inflation factor

The threat of further inflation will continue to be of major importance to all investors. Because this whole matter has such great investment importance. When its true cause is understood, the investoris unlikely to be confused in his basic thinking by various dogmatic comments of some of our political leaders.

The first thing to consider,of course, is just what we mean by inflation. While there are many complex definitions,For practical purposes, it is sufficient to consider inflation as a condition where by (with only minor and temporary reversals) the total amount of things and services that can be obtained for the same number of money.

In a free economy, capital is allocated through the price system. An interest rate is the price paid by a borrower for the use of an investor's capital.

Interest rates provide the vehicle for allocating capital among firms. In a perfect free-market economy, firms with the most profitable investment opportunities attract capital away from companies with less inviting investment opportunities arising from problems such as inefficiency, low demand for products, poor management, etc. However, a perfect free-market economy doesn't exist. There are imperfections, usually introduced by governments, that lead to the allocation of capital to firms that do not necessarily have the most profitable investment opportunities.

Let's look at some of the factors that influence the level of interest rates

The stated or offered rate of interest (r) reflects three factors:
•Pure rate of interest (r*)
•Premium that reflects expected inflation (IP)
•Premium for risk (RP)

Each of these factors increases the stated interest rate. The resulting interest rate calculation is:

r = r* + IP + RP

Time value of money

The term time value of money refer to all aspects of converting the value of cash flows at one point of time to the equivalent values at another time. To facilitate the financial decision process, it is important that we know the value of current and future cash flows.

Every decision has future consequences that will affect the value of the firm. These consequences will generally include both benefits and costs.  A decision is good for the firm’s investors if it increases the firm’s value by providing benefits whose value exceeds the costs. But comparing costs and benefits is often complicated because they occur at different points in time, may be in different currencies, or may have different risks associated with them. To make a valid comparison, we must use the tools of finance to express all costs and benefits in common terms

The calculation for the present value of a series of cash flows may be used to find out how much an investor will be willing to pay for an investment. Because the investor has a specific required rate of return, it is unlikely that a rational investor will pay more than the present value for an investment.

The term net present value refers to an investor's position after making an investment. To calculate the net present value of an investment, we modify the present value formula by subtracting the initial investment from the present value calculation.

When we compute the value of a cost or benefit in terms of cash today, we refer to it as the present value (PV). Similarly, we define the net present value (NPV) of a project or investment as the difference between the present value of its benefits and the present value of its costs:

NPV = PV ( Benefits) - PV (costs)

NPV = CFt (1/(1+r))^t - CFo

Where ,
CFt =Cash flow in period t
R = Discount rate (required rate of return)
T = Number of cash flows generated by the project
CFo = Initial cash investment
A positive NPV means that the investor paid less than the present value for the stream of cash flows. A negative NPV means that the investor paid more than the present value for the stream of cash flows
Example:

Project A requires a capital investment of $2,000 and promises a payment of $1,000 at the end of Years One, Two, and Three. If the investor's required rate of return is 12%, what is the NPV of the investment? We can use the NPV formula with the values CF1, CF2, and CF3 = $1,000, CF0 = $2,000, T = 3, and R = 0.12.

NPV = $1,000[1 / (1.12)]1 + $1,000[1 / (1.12)]2 + $1,000[1 / (1.12)]3 - $2,000
         = $401.83

A positive NPV means that the investor paid less than the present value for the stream of cash flows. A negative NPV means that the investor paid more than the present value for the stream of cash flows.

Financial statements and "Cheap" Stock

Although the Financial statements is a one way to assess and evaluate the company's performance and the success of one company. Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them.

The next logical step in this type of reasoning: it is also necessary to learn as much as possible about the people who are running the a company under investment considerations.

A worthwhile conclusion as to whether the particular company has outstanding potentialities for growth and development should be based on the examination of each subdivision of a company's organization and by detail of the executive personnel, its production, its sales, and each of its major function. In case of really outstanding company, all of these informations are so crystal clear that even a moderately experienced investor who knows what he is seeking will be able to tell which companies are likely to be enough interest to  him to take further investment decision.

