Tuesday, 22 August 2017

Net interest Margin, Leverage and Capital Adequacy Ratio

Net interest Margin is one of the major parameters used in assessing the performance of a finance company


NIM = Net Interest Income / Asset(i)

= (Interest Income – Interest Expense)/Asset

= (Lending Rate X Asset – Borrowing Rate X Debt)/Asset First Formula

= Lending Rate – (Borrowing Rate X (Debt/Asset)) Second Formula

=Lending Rate -(Borrowing Rate X(Debt/Equity X Equity/Asset)

=Lending Rate -(Borrowing Rate X Leverage X Capital Adequacy Ratio) Expanded Formula

(i)  Please note that Assets here are the loans made by the finance company and not other assets.






Monday, 21 August 2017

How to Value the stock price of a Housing Finance NBFC

The HFCS in India catering only to sub prime housing loans must be valued at and only at the future growth prospects of its earnings, provided they have similar ROE/ ROA and NPA levels compared to their peers

When we value the price of a company's share, in the stock market, the parameters that comes to mind are P/E, P/B. ROE, ROA etc

So how do we value a finance company that primarily deals with housing loans catering to subprime category in India.

The subprime housing loan sector is one of the fastest growing in India. In India, unlike in most developed countries, people usually live in their mortgaged property rather than treating the property a trade commodity. As people do not like to lose their home in which they live, they tend to not to default on their loans. Therefore, the NPA for housing finance companies dealing with sub prime mortgage lending is much lower, when compared to other finance companies.

A typical sub prime mortgage HFC, has an average LTV ( loan to value ) of 70%. Thus the customers are required to put up 30% of the consideration as down payment. This also forces them to treat the loan seriously, unlike what happened in the US sub prime mortgage crisis, where more LTV reached more than 100% at one point.

According to estimates only 15% of the population in India are salaried, 35% non salaried, and rest 50% wage earners. Thus the HFCs which have 50% non salaried customers have a huge untapped market.  This lets them grow their loan book at a rate of more than 20%. Their ROE/ROA is also much higher than other Finance Companies.

Since their earnings also grow rapidly, and have a future predictable growth in earnings, the HFCs are typically values based on their P/E than the P/B multiple.

Normally a finance institution is value based on its P/B ie Price to Book value of Equity. But in case of HFCs, the P?B multiples typically are quite higher.

Why?

Let us examine the ROE

ROE=Earnings/ Book value of Equity
P/E = Price / Earnings

So ROE X PE = Price/ Book value of Equity

So P/B=P/E X ROE

Now we can see that, assuming ROE to be constant, P/B will only depend on P/E which in turn depends on the prospects of future earnings. Since the HFCs PE multiples are valued similar to FMCG companies due to their predictable future earnings growth, PE tends to be very high when compared to other finance companies. 


Another way to value an HFC is Market Cap/ AUM multip


AUM is assets under management

So MCap/ AUM = Price per Assets ( Here other assets are considered insignificant )

= P/A

=P/E X E/A
=P/E X ROA

So again we come to P/E multiple if we consider similar ROA companies.





Sunday, 19 March 2017

Cost of goods sold for a manufacturing company

We know that the basic formula for COGS is

 COGS = Cost of Goods Available for sale-Closing Stock 

 Cost of Goods available for sale.= Opening stock + Purchases

The concise formula therefore is

COGS = Opening stock + Purchases - Closing stock.


But this formula is so basic that it can be applied only to a trading company where nothing is manufactured.

Why?

Because manufacturing company has to account for Raw materials consumed, Work in Progress, Manufacturing over heads such as electricity, fuel, salaries and wages,stores and spares consumed.  transport to warehouse, etc. Also the company may purchase and sale stock without manufacturing it.

The formula of COGS for a manufacturing company is

Formula No 1

COGS = (1) Cost of Raw materials consumed 
           + (2) Purchase of Stock in Trade 
           + (3) Opening stock of WIP 
           + (4) Opening stock of finished goods 
           + (5) Opening stock of stock in trade
            - (6) Closing stock of WIP
            - (7) Closing stock of finished goods 
            - (8) Closing stock of stock in trade 
           + (9)  Manufacturing overheads 
           + (10) Cost of Stores and spares ( including packing materials) consumed
           + (11) Stock adjustments due to mergers and acquisitions 
           + (12) Other adjustments.

