Impact Of Adoption Of International Financial Reporting Standards On Key Financial Ratios

Impact of adoption of International Financial Reporting Standards on Key Financial Ratios

By: Deepika Balasubramanian (09IB-016) Gopinath C (09IB-025) Heramb Patil (09IB-026) V Ravikanth (09IB-046)

Introduction

The continental European countries have moved towards a market oriented system from a bank based system with respect to their financial environment. One of the biggest steps taken in this direction was in 2005 when all the listed companies in the European Union started to report their financial statements according to the IFRS (International Financial Reporting Standards). Though the adoption process is cumbersome and expensive, IFRS adoption improves transparency and comparability with other European firms. It helps in improving investor protection and making their capital markets more accessible to the foreign investors. This is a deviation from the general working of the European countries where the information needs of the investor have not been given much preference. To study the impact and consequences of IFRS on the accounting standards, we can consider data from Finland for the following reasons:a) There is extensive transition reporting by Finnish companies as compared to other

European countries. b) The Finnish Accounting Standards (FAS) are similar to the Domestic Accounting Standards (DAS) of other European countries. c) Since it has strong legal enforcement, the transition reporting can be assumed to be

reliable and of good quality. The conversion of FAS into IFRS has the following impact on the key financial ratios:Financial Ratios

Impact

Current Ratio

No significant change

Profitability Ratio

Increase by 9-19%

Price to Earnings (PE)

Decreases by 16%

Quick Ratio

Decreases by 0.5%

Inconsistencies arise when we compare the IFRS and the Continental European Accounting Standards because there are many rules in IFRS which are either not present in DAS or it is optional. Secondly, the DAS may follow tax regulations whereas the IFRS accounting

methods are capital market oriented. Therefore, the domestic standards of the continental European Countries require different accounting and reporting treatment from the IFRS in the following areas:Employees benefits obligations IAS 19 – It requires the employees benefit obligations to be measured at the present value. DAS – Either the rules are missing (e.g. France, Finland) or the calculations are made according to the tax regulations given. Deferred tax IAS 12 – requires a deferred tax liability to be recognized for all taxable temporary differences barring some exceptions. DAS – Rules are missing from DAS or the deferred tax is/can be calculated on the basis of timing differences rather than temporary differences. Intangible assets IAS 38 – An asset can be recognized when it will entail future benefits and when the cost of the asset can be reliably measured. Therefore, items such as research expenditures cannot be capitalized. DAS – Allows research costs internally generated intangible assets, including setup/start-up/pre-operating costs or formation expenses, to be capitalized. Construction contracts IAS 11 – Requires the costs and revenues of construction contracts to be recognized on a stage of completion basis DAS – Recognition by the stage of completion is optional

Inventories IAS 2 – Requires inventory to be measured at the lower of cost and net realizable value. Also it should be valued at full cost.

DAS – Requires inventories to be measured at the replacement cost and instead of net realizable cost and also gives the flexibility to valuate without including production overheads. Share-based payments IFRS 2 – Requires an entity to reflect the effects of share options given to the employees in its profit and loss account. DAS – The general practice is that the share options are not recognized in the financial statements. Fair Value Accounting IFRS – lays emphasis on fair value accounting as it incorporates more information in the financial statements, thus, assisting the investors. It allows the following to be measured at Fair Valuea) Pension liabilities (IAS 19) b) Tangible and intangible fixed assets acquired in a business combination (IFRS 3) c) Pension assets (IAS 19) d) Share based payment liabilities (IFRS 2) e) Investment property (IAS 40) f) Property, plant and equipment (IAS 16)

On the other hand, the continental European countries have been traditionally valuating on the basis of historical cost. In very rare cases there is a fair value measurement option. For instance, if the fair value of a land or water area or security is permanently and significantly higher than its historical cost, the Finnish legislation allows the measurement at market value.

Depreciation IFRS – it requires assets with definite useful life to be depreciated / amortized systematically and assets with indefinite useful life to be assessed for impairment.

DAS – It also requires assets with indefinite useful life to be amortized. The impact of fair value accounting adoption on accounting figures is also an empirical question since it is impossible to predict.

