Month: May 2022

A painter used to sell his paintings. A few weeks later, the painter realised how precious his paintings were. 

So, he went to his customers and bought back the paintings at an increased price. 

Sounds strange? 

This is quite a standard procedure in the stock market and is known as share buybacks or stock buybacks.

So, what is share buyback?

A share buyback is a decision made by a company to repurchase its shares from its shareholders. 

When a company repurchases its shares from the market, it impacts the financial statements. 

Directly reflecting the same in the balance sheet both on the assets and liabilities side, a reduction in liquid cash due to buyback decreases the current asset (cash available). 

On the other hand, shareholder’s equity decreases when buyback occurs, affecting the liability side of the balance sheet too. 

A buyback increases the proportion of shares owned publicly by its investors and reduces the number of shares outstanding in the market. This activity also boosts the respective proportion of earnings per share, thus decreasing the price to earnings ratio (P/E ratio). 

The buyback ratio is the amount of cash a company spends on the buyback of its common share throughout the duration. 

Upon completing the entire repurchase procedure, shares are cancelled to represent them as no longer available publicly or outstanding and are held as treasury shares with the respective companies. 

But what exactly is share buyback meaning?

Share buyback definition

The share buyback, also known as a share repurchase, is an activity by any company or corporation when it purchases its shares available in the open market or through a tender offer to its existing shareholders. There is an increase in the prices of concerning shares to reduce the number of shares outstanding in the prevailing market, thereby increasing earnings per share (EPS) already. 

So, how does a company repurchase its shares?

Methods of share buyback

A stock buyback is executed using open market operations, fixed price tender offer, Dutch auction tender offer and a direct agreement with the shareholders.

Open market stock buyback

In an open market, stock buyback happens directly from the market, and the company buys shares from the markets through their brokers. The company’s brokers are responsible for executing the buyback transactions. 

The buyback of shares, most of the time, is a lengthy procedure because whenever the company decides on a stock buyback, it buys a large number of stocks. Unlike other buyback methodologies, there is no legal obligation on the company to finish the buyback program. 

Hence, the open market stock buyback method provides a company with the comfort of being able to cancel the share buyback anytime. The benefit of open market share buyback happens to be the cost-effectiveness of the method, and the company can buy the shares at market price without paying a premium for the same. 

Fixed-price tender offer

The fixed-price tender offer is an agreement that allows shareholders to buy back the stocks on a specific date and at a fixed price. The tender price is mostly higher than the current share price, including a premium. 

After the tender is released, shareholders who want to sell their stock inform the company about the number of shares they are willing to sell. 

After which, the fixed-price tender offer becomes an obligation to complete the share buyback within a stipulated time. 

Dutch auction tender offer

The Dutch auction offer is a type of agreement that delivers a range of prices to shareholders where the minimum cost of the range is more than the market price. 

After the agreement’s release, the shareholders start bidding by declaring the number of shares they are willing to sell at the minimum price. 

The biddings declared by the shareholders are then reviewed, after which the company decides the most agreeable price from the previous range to complete the buyback procedure.

The primary benefit of this buyback method is that the company can decide the buyback price directly with the help of the shareholders. 

Direct negotiation

In this method, a company can directly approach a shareholder or a group of shareholders to buy back shares. Here, the purchase price of the share is higher than the market price and includes a premium. 

One of the significant advantages of repurchasing shares directly from the shareholders is the opportunity given to the company to negotiate with them directly. 

This method can benefit the company by cutting costs under various circumstances. 

But, a slight disadvantage could be the time consumed during the process.

 Significance of share buyback

It is often believed that an announcement of share buyback hints toward upcoming profits in the company’s prospects. Such information is expected to influence the overall market price of the company’s shares. 

The typical reason believed by the investors when hearing a share repurchase announcement is expected acquisitions or new product launches with improved product lines. 

Overall, the significance of share buyback is an increase in the market valuation of a company. Such positive news helps attract the attention of potential investors, thereby improving the company’s image.

But, specific companies also tend to decide on share buybacks irrespective of their profitable situation. This activity aims to prevent the erosion of already existing capital.

Hence, before deciding on their investment options through buyback, the investors should look at other metrics like the market trend of the stock or earnings per share. 

Looking at other metrics will help investors make well-informed decisions while understanding their implications. 

Merits of share buyback

Dividends are one of the most direct ways to return the profits to the business owners. 

They receive cash payouts in alignment with the percentage of ownership they carry but initiating this process would make them demand it every other year, so giving out so much cash pressurises them. 

Hence, stock buybacks can have a lot of advantages if used efficiently:

A positive impact on share prices

Whenever a company reinvests the capital, this happens for two main reasons; to spare having to take additional debt and deliver a higher share price.

 When this happens, the financial board of the company in question carries this out because they feel that the shares are currently at a low price, and hence repurchasing them now would result in no loss. 

For other stakeholders like the company’s investors, this is considered a signal of confidence from the management’s side that everything is going smoothly.

 They would accept this decision because such decisions are taken after careful analysis, so they would know that such a move won’t happen for shares that are known to decline later.

Tax Saving and Efficiency

When a company pays out dividends, they also have to pay a tax percentage. 

But, when they choose share buybacks as one of their ways to return profits, the increasing share prices are exempted from the tax bracket. 

When sold back to the company, the holder of such shares is recognised as having taxes on capital gains. 

So practically and conceptually, the holders who do not sell them gain better rewards and pay no taxes.

Flexibility

Once dividend payouts begin, every passing year becomes more taxing for the company since the investors demand dividends every year irrespective of constant or increasing rewards.

If they do not, it might upset the investors and make them unhappy, which again brings up more risk for them as it would lead to investor distrust, and the share values might drop. 

Share buybacks, in this case, are a much better option as they have control over it. 

Counterbalancing dilution

 Companies that start expanding will require talent in terms of retainment and acquisition. 

If stock options are made available to retain the existing employees, such continuous use might even increase the company’s outstanding shares.

This decision would reduce the value of the current shareholders, and buybacks would help offset it.

Dodge Poor investment decisions

For companies wanting to grow, suitable investments are the key, and they require both patience and capital that, in turn, can be raised from the equity or debt.

If it is raised from equity, the investors would demand an inevitable return in terms of profits, and if it is borrowed, the lenders would want their money back with interest. 

If a business ends up being messy about its decisions, it will lose a lot of credit and trust. It also leads to creating low value for the shareholders.

Instead, the cash balance should be used to buy back stock as an option and not further the investments. If the latter is exercised, the company gets pressured to provide a better return on shareholdings.

Demerits of share buyback

Stock Buybacks have received a fair share of criticisms and disagreements regarding their objective to create value for the company it is involved with, specifically for its shareholders. 

A few of those criticisms are as follows:

Faulty and poor use of cash

If you keep a few factors like gains and time in mind, stock buybacks are beneficial for short period gains in terms of the price of the shares involved. The profits are short-lived, small, and destroy the longevity of your investment.

The used cash has a thousand more profitable ways of being reinvested. Hence, it simply indicates a wrong and under-researched way of investing. 

Many companies prefer filling up their portfolios or something called stockpiling because such cases might provide gains in the long term. 

Share Buyback through debt

If we consider the present scenario, which is being struck by the pandemic, the entire economy is in an upheaval. 

Before this happened, buybacks of most companies were majorly financed by debt, and low-interest rates fueled them to borrow cash to spend on such a practice. This activity would positively affect their stock prices but be restricted to the short term only.

 If the company fails to clear off the debt on time, it would directly affect its future performance and financial health. Sometimes, they may even have to file for bankruptcy. 

Critics say that such a strategy is not farsighted, and such plans do not end up well in the longer term. 

Missing out on good investment opportunities

If the money is reinvested in the company, it can have both good and bad impacts. Suppose they buy back shares to boost the prices of their current shares without extensive research and analysis on alternative investment sources.

 In that case, they miss out on areas that could have given them a much more significant cash benefit than just repurchasing the stock. This decision would harm the company’s shareholders in the long run.

Companies flooded with money end up having a wreck in the stock market.

Due to continuous exceptional performance, a few companies that offer stock buybacks have accumulated plenty of cash. 

Even though this works positively for the company because of higher valuations, the shareholders receive less value. 

This value reduction happens because the money used for buybacks could have generated better earnings for shareholders if used for other opportunities with a better return. 

Stock-based compensation to members

A range of publicly listed companies provides compensation to senior-level employees in stocks, which seems to lessen the value created by other company shareholders. 

The employees who accept such offers may indirectly help the company conceal the exact and accurate picture of the impact of such compensation on the company’s total shares. 

How is share buyback different from dividends?

Share buybacks and dividends are both companies’ ways of benefiting the shareholders. However, they are entirely different in their fundamentals. 

To clearly understand the matter, here is a detailed comparison chart between dividends and share buybacks.

Final thoughts

We have understood how share buyback signifies expected earnings, and they boost the company’s net worth. 

Both existing and potential shareholders should keep tabs on the buyback prospects of a company to make well-informed investment decisions. 

