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Thursday, December 23, 2010

Rules to Invest in the Stock Market



The Stock Market has been an enigma to many investors over the past 2 years. We have seen the great highs of 21000 and we have dug deep down to the 7000 levels. The stock market movement is not rocket science but the perception of a majority of Indian investors is otherwise.

Markets move in a cycle, after every high there is a low and after every low there is growth and a subsequent high. But, we feel that the market is unidirectional. If the market is going up (in a bull run) we expect it to run indefinitely and if it is going down (in a bear run) we expect it to stay down forever. Let us take an example that happened recently. Two months back the markets were hovering around the 21000 levels and everyone was full of positive news that the markets will touch 23000 by year end or by next year. The bubble burst within days and it crashed an average of 300 to 400 points every day and went back to the 18000 levels. Again people started correlating bombings in Korea and said that the markets would stay down. Again surprises galore and within a few more weeks the market is back in the 20000 levels.

The Market is never going to grow tired of throwing surprises which effectively means that the best and the most knowledgeable market gurus need to pay attention and watch out for it.

Amidst all this commotion, the market has taught us a few very valuable lessons that we need to remember. It would be good if we keep these lessons in mind and be a prudent investor to avoid burning our fingers.

Rule 1: Always Stay Cautious

There is a saying in physics, what goes up has to come down, that is gravity. Stock markets aren’t proficient in physics and they don't really follow the laws of gravity. People feel that if there is a steep growth in the market values, they feel correction will eventually happen and the story other way round is true to a certain extent as well. So the best approach is to stay cautious when people are acting out of impulse.

At the current levels, the Indian economy is definitely healthy and in a much better shape than its world counterparts, however when the market goes up to new heights despite similar fundamental valuations, it definitely means that we need to exercise caution before jumping into the bandwagon.

The Lesson here is: Stay cautious and do get carried away by the market movements irrespective of the direction in which it is moving.


Rule 2: Forget the Herd Mentality

Though almost all of us (stock market investors) are decently educated and are civilized, a majority of us still follow the herd mentality. Have you seen a herd of cattle walking about in barren land? The first cow is walking because the owner is dragging it but the rest are following just because the cow in front of it is moving ahead. This is exactly what majority of us do. “Follow the Herd”

I am not saying that we must always stay unique and do the contra but still, we shouldn't be doing something just because everyone around us is doing it. When the markets crashed, some people panicked and started selling their holdings. This triggered further panic and everyone jumped on the sell flock and the market tumbled. Did the basic fundamentals of the companies change? NO. Did the companies go bankrupt? NO. Did news say that certain companies are making losses? NO. The answer will be a whole bunch of No’s to all possible questions that might trigger us to sell a stock. But still, we all sold our holdings and the market plummeted.

The lesson here is: Don't follow the herd. Do your research and stay invested. Don't sell just because people around you are doing it.

Rule 3: Book Profits Systematically

Though the rule is simple, this is probably the most difficult one to follow. When a company stock is going high all of us are tempted to say this “Just a little bit more and I will sell and make a good profit”. Haven’t we all been in this shoe? Definitely we have. But unfortunately, this approach rarely works. It is always advisable to exit from the market in phases. When we buy a stock, it is good to chart out a future course of action based on market movement. We must plan to sell a % of our holdings in the company when it reaches a certain level. This not only helps us to reduce risk but also provides us with an opportunity if the market moves on further. In the whole greed of a just a little bit more, many of us often lose all our holdings and sometimes even get into red.

The Lesson here is: Decide how much growth a stocks price can make over the next few months and decide a target. If the stock reaches the target, book partial or full profit so that, in case the stock tumbles, you don't end up with a full red portfolio.

Rule 4: Stay Away from Penny Stocks

We are all attracted to Penny Stocks. These stocks cost us around Rs. 10 or 20 each and even a small investor can afford hundreds of thousands of shares. Some of them even blow the roof and grow at over 50 or 60% in a matter of days. However, such rises may be purely based on rumors or speculations and they may lack sound fundamentals or financials. Every time you will see that a penny stock which was a hot pick during a bull run, will be nowhere to see when the markets go bust. In fact, these are the ones that go down first and some may even shut down their businesses.

The Lesson here is: Stay away from penny stocks. It is better to buy the shares of a good company with solid fundamentals at Rs.1000 than buy 100 shares of a tom-dick-n-harry company at Rs.10 each.

Rule 5: Forget Fear and Greed

Fear and Greed are two things that determine the way we act or react. When the markets were at the 21000 levels, everyone was sure that it would keep moving northwards, however when the decline started when least expected, panic selling occurred and the market fell terribly.