Financial Ratios: Introduction

Financial ratios are used to compare the risk and return of different firms in order to help equity investors and creditors make intelligent investment and credit decisions. Such decisions require both an evaluation of changes in performance over time for a particular investment and a comparison among all firms within a single industry at a specific point in time.

Purpose A primary advantage of ratios is that they can be used to compare the risk and return relationships of firms of different sizes. Ratios can also provide a profile of a firm, its economic characteristics and competitive strategies, and its unique operating financial, and investment characteristics.

Limitation The ratio analysis can be deceptive as it ignores differences among industries, the effect of varying capital structures, and differences in accounting and reporting methods.

Classification of ratios Liquidity Measurement Ratios Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash), its short-term liabilities. In general, the greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting its obligations. The biggest difference between each ratio is the type of assets used in the calculation. While each ratio includes current assets, the more conservative ratios will exclude some current assets as they aren't as easily converted to cash. Liquidity measurement ratios are as follows:

a) Current Ratio b) Quick Ratio c) Cash Ratio d) Cash Conversion Cycle

Profitability Indicator Ratios: These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value. The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders. It is these ratios that can give insight into the all important "profit". Profitability indicator ratios are as follows: a) Profit Margin Analysis b) Effective Tax Rate c) Return on Assets d) Return on Equity e) Return on Capital Employed

Debt Ratios: These ratios give users a general idea of the company's overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy.

Debt ratios are as follows: a) Overview of Debt b) Debt Ratio c) Debt-Equity Ratio d) Capitalization Ratio e) Interest Coverage Ratio f) Cash Flow to Debt Ratio

Operating Performance Ratios: Each of these ratios have differing inputs and measure different segments of a company's overall operational performance, but the ratios do give users insight into the company's performance and management during the period being measured. These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash. Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. In general, the better these ratios are, the better it is for shareholders. Operating performance ratios are as follows: a) Fixed-Asset Turnover b) Sales/Revenue per Employee c) Operating Cycle

Cash Flow Indicator Ratios Cash flow indicators will focus on the cash being generated in terms of how much is being generated and the safety net that it provides to the company. These ratios can give users another look at the financial health and performance of a company. At this point, we all know that profits are very important for a company. However, through the magic of accounting and non-cash-based transactions, companies that appear very

profitable can actually be at a financial risk if they are generating little cash from these profits. For example, if a company makes a ton of sales on credit, they will look profitable but haven't actually received cash for the sales, which can hurt their financial health since they have obligations to pay. The ratios in this section use cash flow compared to other company metrics to determine how much cash they are generating from their sales, the amount of cash they are generating free and clear, and the amount of cash they have to cover obligations. Cash Flow Indicator Ratios are as follows: a) Operating Cash Flow/Sales Ratio b) Free Cash Flow/Operating Cash Ratio c) Cash Flow Coverage Ratio d) Dividend Payout Ratio

Investment Valuation Ratios: These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and to get an idea of its valuation. However, when looking at the financial statements of a company many users can suffer from information overload as there are so many different financial values. Investment valuation ratios attempt to simplify this evaluation process by comparing relevant data that help users gain an estimate of valuation.

Investment Valuation Ratios are as follows: a) Per Share Data b) Price/Book Value Ratio c) Price/Cash Flow Ratio d) Price/Earnings Ratio e) Price/Earnings To Growth Ratio f) Price/Sales Ratio g) Dividend Yield

h) Enterprise Value Multiple Key ratios considered for assignment are:

Operating Profit Margin: This is one of the ‘profitability indicator ratios’ used. It is absolute operating profit as a percentage of net sales/ revenues. These ratios help us to keep score, as measured over time, of management's ability to manage costs and expenses and generate profits. Formula: Operating Margin=Operating Profit Net Sales (Revenue)

Where Operating Profit = Gross Profit - Operating expense Operating expenses would include such account captions as selling, marketing and administrative, research and development, depreciation and amortization, rental properties, etc Significance: The objective of margin analysis is to detect consistency or positive/negative trends in a company's earnings. Positive profit margin analysis translates into positive investment quality. To a large degree, it is the quality, and growth, of a company's earnings that drive its stock price.