However, to gain a crystal clear understanding of the fundamentals of share buybacks, one should also understand how it affects investors, existing shareholders and the firm from a comprehensive perspective. 

Expenses incurred to facilitate core operations of a business are key to the net income of the company.

Companies nowadays invest back their profits to grow and expand their business, eventually leaving shareholders with fewer dividends.

Hence, it is a matter of concern for the shareholders to get a holistic picture of a company’s finances and operational activities to understand if the business is growing as promised.

Most cash flow problems arise because of the inability to ascertain revenue expenditure accurately. But, having insights into revenue expenditure management can improve the business operations.

To understand revenue expenditure management, we must first understand revenue expenditure in detail. 

So, what is Revenue Expenditure?

Revenue expenditure can be defined as the cost charged for running the core operations of a business. These expenditures hold substantial importance in the case of revenue generation. 

A company uses the matching principle of accounting to tie costs to revenues generated in a given time. This action improves the accuracy of income statement results.

However, an individual must recognise that the major reason for spending revenue expenditure is to sustain the day-to-day activities that support the course of core business operations. Revenue expenditures are also incurred during asset management. However, they do not significantly contribute to the growth of a corporation.

Revenue expenditures are different for different types of businesses. A few factors help an investor classify certain business activities as revenue expenditure. Some of those factors are 

• Nature of the business
• The cost spent on the activity
• Periodicity of the activity
• Purpose of the activity
• Maintenance of the activity

Revenue expenditures help get deductions in tax during an accounting period because of their recurring nature.

Types of Revenue Expenditure

Revenue expenditures can be divided into two categories, namely direct and indirect expenses.

Direct expenses

These expenses are direct overheads that form a part of the manufacturing activity, forming a part of the cost of goods sold (COGS). These are day to day operational costs. In the case of manufacturing/industrial companies, direct expenses include costs incurred to convert raw materials into finished saleable goods and products. 

Examples of these costs are:

• Wages paid to labourers
• Freight or Carriage inward
• Electricity used in operating machines for production activities
• Shipping charges
• Import duty
• Rent 
• Commission
• Legal expenses

Indirect Expenses

These expenses are incurred to run a business segment and are not directly linked to the production activities. In selling and distributing goods and services, these expenses are usually incurred, and they are required to ensure the proper functioning of the business as a whole. 

These expenses include:

• Taxes
• Depreciation cost of plant and machinery
• Salaries
• Repair and maintenance cost
• Interest on loans or borrowings
• Rents
• Commission 

Illustrations of Revenue Expenditure 

If an individual wants to classify an expense as revenue expenditure, they must first understand the requirements of revenue expenditure. Because of the nature of the business, the criteria for identifying an expense as a revenue expenditure may vary significantly.

We have, however, included some broad examples to help you comprehend revenue spending.

Before that, one must know that revenue expenditures are expenses incurred to generate revenue, directly or indirectly, during an accounting period or fiscal year.

So, the revenue expenditure of a business may include the following cost:

• Expenses incurred during the sale of goods like shipping fees, import duty, freight, etc.
• Costs incurred in marketing and advertising during the launch of a new product.
• Upgradation in the software of the company. 
• Maintenance and repairs of plant and machinery or any other fixed asset.
• Utility and telecommunications cost.
• The rent of the factory or office where core operations of a business are conducted.
• Interest on loan taken for buying the latest equipment. 
• Wages and salaries are paid to the business staff for their service. The commission is also included. 

Accounting treatment of Revenue Expenditure.

The income statement accounts for revenue expenditures. Revenue expenditures or operating expenses are deducted from the revenue generated by a company from sales made during the year. The final result from the deduction will help you arrive at the net income or profit for a specific period.

Revenue expenses are deducted from taxes in the year in which they occur.

Overall, the expenses decrease the profit and reduce the taxable income, reducing the tax paid.

Merits of Revenue Expenditure

Revenue expenses form a substantial part of any business, and an individual must assess this component properly to understand the company’s expected potential better. 

Look at the points listed below to understand the merits of Revenue Expenditure.

• Operating expenses or revenue expenditures are effective in maintaining the cost and inventory management, as well as determining a company’s efficiency.
• The classification of such expenditures aids in the avoidance of excessive costs incurred in the name of revenue-generating expenses, as well as the timely implementation of appropriate actions and modifications. Identifying essential costs gives you a good indication of how effective each revenue expense is.
• Also, keeping a clear cut record of such expenses helps determine the current financial position of that particular company more precisely.
• One can analyse the stock and cost management policies with the help of revenue expenditure.

Irrespective of these merits, it is always helpful to review costs and revenues for deriving the future potential of a company. 

Demerits of Revenue Expenditure

The demerits of Revenue Expenditure are often difficult for the business owner, and understanding these limitations would help an individual stay well-informed while making decisions. So, a few demerits of Revenue Expenditure are as follows:

• One of the many limitations to such expenditures is that it only helps determine a particular company’s current financial position.
• The information is not always necessarily accurate.
• These expenditures are limited to generating revenue for a specific period.
• Revenue expenditures are renowned for giving short-term benefits restricted to one accounting period. 

How is Revenue Expenditure different from Capital Expenditure?

The most vital difference in distinguishing between revenue and capital expenditures is the period over which they occur or are consumed. The short term or current period (incurred within one year) expenditures are the revenue, and the long term ones are capital expenditures.

However, there are a plethora of differences between capital and revenue expenditure. So, here is a table of comparison between capital expenditure and revenue expenditure to facilitate a better understanding of both.

Which one is more critical – Capital Expenditure or Revenue Expenditure?

Both revenue expenditure and capital expenditure are of equal importance. Ascertaining the importance of capital expenditure and revenue expenditure is crucial. However, identifying the most important one can be difficult. It is wrong to interpret that one is better than the other because both are necessary to ensure the smooth operation of a business with profit generation. 

Capital expenditure is a necessity because it facilitates improvement in the efficiency of the business. Similarly, revenue expenditure is as vital as capital expenditure as it ensures interruption-free production activities and prevents any obstacle from hindering the operations of your business. 

A business needs to track both of these expenditures and ensure efficient management to avoid overspending. Doing this at regular intervals can help a business form effective strategies for optimising and regulating these expenses.

Importance of tracking Revenue Expenditure

Understanding the fundamentals of revenue expenditure in particular businesses helps an owner optimise the expense efficiently.

A deeper look into the business expenses can help the owner understand how necessary a cost is for generating revenue. It enables the business owner to know the revenues that need to be prioritised for revenue generation.

Therefore, tracking revenue expenditure is crucial because it facilitates the distinction between necessary and unnecessary expenses that can save the business through cost-cutting during liquidity crises and other such situations.

Final thoughts

Revenue expenditure is the cost incurred by the corporation to perform the business’s day-to-day activities. 

Revenue spending is divided into two categories in general: Expenses for the upkeep of revenue-generating assets and materials required to create revenue for the organisation.

Revenue expenditure generates earnings in the same accounting period in which they are incurred. Cost optimisation and resource efficiency are critical for every firm to achieve maximum profits, which is why analysing revenue spending is vital.

A capital market is a planned market, which is further classified into primary and secondary markets, each serving its specific purposes. 

The primary market is said to enable new stock issues, bonds, and securities to be sold to the public for the first time through IPO (Initial Public Offering), preferred allotment or right issue. 

The initial compliance process comprises filing statements with the SEC (Securities Exchange Commission). 

Then one must wait until approval is granted to issue them in the primary market for sale. 

Companies and government entities sell the shares and stocks to fund business expansion and advancements following the IPO. 

Leveraging investors as they have to pay less for the purchase than the secondary market. 

The Securities and Exchange Board of India (SEBI) regulates such a market in India. 

So, what is the primary market?

A primary market is an introductory market which facilitates fundraising for entities like corporations and governments. 

In a primary market, securities are initially introduced to investors by issuing companies. Upon the initial sale, further trading is conducted and carried forward to the secondary market, where other augmented exchanges and trading occur each day.

Parties in a primary market

The parties to this primary market are the issuing entity/company, investors and underwriters. 

Issuing entity:

The issuing entity/company is the party that wants to raise funds by issuing offerings and securities in the market.

Investor:

The investors are the party interested in buying the securities in the market.

Underwriters:

An underwriter is mainly a broker who helps the issuing company sell its securities to the investing public.

Properties of primary market

A few of the properties of the primary market are mentioned below:

• New Issue Offer 

New issue offer is one of the vital functions of the primary market. This market holds the authority to offer a new issue that has not been traded before. This is one of the reasons that makes the primary market a new issuer market.

 Issuing an offer is not a simple task. A lot of process goes into it. A detailed assessment of the viability of a project is involved, and amongst the financial part of the arrangement, the involvement of taking the promoter’s debt-equity ratio, liquidity ratio, and equity ratio, among others, are also considered.

• Underwriting Services

Underwriting is a vital aspect or a part of offering a new issue. Unsold shares sold in the marketplace are one of the primary functions of underwriting services. Financial institutions earn commission by often playing the role of an underwriter.

 Frequently financial backers rely upon guarantors to measure whether undertaking the risk would merit the profits. It might likewise happen that the guarantor purchases the whole IPO issue, accordingly offering it to financial backers or investors.