Formula No 2

COGS       = Cost of stock in trade sold + Cost of finished goods sold + Cost of Stores and spares ( including packing materials) consumed + Other adjustments.



Most of the balance sheet for Indian companies use the first formula, so that they can represent all the cost components of manufacturing separately.

So, if I am able to start from Formula 2 and slowly expand and reach Formula 1, my mission will be complete.

Now for simplicity sake, let us ignore the Cost of stock in trade sold, Cost of stores and spares (including packing materials consumed) and Other adjustments and focus on Cost of finished Goods only, because, majority of the components of Formula No 1, is present in the Cost of finished goods.

Now before we go further, we need to make a primary assumption, a kind of visualisation, of how the  journey of finished goods, from the purchase of raw materials to the final finished state happens.

For this purpose, we need to imagine that the manufacturing process happens in 3 stages in 3 separate areas of the same building as seen in the image below.




THE FINISHED GOODS AREA


In order to fully understand the concept let us begin at the finished goods area.

In the finished goods area, we manufacture the finished goods, stock them and then sell the finished goods according to the demand from the market.

By using the general formula for COGS, and a bit of thinking, we can accept that the Cost of finished goods sold is

Cost of finished goods sold = Opening stock of finished goods + Cost of manufacturing of finished goods -Closing stock of finished goods. (FORMULA A)

What we need to understand is, what all adds up to the cost of manufacturing of the finished goods.

In the finished goods area, we take the necessary WIP stock from WIP area, use necessary equipments, consumables, fuel and labour to convert WIP to finished goods, which then adds to the finished goods stock.

Cost of manufacturing of finished goods = Cost of WIP used + All the manufacturing overheads for converting WIP to finished goods. (FORMULA B)


THE WIP AREA


In order to find the Cost of WIP used, we need to understand what is happening in the WIP area.

In the WIP area, we source raw material from the raw material area and convert the raw material into WIP, add to the WIP stock and transfer the necessary WIP to the finished goods area.

By using the general formula for COGS, and putting a little spin on it, we can accept that the Cost of WIP used is

Cost of WIP used = 

Opening stock of WIP + Cost of conversion of Raw Material to WIP - Closing stock of WIP. (FORMULA C)


Now let's see, what all adds up to the cost of conversion of Raw materials to WIP.

In WIP area, we take the necessary raw material from raw material area, use necessary equipments, consumables, fuel and labour to convert raw material to WIP, which then adds to the WIP stock.

Cost of conversion of Raw Material to WIP = Cost of Raw material consumed + All the manufacturing overheads for converting Raw material to WIP. (FORMULA D)



THE RAW MATERIALS AREA


In order to find the Cost of Consumed, we need to understand what is happening in the raw materials area.

In the Raw Material area, we purchase and stock raw material, and then supply the necessary raw material to the WIP area for converting to WIP.

Here we cab use the general formula for COGS directly

Cost of Raw material Consumed = 

Opening stock of Raw Material + Purchase Of Raw Material - Closing stock of Raw Material. (FORMULA E)



COST OF FINISHED GOODS SOLD  (A+B+C+D+E)

Cost of finished goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads  (FORMULA F)

Now,  the formula for Cost of finished goods sold component of Formula No 2 is complete. Now we have to add the formula for Cost of stock in trade, Cost of Stores and spares ( including packing materials) consumed, to Formula F and Other Adjustments.

COST OF STOCK IN TRADE

Now we need to understand that a manufacturing company also trades goods, which either they do not manufacture. This means that they purchase finished goods (which they do not manufacture), stock them and sell them in the market, just like a trading company. These kind of goods are called stock in trade.

So they account for the inventory of  stock in trade, just like trading companies do.

So by using the general formula for the COGS

Cost of Stock in trade = Opening stock of Stock in trade + Purchase of Stock in trade-Closing stock of Stock in trade. (FORMULA G)

COST OF STORES AND SPARES AND PACKING MATERIALS

When a company manufactures goods, they consume spares, packing materials  as well as items in stores. The accounting for the cost of stores, packing materials and spares varies from company to company. Either they diclose the cost right away, in a different head, or they include the opening and closing stock along with raw materials, or with the finished goods. 
                                   