Other major question that confronts every investor that are entrapped by the lure of market is whether to invest on the stocks that "are still cheap" and are worthwhile because "they had not gone up yet"'. Is it wise to invest among stocks which are still undervalued in the market?

While a stock could be attractive when it have a low price earning ratio, a low price earning ratio by  itself guaranteed nothing and is apt to be a warning indicator of the degree of weakness in the company.

What really counts in determining whether a stock is cheap or overpriced is not its ratio to the current year's earnings, but its ratio to the earning a few years ahead. If someone could built up in himself the ability to determine what those earning might be in a few years from now. He would have unlocked the key both to avoid losses and to making magnificient profits.

Cash Flow Statement Part 2

With that brief explanation about the sources and uses of funds, let's take a look at Company's Cash Flow Statement.

As you can see, the Cash Flow Statement is divided into OPERATING ACTIVITIES, Sources and Uses, and FINANCING ACTIVITIES. The final calculation is the NET INCREASE or DECREASE IN CASH AND MARKETABLE SECURITIES. Let's see how we get there.

Operating activities: Sources

Net Income Before Preffered Dividens (if available) and the US$ 445.770 million  (US$ 245. 870 + 199.900 million) Depreciation charge are taken directly from the 2014 Income Statement/ Balance sheet.

The current liabilities from the Balance Sheet are listed individually
(Increase In Accounts Payable, Increase In Accrued Wages and Taxes, Increase In Other Current Liabilities) with their net change from 2013 to 2014. Total Sources From Operations ($120.095 million) is the sum of these sources.

Operating activities: Uses

Next, the net change in each asset account except Cash and Marketable Securities is listed: (Increase In Accounts Receivable, Increase In Inventories, Increase In Prepaid Expenses, Increase In Other Current Assets, Increase In Gross Fixed Assets. Gross Fixed Assets is used instead of Net Fixed Assets because we have already adjusted for Depreciation and we do not want to double count. Total Uses From Operations is the sum of these changes.

Financial activities: 

Finally, we summarize the financing activities by listing each net change from 2013 to 2014 for the potential sources of capital: (Increase In Notes Payable, Increase In Long-Term Bonds, Increase In Preferred Stock, Increase Of Common Stock. Net Funds From Financing is the sum of the financing activities

Total funds from operations and financing.

Total Funds From Operations And Financing is calculated by subtracting the uses from the sources and adding to that number the Net Funds From Financing. In our Company example, that calculation is:

Total operating sources                                                          $92.091 million
- Total operating uses                                                             $25.273 million
+ Net financing sources                                                         (- $55.267) million
____________________________________________________________

 Total funds from operations and financing                            $ 12.151 million

 

Finally, we subtract the total value of the Common and Preferred Dividends (from the Income Statement) to arrive at the net Increase or Decrease in Cash and Marketable Securities (if available).

Cash Flow Statement Part 1

The financial statement that is used to show the sources and uses of a company's funds is called a Cash Flow Statement. The analyst uses the Cash Flow Statement to examine the flow of funds into a company and the use of those funds.

The company's Balance Sheet for the past two years  and the Income Statement provide the information for the Cash Flow Statement as follow, 

Cash Flow Statement is grouped into two main sections:
· Funds generated and used by operating activities
· Funds generated by financing activities

Operating Activities

Sources.

1. An increase in a liability or equity account is a source of cash.
For example, an increase in ACCOUNTS PAYABLE

2. A decrease in an asset account is a source of cash.For example, the increase in the INVENTORY account indicates that  Company increased its investment in inventories.

There are two accounts in the Income Statement that represent sources of cash. The first, NET INCOME BEFORE PREFERRED DIVIDEND and DEPRECIATION.

Uses

 1. A decrease in a liability or equity account is a use of funds.
Paying off a loan is one example. in ACCOUNTS PAYABLE (from $46.627 million in 2013 to $39.639 million in 2014) indicates that in 2014. This means that Company paid off $6.988 million of short-term liabilities.

2. An increase in an asset account is a use of cash.
The increase indicates that funds were used to purchase additional assets.