Fear and greed always have an upper hand in markets, during bull run markets are driven 70% by greed and 30% by fear whereas the same is reverse in case of bear phase. A contrarian strategy always helps, when people are fearful that the markets will come down be greedy to grab the stocks at a particular price, when people are greedy that the markets will climb further be fearful and start exiting from the markets.

The Lesson here is: Don't be afraid of making losses. Every person who claims he is a stock market guru would have incurred losses at some point of his life. The trick is to avoid greed and make wise decisions that can bring profit to us.


Rule 6: Don't forget Debt

Almost every stock market expert would say – “Keep a portion of your investment in debt instruments like band deposits or bonds” Yes you read me right. Debt is a very important asset class. It gives us the cash cushion that we always need and also gives our portfolio its much needed diversification. All wise investors know that they mustn’t put all their eggs in the same basket.

The Lesson here is: Have a diversified portfolio and don't forget debt instruments. You may end up with lesser profits than your counterparts during a bull run but you will be the happiest man of the lot during a bear phase or a market crash.

To Conclude:
Am not trying to be spoil sport about the market going to new heights and nor am I suggesting that the market will go down again. All I am saying is, it is better safe than sorry. After all, its our hard earned money isn’t it…

Happy Investing!!!

Saturday, December 4, 2010

Market Ratios



Market Ratios are useful in measuring investor response to owning a company’s shares and also the cost of issuing shares to the public. Almost all of these ratios can be used to take decisions as to whether we should invest in a company’s stock or not. The ratios that fall under this category are:

1. Earnings Per Share (EPS)
2. Payout Ratio
3. Dividend Cover
4. P/E Ratio
5. Dividend Yield
6. Cash Flow Ratio
7. Price to Book Value Ratio (P/B or PBV)
8. Price to Sales Ratio
9. PEG Ratio

Earnings Per Share:

EPS is a very good indicator of a company's performance. It measures the amount of earnings per each outstanding share of a company’s stock.

Formula:

EPS = Net Profit / Total No. of Common Shares or

EPS = Net Income / Total No. of Common Shares

Here the EPS calculated from the Net Profit would always be lesser than the one calculate from the Net Income but invariably both give us a good measure of the ability of the company to grow and generate additional revenue.

Usually EPS values are compared between companies or between values of the same company over a period of years.

Payout Ratio:

Payout Ratio a.k.a Dividend Payout Ratio is the ratio that tell us the amount of dividend paid by the company to its common stock holders in comparison to its total income for the same time period. This percentage tells us how much dividend is paid by a company in comparison to its total revenues.

Formula:

DPR = Dividends Paid / Net Income for the same time period

A Good DPR is always a sign of a well performing company. If two stocks from the same industry are picked for comparison, the one with the higher DPR always scores more than the one that has little or no DPR.

Dividend Cover:

Dividend Cover is actually the inverse of the Dividend Payout Ratio. It is calculated by comparing the Earnings Per Share (EPS) and the actual dividend paid out per share.

Formula:

DC = EPS / Dividend Paid

P/E Ratio:

P/E Ratio also called Price to Earning Ratio refers to the price paid for a share relative to the annual net income/profit earned by the company per share. The P/E ratio is an indicator of how much investors are willing to pay for a company's share. A higher P/E ratio means that investors are willing to pay a higher premium for a company’s share in comparison to its actual value. A stock with a higher P/E is more expensive than the one with a lesser P/E.

Formula:

P/E = Market Price Per Share / Diluted EPS

The P/E value of a share keeps changing everyday based on the market price fluctuation of the company’s stock.

Dividend Yield:

The Dividend Yield refers to the ratio that helps us identify the dividend income generated by a company for its share holders. A good dividend yield means that the company is doing good business and is also sharing its profits with its investors/share holders.

Formula:

Dividend Yield = Dividend Per Share / Current Market Price per Share

Or

Dividend Yield = Total Dividend Paid / Market Capitalization

Cash Flow Ratio:

The Cash Flow Ratio is used to compare a company's market value to its cash flow.

Formula:

CFR = Market Price per Share / Present Value of Cash Flow per Share

Cash Flow per Share = Total Cash Flow / Total No. of outstanding Shares

Price to Book Value Ratio:

The PBV is a financial ratio that is used to compare a company’s book value to its current market price. Book value denotes the portion of the company held by shareholders.

