Accounting Definations - 4

 1.             Financial Leverage:  It arises from the use of fixed financing costs such as interest. When a firm has fixed cost financing. A change in 1% in E.B.I.T results in a change of more than 1% in earnings per share.

F.L =% change in EPS / % change in EBIT

Degree of Financial leverage= EBIT/ Profit before Tax (EBT)

                      Significance: It is double edged sword. A high F.L means high fixed financial costs and high financial risks.

2.             Combined Leverage: It is useful for to know about the overall risk or total risk of the firm. i.e., operating risk as well as financial risk.

                         C.L= O.L*F.L

                               = %Change in EPS / % Change in Sales

                            Degree of C.L =Contribution / EBT

A high O.L and a high F.L combination is very risky. A high O.L and a low F.L indicate that the management is careful since the higher amount of risk involved in high operating leverage has been sought to be balanced by low F.L

A more preferable situation would be to have a low O.L and a F.L.

Working Capital: There are two types of working capital: gross working capital and net working capital. Gross working capital is the total of current assets. Net working capital is the difference between the total of current assets and the total of current liabilities.

Working Capital Cycle:                                                 It refers to the length of time between the firms paying cash for materials, etc.., entering into the production process/ stock and the inflow of cash from debtors (sales)

            Cash                          Raw materials                                  WIP                       Stock

                                                Labour overhead

                                                                                              Debtors

Capital Budgeting: Process of analyzing, appraising, deciding investment on long term projects is known as capital budgeting.

Methods of Capital Budgeting:

1.             Traditional Methods

                              Payback period method

                             Average rate of return (ARR)

2.             Discounted Cash Flow Methods or Sophisticated methods

                              Net present value (NPV)

                              Internal rate of return (IRR)

                              Profitability index

Pay back period: Required time to reach actual investment is known as payback period.

                    = Investment / Cash flow

ARR: It means the average annual yield on the project.

                = avg. income / avg. investment

                               Or

       = (Sum of income / no. of years) / (Total investment + Scrap value) / 2)

NPV: The best method for the evaluation of an investment proposal is the NPV or discounted cash flow technique. This method takes into account the time value of money.

              The sum of the present values of all the cash inflows less the sum of the present value of all the cash outflows associated with the proposal.

NPV = Sum of present value of future cash flows – Investment

IRR: It is that rate at which the sum total of cash inflows after discounting equals to the discounted cash outflows. The internal rate of return of a project is the discount rate which makes net present value of the project equal to zero.

Profitability Index: One of the methods comparing such proposals is to workout what is known as the ‘Desirability Factor’ or ‘Profitability Index’.

In general terms a project is acceptable if its profitability index value is greater than 1.

Derivatives: A derivative is a security whose price ultimately depends on that of another asset.

Derivative means a contact of an agreement.

Types of Derivatives:

1. Forward Contracts

2. Futures

3. Options

4. Swaps.

1. Forward Contracts: - It is a private contract between two parties.

                                                An agreement between parties to exchange an asset for a price that is specified todays. These are settled at end of contract.

2. Future contracts: - It is an Agreement to buy or sell an asset it is at a certain time in the future for a certain price. Futures will be traded in exchanges only. These is settled daily. 

Futures are four types:

1. Commodity Futures: Wheat, Soya, Tea, Corn etc..,.

2. Financial Futures: Treasury bills, Debentures, Equity Shares, bonds, etc..,

3. Currency Futures: Major convertible Currencies like Dollars, Pounds, Yens,                                    and Euros.

4. Index Futures: Underline assets are famous stock market indices. New York Stock Exchange.

3. Options: An option gives its Owner the right to buy or sell an Underlying asset on or before a given date at a fixed price.

There can be as may different option contracts as the number of items to buy or sell they are:

Stock options, Commodity options, Foreign exchange options and interest rate options are traded on and off organized exchanges across the globe.

Options belong to a broader class of assets called Contingent claims.

The option to buy is a call option. The option to sell is a Put Option. 

The option holder is the buyer of the option and the option writer is the seller of the option.

The fixed price at which the option holder can buy or sell the underlying asset is called the exercise price or Striking price.

A European option can be exercised only on the expiration date where as an American option can be exercised on or before the expiration date.

Options traded on an exchange are called exchange traded option and options not traded on an exchange are called over-the-counter options.

When stock price (S1) <= Exercise price (E1) the call is said to be out of money and is worthless.

When S1>E1 the call is said to be in the money and its value is S1-E1.

4. Swaps:   Swaps are private agreements between two companies to exchange cash flows in the future according to a prearranged formula.

So this can be regarded as portfolios of forward contracts.

Types of swaps:

1: Interest rate Swaps

2: Currency Swaps.

1. Interest rate Swaps:  The most common type of interest rate swap is ‘Plain Vanilla ‘.

Normal life of swap is 2 to 15 Years.

It is a transaction involving an exchange of one stream of interest obligations for another. Typically, it results in an exchange of fixed rate interest payments for floating rate interest payments.

2. Currency Swaps: - Another type of Swap is known as Currency as Currency Swap. This involves exchanging principal amount and fixed rates interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately equivalent loan in another currency. Like interest rate swaps currency swaps can be motivated by comparative advantage.

Warrants: Options generally have lives of up to one year. The majority of options traded on exchanges have maximum maturity of nine months. Longer dated options are called warrants and are generally traded over- the- counter.

American Depository Receipts (ADR): It is a dollar denominated negotiable instruments or certificate. It represents non-US companies publicly traded equity. It was devised into late 1920’s. To help American investors to invest in overseas securities and to assist non –US companies wishing to have their stock traded in the American markets. These are listed in American stock market or exchanges.

Global Depository Receipts (GDR): GDR’s are essentially those instruments which possess the certain number of underline shares in the custodial domestic bank of the company i.e., GDR is a negotiable instrument in the form of depository receipt or certificate created by the overseas depository bank out side India and issued to non-resident investors against the issue of ordinary share or foreign currency convertible bonds of the issuing company. GDR’s are entitled to dividends and voting rights since the date of its issue.