general. A change in these ratios helps to bring about a change in the way a company works. It helps to identify areas where the management needs to change. Types of Ratios Calculated A number of ratios are calculated by companies for evaluating their short and long term performance and also to know liquidity and profitability. Some of the most commonly used ratios are: Liquidity ratios: Can be defined as a ratio that indicates what proportion of a company's assets can be readily converted into cash in the short term. Some of the liquidity ratios are:

Current ratio Quick ratio Defensive interval ratio Activity ratio Acid turnover Receivable turnover Inventory turnover

Profitability ratio: Can be defined as a ratio that explains the profitability of a company during a specific period of time. It explains how profitable a company is. These ratios can be compared during different financial years

to see the overall performance of a company. Some of the profitability ratios calculated are: Return on assets Degree of financial leverage Return on common stock Per share ratios Earnings per share equity Price earnings ratio Book value per share Profit margin Yield on common stock Leverage ratio Debt ratio Dividend payout ratio Equity ratio Debt to equity ratio

Times interest earned

SUMMARY OF FINANCIAL ACCOUNTING RATIO PROFITABILITY RATIO: Financial Ratio Formula Measurements

Return on Total Assets

Measures rate of return Operating profit before earned through income tax + interest operating total assets expense/ Average total provided by both assets creditors and owners Operating profit & extraordinary items Measures rate of return after income tax minus earned on assets Preference dividends / provided by owners Average ordinary shareholders equity Gross Profit / Net Sales Operating profit after income tax / Net Sales Revenue Profitability of trading and mark-up Measures net profitability of each dollar of sales

Return on ordinary shareholders equity

Gross Profit Margin

Profit Margin

MARKET BASED FINANCIAL RATIO: Financial Formula Measurements

Ratio Operating profits after income tax less Preference Earnings per dividends / Weighted share average number of ordinary shares issued Market price per ordinary share / Earnings per ordinary share

Measures profit earned on each ordinary share

Priceearnings ratio

Measures the amount investors are paying for a dollar of earnings Measures the return to an investor purchasing shares at the current market price. Measures the rate of return to shareholders based on current market price.

Earning Yield

Earnings per ordinary share / Market price per ordinary share

Dividend Yield

Annual dividend per ordinary share / Market price per ordinary share

Dividend Payout

Measures the Total dividend per ordinary percentage of profits share / Market price per paid out to ordinary ordinary share shareholders Ordinary shareholders equity / No of ordinary shares LIQUIDITY RATIO: Measure the assets backing per share

Net Asset Backing (NTA)

Financial Ratio Current Ratio

Formula Current Assets / Current liabilities

Measurements A measure of shortterm liquidity. Indicates the ability of entity to meet its

short-term debts from its current assets A more rigorous measure of short-term liquidity. Indicates the ability of the entity to meet unexpected demands from liquid current asses

Quick Ratio

Current Assets less inventory / Current liabilities

ASSET MANAGEMENT/UTILISATION/ACTIVITY RATIOS: Financial Ratio Formula Measurements

Measures the effectiveness Net sales revenue / of collections; used to Receivables Average receivables evaluate whether turnover balance receivables balance is excessive Average collection period Measures the average Average receivables number of days taken by an balance x 365 / Net entity to collect its sales revenue receivables Indicates the liquidity of inventory. Measures the number of times inventory was sold on the average during the period Measures the effectiveness of an entity in using its assets during the period. Measure the efficiency of the usage of fixed assets in generating sales

Inventory turnover

Cost of goods sold / Average inventory balance

Total Asset turnover ratio Turnover of Fixed Assets

Net sales revenue / Average total assets

Net Sales / Fixed Assets

GEARING/FINANCIAL STABILITY RATIO:

Financial Ratio

Formula

Measurements Measures percentage of assets provided by creditors and extent of using gearing Measures percentage of assets provided by shareholders and the extent of using gearing The reciprocal of the equity ratio and thus measures the same thing

Debt ratio

Total Liabilities / Total assets

Equity ratio or Proprietary ratio

Total shareholders equity / Total assets

Capitalizatio Total assets / Total n ratio shareholders equity

Times interest earned

Operating profit Measures the ability of the before income tax + entity to meet its interest Interest expense / payments out of current Interest expense + profits. Interest capitalized CASH SUFFICIENCY RATIO:

Financial Ratio

Formula

Measurements

Cash flow adequacy

Cash from operations / Measures the entitys ability to Long-term debt cover its main cash paid + Assets requirements acquired + Dividends paid Long-term debt Measures the entitys ability to repayments / cover its long-term debt out of Cash from cash from operations operations Dividends paid / Measures the entitys ability to Cash from cover its dividend payment

Long-term debt repayment Dividend payment

operations Non-current Measures the entitys ability to asset payments Reinvestment pay for its non-current assets / Cash from out of cash from operations operations Total long-term Measures the payback period Debt coverage debt / Cash for coverage of long-term from operations debt. CASH FLOW EFFICIENCY RATIO: Financial Ratio Cash flow to sales Formula Measurements

Cash from Measures ability to convert operations / Net sales revenue into cash flows sales revenue Cash from An index measuring the operations / relationship between profit Operating profit from operations and after income operating cash flows tax Cash from operation + Tax Measures the operating cash paid + Interest flow return on assets before paid / Average interest and tax total assets

Operation index

Cash flow return on assets

FORECAST BANKRUPTCY RATIO: Refer to Altman Zs Financial Ratio Each financial ratio is linked to the respective topic in this blog to provide more details for the readers.

Cash Flow Statement A cash flow statement, also known as the statement of cash flow is a financial report depicting amount of incoming and outgoing money during a particular time period. The statement does not include noncash items like depreciation, thus making it useful for determining the short-term ability of a company to meet its liabilities. It summarizes the company's cash receipts and cash disbursements over a period of time. It also lists cash to and cash from operating, investing, and financing activities, and also the net increase or decrease in cash for a particular period. A cash flow statement collects, organizes and reports the cash generated and used in the following categories:

Operating activities: Converts the items reported on the income statement from the accrual basis of accounting to cash. Investing activities: Reports the purchase & sale of long-term investments, property, plant and equipment. Financing activities: Reports the issuance and repurchase of the company's own bonds, stock and the payment of dividends. Supplemental information: Reports the exchange of significant items that did not involve cash and reports the amount of income taxes paid and interest paid

Most companies hire professionals or take the help of accountants for getting the cash flow statements made. This helps them have an accurate analysis of the firm's ability to meet its current liabilities. Advantages of a Cash Flow Statement

Helps the company to know whether it will be able to cover payroll and other immediate expenses Helps the lenders to know the company's ability to repay Helps the investors judge whether the company is financially sound Helps the newly formed companies to know their inflow and outflow of cash and thus prevent cash shortage