Return on Equity: This is another ‘profitability indicator ratios’ used. This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. Formula: Return on Equity=Net IncomeAverage Shareholders'Equity

Significance:

The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors. In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio. Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favored with a relatively high ROA because of a low denominator number. It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio. For the most part, the ROA measurement should be used historically for the company being analyzed. If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type. Simply being categorized in the same industry will not automatically make a company comparable.

Current Ratio: This is one of the ‘liquidity measurement ratios’ used. The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.

Formula: Current Ratio=Current AssetsCurrent Liabilities

Significance: The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better. But in practice a high current ratio is not necessarily good, and a low current ratio is not necessarily bad. When looking at the current ratio, it is important that a company's current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on

company liquidity. Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle. By digging deeper into the current assets, we gain a greater understanding of a company's true liquidity.

Quick Ratio: This is one of the ‘liquidity measurement ratios’ used. The quick ratio or the acid-test ratio - is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Formula: Quick

Ratio=Cash

equivalents+Short-term

Investments+Accounts

ReceivableCurrent Liabilities

Significance: Higher ratio means a more liquid current position. The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a company to meet its short-term liabilities with its short-term assets. Another beneficial use is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory.

Price/ Earnings Ratio: This is one of the ‘investment valuation ratios’ used. The financial reporting of both companies and investment research services use a basic earnings per share (EPS) figure divided into the current stock price to calculate the P/E multiple (i.e. how many times a stock is trading (its price) per each unit of money of EPS). Formula:

PE Ratio=Stock price per ShareEarnings per Share

Or PE Ratio=Total Stock price of all Shares in the marketNet Income

Significance: A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market, as investors are paying more for today's earnings in anticipation of future earnings growth. Hence, as a generalization, stocks with this characteristic are considered to be growth stocks. Conversely, a stock with a low P/E ratio suggests that investors have more modest expectations for its future growth compared to the whole market. The growth investor views high P/E ratio stocks as attractive buys and low P/E stocks as flawed, unattractive prospects. Value investors are not inclined to buy growth stocks at what they consider to be overpriced values, preferring instead to buy what they see as underappreciated and undervalued stocks, at a bargain price, which, over time, will hopefully perform well.

Impact of IFRS Adoption The study analyzed the impact of adoption of IFRS on five key financial ratios and one market based ratio and the results seem to indicate that IFRS changes the magnitude of the ratios significantly. Profitability ratios – Operating Profit Margin (OPM), Return on Equity (ROE), two liquidity ratios – Current Ratio (CR) and Quick Ratio (QR) and the market-based ratio – Price to Earnings ratio (PE) are the ratios used in the study. Among the financial ratios, Current Ratio does not show any significant alteration upon adoption of IFRS. The results of comparison of financial ratios are shown in table 3.

Examining the Balance sheet & Income Statement Balance sheet The results observed can be attributed to the change in the balance sheet and income statement figures reported, conforming to the IFRS standards. The overall effect of IFRS adoption seems to be an increase in the income statement figures reported and lowering of values

reported in balance sheet. Financials reported under heads current assets, equity and advances remain unchanged. The median values of various heads of balance sheet and income statement are shown in table 1. The different entries in a Balance Sheet affected due to the adoption of IFRS / IAS accounting standards are as follows. The entries are in thousands of Euros. Each row in the following table explains the value of the assets & the liabilities recorded as per the FAS or the IFRS / IAS standard. Also the absolute difference in the values and percentage of differences has been displayed.

Table 1 FAS

IFRS/IAS

Difference

% Difference

Assets Inventories

12290

9956

-2334

-18.991

6601

6601

0

0

46444

45610

-834

-1.79571

Equity (1 January)

52799

48104

-4695

-8.89221

Equity (31 December)

46163

48238

2075

4.494942

Equity (average)

49928

49834

-94

-0.18827

Long-term debt (1 January)

12200

16015

3815

31.27049

Cash & Cash Equivalents Current assets Shareholder’s equity & liabilities

Long-term debt (31 December)

11300

15300

4000

35.39823

Long-term debt (average)

11750

15405

3655

31.10638

Current debt (1 January)