• Distribution of New Issue

 This is one more vital capacity of the primary market. The dispersion cycle or the distribution process is started with another plan and a new perspective issue.

 People, in general, are welcome to buy the new issue. Factual data or information is given on the company’s organisation and the issue terms alongside the underwriters.

Example of stock selling in the primary market

Many pioneer companies went for Initial public offerings in the past.

The most well-known international example happens to be Facebook. Facebook, a technology giant, decided to go for an Initial public offering (IPO) in 2012. The company raised 16 billion USD with its IPO.

Now, let us look at a domestic example.

Coal India went for an initial public offering (IPO) in 2010, and it raised over INR 15,000 crores. To the investors, there was a discount of 5 per cent on the final price of the IPO.

 We all know that LIC, the behemoth, is set to launch its IPO in the upcoming season. 

The IPO initiated by the government of India is all set to become the biggest IPO in the history of Indian primary markets.

Types of primary market issues

There are different ways of purchasing security from the primary market. After the issuing entity issues the securities, investors can buy them in five different ways, depending on the method executed by the issuing company. 

So, the five different ways to purchase securities from the primary market are as follows:

Public Issue

Public issue is the most common methodology of allowing the public to purchase security. The initial public offering (IPO) policy is used to issue shares to a large crowd. 

Once the IPO is announced, companies allow the public to help them raise capital for their business. After this, the stocks are listed on the stock exchange for trading purposes.

When a private limited company decides to go public, they do it with the help of an IPO. The capital raised by the company through IPO is used to strengthen the company’s liquidity, better the firm’s infrastructure, and repay debts.

If a private company wants to go for an initial public offering, it must face multiple enquiries from SEBI (The Securities and Exchange Board of India). To ensure authenticity, India’s Securities and Exchange Board closely follows the IPO and the firm before going for an IPO. 

Private Placement

 When a company decides to issue securities only to a limited number of investors, it is known as Private Placement. The small group of investors can have institutions as well as individuals. The securities issued to private placement can be stocks, bonds or any other type of security.

 Unlike Initial public offerings (IPO), private placement has fewer follow-ups from The Securities and Exchange Board of India. The regulations for private placement are more liberal than those of IPO.

A private placement is an appropriate method of issuing shares for typically new companies, and it helps reduce the cost and time involved in issuing shares. Hence, companies in their formative years should opt for private placement.

Preferential Issues

 Preferential issues are like issuing preference shares. The companies can give securities to a group of investors, irrespective of their listing in the stock market. It includes paying dividends to preference shareholders before ordinary shareholders. 

However, one should not confuse the preferential issue with public or right issues. This is one of the fastest methods to raise capital for a company.  

Qualified Institutional Placement

 Qualified institutional placement involves selling securities to Qualified Institutional Buyers (QIB). Listed companies use this placement as a fundraising tool to raise capital from Qualified Institutional Buyers (QIBs). 

Qualified institutional placement is a private placement introduced by The Securities and Exchange Board of India and facilitates the companies raising capital by issuing securities to QIBs.

Qualified Institutional buyers are expert investors with ample financial knowledge to make intelligent investments in the capital market. 

Some highly recognised QIBs are:

• Alternate investment funds
• Mutual funds
• Insurers
• Pension Funds 
• Public Financial Institutions
• Scheduled commercial banks
• SEBI registered Institutional foreign investors
• Foreign venture capital investors.

This Qualified Institutional placement methodology is easier than preferential placement as they do not require any heavy procedure following like submission of pre-issue filings to SEBI. It reduces the cost and time of issuing securities by a significant amount. 

Rights and Bonus Issues

Right, and bonus issues are when the company decides to issue securities to the already existing investors. This policy is formed to give additional benefits to a company’s investors. 

The investors are allowed to buy securities at a predetermined rate, and they can get extra shares allotted during the bonus issue.

The right issues facilitate investors to buy stocks at a discounted price for a specific time. 

The shares are given to the existing shareholders during bonus issues as a bonus for being loyal.

Merits of the primary market

After accumulating enough information on primary market functions, features and definitions. 

Let us dive into the advantages of the primary market:

• A Cost-Effective Way to Raise Capital 

Organisations can obtain financing for their businesses in a cost-effective and seamless manner. Additionally, securities are often presented in the primary market, which can nearly be immediately sold in the optional secondary market, subsequently giving high liquidity.

• Fewer Chances of Price Manipulation

 When contrasted with the auxiliary secondary market, there are fewer possibilities for cost control in the essential primary market. This prompts better straightforwardness and activities in the working of the market.

• Offers Diversification

The essential primary market fills in as an expected road for expansion for financial backers or investors, subsequently cutting down the quantum of a chance of risk. Financial backers can allot their speculations across resource classes in numerous monetary instruments.

•   Mobilisation of savings

In an economy, the primary market is crucial in mobilising the savings, and the currency flows from the general public to variegated investment channels. Hence, the monetary wealth of the country is efficiently used for investment purposes.

•   Fluctuations in the market.

The primary market does not experience any market fluctuations. The prices are pre-determined, and investors know the price before investing in a particular security.

Demerits of the primary market.

When we look at the upside of the primary market, we should also know about this market’s downside aspect, which should be looked into before investing. 

Hence, the disadvantages of the primary market are:

• Limited Information Available to Investors 

The amount of information available to the suitors before they invest in the IPOs is more petite, giving rise to unwanted speculations and hurdles in the entire financing process. 

This is because unlisted companies are outside the purview of SEBI’s regulations and the chances of risk are high and probable investors might not just add up to the entire scenario 

• No Historical Trading Data

Since the shares are issued for the first time, there’s no historical data available that analyses the IPO shares, making investing a little speculative for the investors. Also, if a share is oversubscribed, small investors may not be able to receive their allocation for the time being.

• Unfavourable for small investors

Small investors tend to invest small amounts into the primary market. If many investors want an offering, the issuing company might not be able to allot shares to a small investor. 

Hence, the primary market is unfavourable for small investors.

How is the primary market different from the secondary market?

A key difference in the primary market is that a primary market is only concerned with the transactions where the issuing company issues a public offering to the investors for the first time. Further selling of those same shares takes place in the secondary market.

To get a detailed understanding of how the primary market differs from the secondary market. 

Let us provide a detailed comparison chart comparing the primary and secondary markets.

What is the primary market in the stock market for investors?

Security offerings in the primary market are subjective to investors. 

Most of the issue offerings in a primary market are not available to an individual investor. 

This selectiveness in offerings does not allow individual investors to understand or experience a primary market offering. 

Only certain shareholders and institutions are privileged enough to experience all kinds of primary market issuance. 

For example, only institutional investors and underwriting investment bank clients can avail securities during IPO transactions. Similarly, only accredited investors are allowed to avail the private placements.

Hence, individual investors buy individual stocks or invest in mutual funds through retirement or brokerage accounts. Secondary market sales purchase mutual funds, individual stocks, and exchange-traded funds through retirement or brokerage accounts. Secondary market selling is prevalent among individual investors. 

In the share market, the primary market possesses unique risk. The SEC says that an IPO is a speculative investment. Speculative investments are high-risk investments, and primary market offerings do not have the desired liquidity.

Further, primary market investors cannot simply sell their securities in the secondary market like one can do with public shares. Hence, being a primary market investor might look promising, but it comes with its allocation of risk. 

Bottom line

Understanding the fundamentals of the primary market can help an individual make well-informed investment decisions. Investing in the primary market helps diversify the portfolio because Initial public offerings (IPOs) can offer substantial returns. 

Are you still wondering why there is so much euphoria around IPO announcements?

Nowadays, leverage has been a principal instrument in the corporate world, and it is also a crucial tool required for the expansion of a business. 

However, the other side of leverage can be risky. 

Debt obligations might become burdensome for a business if they are rising at a more incredible speed than the business operations. 

Savvy investors are known for assessing such risks before investing in a company. How? 

Interest coverage ratio! 

An interest coverage ratio is a crucial tool for risk management. 

The interest coverage ratio is a metric that can determine how easily a company can pay the interest on its debt with its current earnings. It gives you valuable insights into the current financial health of a company. The value of this ratio determines the number of times a company can pay its debt interest with its current earnings. 

A higher value provides a better safety net for the investors, thereby helping them make safe and well-informed investment choices. 

Read ahead to learn everything about how the interest coverage ratio is capable of helping investors make intelligent investing decisions.

What is the interest coverage ratio?

The interest coverage ratio, also known as the times interest earned ratio, is a debt and profitability ratio. It represents the ability of a company to pay the interest on its debts with its current earnings. 

The term ”coverage” stands for the number of times or financial years a company can make interest payments with the current revenue earned by the company.

Investors use this ratio to assess a company’s financial health, while creditors also use this ratio to determine a company’s creditworthiness. 

Interest coverage ratio – meaning

The interest coverage ratio is the proportion of earnings before interest and tax to the total interest on the debt.

Interest coverage ratio formula

The formula for interest coverage ratio is as follows:

Interest coverage ratio = Earnings before interest and tax / Interest expense.