STOCK ADJUSTMENTS DUE TO MERGERS AND ACQUISITIONS

During mergers and acquisitions, the stock of the merged or the acquired company may be added to the opening stock and closing stock of the Raw materials, WIP and finished goods, in the year of the merger and acquisition, Normally, they are disclosed separately. 

OTHER ADJUSTMENTS

I will add the cases for other adjusments later.



CONCLUSION

FORMULA No 2 to FORMULA No 1


Let us write down the FORMULA F again

Cost of finished goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads  (FORMULA F)

Merging formula G to Formula F and adding the additional costs of Stores, packing materials and spares, Stock adjustments due to mergers and acquisitions, and other adjustments

we get

Cost of  goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads + (5) Opening stock of Stock in trade + (2) Purchase of Stock in trade-(8) Closing stock of Stock in trade + (10) Cost of Stores and spares ( including packing materials) consumed+ (11) Stock adjustments due to mergers and acquisitions + (12) Other adjustments.

So we have successfully assembled all the components of Formula No 1 by expanding Formula No 2

Accounting for unclaimed cash dividend

Lets start with an example. 

A company had 100000 shares outstanding (par value of Rs 1). The company plans to declare a 1:1 dividend. 

The following entry is made at the closure of financial statements

Provision for proposed dividend                                          100000
Appropriation to PL account                       100000

In the first quarter of the next financial year, the dividend is declared.

The entry is

Provision for proposed dividend                  100000
Dividend Payable                                                                100000


On the date of payment, the company is unable to pay a few shareholders amounting to Rs 10000, due to technical issues. 

The entry for the payment is

Dividend Payable                                        100000
Unclaimed dividend                                                             10000
Cash                                                                                   90000

And another entry for earmarking the fund for unclaimed dividend

Cash earmarked for  unclaimed dividend         10000
Cash                                                                                    10000

Saturday, 18 March 2017

A small note on Foreign Currency Gain/ Loss due to Translations and Transactions

FOREIGN CURRENCY TRANSLATIONS GAIN/LOSS

When a parent company holds subsidiaries, in foreign countries, they need to translate the Assets and Liabilities of their subsidiaries from the foreign currency in which they are reported abroad, onto the reporting currency in the consolidated statements of the parent company. Since there may be fluctuations in the exchange rates, every year, there may arise translation Gain/Loss, every reporting year.

Indian companies have an option to either report the translation Gain/Loss in the PL statement or capitalize them in the balance sheet.

Entries for Reporting in PL statement

Foreign currency translation Loss           XXX
Cash                                                                                              XXX

Foreign currency translation Gain                                                     XXX
Cash                                                    XXX

In this case, since the Gain/Loss is recorded in the operating expenses and is a real cash transaction, they wont show up as as separate head in the Cash flow from operating activities in the CF statement. 

Entries for capitalizing in the balance sheet

Foreign currency translation Reserve           XXX
Cash                                                                                                 XXX

Foreign currency translation Reserve                                                   XXX
Cash                                                        XXX

In this case, since the Gain/Loss is not recorded in the operating expenses and is a real cash transaction, they will show up as as separate head in the Cash flow from operating activities in the CF statement.

FOREIGN CURRENCY TRANSACTION GAIN/LOSS

Whenever a company exports or imports in trade, or does transactions with a foreign country, there is bound to be an exchange gain loss. This will have to be record n the PL statement. 

For Eg:

An Indian company sells a product to the US for $1000 in January 2017. The prevailing currency rate at that time was Rs 66/$. The company records the transaction as follows

Sale                                                                                            66000
Recievable                                     66000 

The company receives the payment in February 2017, when the exchange rate changed to Rs 67/$. The company records the transaction as follows

Recievable                                                                                   66000
Foreign currency transaction Gain                                                    1000
Cash                                              67000
   



Wednesday, 1 March 2017

How Provisions and Contributions for Employee benefits is recorded.