Formula:

PBV = Market Capitalization / Total Book Value as per the Balance Sheet

Or

PBV = Market Value per Share / Book Value per Share

Book Value per Share = Total Book Value / Total No. of outstanding shares

A point to note here is that, PBV ratios do not directly provide us any information on the company’s ability to generate profits for itself or its shareholders. It gives us some idea of whether an investor is paying too much for what would be left if the company were to go bankrupt immediately.

Price to Sales Ratio:

The Price to Sales Ratio (PSR) is a valuation ratio for stocks that is similar to the EPS ratio we saw earlier in this article. It is used to identify how much of revenue is generated compared to the company’s market price.

Formula:

PSR = Market Capitalization / Total Revenue

Or

PSR = Current Market Price per Share / Revenue per Share

Revenue per Share = Total Revenue / Total No. of Outstanding Shares

PEG Ratio:

Price/Earnings to Growth Ratio is used to determine the relative trade-off between the price of a stock, the EPS and the company’s expected growth. In general, the P/E ratio is higher for a company with a higher growth rate. Thus, using just the P/E ratio would make high growth companies appear to be overvalued in comparison to its peers. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

Formula:

PEG Ratio = PE Ratio / Annual EPS Growth

PEG ratio is a widely employed indicator of a stocks possible true value. Similar to PE ratios, a lower PEG means the stock is undervalued. The PEG is favored by many over the PE ratio because it also considers the company’s growth prospects. The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth. A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns

Debt or Leveraging Ratios




Debt Ratios measure the company’s ability to repay its long-term debt commitments. They are used to calculate the company’s financial leverage. Leverage refers to the amount of money borrowed in order to maintain the stable/steady operation of the organization.

The Ratios that fall under this category are:

1. Debt Ratio
2. Debt to Equity Ratio
3. Interest Coverage Ratio
4. Debt Service Coverage Ratio

Debt Ratio:

Debt Ratio is a ratio that indicates the percentage of a company’s assets that are provided through debt. Companies try to maintain this ratio to be as low as possible because a higher debt ratio means that there is a greater risk associated with its operation.

Formula:

Debt Ratio = Total Liability / Total Assets

Debt to Equity Ratio:

This ratio is used to identify the financial leverage of the company i.e. to identify the degree to which the firm’s activities are funded by the owners money versus the money borrowed from creditors.

The higher a company’s degree of leverage, the more the company is considered risky.

Formula:

DER = Net Debt / Equity

Note: This is the same as the Gearing Ratio that was discussed in Efficiency Ratios

Interest Coverage Ratio:

This ratio is used to determine how easily a company can repay the interest outstanding on its debt commitments. The lower the ratio, the more the company is burdened by debt commitments. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet its interest expenses becomes questionable. An interest coverage ratio of < 1 indicates that the company is not generating sufficient revenue to satisfy its interest expenses. Formula:

ICR = EBIT / Interest Expenses

EBIT – Earnings Before Interest and Taxes

Debt Service Coverage Ratio:

DSCR is similar to the other debt ratios. This is a measure of the amount of cash flow available with the company to meet its annual interest and principal payments on its debt obligations. A DSCR of less than 1 means a negative cash flow. i.e., the company is not generating enough cash flow to meet its debt obligations. Company's try to keep their DSCR to be a value much higher than 1.

Formula:

DSCR = Net Operating Income / Total Debt Service

Activity Ratios




Activity Ratios or Efficiency Ratios are used to measure the effectiveness of a firm’s use of resources. Good companies would always put their resources to optimum utilization. Better the activity or efficiency ratio, the better it is for the company and it means the company is utilizing its resources properly and effectively.

The ratios that come under this category are:

1. Average Collection Period
2. Degree of Operating Leverage
3. Days Sales Outstanding Ratio
4. Average payment period
5. Asset Turnover Ratio
6. Stock Turnover Ratio
7. Receivables Turnover Ratio

Let us take a look at these ratios in a little bit more details.

Average Collection Period:

Most organizations make sales on credit. They usually deliver goods/services to their customers without taking the payments due immediately. There could be a credit cycle understanding between them and their customers who would make periodic payments for the goods/services rendered to them. This ratio is used to calculate the efficiency with which an organization is able to collect the payments due to them from their customers.

Formula:

ACP = Accounts Receivable / (Annual Credit Sales / 365 days)

Here, only credit sales are taken into consideration. Cash sales that are settled immediately are not considered for this calculation.

Degree of Operating Leverage:

DOL is a ratio that is used to identify the changes in the operating leverage that a company requires with growth in sales and income. As and when a company grows and its sales increases, the operating costs also increase and the operating leverage required by the promoters also changes. This ratio helps us identify that value.