Components of the formula

The formula for interest coverage ratio comprises two main components, and they are:

1. Earnings before interest and tax (EBIT): 

Earnings before interest and tax generally refer to a company’s operating profit.

2. Interest expense:

The interest expense is the interest payable on the company’s outstanding debt, and the interest is calculated on various business borrowings like loans and bonds.

Let us understand an example to gain clarity about the interest coverage ratio.

Example of interest coverage ratio

Assume a company named Makati Limited whose earnings during a given quarter are INR 7,55,000. The information provided from the accounting books of Makati Limited tells us that it has debts for which it must pay INR 42,000 every month.

We are required to calculate the interest coverage ratio for Makati Limited for this quarter.

 To calculate the interest coverage ratio, we need to have information about two main components: Earnings before interest and tax and interest expense.

We already know that,

Earnings before interest and tax for the quarter = INR 7,55,000

Interest expense per month = INR 42000

We are calculating the interest coverage ratio for the quarter. Hence, we need to multiply the monthly interest payments by three to find the value of the quarterly expense. 

So, interest expense for the quarter = 42000 X 3 = INR 1,26,000.

Now that we know both the quarterly findings for this quarter. Let us calculate the interest coverage ratio.

The formula for interest coverage ratio is,

Interest Coverage Ratio = Earnings before interest and tax / Interest expense.

So, for Makati Limited the interest coverage ratio is:

Interest coverage ratio = INR 7,55,000 / INR 1,26,000 = 5.99

Interpretation

Makati Limited has an interest coverage ratio of 5.99 times, which means that Makati Limited can pay its interest expense for this quarter 5.99 times with its quarterly earnings. 

or,

It can also mean that the revenues for this quarter are enough to pay the interest expense for the next six quarters.

What is the ideal interest coverage ratio?

The ideal interest coverage ratio differs from industry to industry and company to company. However, an interest coverage ratio above 1 indicates that the company can pay its debt interest with the earnings of that period. 

An interest coverage ratio above 1.5 is expected to be the minimum standard for every company. Investment experts prefer an interest coverage ratio above 2. 

If a company is highly prone to fluctuation, then an interest coverage ratio above three is expected to be the minimum standard to gain investors’ trust.

Importance of Interest coverage ratio

Outstanding debt interest is like quicksand. The company has to borrow money to repay interest on already borrowed money, which increases the debt burden on the company.

Not being able to maintain your debt repayment is an alarming situation for any organisation. This is why having a safety net for paying debt is crucial for every company. 

The interest coverage ratio efficiently provides insights into the company’s financial health. Using this ratio will give you a holistic picture of a company’s upcoming trajectory or current financial position. 

Investors look at the past records of interest coverage ratios to assess the financial stability of a company. This assessment provides excellent information about the performance graph of a company, thereby helping the investor evaluate its current financial health accurately.

It can also be a metric of assessment for banks. Some banks use an interest coverage ratio with a low value as a medium to charge a high-interest rate on loans from such companies. 

Types of Interest coverage ratio

Apart from earnings before interest and tax (EBIT), other numerators are considered for calculating the interest coverage ratio. Two types of numerators are used instead of EBIT to calculate this ratio, and those numerators are:

Earnings before interest, taxes, depreciation and amortisation (EBITDA)

Earnings before interest and after taxes (EBIAT)

Earnings before interest, taxes, depreciation and amortisation (EBITDA)

Sometimes, we use earnings before interest, taxes, depreciation and amortisation (EBITDA) instead of simply using earnings before interest and taxes (EBIT) to calculate the interest coverage ratio. We use this numerator because EBITDA will give a higher interest coverage ratio. Depreciation and amortisation are not a part of interest expenses. 

They are also non-operating expenses and should not be included in calculating the interest coverage ratio.

If a company has depreciation and amortisation, then it is better to calculate the interest coverage ratio after deducting depreciation and amortisation along with interest and taxes from the company’s earnings to get a clear picture of the industry payment capabilities of the company.

Earnings before interest and after taxes (EBIAT)

Earnings before interest and after taxes (EBIAT) are used to calculate earnings before interest and tax (EBIT) during interest coverage ratio calculation because tax is a payable expense. 

Hence, deducting taxes from earnings helps the investor get a clear picture of the coverage ratio and the actual payments of the company. This clarity will allow them to make wise and well-informed investment decisions.

Merits of Interest coverage ratio

Some commendable characteristics of the interest coverage ratio are as follows:

• The interest coverage ratio is an essential metric to gauge the power of a company to repay its interest expense on outstanding debts.
• The interest coverage ratio is a financial measure to assess a company’s creditworthiness.
• An interest coverage ratio is a tool that can help an individual forecast a company’s future. If there is a decline in the figures when the past interest coverage ratios are taken into account, it is indicative of the declining state of the company’s abilities. It means that a company’s creditworthiness is decreasing, and it might not perform well in the future if this continues.
• The interest coverage ratio is an excellent measure to analyse the short term financial position of a company.
• Analysis of the past interest coverage ratios gives valuable insights into the company’s stability.

Demerits of Interest coverage ratio

There are two sides to a coin. Similarly, like other financial metrics, the interest coverage ratio also has its fair share of demerits that the investors should be aware of before using it for their financial analysis.

The demerits of the interest coverage ratios are as follows:

• The interest coverage ratio is not standardised and does not provide significant insights when comparing companies in different industries. It also has less to offer when it comes to peer-to-peer comparison.
• The standard interest coverage ratio varies from industry to industry. 
• A company with consistent revenue generation can have an interest coverage ratio with a lower value. For a utility company, the fair interest coverage ratio value is two. This desirable value originates from the regular revenue enjoyed by a utility company because of its consistent production cycles. So, the company may be able to pay its interest expense with ease even after having a low value of interest coverage ratio.
• Industries that experience significant fluctuations should have a higher value for interest coverage ratio like manufacturing industries. Companies under volatile industries might face difficulty with interest payments during the low revenue phase.
• The interest coverage ratio is suitable for comparison only when comparing companies in the same industry or business model. Comparing companies of different scales is also a difficult task to accomplish with the help of the interest coverage ratio.
• A company might exclude particular debts while calculating its interest coverage ratio. Hence, it is essential to dig deep and look for transparency in the debt list while using the interest coverage ratio for analysis.

Final thoughts

An interest coverage ratio is an essential financial tool for analysing the ability of a company to pay its interest on outstanding debt. However, it can be challenging to find a clear-cut method to explore a company through interest coverage ratio. This difficulty arises because the analysis of a company through interest coverage ratio is influenced by the risk-taking capability of a creditor or investor. 

A bank might be more comfortable with an interest coverage ratio of a higher value if it is looking for companies with a high credit score. But if the bank is looking for companies with a low-interest coverage ratio, they must be willing to take the risk of incorporating a higher interest rate on loans that they give to that company. 

The standardisation of interest coverage ratio remains the same. If it is less than one, the company is not earning enough to pay its interest on outstanding debt. Such companies are hazardous and are not entertained by funding institutions. 

Similarly, if the interest coverage ratio is greater than 1, the company is earning enough to pay interest on its outstanding debt.

A company that is barely making it through and operating penny to penny tends to have an interest coverage ratio of 1.

What is Nifty 50?

Nifty 50 is an index of the national stock exchange of India Ltd., which evaluates the performance of the top 50 blue-chip stocks, introduced on 21st April 1996. It is one of the largest benchmarking indexes in India. Nifty 50 is created by selecting the top 50 companies out of a total of 1641 companies listed on NSE. Stocks on NSE are categorized under 13 sectors of the Indian economy which are: Financial Services, Information technology, Oil & Gas, Consumer goods, Automobile, Metals, Pharmaceuticals, Construction, Cement & cement products, Telecommunication, Power, Services, and Fertilizers & pesticides.

Out of the 50 companies’ stocks listed on NSE, the top 5 companies’ stocks are weighted more than 40% of the total weight. Reliance industries ltd. has the highest weight of around 11.0% approx. followed by Infosys Ltd. with a weightage of 8.67% approx. If we talk about weighting by sector, then the Financial Services sector would be leading the Nifty 50 index by weightage of approx. 38%.

Below is the list of the top 10 companies which are included in the Nifty 50 stock:

1 The weightage in this table may vary from today as share prices change on daily basis. The data in this table is as of February 2022.

Eligibility for Listing in Nifty

Investors have the advantage of picking the best companies to invest in and trade to increase their profits because stocks listed on Nifty are among the best-rated corporations. The performance of these companies is evaluated over the last six months to see if they should be removed or added to the Nifty list of companies.

The particular qualifying criteria that companies must meet to be listed on Nifty are outlined below.

• The first and most important requirement is that the corporation be an Indian entity that is listed on the National Stock Exchange.
•  A firm stock should be extraordinarily liquid. The average impact cost is used to determine the liquidity of a company’s stock.
•  The trading price of a single share about its weight to the company’s market capitalization is referred to as the impact cost.

In this case, the company’s effective cost must be less than or equal to 0.50% for six months, with 90% of the observations being made on a portfolio worth Rs.10 crores.