Financing Activities

Financing activities are related to the buying and selling of capital.  Remember, a company has two alternatives for raising capital: debt and equity. This section of the Cash Flow Statement is a summary of the equity raised and the debt borrowed and paid off. Usually, only the net changes of each account are listed.

Financing activities are related to the buying and selling of capital. Remember, a company has two alternatives for raising capital: debt and equity. This section of the Cash Flow Statement is a summary of the equity raised and the debt borrowed and paid off. Usually, only the net changes of each account are listed.

Depreciation: Case study

The various financial statements are of critical importance to investors and financial managers alike. Depreciation is not a cash expense like Labor and material costs; it is simply a bookkeeping entry on the Balance Sheet and on the Income Statement. Depreciation is deducted when computing net income, but it is not an actual cash outflow. Thus, we add it back to net income when determining the amount of cash the firm has generated.

For a case study, we will use PT XL axiata as an example. PT XL Axiata Tb (EXCL) is a telecommunications services and/ or telecommunications networks company. The Company commenced its commercial operations in 1996. The Company’s majority shareholder, Axiata Investments (Indonesia) Sdn. Bhd., is a wholly owned subsidiary of Axiata Investments. With the market value of 21.352 billion IDR, PT XL Axiata is the second largest Telecommunication provider in Indonesia.

From an investment standpoint, there is important trait that the telecommunication industries have,It has a virtual surety of tremendous growth ahead. Here is an area where annual growth rates are maintained year after year that elsewhere in the financial world would be incredible But as in the fierce competitive struggle in a tropical jungle, many of these exotic
growths can fade about as quickly as they bloom.

During 2007 to 2009, PT XL axiata was going through transformation to upgrade existing telecommunication signal capacity and coverage and investment in data transmission technology.

After  a few years, this company took the lead in the commercial development of the
telecommunication service provider. 

 

Table above shows the income statement for a PT XL axiata.  During 2008 period, the company managed to had its revenue and EBITDA increase 46%. But after EBITDA had adjusted for other other sources of income or expenses, the company had -15 billion IDR net income.

The company used depreciation methods to add the depreciation back to net income, therefore the company managed to have 3,379 billion IDR amount of cash which enable them to invest on data transmission technology and took the lead in Indonesian commercial telecommunication service provider.

 

Keep Them "Barefoot and Pregnant"

 

Indonesia's economic is currently facing the downturn. Its steady economic growth over the past five years has tapered off recently . Most of the price of stocks in Indonesia have escalated compare to its asset values and other earning assets which were exhibited by the high earning/ price ratios over the past five years now begin to fell sharply.

Indonesia's economic decline were caused by several major factors such as corruption, overregulation , inefficiencies of labor supply, etc. But above all of that, the author believes that there were systemic flaws occurred on the indonesia market which leads to highly inflated stock prices over the past years.

This escalated prices were caused by lack of law enforcement in Indonesian securities markets, lack of accountable financial education, and irrational investor sentiment which were propagated mainly by media or the other parties which have the access to the news.

All of the above factors have made "overpriced" equities which will leads to bubble that will burst eventually. The extreme case was the Indonesian economic crisis in 1997 which were mainly caused by the excessive private foreign debt and eventually lead the banking system in Indonesia into demise.

Whilst the government has always careful in managing government debt, 85% of Indonesia's foreign debt increase comes from private loans, and by December 1997 the number of debts to be repaid in private sectors in less than one year amounted to U.S. $ 20.7 billion (World Bank 1998).

This lead to private banks bail out and assets seizure by the Indonesian government which were financed by Indonesian recaps obligation. Up until now the the recaps obligation payment have yet not settle and most of the Indonesian people still have to pay the obligation.. While most of the bankers who received the bail-out had run away with the money or able to buy back its assets long after the crisis with deflated prices.

In this blog, the author hope to give a little contribution for a better Indonesian market with his naive financial opinion rather than keep them "bare foot and pregnant".

Depreciation

Depreciation in the Income Statement is a charge against income based on an estimate of the percentage of the original cost for fixed assets that has been used up in the production process during the period covered by the Income Statement.

