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Learning Outcomes.

Â After watching this video, you will be able to calculate the accrual ratio and

Â the cash ratio.

Â [MUSIC]

Â >> Now let's go further.

Â You must be thinking that we can start trading right now.

Â Get into that tool trading strategy, no you're allowed to wait for a while.

Â We are in order that what did we do?

Â We actually figured out how to compute the accrual component of earnings.

Â That's what we did.

Â Now, the next task is to separate accrue and competent from cash competent.

Â So if you are given a total earnings, how do we separate accrual and cash.

Â That's our next task.

Â That's what we'll do right now.

Â So let's say you pick up an income statement.

Â So you will get this, the income number that weâ€™re interested in is what?

Â Income from?

Â 1:19

Income from continuing operations.

Â So we are interested in income from continuing operations.

Â Always pick up this number first.

Â Now why are we stressing on this income from continuing operations?

Â First, let's focus on this operations part.

Â 1:36

In all our trading strategies, unless and

Â otherwise specified, we're interested in that part of earnings,

Â which is from operating, which comes from businesses core operations.

Â 1:49

Why this?

Â Because our task is to find out or

Â aim is to find out earnings which is sustainable, right.

Â So earnings which is coming from core operations of the company.

Â Is considered sustainable.

Â Now assume that a company has sold a large asset in a year and made some profit,

Â suppose it does sold some land, our company had a land which it bought 50

Â years back and sold, it's possible that it makes a huge one time gain but

Â you know clearly that every year cannot be selling your land, right.

Â Well as you [INAUDIBLE] at times it might happen you might get a large tax refund.

Â 2:28

It doesn't happen all the time.

Â So such incomes should be excluded.

Â So if you have incomes which are one time in nature, which are not from operations,

Â which are sort of exceptional items, such income should be excluded.

Â Similarly, if you have expenditures which are extraordinary in nature.

Â What do I mean by extraordinary in nature?

Â Think about an expense of you had provided less for tax in the previous years and

Â it was decided you file a case, and it was decided that the tax expenditure,

Â actual tax that you were supposed to pay, is more than what you provided.

Â So this year you had to pay a certain amount of tax applicable

Â to previous years.

Â Let's, I'm just giving you an example

Â now in the income statement that will be treated as an expense but then.

Â That is not a part of current year and that is not a regular occurrence.

Â It is not the case that every area you love this instance.

Â So such expenses also should not be included.

Â So what do you have to do when I say such expenses should not be included?

Â Think about it.

Â When I said such income should not be included,

Â I said deduct that income from the final number that you have.

Â Similarly, when you think about, if I say that an expense should not be included,

Â you ought to add it back.

Â You ought to add it back to the income number.

Â All extraordinary items should be removed.

Â And, finally, focus on this word continuing as well.

Â 4:08

Now, you may make a one time gain, or a one time loss.

Â So this is very common, right?

Â Companies acquire other companies, sell off some of their divisions.

Â All this happens all the time.

Â So, suppose you have some income from such operations which are discontinued.

Â That should not be incorporated,

Â even the expenditure there should not be incorporated.

Â So first, arrive at this number, income from continued operations.

Â In many forms this is reported, this asset is.

Â You will read this number, income from continued operations.

Â Otherwise, you will have to pick up this number and

Â do this, a little bit of arithmetic here.

Â So that's the reason why I'm explaining how do I average this number.

Â Now, why we're down this line, think about Petrovsky,

Â every number that we have taken there we have normalized it.

Â What do I mean by normalizing?

Â Dividing it by some common element like total assets or total sets.

Â Now why do we do this?

Â So why do we do this normalizing thing every time?

Â We are normalizing by average total assets.

Â Okay, so this is done just to compare, right?

Â Think about the farm with the billion dollar in sale profit.

Â And a firm with $1 million and if you compare that accruals and cash components,

Â it's always the case that the $1 billion firm will have higher accrual and

Â higher cash.

Â 5:41

Let's take a very extreme case, suppose that billion dollar profit firm

Â has 10% in cash and 90% in accrual.