8161

8164

3

0.03676

Current debt (31 December)

9900

10281

381

3.848485

Current debt (average)

9221

9549

328

3.557098

Total debt and equity (average)

69249

73079

3830

5.530766

Advances

11600

11600

0

0

Total current liabilities

29656

30097

441

1.487052

Total equity and liabilities (1 January)

79573

83310

3737

4.696317

Total equity and liabilities (31 December)

84848

95247

10399

12.25603

Total equity and liabilities (average)

85442

93844

8402

9.833571

Table 1: Medians of Balance sheet items (thousand Euros)

It can be observed that three Asset & Liability entries have been affected by the new standard, and explained. And it can also be observed that the Long-term debt, as recorded on 31st December, has by 35 % which is the highest change affected by IFRS / IAS. The least effect is on the Cash & Cash equivalent assets and also the Advances. The highest decrease is in the value of the Inventories which decreased by over 19 %, while current assets have decreased only by 1.8 %. The net effect of the adoption of the IFRS on the Assets is of decrease, while the effect on the Liabilities is to increase the values of the entries. This effect can be attributed mainly to the Fair Value accounting advocated by the IFRS.

Also it can be observed that the equity (on an average) decreased by 0.2 % approximately, and current debt (on an average) has decreased by 3.6 %, whilst the total current liabilities decreased only by 1.5 %. In spite of the very large increase in the Long term debt, the Total debt & equity (on an average) changed only by 5.5 % - which is to say that the Long term debt as a percentage of the total debt is less. Since the effect of these standards on the Advances is null, the Total liabilities & equity decreased only by a meager 9.8 %. So, although significant difference can be observed in the Long term debt, the new standard doesn’t affect the Liabilities too much. But the assets are significantly affected by the new standard.

Income statement The new standard has led to a decrease of the Income Taxes by 8.2 %, which is the highest change effected in the Income statement. And Sales has the least effect of a decrease of 0.7 %. The financial income & expenses has increased by 6.7% which is the second highest change recorded in the impact on the Income statement. Table 2: FAS Sales

IFRS/IAS

Difference

% Difference

97140

96469

-671

-0.69076

Operating profit

8896

9298

402

4.518885

Financial income & expenses

-730

-779

-49

6.712329

-2271

-2084

187

-8.23426

7966

7586

-380

-4.77027

Income taxes Net profit

Table 2: Income statement

Examining the Financial Ratios

The analysis reports an increase of 8.4 percent (Table 3) in operating profits margin, OPM, after adoption of IFRS. The change in both sales and operating profits affect the operating margin of a firm and both of them seem to have had significant change after IFRS adoption. But the change in operating profit, the numerator, seems to be much higher than that of sales and has contributed to the big change in operating profit margin ratio. Table 3 FAS

IFRS/IAS

Difference

% Difference

Operating Profit Margin

0.0616

0.0668

0.0052

8.441558

Return On Equity

0.1063

0.1282

0.0219

20.60207

Quick Ratio

0.9638

0.9584

-0.0054

-0.56028

Current Ratio

1.4403

1.416

-0.0243

*

13.3415

11.1048

-2.2367

-16.765

Price to Earnings ratio

Table 3: Comparison of FAS and IFRS based values of financial ratios. All values tabulated are median values for the respective ratios. * Change omitted for CR owing to statistical insignificance.

ROE measures a company’s profitability by revealing the profit generated with the shareholder’s investment and it has had the largest change (20 percent) among the ratios investigated, as can be seen from Table 1. This can be attributed to the increase in numerator of the ratio, net income though there is also a downward revision of the denominator, average shareholder’s equity. This is because change in net income appears to be considerably larger than the change in equity. The PE ratio is the ratio of company’s current share price to average earning per share and is extensively used in investment analysis. The 16 percent decrease in PE multiple can

primarily be explained by the increase in net income of the company and hence an increase in the denominator of the ratio, earnings-per-share. The liquidity ratio (QR) decreases 0.5 per cent, because the denominator (total current liabilities) increases relatively more than the numerator (i.e. current assets minus inventories). As can be seen from the above discussions, the changes in profitability ratios (OPM, ROE, ROIC) and the market-based ratio (PE multiple) are a direct consequence of increase of the figures reported in the income statement. The changes in the liquidity ratio (QR) are primarily because of changes in the assets and liabilities reported in the balance sheet.