Formula:

DOL = Percentage Change in Net Operating Income / Percentage Change in Sales

Days Sales Outstanding Ratio:

The DSO ratio is a financial ratio that illustrates how well a company’s accounts receivables are being managed. Here accounts receivables refer to the amount of money due to the company for the services/goods provided to its customers.

Formula:

DSO = Accounts Receivable / Average sales per day or

DSO = Accounts Receivable / (Annual Sales / 365)

Average Payment Period:

Average Payment Period is the total opposite of the Average Collection Period. This is the average time taken by the company to pay off its credit purchases.

Formula:

APP = Accounts Payable / (Annual Credit Purchases / 365)

Asset Turnover:

Asset Turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating revenue or income for the company. A higher asset turnover ratio implies that the company is operating efficiently and is able to generate solid revenue income using the assets at their disposal.

Formula:

Asset Turnover = Sales / Average Total Assets

Stock Turnover Ratio:

Also called the Inventory Turnover Ratio, this is a measure of the number of times inventory is sold or used in a time period corresponding to the average inventory held by the company. This ratio can help us determine how efficiently the company is using its inventory (raw materials) to generate revenue and income. i.e., how quickly is the company able to transform the inventory into finished goods that can be sold and generate an income.

A high turnover rate means that the company is utilizing its available inventory effectively but a very high value may cause risks of inadequate inventory levels. Whereas, a low turnover rate means that the company is overstocking or there are deficiencies in the production strategies.

Formula:

STR or ITR = Total cost of goods sold / Average Inventory

Receivables Turnover Ratio:

The Receivables turnover ratio is used to measure the number of times on an average; the receivables are collected during a particular timeframe. A good receivables turnover ratio implies that the company is able to efficiently collect its receivables.

Formula:

RTR = Net Credit Sales / Average Net Receivables

Liquidity Ratios




Liquidity refers to the ability of a borrower to pay his debts as and when they fall due. Good liquidity is a requirement of all companies especially banks and other financial institutions. Imagine going to your bank to withdraw cash and the cashier at the counter says, I don't have enough money in the branch come back later. It would be frustrating wouldn't it be? This would not happen if the bank had enough liquidity to meet its daily customer withdrawal needs.

Ok, now coming back to the topic, Liquidity Ratios are the ratios that can be used to measure the liquidity of a company. As a rule of the thumb, all companies must have good liquidity ratios.

The four main ratios that fall under this category are:

1. Current Ratio or Working Capital Ratio
2. Acid-test Ratio or Quick Ratio
3. Cash Ratio
4. Operation Cash-flow ratio

Let us take a look at each of them in detail.

Current Ratio:

The Working Capital Ratio or Current Ratio is a financial ratio that measures whether or not a company has enough cash to pay off all the debt payments that are due over the next 1 year (12 months) It compares the organizations current assets and its current liabilities.

Formula:

WCR = Current Assets / Current Liabilities

Ex: Let us say ABC Corp has total assets of 5 crores and owes State Bank of India a loan of 3 crores to be repaid before the end of next year, the WCR for them would be

WCR = 5,00,00,000/3,00,00,000 = 1.66

This effectively means that, as of today ABC corp has 1.66 rupees for every rupee of debt it owes SBI.

Though this is good, an acceptable WCR in market terms is 2 or greater which shows that the company is sufficiently liquid and financially stable.

Acid Test Ratio:

Acid-test or Quick Ratio measures the ability of a company to use its cash or near cash assets to extinguish or pay-off its current liabilities immediately. Near cash assets are those that can be quickly converted to cash at close to their book values.

Formula:

ATR = (Current Assets – (Inventories + Prepayments)) / Current Liabilities

A company with a quick ratio of less than 1 cannot currently pay-off all its current liabilities. Any good company would want to maintain their acid test ratio to be greater than 1 at all times.

Cash Ratio:

Cash Ratio is a financial ratio that is used to identify the amount of a company’s assets that are maintained as cash or near cash entities. This is extremely important for banks and financial institutions (If you go back to the beginning of this article to the bank – cash withdrawal example, you can now relate the fact that I was in fact talking about this ratio only)

Formula:

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.

Companies strive to maintain a good cash ratio but at the same time try to ensure that they do not hold on to too much cash that is lying idle in their bank accounts.