• The industry’s trading frequency is also taken into account, and this frequency must be 100 per cent.
• The free-floating average market capitalization is another crucial element. It must be 1.5 times larger than the index’s smallest company.
• Shares of firms with Differential Voting Rights (DVR) can also be included in the Nifty 50 index as qualified companies.

Methodology to How to Calculate Nifty 50 index

Price Index Calculations:

Nifty 50 is calculated by using float-adjusted, and market capitalization methods are used to calculate Nifty 50 indexes. To understand how nifty 50 indexes are calculated, we first have to understand what is float-adjusted and market capitalization methods. This is a method of calculating the market capitalization of a stock market index’s underlying companies. Under this method, market capitalization is determined by taking the equity’s price and multiplying it by the number of shares that are available in the market (also known as free float share).

For a certain period, the level index represents the aggregate market value of the companies in the index. The Nifty Index’s base duration is November 3, 1995. Stocks have a 1,000 starting value. The minimum capital requirement is Rs. 2.06 trillion.

 How to calculate nifty 50, the formula is as follows:

• Market Capitalization = Shares outstanding * Price
• Free Float Market Capitalization = Shares outstanding * Price * Investible Weight Factor (IWF)
• Index Value = Current Market Value / Base Market Capital * Base Index Value (1000)

The IWF (Investible Weight Factor) is a factor in the formula above that is used to determine the number of shares available for trading in the market. Because the value of stocks fluctuates daily, as the index is calculated in real-time.

The method above also takes into account changes in the business environment. Stock splits, rights issues, and other similar modifications are examples of these developments. Nifty maintains the index regularly to ensure its stability and effective operation. This is how nifty 50 is calculated.

Total Return Index Calculation: 

The NIFTY 50 is a measure of how much money you’d make if you invested in an index portfolio. Because the NIFTY 50 is calculated in real-time, it solely considers stock price changes. The return from dividend payouts of index constituent stocks, on the other hand, is not taken into account by price indices. The price index only measures capital gains and losses related to price change. Dividends received from index constituent equities must also be included in the index movement to get a true picture of results. The total return index is a type of index that includes dividends received.

Total Return Index (TR) is a separate series of indexes that reflects the returns on the Index portfolio, including dividends.

This is how Nifty index is calculated:

Total return Index = Previous TR x [1 + {[(Today’s PR index + Indexed Dividend) ÷ Previous PR index]-1}]

Index dividend for the day ‘t’ = Total Dividends of the scrips in the Index / Index divisor for the day

Total dividends of scrips in the Index = Σ (Dividend per share * Modified index shares)

Modified index shares = Total outstanding shares * IWF * Capping Factor.

Index Maintenance:

We have understood how to calculate the Nifty 50 index; now, it is important to know how this index is maintained and rebalanced. Index maintenance and rebalancing is an important part as it helps to maintain the consistency of a benchmark index.

Changes in the index level take into account changes in the index’s market capitalization, which are caused by market stock price volatility. They do not reflect changes in the index’s or individual shares’ market capitalization caused by business actions, including dividend payouts, stock splits, distributions to shareholders, mergers, or acquisitions. Whenever a stock in the index is replaced by another stock, the index divisor is adapted so that the change in index market value caused by the accumulation and deletion does not affect the index level. This is how nifty 50 is calculated.

Index Governance

The index is led by an experienced group at NSE Indices Limited. The Index Advisory Group (Equity) of NSE Indices Limited has been formed to guide macro problems relating to equity markets. The Graph Maintenance Sub-committee makes all decisions on company additions and deletions in equity indices, while the Index Advisory Group (Debt) guides on macroeconomic issues affecting fixed income indices. The committees comprise representatives from the financial market, including Asset Management Companies, insurance companies, rating agencies, and so on. The names of the committee members are public company websites to maintain transparency. Except for the trade representatives (who coordinate between the Index Expert Panel – Equity and IMSC), no member of the above committee represents more than one committee.

 Index Policy

For the NIFTY 50 index, NSE uses transparent, researched, and publicly documented rules for index maintenance. These rules are applied consistently to manage changes to the index. Index evaluations are carried out semi-annually to ensure that each security in the index fulfils eligibility criteria.

Benefits of Investing in Nifty 50

Investment in Nifty 50 has given decent returns to its investors over some time. The Index, which covers 50 large-capitalized and liquid equities from 13 sectors, has increased 15 times in 25 years, giving average returns of 11.2 per cent.

India is a developing country, and its GDP is expected to grow with a growth rate of 8.4% in FY 23, which is one of the highest growth rates in the world and would have a very positive impact on the Indian stock market.

At present, a very small portion of Indians invest in the stock market; therefore, it is highly unpenetrated, as Nifty 50 companies consist of top listed companies in India that have strong financials and high growth potential. It is considered a good investment avenue. The stock market has beaten inflation in the long run and awarded it invested a decent return, which is better than most other financial instruments such as saving accounts and fixed deposits return.

Apart from investing directly in NIFTY 50 listed securities through a Demat account, an investor can make investments through Nifty index funds, ETFs, Nifty futures. Investment in these products has many benefits that investors can enjoy. Some of the benefits are mentioned below.

• Lower risk

When compared to certain other investment products such as personal stocks or mutual funds, investing in index funds or ETFs carries a lower risk. These funds simply monitor and replicate the performance of the Nifty as precisely as possible. As a result, the risk factor is quite low.

• Better returns in long term

While investing in the market is subject to huge volatility; the Nifty 50 will eventually always grow in the long run. Hence, investment in Nifty would provide the investor with better returns in the long term.

• Reduced expense ratio

Nifty index funds and exchange-traded funds (ETFs) are actively managed funds. As a result, unlike mutual funds, fund managers play a less active role. As a result, the investors’ expense ratio is reduced.

• Free from fund manager bias

As previously stated, index funds or ETFs simply track the index fund and attempt to replicate its performance with as few tracking problems as possible. As a result, because they are actively managed funds, the investment managers do not have any bias when selecting investments for the fund.

• Diversified portfolio

Investors in index funds and marketplace funds (ETFs) get a diversified portfolio for each unit of the fund. Through index funds and ETFs, investors can gain access to not only various stocks but also various industries.

Limitations of Investing in Nifty 50

The companies listed on Nifty 50 are large companies that have matured businesses and pose a low risk to investors; therefore, the company may have a stagnant growth rate as compared to mid-cap and small-cap companies that might give its investors an exceptional return on their investments, which is very unlikely in companies having matured businesses.

As we are aware that market forces determine the prices of securities; therefore, it is very difficult to predict the movement of indices accurately. The factors that affect market prices are

•  Supply and demand for its shares in the market
•  Market sentiment
•  Government policies; which may change from time to time
•  Financial performance, and future expected performance of a company
•  Other related news.

 Conclusion:

Nifty 50 is an index that includes India’s top 50 listed companies calculated using float-adjusted and market capitalization methods. The index’s value fluctuates in real-time as the share price changes. Old corporations that do not do well are gradually replaced by new ones that match the index’s parameters. The math above is only valid for the Nifty. Other indexes, such as the Sensex, are calculated differently and use different base periods and base values.

Nifty 50 is one the most prominent index on NSE with quality stocks under its portfolio. This classification of this benchmark is acceptable as it uses shares available to investors (i.e., free float shares) with market capitalization to weight the stock as this helps to understand demand and supply in the market.

Even a non-specialist can understand what someone is referring to when they use the term cash flow. Cash flows have been the basis of identifying a business from aeons. 

In corporate finance, FCF, or Free cash flow, represents the amount by which a business’s cash flow from operations exceeds its working capital requirements and capital expenditures. 

Free cash flow includes capital expenditures such as spending on pieces of equipment and assets and changes in working capital. Still, it excludes non-cash expenses from the Profit and Loss Statement.  

In most cases, analysts and investors use free cash flow to evaluate a company’s performance as a measure of profitability instead of EPS (Earnings per share).

How vital is free cash flow?

Free cash flow tends to facilitate decision-making in a company. The value of free cash flow can help decide whether the company wants to expand its business or pay a dividend on the shares. Expansion of business is also beneficial for the shareholder value.

As a result of free cash, a company can also settle its leverage. 

Free cash flow is a crucial metric. It allows an investor to analyse the future potential of a company to generate profits with more transparency than earnings per share.

Companies with higher free cash flow values look more promising than other companies. It portrays free cash flow as an essential basis for stock pricing. But what makes free cash flow so crucial? To know that, we need to dive into the details.

So, what is free cash flow?

Free cash flow meaning

Free cash flow represents the cash available with the company to repay its creditors or payout interests and dividends to its investors. Generally, it is calculated by deducting capital expenditure from operating cash flow.

Free cash flow formula

The standard formula for calculating free cash flow is:

Free cash flow = Operating cash flow – Capital expenditure.

For a better understanding, let us analyse free cash flow with the help of an example.

Free cash flow calculation

Let us assume a company named Aika Limited published its cash flow statement for the financial year ending 2021.