Â And this million dollar form, has on the other hand,

Â 90% cash and 10% accrual.

Â Even then, you will rank the first form higher in terms of accruance,

Â or even in terms of cash, which is not correct.

Â So to make two forms comparable,

Â you general normalize it with either a [INAUDIBLE] sales so

Â that this accrual and cash component can be expressed as a proportion of something.

Â So that's the purpose.

Â So you get this normalized number, income from continuing operations.

Â Now what is step two?

Â Step two is we have already calculated this accrual number, right?

Â So, you remember, how did we calculate?

Â We took the increase in current asset,

Â 6:39

after taking into account increase in cash.

Â So, non-cash current asset that we took from,

Â that we subtracted changing current liabilities but while subtracting changing

Â current liabilities we made sure that the debt, short term debt used for

Â financing operation is not included in current liabilities.

Â And we also made sure that

Â 7:03

any change in tax payment is not included in current liabilities.

Â So, finally we also subtracted depreciation.

Â So we did these three things and arrived at this number.

Â So that is accrual component.

Â So, now what you do is the accrual that you arrived at

Â 7:32

This is the accrual component.

Â Now you have income component,

Â total income component, accrual component, what next?

Â You should be able to get this.

Â The difference between the two is what?

Â 7:45

Yes, cash component.

Â So, now, the third thing is cash component.

Â All that youâ€™re to do is, letâ€™s call this 1,

Â letâ€™s call this 2, and 1-2, here you go.

Â 8:01

You will have your cash component.

Â So you have your total income component.

Â You have your accrual company and you have your cash flow.

Â So now you're equipped to any income statement,

Â if I give you any income statement,

Â you should be in a position to first calculate accrual.

Â How will you do it?

Â Already done go back to the, go back few minutes in this video you will get it.

Â So you should be able to build accrual component,

Â you should be able to arrive at different from continued operations subtract and

Â obviously pick up two subtract this second one from one and

Â you'll get income from cash component.

Â So you got these numbers for all companies.

Â What do you do next?

Â Now, we'll get into trading before that a little bit of why this strategy works,

Â go back to this discussion that we had on after.

Â Now what did, what does loan say in the paper?

Â Sloane says that accrual component of income which is

Â driven by accrual component is less persistent when compared to

Â income which is driven by cash component.

Â 9:21

Now that is one part of value.

Â What is most important for the trader?

Â Most important practice, the market prices, or

Â reacts to earnings announcements as if there is no difference between the two.

Â Now the best part is although there is a difference,

Â the market in the short-term fails to distinguish.

Â Now this is the market failure that leads to profits in the strategy,

Â which this is all Sloane's argument.

Â Now if that is the case, and then the third part is markets correct themselves

Â once the next cycle of earnings are announced.

Â So that's the whole argument.

Â 10:01

So in this paper works Sloane does before actually getting into this

Â actual training, what he does whether he test whether this hypothesis is true.

Â So, many of you may not be interested in regression, and

Â all this testing, and all that.

Â That's not required for my training, but

Â those of you who are interested in this part can look at that part of the paper.

Â Those of you who are interested in learning what is actually going on in

Â Sloane's paper can go through that party actually shows through a regression that

Â the accrual component is less persistent when compared to cash component.

Â That means if a company has high earnings.

Â And if most of its high earnings, what do you mean by high earnings by the way?

Â High earnings is nothing but better than expected earnings.

Â And most of it is driven by sale accruals.

Â You will not see such a firm continuously reporting high earnings in futures.

Â On the other hand, if there are firms which are reporting high earnings, which

Â is driven by cash component, you will see that repeatedly these forms perform.

Â You're on the next quarter or the next year earnings are likely to be better.

Â You can actually verify.

Â You need not get into regressions.

Â You can just separate out companies into high accrual, low accrual.

Â And see what happens to earnings in future.

Â That's a nice exercise to do.

Â I strongly encourage you to do it so

Â that you convince yourself that these firms which are high cash earnings

Â keep performing better of where as firms which are of high accrual earnings

Â do not keep outperformed so that is very important for our strategy.

Â