Depreciation is not a cash expense like Labor and material costs; it is simply a bookkeeping entry on the Balance Sheet and on the Income Statement. The cash expense for fixed assets is incurred at the time of purchase.

On the Balance Sheet, Gross Fixed Assets (capitalized purchases of property, plants, and equipment) are listed at their purchase price. Accumulated Depreciation (sum of all depreciation charges over the life of the assets currently on the company's Balance Sheet) is deducted to arrive at Net Fixed Assets. Net Fixed Assets can be considered as an estimate of the value of those assets for the remainder of their useful lives.

On the Income Statement, the total Depreciation for the period for all Capitalized Assets is deducted from earnings as an Operating Cost.

For example, the piece of equipment may have an estimated useful life of five years and, therefore, will have no value at the end of the five years. Using a straight-line depreciation method, the annual amount that the company may deduct is ($500,000 - $0) / 5 yrs. = $100,000. There are several different depreciation methods and any accounting text can provide a more detailed discussion of their calculations and uses.

Income Statement

The Income Statement provides a summary of a company's operations and profitability over a given period of time. The income statement or statement of financial performance lists the firm’s revenues and expenses over a period of time. It shows the value of the products and services sold by the company for the reporting period, the costs incurred in achieving those sales, and the distribution of the residual income. The Income Statement provides an analyst with clues about the profitability of a company's operations. A typical Income Statement is shown below

Description of accounts

Whereas the balance sheet shows the firm’s assets and liabilities at a given point in time,

the income statement shows the flow of revenues and expenses generated by those assets
and liabilities between two dates.

Gross Profit. The first two lines of the income statement list the revenues from sales of products and the costs incurred to make and sell the products. Cost of sales shows costs directly related to producing the goods or services being sold, such as manufacturing costs. 

Operating Expenses.  These are expenses from the ordinary course of running the business that are not directly related to producing the goods or services being sold. They include administrative expenses and overhead, salaries, marketing costs, and research and development expenses. The third type of operating expense, depreciation and amortization, is not an actual cash expense but represents an estimate of the costs that arise from wear and tear or obsolescence of the firm’s assets.

Net income. represents the total earnings of the firm’s equity holders. It is often reported on a per-share basis as the firm’s earnings per share (EPS), which we compute by dividing net income by the total number of shares outstanding.

Capital Structure

The companies with the greatest growth prospects were under tremendous pressure on their need for funds and their ability to use funds productively.

The cost of developing the new products followed by the heavy marketing needed to introduce them to the customer was just the first heavy drain on capital needed to finance growth.

One of the fundamental questions in corporate finance is how a firm should choose the set of securities it will issue to raise capital from investors. This decision determines the firm’s capital structure, which is the total amount of debt, equity, and other securities that a firm has outstanding. The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. 

Consider the following investment opportunity. For an initial investment of $500 this year, a project will generate cash flows of either $1100 or $600 next year. The cash flows depend on whether the economy is strong or weak, respectively. Both scenarios are equally likely. Due to the project cash flows depend on the overall economy, they contain market risk. Suppose the current risk-free interest rate is 5%, and the market risk of the investment the appropriate risk premium is 10%.

The expected cash flow in one year is 1/2($1100)+1/2($600)=$850.

The net present value would be NPV = -500 + 850/(1 + 0.15) = 239.1
Thus, the investment has a positive net present value.

If this project is financed using equity alone, how much would investors be willing to pay for the firm’s shares? the market value of the firm’s equity today will be

PV (equity cash flow) = $850/ 1.15 = $ 739.1

The company can raise $739.1 by selling the equity in the firm. After paying the investment cost of $500, the entrepreneur can keep the remaining $239.1 as a profit.

Given equity’s initial value of $ 739.1 shareholders’ returns are either $ 360.9 or - $ 139.1.

The strong and weak economy outcomes are equally likely, so the expected return on the unlevered equity is 1/2($ 360.9 )+1/2 (- $ 139.1 )= 180.45 -69.55 = 110.9.