Operation Cash Flow Ratio:

Operation Cash Flow Ratio is a financial ratio that is used to identify the percentage of money raised by the company as part of the operation cash flow to the total debt the company owes. Operating cash flow is the cash generated from the operations of the organization after excluding taxes, interest paid, investment income etc.

Formula

OCFR = Operation Cash Flow / Total Debts

Profitability Ratios




Profitability Ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return. The purpose of these ratios is to help us identify how profitable an organization is. As an investor I would like to invest only in company’s that are profitable and in best case profitable than all their industry peers.

Some of the ratios that can help us identify a company’s profitability are:

1. Gross Margin or Gross Profit Margin
2. Operating Margin or Operating Profit Margin or Return on Sales (ROS)
3. Profit Margin or Net Profit Margin
4. Return on Equity (ROE)
5. Return on Investment (ROI)
6. Return on Assets (ROA)
7. Return on Assets DuPont (ROA DuPont)
8. Return on Equity DuPont (ROE DuPont)
9. Return on Net Assets (RONA)
10. Return on Capital (ROC)
11. Risk Adjusted Return on Capital (RAROC)
12. Return on Capital Employed (ROCE)
13. Cash Flow Return on Investment (CFROI)
14. Efficiency Ratio
15. Net Gearing or Gearing Ratio
16. Basic Earnings Power Ratio


Gross Margin or Gross Profit Margin:

Gross margin or gross profit margin is the difference between the sales and the production costs of the company after excluding overhead, payroll, taxation, and interest payments. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each rupee of a company's revenue is utilized to cover the costs of goods sold.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income.

Most company’s work towards attaining a particular gross profit margin or bettering it. So in many cases, the selling price of the finished goods is determined based on the margin that the company wishes to attain by selling these goods.

Example: Let us say Mr.X manufactures leather belts and sells them to retail show-rooms. The cost that Mr.X incurs during the production of a single premium quality belt is Rs. 400/- He wishes to maintain a profit margin of 25% on his products. So the price he would sell his belts to his retailers is Rs. 500/-

Formula:

1. Gross Profit / Net Sales or
2. (Net Sales – COGS) / Net Sales

Operating Margin:

Operating Margin is a measurement of what proportion of a company’s revenue is left over, before taxes and other indirect costs are incurred, after paying for variable costs of production like wages, raw materials etc.

A good operating margin is required for a company to be able to pay for its fixed costs like interest on its debt. A higher operating margin means that the company has less financial risk.

Formula:

Operating Margin = (Operating Income / Revenue)

Operating income is the difference between operating revenues and operating expenses

Net Profit Margin:

Net Profit margin is an indicator of the profitability of an organization. This refers to the actual amount of profit the company makes after deducting taxes and operating expenses. All company’s strive to attain a good or rather high net profit margin. A net profit margin is also an indicator of the ability of the organization to control cost and also a good pricing strategy.

Formula:

Net Profit Margin = (Net Profit (After Taxes)/ Revenue) * 100%

Note: It is easy to confuse gross profit margin and net profit margin. Gross profit is the amount of money left after paying for the operating expenditure. Net profit is the amount of money left after paying for operating expenses as well as government taxes. This is the actual amount of profit that goes into your pocket.

Return on Equity:

Return on Equity is a measure of the returns generated by every share of common stock of a company. High ROE does not mean any immediate benefits but an increasing ROE year-on-year means that the company is doing well and is able to grow on its profits.

Formula:

ROE = Net Income / No. of Shares

Net Income – This is the total income of the company after paying preferred stock dividends
No. of Shares – This is the total number of common shares in the market (Does not include Preferred Shares)

Return on Investment:

Return on Investment or Rate of Return or just return is the ratio of the money gained or lost on an investment relative to the amount of money invested. In business perspective, return on investment is the amount of money earned relative to the amount of money put up as capital. ROI is usually expressed as a percentage.

Formula:

ROI = Net Income/Average Owners Equity or

ROI = Net Income/Invested Capital

Return on Assets:

Return on Assets percentage shows us how profitable a company’s assets are in terms of generating revenue. This number tells us what the company can do with the assets it has i.e., how many rupees the company has earned based on every rupee of asset they control. It is a useful number for comparing two evenly matched or competing companies in the same industry. This number may vary widely when we compare companies across industries. Usually companies in capital intensive industries will have lower return on assets.

Formula:

ROA = Net Income from Assets / Total Assets

Return on Assets DuPont:

Return on Assets DuPont is a ratio that shows how the return on assets depends on both asset turnover and profit margin. The DuPont Method or Formula breaks out these two components (asset turnover & profit margin) in order to determine the impact of each on the profitability of the company. This ratio helps to highlight the impact of changes in asset turnover and profit margin.