Impact of IFRS Adoption on key financial ratios Profitability ratios The table 3 (mentioned above) captures the various standards that have an effect on the Profitability ratios and the Price to Earnings ratio. It has been observed that the effect of the IAS 19 and IFRS 2 standards on the transition is almost zero, but the overall impact might be significant owing to the presence of large number of firms in the market.

Operating Profit Margin: IAS 19 caters to the Employment benefits IFRS 2 caters to the Share based payment IFRS 3 caters to the Business Communications All these three standards have an effect on the Profitability ratios i.e. Operating Profit Margin, Return on Equity and Return on Invested Capital. The IAS 19 (Employment benefits), IFRS 3 (Business Communications) standards have a positive effect, while the IFRS 2 (Share options) standard leads to a decrease in all the three ratios. And contrastingly, IAS 19 and IFRS 3 have a negative impact, while the IFRS 2 has a positive impact on the Price to Earnings ratio. It

is also observed that the strongest impact on all these ratios has been produced by the IFRS 3 standard that refers to Business Communications. In other words, the IFRS 3 produced the maximum impact on the median of all these ratios. The OPM ratio increased by a good 8.4 %, which is attributable to the prominent increase in the Operating Profit by IAS 19 and IFRS 3 and a dilute decrease by the IFRS 2 standard.

Return on Equity: IAS 16 caters to valuation of Property, plant & equipment IAS 32 caters to Disclosure & Presentation These ratios in addition to the standards mentioned above produce a significant effect of 20% on the Return on Equity ratio. The IAS 16 (Valuation of Property, plant & Equipment) and IAS 32 (Disclosure & Presentation) standards dictate the restatement of the Shareholders’ equity and the value of the ROE increases. Though, the IFRS 3 (Business Communications) affects both the Net Profit & Shareholders’ equity, the impact on the numerator is higher than that on the denominator, and thus the ratio increases.

Price to Earnings ratio: The Price to Earnings ratio decreased by a considerable 16 %, mainly due to the IAS 19 (Employee benefits), IFRS 3 (Business Communications). But the IAS 17 (Leases) and IFRS 2 (Share based payment) increase the PE ratio. But the decreasing impact is far higher than the increasing impact and thus leading to an overall decrease in the ratio.

Summary:

The IAS 19 (Employee benefits) increased the Net profits, decreased the Equity & Invested Capital. While, IFRS 3(Business Communications) increases the Net profits considerably and Equity & Invested Capital slightly mainly due to the requirement to assess goodwill for impairment annually instead of amortizing it systematically. And these ratios increase the Profitability ratios and decrease the PE ratio. The IAS 16 (Valuation of Property, plant & Equipment) & IAS 32 (Disclosure & Presentation) decrease the Equity and Invested Capital thus improving the ROE. The requirement to recognize share-base payments or share options in the financial statement and measurement at fair value (IFRS 2) decreased the Net Profits and thus reducing the PE ratio.

Table 4 Operating Profit Margin

Return On Equity

Price to Earnings ratio

IAS

2

None

None

None

IAS

16

None

Average Shareholders’ Equity

None

IAS

17

None

None

Net Income

IAS

19

Operating Profit

Net Income & Average Shareholders’ Equity

Net Income

IAS

32

None

Average Shareholders’ Equity

None

IAS

40

None

None

None

IFRS

2

Operating Profit

Net Profit & Average Shareholders’ Equity

Net Income

IFRS

3

Operating Profit

Net Profit & Average Shareholders’ Equity

Net Income

Liquidity ratios Restating the FAS-based Quick Ratio and Current Ratio led to a decrease in the ratios.

Quick ratio: IAS 39 caters to the recognition and measurement of Derivative Instruments The overall ratio decreased only a meager 0.5 % and is basically because of the decreasing impact of IAS 17 (Leases) and IAS 39 (Derivative instruments) on the denominator.

