Thursday, January 27, 2011

CAPM - Capital Asset Pricing Model


The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula.

Formulae Sheet:

E(ri) = Rf + βi(E(rm) - Rf)

E(ri) = return required on financial asset i

Rf = risk-free rate of return

βi = beta value for financial asset i

E(rm) = average return on the capital market

The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific discipline’ when William Sharpe published his derivation of the CAPM in 1986

Financial Statement Analysis:

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

Tools and Techniques of Financial Statement Analysis:

Following are the most important tools and techniques of financial statement analysis:

Horizontal and Vertical Analysis

Ratios Analysis

1. Horizontal and Vertical Analysis:

Horizontal Analysis or Trend Analysis:

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form.

Trend Percentage:

Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years' financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base

Vertical Analysis:

Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements.

2. Ratios Analysis:

Accounting Ratios Definition, Advantages, Classification and Limitations:

The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another.

Profitability Ratios:

Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under:

Gross profit ratio

Net profit ratio

Operating ratio

Expense ratio

Return on shareholders investment or net worth

Return on equity capital

Return on capital employed (ROCE) Ratio

Dividend yield ratio

Dividend payout ratio

Earnings Per Share (EPS) Ratio

Price earning ratio

Liquidity Ratios:

Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most important liquidity ratios.

Current ratio

Liquid / Acid test / Quick ratio

Activity Ratios:

Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios:

Inventory / Stock turnover ratio

Debtors / Receivables turnover ratio

Average collection period

Creditors / Payable turnover ratio

Working capital turnover ratio

Fixed assets turnover ratio

Over and under trading

Long Term Solvency or Leverage Ratios:

Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios.

Debt-to-equity ratio

Proprietary or Equity ratio

Ratio of fixed assets to shareholders funds

Ratio of current assets to shareholders funds

Interest coverage ratio

Capital gearing ratio

Over and under capitalization

Financial-Accounting- Ratios Formulas:
A collection of financial ratios formulas which can help you calculate financial ratios in a given problem

Limitations of Financial Statement Analysis:

Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.

Advantages of Financial Statement Analysis:

There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.

EPF can make you a crorepati

Don't you hate it when you look at your salary slip and find that sundry deductions have pared it down. But believe us, you should actually feel happy about one of these deductions-the monthly contribution to the Employees' Provident Fund (EPF). The 12% of your basic salary that flows into the EPF every month has the potential to make you a crorepati when you retire.

Sounds unbelievable? After all, the investment seems too small and the interest rate offered doesn't seem too high. But don't forget that a matching contribution comes from your employer every month. Don't also underestimate the power of compounding and what it can do to your retirement savings over the long term. As the graphic above shows, the 8.5% interest earned on the EPF can help a person with a basic salary of Rs 25,000 a month accumulate a gargantuan Rs 1.65 crore in 35 years.

The Direct Taxes Code had initially proposed that new contributions to the EPF be taxed on withdrawal. However, the revised draft has once again made EPF fully exempt. This makes it the best debt option available in the market.

In fact, the EPF can single-handedly account for the debt portion of your financial portfolio. You need not invest in tax inefficient fixed deposits or worry about which debt fund to invest in. All you need to ensure is that you don't ever withdraw from your EPF account till you hang up your boots. If at any stage you find that your debt portion is lagging, you can add more through a voluntary increases in your contribution.

However, few people are able to reach even the Rs 1 crore milestone in their careers. EPF rules allow encashment of the accumulated corpus when a person quits a job and it's not uncommon for people to withdraw their PF at that stage.

This is despite the fact that the government discourages you from withdrawing the money. The withdrawals from the EPF within five years of joining are taxable. The tax will be minimal if the person is jobless and has no significant income from other sources but he won't completely escape the tax net. "When you withdraw you do not let the power of compounding to come into play," cautions Suresh Sadagopan, a Mumbai-based financial planner.

Transfer, don't withdraw - Instead of withdrawing money from the EPF on switching jobs, one should transfer the balance to the new account with the new employer. This does not happen automatically. You need to fill a ‘Form 13' and deposit it with the EPFO. Financial advisers recommend that you put this down among the list of priorities at the new workplace. "You should take up the matter with new organization as soon as you join. With passage of time you might get busy. Also, if your previous organization has lost the records, you could face a hard time looking for your PF details," adds Sadogapan.


What if you don't transfer - Till now, there was no compelling reason to transfer the money from an old account to a new one. Even if you stopped putting money in your account, the balance kept earning interest till the time of withdrawal. This will stop from April 2011. After three years of inactivity, the balance will stop earning interest.

Even otherwise, multiple accounts can be a pain. They only add to your paperwork because you need to keep records of different accounts. Also, you will need to fill up separate forms to withdraw the money from the accounts. The process gets more cumbersome if accounts are located in different cities. "Transferring the balance not only makes it easy to transact, but also gives the subscriber a better idea of how much he has in his account.

In future the social security number, which is in progress, would make EPF portable. "Once this number is allotted to members, they need not switch the funds. The new employer would make the contributions into that account. It will be completely independent of the workplace," he adds