The accounting statement of Aika Limited states that:

Cash Flow From Operating Activities = INR 10,000 crores

Capital Expenditures = INR 3,500 crores.

We are required to calculate the free cash flow of the company.

Now, we already know that,

Operating cash flow of Aika Limited = 10,000 crores

and,

Capital expenditure of Aika Limited = 3,500 crores.

The formula for free cash flow:

Free cash flow = Operating cash flow – Capital expenditure

Free cash flow = INR 10,000 crores – INR 3,500 crores 

Free cash flow = INR 6,500 crores.

Interpretation

Aika Limited has a free cash flow of INR 6,500 crores, which means it has INR 6,500 crores remaining after paying its capital expenditures. Aika Limited can use this money to pay dividends or debts, and they can also use it to expand their business.

Three types of free cash flow formula

Different companies have different accounting fundamentals. Hence, there are various ways to calculate free cash flows.

 Irrespective of the method used to calculate free cash flow, the end value will be the same for the given information. 

There are three ways to calculate free cash flow. The methodologies involve calculating free cash flow by using operating cash flow, sales revenue, and net operating profits after tax. 

Let us understand how to calculate free cash flow by using each one of them.

Operating cash flow

The most common method of calculating free cash flow is operating cash flow, and it is the simplest method, involving only two components: operating cash flow and capital expenditure. To determine the free cash flow value, one must deduct capital expenditure from operating cash flow.

The formula for calculating free cash flow using operating cash flow is:

Free cash flow = Operating cash flow – Capital Expenditure.

Sales Revenue 

Calculating free cash flow by using sales revenue means adding the income earned by a company through its core operations and then deducting the total cost incurred to carry out those operations. 

This method is used to calculate free cash flow when the income statement and balance sheet are the primary sources of information.

The formula for calculating free cash flow using sales revenue is:

Free cash flow = Sales Revenue – (Operating Costs + Taxes ) – investments required in operating capital. 

Where,

Investments required in operating capital = Total net operating capital of 1st year – total net operating capital of 2nd year.

Now, Total net operating capital = Net operating working capital + Net plant, property and equipment (operating long-term assets).

Further, Net operating working capital = Operating current assets – Operating current liabilities.

And, Operating current assets comprise cash, account receivables and inventories, while current operating liabilities include account payables and accrued payments.

Net operating profits after tax

We find that it is similar to calculating sales revenue during the free cash flow analysis by using net operating profit after tax. But, in this method, operating income is used instead of sales revenue.

The formula for calculating free cash flow using net operating profits after tax is:

Free cash flow = Net operating profit after taxes – Net investment in the operating capital.

Where,

Net operating profit after taxes = Operating income X (1 – tax rate ) 

Now, Operating income = Gross profit – Operating expenses. 

Significance of free cash flow

Free cash flow is a professional financial tool for analysing a company’s profitability, liquidity, and efficiency. 

A movement in free cash flow value often indicates the firm’s performance, and the performance may be positive or negative depending upon the change. 

Let us understand the significance behind changing values of free cash flow.

Increased value

There can be many reasons behind an increase in the value of free cash flow, and these reasons are an indicator of the company’s performance. Here is a list of reasons behind increased free cash flow.

• The company must have sold some of its corporate assets.
• The company must have reduced its capital expenditure (CAPEX)
• The company must have delayed the salary payment to its employees.
• The company must have decided on cost-cutting. It must be reducing a few costs like marketing costs.
• The company must have booked a colossal deal that could have resulted in a substantial deposit.
• The account receivables of the company might have increased.
• The company must have delayed the payment of its account payables.

Decreased value

A decrease in the value of cash-free flow could be because of the following reasons:

• The company must have increased its working capital.
• The company must have received a large stock order. 
• The company must have invested in a piece of significant machinery or equipment.
• The company must be experiencing rapid growth and development and expanding too fast.

A calculation of the firm’s free cash flow and equity

The free cash flow can be categorised into two types: 

1. Free cash flow to the firm (FCFF) 

Free cash flow to the firm is a metric to gauge the ability of a firm to generate cash by factoring in its capital expenditure. 

Free cash flow to the firm is also known as unlevered free cash flow. The calculation of this metric is facilitated through cash flow generated from operations. 

Instead of cash flow generated from operations, an individual can also use the net income of the organisation to calculate free cash flow for the firm (FCFF).

The formula used for calculating free cash flow to the firm:

Free cash flow to the firm = Cash flow generated from operating activities – capital expenditure

Or

Free cash flow to the firm = Net earnings – capital expenditure. 

2. Free cash flow to equity (FCFE)

Also known as levered cash flow, free cash flow to equity determines the money a company can distribute as dividends to its equity shareholders. 

If all the reinvestments are taken care of along with payment of all expenses and debt, a company might also use free cash flow to equity for share buybacks. 

But, overall, free cash flow to equity (FCFE) is the free cash flow available for equity shareholders after deducting the tax on the interest amount.

The formula used for calculating free cash flow to equity (FCFE) is as follows:

Free cash flow to equity = free cash flow to the firm + Net borrowing – Interest amount*(1-tax).

Merits of free cash flow

Free cash flow is beneficial for various parties like investors, creditors and partners. To provide a better understanding, we have listed the merits of Free cash flow for each party. 

For investment analysts and financial experts.

• The free cash flow amount indicates the excess revenue after payment of capital expenditure. An excess of free cash flow signifies growth. Hence, the free cash flow helps an investor identify companies with potential future development.
• The free cash flow helps an investor identify the financial position of a company. This information is crucial for the investor to determine if the company will pay dividends or not. 
• The free cash flow value also makes investors aware of whether the company is paying dividends on the total amount they have earned or used for another purpose.
• The value of cash available is helpful for the investor to associate this amount with the company’s profitability.

Creditors

Creditors are the ones who provide substantial capital to businesses for their ventures. They are lending considerable wealth at times, and it can be risky. Therefore, creditors like to stay aware of specific figures. The free cash flow provides those figures to the creditors. It is a tool used by creditors to analyse the repayment capabilities of any company. 

After analysing the repayment capabilities of a company through free cash flow, the creditors can then decide with ease whether they want to sanction a loan amount to a particular company or not.

Partners

If someone is looking for a business partner, they often look for entities skilled at having enough earnings to sustain themselves. 

The free cash flow helps individuals analyse a company’s operations before deciding on their partnership business model. A company with better free cash flow is always preferred over others.

Demerits of free cash flow

Now, let us look at the flip side of free cash flow. There are certain restrictions when it comes to free cash flow, and the demerits are as follows:

• Capital expenditure by a company varies every year, and it is also different for companies in various industries. Hence, if one wants to gain a holistic picture of the company’s backdrop, one needs to analyse the company’s past free cash flows for an extended period.
• A company can have a higher value of free cash flow. Though, it is said that an excellent free cash flow states that a company is financially stable. But, an extremely high value of free cash flow can be alarming. Such a value indicates that the company is not investing money in its business venture, which can be detrimental to its business expansion objectives. 
• A low value of free cash flow does not always mean that the company is not financially stable, and it might also be that the company reinvest most of its funds to facilitate growth and expansion. To look at the unbiased picture of a business, an individual must consider looking into other metrics along with the free cash flow. 

Why are Amortisation and Depreciation added back during free cash flow calculation?

If one wants to calculate free cash flow with the help of depreciation and amortisation, then one needs to add them back to the net income. 

Sometimes, additional changes are made in working capital by subtracting current liabilities from current assets. 

The formula for calculating free cash flow with depreciation and amortisation is:

Free cash flow = Net cash flow + Depreciation/Amortisation – (current assets – current liabilities) – capital expenditure.

One might ask why we add back depreciation and amortisation when they are capital expenses. 

The primary purpose of adding depreciation and amortisation is to look at current cash spending instead of past transactions. 

The judgement makes free cash flow a crucial instrument for identifying potential companies with high upfront costs.

Note: Upfront costs can severely reduce earnings currently but can contribute to substantial future growth in a company.

Final thoughts

Free cash flow is a crucial metric for analysing the financial stability of a company. It informs an individual about the cash funds left in a company after accounting for the operating and capital expenditures. 

A higher free cash flow indicates a robust company with a better financial position. The company can distribute its free cash flow to the shareholders by paying dividends, and it can also reduce the debt by repaying the creditors with free cash flow. 

Free cash flow is also said to deliver more transparent results than earnings per share.

We have realised, time and again, how assets run as the criterion for the successful evaluation of a business. But, accurately quantifying the financial health of a firm is not a cakewalk. For this, one needs to consider various parameters of fundamental analysis but especially the firm’s liquidity, i.e., Current Ratio and Quick Ratio. 

But. What is liquidity?!

Well. It is the pace at which a company can encash its assets. 

Let us suppose that things start drifting south suddenly, and all bills are due now. So, does the company have enough resources to encash immediately and resolve the situation? 

This question is a vital concern of investors. 

Irrespective of profitability, non-liquidity is always a big red flag for an organisation. Luckily enough, spotting these red flags is not some quantum physics. The most popular method for measuring liquidity is using financial ratios, or should we say, liquidity ratios, to be more precise.