Formula:

ROA DuPont = (Net Income/Sales) * (Sales/Total Assets)

Return on Equity DuPont:

DuPont Corporation created this type of calculation for Return on Equity. This theory breaks down ROE into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) returns by comparison with companies in the same industry or even between industries.

Formula:

ROE DuPont = Profit Margin * Asset Turnover * Equity Multiplier

Profit Margin = Net Profit / Sales
Asset Turnover = Sales / Assets
Equity Multiplier = Net Profit / Equity

Return on Net Assets:

The Return on Net Assets is a measure of the financial performance of a company that considers the use of its assets into account. The assets the company has at its disposal is also considered as a source of income while calculation of this parameter. Higher the RONA, the better it is for the investors. This directly means that the company is putting its assets to effective use and is generating additional revenue out of the assets rather than let them stay idle like say in a bank account.

Formula:

RONA = Net Income / (Fixed Assets + Working Capital)

If you see this formula, the working capital is also taken into consideration. This is because; the company is anyways using its working capital to generate revenue/income. This number RONA would equate to the Return on Investment if the company’s assets are generating zero revenue.

Return on Capital:

Return on Capital is a financial measure that qualifies how well a company can generate cash flows (income) relative to the capital that was invested in the business. Here capital invested includes all monetary capital invested into the business like long-term debt, common and preferred shares etc.

When the ROC is greater than the cost of capital, the company is generating value a.k.a, the company is making profits. Whereas if the ROC is less than the cost of capital, the company is making losses.

Formula:

ROC = (Net Operating Profit – Adjusted Taxes) / Invested Capital

ROC is usually indicated as a percentage.

Risk Adjusted Return on Capital:

RAROC is a risk based profitability measurement for analyzing the risk-adjusted financial performance of the company and for providing a consistent view of the profitability across businesses. RAROC is usually used in banking parlance where companies have to handle the risk of losses.

In business enterprises, risk is traded off against benefits. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is required to secure the survival of the organization in a worst case scenario; it is a buffer against expected shocks in the market values. Economic capital is a function of credit risk, market risk and operational risk and is often calculated by VaR (Value at Risk). This use of capital based on risk improves the capital allocation across the different functional areas of banks, insurance companies or any other business in which capital is placed at risk for an expected return above the risk-free rate.

Formula:

RAROC = Expected Return / Economic Capital or
RAROC = Expected Return / Value at Risk

Return on Capital Employed:

ROCE compares the earnings of the company based on the capital invested in the company. We compare the pre-tax operating income and the money invested as capital to run the business to derive the ROCE

Formula:

ROCE: EBIT / Capital Employed

EBIT – Earnings before Interest and Taxes
Capital Employed – This is actually the capital investment required to run the company. It can be shareholder funds, bank loans and other debt etc

Capital Employed = Total Assets – Current Liabilities

Cash Flow Return on Investment:

CFROI is a valuation that assumes that the stock market sets prices based on the company's cash flow and not on the corporate performance and earnings. It is calculated by comparing the gross cash flow generated by the company and the gross investment done into the same.

Formula:

CFROI = Gross Cash Flow / Gross Investment

Here Gross Investment refers to the Market Capitalization of the company.

Efficiency Ratio:

Efficiency ratio is a ratio that is usually applied to banks. It is used to determine how effectively an organization is able to carry out its operations. It is calculated by comparing the operating expenses and the revenue. A lower percentage is always better because it means lower expenses and higher earnings.

Formula:

ER = Expenses / Revenue

Net Gearing:

Also called as Gearing Ratio, this ratio is used to identify the financial leverage of the company i.e. to identify the degree to which the firm’s activities are funded by the owners money versus the money borrowed from creditors.

The higher a company’s degree of leverage, the more the company is considered risky.

Formula:

Gearing Ratio = Net Debt / Equity

Basic Earnings Power Ratio:

The basic earning power ratio (or BEP ratio) compares earnings apart from the influence of taxes or financial leverage, to the assets of the company. It is just a ratio of the earnings of the company and its assets and does not include the capital invested into the company or the tax and interest liabilities.

Formula:

BEPR = EBIT / Total Assets

Financial Ratio

A financial ratio is a relative magnitude of two selected numerical values taken from a Company’s Financial Statements. There are many standard ratios that can be used to evaluate the overall financial condition of a company. Financial ratios can be used by managers of a firm or shareholders (both current and potential) or banks or anyone else to gauge the financial strength of the company. They can be used also to compare the strengths and weaknesses of two or more organizations.