Current Ratio: IAS 12 caters to Income Taxes In addition to the above mentioned ratios, IAS 12 (Income tax) decreased the Current Ratio, while the IAS 2 (Inventories) increases the numerator.

Summary: The decrease in the liquidity ratio is prominently because of the IAS 17 (Leases). Quick Ratio

Current Ratio

IAS

2

None

Cash instruments

IAS

12

None

Liabilities

IAS

17

Cash Instruments & Current Liabilities

Cash Instruments & Current Liabilities

IAS

32

Current Liabilities

Current Liabilities

Where Cash instruments = Cash equivalents, Short-term Investments, Accounts Receivable

Summary: All the companies adopting the IFRS standard are supposed to produce a transition report that details their financial statements in both the existing standard and IFRS. The impact of IFRS

adoption on key performance indicators considers data from Finland because the transition reporting of Finnish entities is extensive enough. Also the Finnish accounting standards are comparable to the DAS of the continental European countries, and so Finnish data is taken as an appropriate representative of the European conditions. This report discussed the impact of IFRS adoption on the key performance indicators. The report explains the impact in four parts: a) Introduces the IFRS, DAS standards and explains the ground assumptions b) Explains some key financial ratios c) Change in the key financial ratios d) Examining the changes and identifying the various standards that produce the impact The Profitability ratios increased considerably, and the PE ratio decreased significantly. The removal of amortization of purchased goodwill is the reason for increase in the Profitability ratios. The equity and quick ratios decreased slightly. The decrease in the liquidity ratios is explained by the increase in the current liabilities. Overall, the fair value accounting, lease accounting and income tax accounting explain the changes in the key financial ratios. Adoption of the fair value accounting & stricter restrictions with respect to certain accounting issues are the reasons for the changes observed in the accounting figures.

ANNEXURE I – CASELETS Case 1: Issues to look into while analyzing cash flow indicators

Typically when we analyze the cash flows for some infrastructure company always look at the kind of jobs being executed. Also note the major deliverables, their respective schedule and the payment terms accepted in the contract document. These give insight in what can be the impact on the cash flow when the Contractor Company delays in achieving a milestone or say the customer defaults on payment against any one of the milestone activity. Also there can be substantial impact on cash flow for an Infrastructure company (Contractor) when there is difference in agreed payment terms between Contractor and Customer and between Contractor and Vendor. If the vendor delays the cost of delay will be the equivalent to gap risk carried by the Contractor on account of payment terms. For example for a typical combined cycle power project (350 – 400 MW) delay of delivery of critical equipment like Turbine can have impact of INR 30-40 Crores depending on the quantum of delay and weighted average cost of capital for the contractor company.

Case 2: Factors to be looked into when analyzing profitability ratios When you analyze return on equity, look for assets where the equity has been employed. Check if the company under consideration is undergoing change in the assets hold by the company. This may be an issue to be looked in typically for big conglomerates where the company may reduce or withdraw from exposure to one kind of business and/ or get into other kind of business requiring certain different kind of assets. For example, Larsen & Toubro which was initially into Cement business came out of the business and got into new business areas like Power equipment manufacturing and shipbuilding. This restructuring of the company led to change in the asset class hold by the company which also affected the returns from the assets for almost similar quantum of equity.

Case 3: Factors to be looked into when analyzing current ratio or quick ratio If two companies may be having almost same cash ratio or quick ratio then we need to look for other indicators like collection period for accounts receivable and/ or the inventory being turned over in the given period. For instance, the payment terms typically agreed by

General Electric (GE) are on the basis of period from the date of contract whereas in case of Hitachi the payment terms are against the milestones. The result being better cash flow for GE than Hitachi which means GE has better ability to pay off its short term debt obligations in comparison to Hitachi. Also when we compare companies say GE & Mitsubishi Heavy Industries (MHI) in terms of product portfolio, we find MHI offers limited models of turbines typically of higher size whereas GE offers turbines in small size to large size range. Thereby the delivery schedules for GE are more spread over a period when compared to that of MHI for same quantum of order booking. The cash flow are the result of the delivery schedules. Thereby GE has better ability to pay off its short term debt obligations in comparison to MHI because of its wide product portfolio.