The Current Ratio and the Quick Ratio play a pivotal role in the smooth execution of operations in a firm. Curious about the know-how? 

Read on. We have it all covered.

Why are Current and Quick Ratios important? 

The Current Ratio and Quick Ratio are the crowning glories of financial analysis. They are strong indicators of the cash availability in a company. The ratios are perfect for ascertaining the short-term financial health of a company.

A higher value of these ratios indicates stability in the financial position, whereas low numbers might signal financial hardships.

Now, these ratios are also a token of efficiency. They explain how fast-paced conversion can a company execute from inventories into cash. It tells you the efficiency of operations of the firm in the market. Keeping in mind the motives of the creditors, we can say that liquidity ratios make it easy to determine the creditworthiness of a company. It is, in turn, helpful in offering short-term debts.

The ratios are also a great tool to streamline the working capital requirements of a company. It gives you valuable insights into the operating cycle of the firm. Knowing these insights helps you study the levels of cash and liquid assets at a certain period. Hence, it helps you plan your investments efficiently eventually.

In a nutshell, Current and Quick Ratios are vital for knowing how much money is readily available in the company. It tells you the number of liabilities that a company can pay immediately. So, the main question is, how are these ratios capable of doing that? 

To answer this question, we need to dive into the details of Current and Quick Ratios. Hence, without any further ado, let us dive right in. 

So, what exactly are these ratios?

Let us dissect both the ratios for you step by step. 

Current Ratio 

Definition.

The Current Ratio is the ratio of cash and assets due within a year to the liabilities that require clearance within a year.

The merits of the Current Ratio are as follows:

• It compares all the current assets to the current liabilities.
• It helps the investors by providing information about the liquidity of a company.
• It provides them with a lateral comparison of a company with the other companies.

Demerits of the Current Ratio are as follows:

• It generalises the balance of certain assets and liabilities excessively.
• It also lacks trending information.
• It is difficult for investors to compare industry groups with the help of this ratio.

Formula.

The experts calculate this ratio by comparison of the current assets of a company with its current liabilities.

Hence, the formula for calculating current assets is

CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES.

• Components that are included in the formula.

As listed above, two vital components of the formula are current assets and current liabilities.

Current assets include cash and cash equivalents, trade receivables, prepaid expenses, marketable securities, and Inventories.

Current liabilities include short-term debt (payable within 12 months), outstanding liabilities, trade payables, and other current liabilities.

Examples of Current Ratio 

When a company calculates the Current Ratio just after receiving payment from its debtors, this leads to a high Current Ratio. 

Similarly, when the company calculates the Current Ratio after making payments to creditors, this leads to a low Current Ratio.

Given below is an example to demonstrate the calculation of the Current Ratio.

Manga collections have current assets worth INR 3,00,000 and current liabilities worth INR 1,60,000. Let us calculate the Current Ratio for Manga collections with its formula.

Given,

Current Assets = 3,00,000

Current liabilities = 1,60,000

We know that,

Current Ratio = Current Assets / Current liabilities

Current Ratio = 1,50,000 / 80,000

Current Ratio = 1.875

Interpretation –

A Current Ratio of 1.875 indicates the company can pay its obligations 1.875 times more than its actual value.

Quick Ratio 

• Definition

A Quick Ratio, otherwise called the Acid Test or Liquid Ratio, is a ratio that measures how a company could pay off its liabilities without requiring an additional loan or financial help from major lenders or without having to sell off its assets. 

An asset is said to be liquid if it can be converted into cash in a short period of time without considerable loss of value. 

The vital difference between the Current and Quick Ratio is current assets and liabilities compared to quick assets and liabilities. It determines how liquid your assets and liabilities are and how easily you can convert them into cash. 

The easier it is for the firm to convert assets into cash, the higher the ratio, and the company is less likely to suffer and vice versa.

• Formula

There are many ways to calculate Quick Ratio (QR). 

One of the formulas is by summing up Cash and Equivalents (CE), Marketable Securities (MS), and Account Receivables (AR) and dividing them by Current Liabilities (CL). 

The formula is:

Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivables)/ Current Liabilities.

In another formula, we deduct prepaid expenses and inventories from the current assets and bank overdrafts from the current liabilities.

The formula is:

Quick Ratio= Current assets – (Inventories + Prepaid Expenses)/ Current Liabilities – Bank Overdraft.

The numerator of the formula should include assets that are easy to encash within 90 days or less.

• Components that are included in the formula.

The two main components included in the Quick Ratio are Liquid assets or quick assets and current liabilities. 

Liquid Assets include cash in hand, cash at the bank, bills receivables, Sundry debtors, and Marketable Securities. 

Liquid Assets are ones you can convert into cash as soon as possible, and while doing so, the company does not incur higher costs, and there should be minimal to no loss in value.

Current Liabilities include outstanding expenses, bills payable, sundry creditors, to-be-paid income tax, and dividends payable. 

A company’s short-term obligation becomes due in the next year and is present on the balance sheet.

Examples of Quick Ratio 

Suppose a company named Doodle has following data:

Bank loan = 1,00,000                                                        

Stock in Trade = 1,35,000

Sundry Creditors = 1,50,000                                           

Sundry Debtors = 70,000

Bills payable = 20,000                                                        

Cash in Hand and Cash at Bank = 15,000 + 1,10,000

Then, how do you calculate its Quick Ratio?

We know that,

Quick Ratio = Quick Assets/Current Liabilities.

Now,

The calculation of quick assets includes summing Cash in Hand and at Bank and Sundry Debtors. The calculation for the following are:

 1,25,000 + 70,000 = 1,95,000

Similarly, the calculation for current liabilities includes summing Sundry Creditors and Bills Payable. The calculation for the following are:

1,50,000 + 20,000 = 1, 70,000

So, the Quick Ratio would be = 1,95,000/1,70,000 = 1.14. 

Interpretation –

This ratio indicates that company Y can pay its obligation 1.14 times its actual value.

What are the ideal Current Ratio and Quick Ratio for a company? 

The ideal Current Ratio is 2:1. Now, we know that the Current Ratio denotes the ability of a firm to pay its short-term obligations. 

So, a Current Ratio below 1 signifies that the firm does not have enough liquid assets to meet its short-term obligations if all of them are due at once. 

But, a Current Ratio above 1 signifies that the firm can resolve its insolvency in the short term. 

However, one should not view the Current Ratio as a whole picture. Because it only provides short-term synopsis of the financial health of a company.

So, even if the firm has an ideal Current Ratio, a few factors can be deceiving. Like,

• A firm can demonstrate a Current Ratio of high value, but it might still receive late payments from its debtors. In such a situation, this ratio lacks clarity and can be deceiving.
• The experts say that unwanted inventories might spike the Current Ratio when, in reality, it is nothing but dead stock. 

The ideal Quick Ratio is 1:1. This result of 1:1 suggests that the company has enough assets to pay its short-term obligations. The current assets used in the Quick Ratio are the ones that can be liquidated within a day or two. 

A company with a Quick Ratio value below one might fall short of paying its short-term debts fully. But, a Quick Ratio above one signifies a company that can immediately pay its short-term debt.

Similar to the Current Ratio, the Quick Ratio offers a synopsis of short-term financial health but fails to represent the whole picture of a company. 

It is vital to take into consideration other financial ratios to have a full-fledged assessment of the financial position of an organisation.

A key difference between the Current Ratio and Quick Ratio. 

The ultimate difference between the Current Ratio and Quick Ratio is the difference in measuring a firm’s liquidity. 

The Quick Ratio appears to be all buttoned up with its methodology. It does not include inventory and other assets that cannot be turned into cash instantly. The Quick Ratio is strict in terms of liquidity measurement of an organisation.

Both Current Ratio and Quick Ratio include receivables during their measurement. However, not all receivables are quickly liquidated. So, they both might misrepresent to a certain extent. But, the Quick Ratio is less flawed than the Current Ratio.

Current Ratio v/s Quick Ratio. 

An all-encompassing comparison chart between the Current Ratio and  Quick Ratio would be perfect to deliver a quick overview of the topic. 

So, here we go.

Analysis and special considerations

Companies with an industrial background that requires stocking up the inventories for a season before selling them have a higher Current Ratio. Inventory stock is higher in the peak season but ebbs as the season passes away. 

So, if a company measures its Current Ratio in the peak season, it can show a higher value. But, the off-season calculation may degrade the amount completely. 

Therefore, the Current Ratio may fluctuate heavily for such companies.

However, removing inventory and calculating the Quick Ratio might also deceive you from the true picture. Companies with an industrial background in selling inventory that sells quickly might face low value in Quick Ratio. But, in reality, their inventories are as good as any other quick asset. 

So, the efficacy of the Current Ratio and Quick Ratio is subjective to the type of industry of a business.

Conclusion

The liquidity ratios are vital in understanding the short-term financial health of a firm. But, one ratio can never represent its overall financial position. It is necessary to consider several financial ratios to critically ascertain the accurate report of the financial status of an organisation. 

Once you start understanding what each ratio is trying to tell you, no company can deceive you about its financials.