Financing the firm exclusively with equity is not the company’s only option. The company can
also raise part of the initial capital using debt. Suppose the company decides to borrow $500 initially, because the project’s cash flow will always be enough to repay the debt, the debt is risk free. Thus, the firm can borrow at the risk-free interest rate of 5%, and it will owe the debt holders 500 * 1.05 = $525 in one year.

Financial Statement Analysis part 2

 

Liabilities (Debt) and Equity

Current liabilities
This includes all current liabilities which thecompany is obligated to pay within the next 90 days
· ACCOUNTS PAYABLE – amount owed by the company for materials they have purchased on credit
· NOTES PAYABLE – amount the company has borrowed from banks in the form of short-term loans
· ACCRUED WAGES AND TAXES – for wages, the amount of wages earned by the employees, but not yet paid by the company; for taxes, the amount of taxes incurred by the business, but not yet paid to the respective governments by the company.

Long-term liabilities
These accounts include:
· LONG-TERM DEBT – amount the company has borrowed in the form of bonds sold to investors or banks
· PREFERRED STOCK – amount paid by investors to the company wanting a priority claim on the assets of the company
· COMMON STOCK – amount paid to the company by investors in exchange for a claim on the ownership of the company. Often, the number of outstanding shares is included on this line.
· RETAINED EARNINGS – value of the assets of the company in excess of the claims upon those assets (liabilities and stockholders' ownership). This does not represent cash held in the company.

The stockholders' (common) equity, also known as net worth, is the residual between the value of the assets and the value of the liabilities.
Assets - Liabilities = Common Equity (Net Worth)

Financial Statement Analysis part 1

Public companies are often widely held with investors ranging from individuals who hold one share to large financial institutions that own millions of shares.It  means that stock ownership is most investors’ sole tie to the company. How, then, do investors learn enough about a company to know whether or not they should invest in it? One way firms evaluate their performance and communicate this information to investors is through their financial statements

Companies use financial statements to record their asset investments, report their profitability, and describe their cash flow. There are three types of financial statements:
· Balance Sheet
· Income Statement
· Cash Flow Statement

A typical Balance Sheet looks like the example.

Assets

Assets are used to produce the products or generate the services that are sold by the company. Although all assets are stated in monetary terms, only cash represents actual money.

Some asset accounts represent the current (short-term) assets of Corporation. They include

· CASH – amount of cash held by the company in liquid bank accounts

· MARKETABLE SECURITIES – value of short-term investments held by the company
· ACCOUNTS RECEIVABLE – amount owed to the company by its customers who have purchased their products or services on credit terms
· INVENTORIES – amount of money the company has invested in raw materials, work-in-progress, and finished goods available for sale
· PREPAID EXPENSES – amount of expenses paid by the company before the expense is incurred. One example is rent on an office building paid at the beginning of the year for the entire year.
· OTHER CURRENT ASSETS – any other item related to production that does not fit into the above classifications.

Corporation also has long-term investments for the operation of its business. These asset accounts include:

· GROSS FIXED ASSETS – amount that the company paid for its property, manufacturing plants, and equipment when it acquired those assets at some time in the past
· DEPRECIATION – total amount of money that the company has charged as an expense for using the plants and equipment. Since this account is a deduction from an asset account, it is referred to
as a contra-asset account

· NET FIXED ASSETS – difference between GROSS FIXED ASSETS and DEPRECIATION. This is often called the book value of the fixed assets.

PROGRESS CHECK

1. Suppose that $1.2 million worth of equipment damaged before the company was able to package them. What asset account would be affected?
a) Cash
b) Accounts Receivable
c) Raw Goods Inventory
d) Prepaid Expenses
e) Gross Fixed Assets

2. What should the correct amount be for the Balance Sheet to be correct?
a) 319.4 million
b) 11.12 million
c) 55.93 million
d) 11.55 million
e) 3.545 million

3.  A customer  is no longer able to pay its bills. The amount to be written off as a loss is $1.9 million. What will the new ACCOUNTS RECEIVABLE amount be?

4.  This event will also affect an account on the other side of the Balance Sheet. What is this account?
a) Accounts Payable
b) Notes Payable
c) Long-term Debt
d) Preferred Stock
e) Retained Earnings