For Ex: If I were to buy a banking stock from the Indian stock market, I can compare the financial ratios of a few of the country’s leading banks like ICICI, HDFC, SBI etc and then choose the one which I feel has the most impressive financial background and strengths.

Sources of Data for Financial Ratios:

Financial ratios of all company’s can be calculated based on their financial statements that would be declared during their quarterly result announcement. Balance Sheet, Income Statement, Statement of Cashflows, Statement of Earnings etc are some of the documents from which the information required for calculating these financial ratios can be picked up. Also, if the company is listed in the stock market, its current stock price too is used for calculating some of these ratios.

Types of Ratios:

There are many different types of financial ratios that can be calculated based on their purpose. They include:

1. Liquidity Ratios – Ability of the company to pay off debt
2. Activity Ratios – How quickly a firm can convert its non-cash assets to cash assets
3. Debt Ratios – Ability of the firm to repay long-term debt
4. Profitability Ratios – To Measure the firms use of its assets and control of its expenses to generate an acceptable rate of return
5. Market Ratios – To Measure the investor response to owning a company’s stock and also the cost of issuing stock


Use of Financial Ratios:

Financial ratios can be used for comparison
• between two or more companies (ex: comparison between ICICI and HDFC Banks)
• between two or more industries (ex: comparison between the Banking and Auto industry)
• between different time-periods for the same company (ex: comparison on the results of the company in the current financial year and the previous year)
• between a single company and the industry performance

Ratios are generally meaningless unless we benchmark them against something else. Like say past performance or another company. Ratios of firms that operate in different industries, which face different risks, capital requirements, competition, customer demand etc can be very hard to compare.

Terms from a financial statement that will be used in calculation of a ratio:

1. Sales – This refers to the net sales done by the company during the reporting period (After deducting returns, allowances and discounts charged on the invoice)
2. Net Income – Amount earned by the company after taxes, depreciation, amortization and payment of interests
3. COGS – Cost of goods sold or cost of sales
4. EBIT – Earnings before Interest and Taxes
5. EBITDA – Earnings before Interest, Taxes, Depreciation and Amortization
6. EPS – Earnings Per Share

Subsequent articles would involve in depth details about the different types of financial ratios explained in this article.

Please Note: Many of these ratios are complicated and their explanations would run along to pages. I have tried to keep the explanation as short as possible to ensure that the topic does not become boring :)

Happy Reading!!!

Friday, December 3, 2010

Can I Withdraw Money from My Employee Provident Fund (EPF) Account?


Almost all of us are working for a company and we contribute a small percentage of our monthly salary into our EPF accounts. We all know that PF is a great saving instrument and it will help us generate a corpus for our retirement. All that being said, many of us do not know the fact that we can withdraw money from our PF account for emergency cash requirements. Yes, you read me right. WE CAN withdraw money from our PF accounts. After all, it is our money and we definitely have the right to take it when we need it the most.

A Word of Caution before we proceed:

The Purpose of the PF account is to generate a corpus for our retirement. So, we cannot and should not treat it like a bank account. We cannot try and withdraw every few months of whatever is left in our account. If possible, try to manage the situation without having to dip into the PF Savings. If nothing works, then check if you meet any of the below mentioned criterion and if you do, get the money from your PF Account.

Premature withdrawals can be made from your EPF corpus if the reason falls under any of the below mentioned categories and you satisfy all the necessary requirements.

Justified Reasons for PF Withdrawal
Reason Requirements Amount You Can Withdraw No. of Times allowed
Marriage or Education 1. Must have completed 7 years of Service
2. Can withdraw for self/children/siblings marriage
3. Can withdraw for self/childrens education
50% of the corpus 3 times during your Total service
Medical Treatment 1. Can withdraw for medical treatment of self/children/spouse/parents
2. No Restrictions on No. of years of service
Total corpus or 6 times your Monthly Basic Salary (Whichever is lesser) No Restrictions (Anytime)
Purchase or Construction of House 1. Must have completed 5 years of Service
2. House must be registered in your name or spouse's name or jointly owned
Upto 36 times your Monthly Basic Salary Only Once in your Total Service
Repayment of Housing Loan 1. Must have completed 10 years of service
2. House must be registered in your name or spouse's name or jointly owned
Upto 36 times your Monthly Basic Salary Only Once in your Total Service
Purchase of Plot 1. Must have completed 5 years of service
2. House must be registered in your name or spouse's name or jointly owned
Upto 24 times your Monthly Basic Salary Only Once in your Total Service
Alteration of House 1. Must have completed 5 years of Service
2. House must be registered in your name or spouse's name or jointly owned
Upto 12 times your Monthly Basic Salary Only Once in your Total Service
Pre-Retirement 1. Must be 54 years of age or
2. One year before Retirement whichever is Later
90% of your Total Corpus Only Once in your Total Service