If an investor has invested their money in a particular firm, they will undoubtedly have concerns about it because they do not want a failed investment. 

I mean, who does? 

The Return on Equity Ratio is a financial metric that tells investors about the management methodology of shareholders’ money by the concerned organisation.  

This ratio can be used to compare companies in the market and deliver peer-to-peer comparisons. It gives accurate indications of the financial efficiency of a company, thereby helping an investor make well informed financial decisions. 

If you also want to make well-informed financial decisions, keep scrolling to read about the meaning of return on equity ratio in detail.

What is Return on Equity Ratio?

Return on Equity Ratio Meaning

Return on Equity (ROE) is calculated by dividing a company’s net income by its shareholders’ equity. It is a metric that describes how well a company manages the money invested in it by shareholders. 

Specifically, it shows what percentage of shareholder’s money is earned as profit by the company after tax and interest costs are considered.

Return on Equity Ratio Formula

The value of the Return on Equity (ROE) ratio is expressed in percentage terms. The formula is:

Return on Equity = Net Income / Equity of the shareholders

or one can also use a different formula derived from the above one like,

Return on Equity = Return on assets x leverage

One can use the latter formula because the return on assets divides net income by total assets, whereas leverage is a division of total assets by equity. So, when we multiply these two parameters together, the total assets are eliminated through cancellation, and it serves the same purpose as the former formula.

Components of the formula

The ROE formula has mainly two components – Net income and Shareholders’ Equity.

Net Income:

The net income reported on a company’s income statement is its bottom-line profit before paying common-stock dividends. Profitability can also be expressed as free cash flow (FCF), which one can use in place of net income.

The income statement shows net income for the previous fiscal year or trailing 12 months—a total of financial activity for that period. The balance sheet is the source of shareholder equity as it consists of a balance of assets and liabilities.

Net income is the sum of a company’s income, net expenses, and taxes for a given period. 

Shareholders’ Equity:

The calculation of the average equity of the shareholder is done by calculating from the start of the period. The periods irrespective of their nature, should correspond to the period in which one earns the net income.

Shareholder equity is the accounting value left for shareholders after a company settles its liabilities with its reported assets. It is equal to assets minus liabilities on a company’s balance sheet. It is important to note that ROE is not the same as return on total assets (ROTA). ROTA is a profitability metric calculated by dividing a company’s earnings before interest and taxes (EBIT) by the number of employees.

Example of ROE calculation

JDP Company is a retail store that sells tools to interior development companies nationwide. They reported INR 3,00,000 as their annual income in the net income statement and average shareholder equity of INR 15,000 during the year. 

How do we calculate the ROE Ratio of JDP?

We are already aware of net income and average shareholder equity figures.

The net income = 3,00,000

and,

Average Shareholders’ Equity = 15000

According to the ROE Ratio Formula,

Return on equity Ratio = Net income/Average Shareholder’s Equity

Hence, return on equity Ratio = 3,00,000/15,000 = 20 %

The Return of Equity of the JDP company is 20 percent.

Interpretation

An ROE Ratio of 20 per cent means that for every rupee invested, the company has generated a profit of 20 paise. This value indicates that the return on investment made by the shareholders is 20 percent. 

The company might distribute some of this profit to the shareholders and reinvest the rest in the business.

DuPont Decomposition of ROE calculation.

The DuPont decomposition is the methodology of calculating the return on equity ratio by detailing the formula into well-formed steps to gain more insights from this ratio.

There are two varieties of return on equity ratio from the perspective of DuPont Analysis.

The first analysis has three steps, while the second analysis has five stages.

Three-step analysis:

Return on Equity Ratio = Net income margin x Asset turnover x Equity multiplier.

Where, Net income margin is the net profit calculation as a percentage of total revenue.

Asset turnover is the division of total revenue by average total assets.

The equity multiplier is a risk indicator that measures leverage in a company.

Five-step analysis:

Return on Equity Ratio = ( Earnings before tax / Sales ) x (Sales / Assets ) x ( Assets / Equity) x (1- Tax Rate)

DuPont analysis is an insightful way of analysing your investment decisions. The five-step and three-step analyses are designed to provide a more profound and better understanding of a company’s financial statements. 

If you are comparing the ROE ratio of two companies with the help of DuPont Analysis, you can quickly point out the facet in which one company is better than the other. 

This ease of analysis is facilitated through detailed steps of DuPont Decomposition.

What is the ideal ROE Ratio?

Performance analysis of a company’s peers determines the return on equity of that stock in terms of better or worse. Utilities, for example, have a lot of assets and debt on their balance sheets but only a modest net income. 

A typical ROE in the utility sector could be 10% or less. A technology or retail company with smaller balance sheet accounts relative to net income may have an 18% or higher standard ROE.

A fair estimate for better decision making is to aim for a return on equity equal to or higher than the average of companies in the same industry. 

For instance, XYZ company has had an 18% return on equity over the last few years with consistent maintenance. 

With this figure, an investor might believe that XYZ’s management is better at generating profits from the company’s assets.

In comparison, ROE ratios that are high or low will differ significantly from one industry group or sector to the next. 

In S&P 500, a ratio at or near 14 percent is acceptable, and a ratio below 10 per cent is poor performance.

Identifying problems with the help of ROE Ratio

It might be the point of discussion for investors as to why an average return on equity is preferable to a return on equity that is double, triple, or even four times that of its peers.

Aren’t stocks with a high return on equity a better buy?

Well, a high return on equity can benefit an investor if the reason behind a company’s substantial net income compared to its equity is nothing but good management and performance. 

But, on the other hand, if a company has a high return on equity because of a low average shareholder equity value compared to net income, it indicates a risky investment.

Substantial Debt

Significant debt is a substantial issue that could result in a high return on equity. Because equity equals assets minus debt, a company’s ROE can increase if it has been borrowing aggressively. 

The greater a company’s debt, the lower its equity can fall. A typical scenario is when a company borrows large sums of debt to repurchase its stock. 

This activity can increase EPS, but it does not affect actual performance or growth rates.

Ever-varying gains

A vital problem with return on equity is that its profits may be inconsistent. 

For instance, Y company has been losing money for several years, and they record each year’s losses as a “retained loss” on the balance sheet in the equity section. The losses faced by company Y have a negative value and reduce shareholders’ equity.

Now assume that Y company received a push in the previous year and has returned to profitability. After many years of losses, the denominator in the ROE calculation is now minimal, making its ROE appear to be misleadingly high.

A negative value of Net income

Finally, a negative net income and a negative shareholders’ equity can result in an artificially high ROE. However, ROE should not be calculated if a company has a net loss or negative shareholders’ equity.

Significant debt or inconsistent profitability are the most common causes of negative shareholder equity. There are exceptions to this rule for profitable companies that have used cash flow to repurchase their stock. 

This methodology is a substitute for paying dividends for most organisations. It has the potential to reduce equity (deduction of buybacks from equity) to the point where the calculation becomes negative. 

In all cases, one should regard high or minus return on equity levels as a red flag that warrants further investigation.

A negative ROE ratio may occur in rare cases due to a cash flow-supported share buyback programme and excellent management, but this is less likely. One cannot compare a company with a negative ROE ratio to other companies with positive ROE ratios.

How do you evaluate the growth rate of stocks with the help of Return on Equity?

ROE can estimate sustainable growth rates and dividend growth rates, assuming that the ratio is in line with or slightly above the peer group average. 

Despite some difficulties, ROE can be a good starting point for developing future estimates of a stock’s growth and dividend growth rates. Both the metrics complement each other when comparing similar businesses more efficiently.

Multiply the ROE by the retention ratio to estimate a company’s future growth rate. The retention ratio is a metric to calculate the net income that the company keeps or reinvests to fund future growth in percentage terms.

Uses of ROE Ratio.

A return on equity of higher value indicates that a company is making good use of its investors’ money, which is why many investors choose companies with High Returns on Equity. 

The ratio of higher value always has the edge over ratios of lower value, but one must not compare them to the proportions of other companies in the industry. Because each industry has a different level of investors and income, ROE cannot be used to compare companies outside of their industries effectively.

Many investors want to also calculate the return on equity at the beginning and end of a period to see how the return changes—this aids in tracking a company’s progress and ability to sustain a positive earnings trend.

Loopholes in ROE Ratio.

Return on equity of a high value is not always cherished. A return on equity value that is alarmingly high can indicate variegated problems.

These problems might include irregular profits or substantial debt and can be harmful to the investment choices of an investor.

To analyse a company, an investor should not use a negative return on equity resulting from a net loss in the income statement or negative shareholders’ equity.

One should never compare companies with negative return on equity to companies with a positive return on equity.

Final Thoughts.

Return on equity assesses how effectively a company can use money from shareholders to generate profits and grow the business. Unlike other return on investment ratios, return on equity measures profitability from the investor’s perspective rather than the company’s. 

In other words, this ratio determines how much money is made by the investor’s share in the company, and it avoids determining profitability through assets or something else.

Overall, the return on equity ratio is well-suited for making better financial decisions by analysing any company’s profitability in the share market.