Table of Contents
Cash flows vs. Profit
Relevant Cash Flows.
‘Make or Buy’ Decision.
Part a: Adjusted Book Value Approach.
Part b: Market Multiple Ratios For Reliance Ltd.
Both the income statement and the cash flow statement (and the position statement) are considered to be the integral parts of company’s financial statements. The income statement determines the financial performance of a company by quantifying factors including sales, expenses, losses, or profits over a specific time period. On the other hand, the statement of cash flows (or the cash flow statement) determines the inflows and outflows of cash from the company, in other words, the sources of cash and its relevant uses for a company over a specific time period.
Income statement are prepared on accrual basis that means credit sales for which cash has not yet been received are also included to increase the profit figures. On the other hand cash flow statement is prepared on the cash basis and shows whether a company is actually generating cash or not, that means credit sales will not become a part of cash flow statements.
Cash flow statement is divided into three major parts including cash flow from:-
Cash flow from operating activities resembles income statement, but relatively produces better performance results. Although, large numbers of corporate managers, investors and other stakeholders are more relied toward net income, but cash flow statements can provide better metric of the financial health of the company due to the following two main reasons:-
Cash is king
It is an accounting fact that cash flow position can remain negative while company is making a profit. It can be understand with the case study of rogue trader Nick Leeson, an employee at Barings banks, who booked huge profits on papers but there were zero cash inflows. Considering the large book-profits that Leeson showed, Barings kept on funding (cash outflow) him, which eventually led into bankruptcy of Barings- Bank.
An example of income manipulation can be "stuffing the channel". To increase sales, company liberates its credit policy and provides incentives to retailers. As a result accrued earnings get increased, but actual cash never get received. The company’s sales increase for one quarter, at the cost of next period called "stealing of sales”.
The cash flow statement can catch such gimmicks. For example, when operating cash flows are lower than net income, then it becomes evident that there are some errors or loopholes in the cash cycle of the company.
In extreme cases, a company could report negative operating cash flow in consecutive quarters, but legitimately report positive EPS in accordance with AASB, such situations indicates towards a cash hemorrhage (receivables, inventories, etc.). These situations can cause liquidity or solvency issues to the company.
The main factors that drive the use of relevant cash flows while performing investment appraisal capital budgeting analysis are as follows:
Relevant Cash flow includes:
Non-Relevant Costs includes:
Investment appraisal forecasts need to keep in mind ‘inflation’ in the economy because the inflation factor can affect the capital budgeting process in a significant way. It costs a relatively high part of the market rate of return, and the capital budgeting process determines the true cost of the project while utilizing the real rate of return (RRR), rather than the market rate. The real rate of return is calculated by subtracting the inflation by the market rate of return.
The market cost of capital is not able to represent the real cost of borrowing funds, because it does not values for the prevailing inflation rates, which is measure of the decline in the purchasing power of consumers within an economy. For example, an asset worth Rs. 5000 today can be probably valued at Rs. 10,000 after a few years. Therefore it can be said that the discounting rates can be impacted by inflation as project appraisal accounts for forecasting the future and discounting them back to the present value. Thus, when formulating a capital budgeting scenario with the real rate of return, the answer has been adjusted for inflation.
For in-house production, it is required for the business to include expenses that tare related to the procurement of the production equipment, machines and also its maintenance. Apart from that the cost of production or raw material materials has to be accounted. The production costs can further include labor, storage requirements, storage costs overall, proper disposal of byproducts and others.
For buy decision or outsourcing, the primary cost is related to the procurement of the products itself which includes product cost, transportation charges, sales tax charges, etc. The company is also required to account for expenses related to storage and other costs including labor.
The technique that a manager can use to figure out whether in-house manufacturing (making) is better or outsourcing the production to a third-party and buying from there is better is the quantitative analysis that makes determination on the basis of cost-effective approach. That means which ever proposal is incurring lesser costs will be considered to be appropriate for acceptance and the other must be rejected
Economic value determines the maximum amount or price that an investor is willing to pay for a share of profit in the company. Economic value can be higher than the book value.
The book value is the value of a business as per its books of accounts. Theoretically, it represents the total worth of the company in case of liquidation, which the investors and creditors will receive at the end, when all the assets are sold and liabilities are paid.
Adjusted book value measures the value of a company after assets (adjusted for fair market value) and liabilities (including off-balance sheet liabilities). Adjusted book value is used to determine a minimum price or value of a company, anticipating the company to go under liquidation or bankruptcy or sale.
As per the above discussion the adjusted book value approach drags the book value nearer to economic value, because the method makes various adjustments in the values of the balance sheet items as per the financial statements records. These adjustments are made to reflect the true fair market values of these items. Now when these adjustments are made, the assets and liabilities start to account for the actual value or the economic value.
Four specific elements in Reliance’s balance sheet that might need to be adjusted to arrive at an economic value are:-
P/ CF Ratio
The EV/ EBITDA Ratio:
EV/EBITDA of RIL is 11.50. The ratio compares Enterprise Value (EV) of a company with its Earnings before Interest, Tax, and Depreciation & Amortization (EBITDA). The ratio is typically used as a valuation tool to “compare the relative values” of businesses. It determines the amount in EBBITDA times that investors needs to pay to acquire the overall business. A low EV/ EBITDA value is generally preferred.
This is a popular relative valuation tool, in order to value a business; the ratio of the company is compare with the industry average. Since, the EV/ EBITDA measure of RIL (as calculated) is 11.50, now if the industry average is less than 11.50, then the stock is over-valued and vice versa. The metric is also used in calculating the terminal value in a Discounted Cash Flow DCF model.
The PE ratio of the company is 20.08 times. It indicates that to claim every single rupee of profit in the Reliance Ltd, then an investor has to pay Rs 20 (approx). A lower PE ratio is preferred. A PE ratio of 20 might looks high, but the PE ratio and all other market multiples ratios are relative ratios and are required to be compared with peer companies or with industry average to determine relevant information.
Similar to PE ratio, the PCF ratio determines the ability of the company to generate cash (from operations) relative to its stock price. The PCF ratio of RIL is 17.5, which means that the investors of RIL are willing to pay Rs. 17.5 for every Rupee of cash flow.
The P/B ratio reflects the value that investors attach to the equity value of a company as compared to the book value of its equity. The PB ratio of RIL comes out to be 2 times (approx), this indicates that the market price is valued at twice the book value of the company.
Analysis of market multiple ratios:
Market multiples are financial measurement tools that helps in quantifying the values of a company. However, these types of valuation metrics are generally not used in isolation but while comparing a company with another. E.g. the PE ratio of SBI of 9.81 (Yahoo Finance) alone provides very less material information about the valuation of the company, but when it is compared with the PE ratio of HDFC Bank of 17.75, it can be said that to claim a single rupee of earnings stock of SBI is cheaper than HDFC.
Accounting ratios determines the financial health and periodical performance of the company while valuation ratios provide value to the company on the basis of such health and performance. Valuation ratios include and uses market related information for various ratio calculations.
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