Things to Remember:

1. Salary here refers to your basic salary and not your total monthly salary
2. If the actual amount in your PF corpus is not enough to meet the multiple mentioned above, you will get whatever is present in the corpus. For ex: For repaying house loan you can actually get 36 times. If your Basic Salary is Rs. 10,000 you can get upto 3.6 lakhs provided your PF corpus actually has 3.6 lakhs. If your PF Account does not have 3.6 lakhs you will get whatever money is present in your PF Account.

Documents Required:

In the below section, the most important documents required to apply for the withdrawal facility is mentioned. Note that, the term Member here refers to the person on whose name the Employee Provident Fund account is held (a.k.a The Employee/You/Me)

Marriage:

Marriage Invitation card should be submitted along with form as proof for marriage through employer.

Education:

Member should apply in Form 31 through employer. A Bonafide certificate duly indicating the fees payable from the educational institution must be submitted as proof.

For Medical Treatment:

Member should obtain certificate from ESI or from employer that E.S.I. facility are not available for the member. A doctor of the hospital certifies that a surgical operation or hospitalization for 1 month or more is/was necessary. Incase of TB or leprosy etc, a specialist doctor should certify the disease. A certified proof for the said disease has to be submitted along with the application in Form 31 through employer.

Purchase of Flat/House:

House/Flat should be free from encumbrances or Legal Issues. An Agreement with the Flat promoter should be registered under the Indian Registration Act and submitted as proof along with the application form.

Alteration / Modification of House:

The Member must have resided atleast 5 years or more in the house that he/she wishes to alter/modify. I could not find any concrete evidence about the documents required in this case. I assume you will need some sort of quotation that will state the amount you will incur in the alteration of the house from a registered contractor/builder. Without this, there is no way to know if you really are going to alter your house.

Repayment of Loan:

Property must be singly or jointly owned by the Member. Proof of owning the property & repayment of the loan must be submitted along with the application form. The amount will be paid directly to the loan lending agency and will not be released to the member.


To Conclude: As mentioned in the beginning of the article, the purpose of the EPF corpus is to help us post Retirement. It is advisable to leave it as such and reap the full benefits of compounding post retirement. Of course, if it is an emergency the money is all yours to spend.

Happy Saving!!!

Some Additions - 19-Oct-2012:

One of our blog readers had emailed me asking what could he do to withdraw his EPF corpus after he quit his job. The employer too wrapped up and went out of business. So, he is now stuck without know how to get his money. I believe some of our blog readers who resign from a company in not-so-good kind of terms with their current employer too face scenarios where they do not cooperate in the withdrawal of our life savings. So this next section is for them:

What happens if my past employer is Unavailable?

In the rare scenario that your old employer is unavailable (They closed down or for whatever reason) you can still get the Transfer/Withdrawal completed.

In such a case – the employee (you) has to submit an identity proof (PAN Card, Voters ID Card, Ration Card or Passport) and proof of residence (Copy of electricity bill, landline phone bill or drivers license) must be submitted along with the form.

The Withdrawal request is usually attested by the employer involved. In this case, if the old employer around to attest it you can get the form attested by the bank manager (of the bank branch where you hold an account, the account where the PF money will get credited) and then submit it to the PF Office.


Where can I get the PF Forms?

The following website has all the forms you will need with respect to your EPF Accounts.
http://www.epfindia.gov.in/downloads_forms.html


Things to remember:

1. Final settlement withdrawal request can be made only after 2 full months after resignation
2. Any payment above Rs. 2000/- will be done via direct credit into the bank account.
3. Form 19 is for EPF withdrawal and Form 10C is for EPS (Pension) withdrawal
4. EPS withdrawal will be approved only if your PF account was active for a continuous 10 year period.


An Appeal:
If you feel this article would be useful to all your friends and colleagues employed in India, please share the link to them. Let them also get this important information that maybe useful in future.

All - It seems there is some problem with the comments widget for this article because there are more than 200+ comments in this article. So, if you have any queries about this article or EPF Withdrawal leave your comment in the facebook page of this blog and I will answer it. Thank you for the understanding
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