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Learning Outcomes.

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

the cash ratio.

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>> Now let's go further.

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

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

We are in order that what did we do?

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

That's what we did.

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

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

That's our next task.

That's what we'll do right now.

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

So you will get this, the income number that we’re interested in is what?

Income from?

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Income from continuing operations.

So we are interested in income from continuing operations.

Always pick up this number first.

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

First, let's focus on this operations part.

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In all our trading strategies, unless and

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

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

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Why this?

Because our task is to find out or

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

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

Is considered sustainable.

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

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

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

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

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

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It doesn't happen all the time.

So such incomes should be excluded.

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

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

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

What do I mean by extraordinary in nature?

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

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

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

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

to previous years.

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

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

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

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

So such expenses also should not be included.

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

Think about it.

When I said such income should not be included,

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

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

you ought to add it back.

You ought to add it back to the income number.

All extraordinary items should be removed.

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

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

So this is very common, right?

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

All this happens all the time.

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

That should not be incorporated,

even the expenditure there should not be incorporated.

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

In many forms this is reported, this asset is.

You will read this number, income from continued operations.

Otherwise, you will have to pick up this number and

do this, a little bit of arithmetic here.

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

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

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

What do I mean by normalizing?

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

Now why do we do this?

So why do we do this normalizing thing every time?

We are normalizing by average total assets.

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

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

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

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

higher cash.

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

has 10% in cash and 90% in accrual.

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

90% cash and 10% accrual.

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

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

So to make two forms comparable,

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

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

So that's the purpose.

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

Now what is step two?

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

So, you remember, how did we calculate?

We took the increase in current asset,

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after taking into account increase in cash.

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

that we subtracted changing current liabilities but while subtracting changing

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

financing operation is not included in current liabilities.

And we also made sure that

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

So, finally we also subtracted depreciation.

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

So that is accrual component.

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

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This is the accrual component.

Now you have income component,

total income component, accrual component, what next?

You should be able to get this.

The difference between the two is what?

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Yes, cash component.

So, now, the third thing is cash component.

All that you’re to do is, let’s call this 1,

let’s call this 2, and 1-2, here you go.

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You will have your cash component.

So you have your total income component.

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

So now you're equipped to any income statement,

if I give you any income statement,

you should be in a position to first calculate accrual.

How will you do it?

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

So you should be able to build accrual component,

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

obviously pick up two subtract this second one from one and

you'll get income from cash component.

So you got these numbers for all companies.

What do you do next?

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

go back to this discussion that we had on after.

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

Sloane says that accrual component of income which is

driven by accrual component is less persistent when compared to

income which is driven by cash component.

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Now that is one part of value.

What is most important for the trader?

Most important practice, the market prices, or

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

Now the best part is although there is a difference,

the market in the short-term fails to distinguish.

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

which this is all Sloane's argument.

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

once the next cycle of earnings are announced.

So that's the whole argument.

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

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

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

all this testing, and all that.

That's not required for my training, but

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

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

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

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

That means if a company has high earnings.

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

High earnings is nothing but better than expected earnings.

And most of it is driven by sale accruals.

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

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

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

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

You can actually verify.

You need not get into regressions.

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

And see what happens to earnings in future.

That's a nice exercise to do.

I strongly encourage you to do it so

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

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

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