PROVISIONS FOR EMPLOYEE BENEFITS

I am going to explain this in a simple manner. Provisions are required in defined benefits pan. Defined benefits, are estimates of expenses that has to be paid to the employees. Since they are estimates, they are provided for (provisions) in the balance sheet. Provisions for Gratuity, leave encashment are examples. 

There are two kinds of provisions for employee benefits that needs to be recorded by a company.

Short term provisions.

                       Short term provisions are quite simple to record. They are liabilities which are due to employees within a years time. Lets take a look at the entry for a short term provision.

 Employee benefit expense                   XXX
 Provision for Employee benefit                                  XXX

We do not need a separate fund for paying for these provisions, as they come under current liabilities.

Long term provisions.

                       Long term provisions are provisions estimated and recorded every year in anticipation of a lump sum payout to employees, when they retire, or when they complete the tenure required for availing the benefit. There are various methods used for estimating the long term liability to the company for these lump sum payments. Lets look into an example.

Company XYS Ltd  gives salary to an employee of 10000 per year. He is eligible to retire after 5 years with a gratuity of 10% of his last annual salary multiplied by the years of his service to the company. 

The company estimates a salary rise of 10% each year. 

His last year salary can be estimated as 10000 X (1.1)^5 = 16105

So the company will have to pay him 5 X 16105 X 10% = 8052.5 when he retires.

For this the company has to make a provision each year till he retires. 

For that the company divides 8052.5 by 5 and multiplies by the present value factor to obtain the estimate for the provision for each year. 

For year 1, year 2, year 3, year 4 and year 5  the provision estimate is calculated as 1099, 1209, 1330, 1464 and 1610. Along with that, some other costs are added such as interest costs and other costs. Now the provisions are increased to say 1500, 1750, 2000, 2250, and 2500. The entry for provisions for each year will be

Year 1

Employee gratuity expense                   1500
Provision for Employee gratuity                                  1500

Investments                                           1500
Cash                                                                              1500

Year 2

Employee gratuity expense                   1750
Provision for Employee gratuity                                  1750

Investments                                           1750
Cash                                                                              1750

Year 3

Employee gratuity expense                   2000
Provision for Employee gratuity                                  2000

Investments                                           2000
Cash                                                                              2000

Year 4

Employee gratuity expense                   2250
Provision for Employee gratuity                                  2250

Investments                                           2250
Cash                                                                              2250

Year 5

Employee gratuity expense                   2500
Provision for Employee gratuity                                  2500

Investments                                           2500
Cash                                                                              2500

Note that an equivalent amount of investments is done each year. Some companies do not make investments,but rather manage the expenses by insuring for the same.

Along with these expenses, additional expenses such as acturial Gain/loss, Gain/ Loss from Investments, and Actual settlements/ curtailments is charged to income statement each year.

CONTRIBUTIONS TO EMPLOYEE BENIFITS

These are contributions done by companies on monthly basis for future payments to the employees. The amount for these contributions are know to the company, so there is no need for any provisions. Which is why they come under defined contributions plan. They are recognized in Profit and loss as expenses.  Contributions to provident fund and superannuation are examples.

The entry for a contribution is


Contribution to PF/ Superannuation               XXX
Payables/cash                                                                                      XXX



Friday, 27 January 2017

Du Pont Analysis Simplified with an Example



The simplified formula for Du Pont analysis is shown below.



Before we go deeper we need to clarify each term used in the above formula.

RETURN ON EQUITY 

Return on Equity (ROE) basically, is the return from a business, as seen from the owners perspective. It shows what percentage of equity (Shareholder's equity or Owner's capital), the net profit is.

So ROE= Net profit/ Average shareholders equity.

Now we use average shareholders equity due to the fact that the shareholders equity can increase (or decrease) through out the course of the running financial year. For calculating average shareholders equity, we find the average of the beginning and ending balance of the shareholders equity account. It will be more clear in the example given to illustrate the idea.

NET PROFIT MARGIN

The net profit margin gives an idea of what percentage of total revenue, the net profit is. The concept will be clearer in the given below example.

ASSET TURN OVER RATIO

This ratio basically gives an idea of  how many times the assets of a company is turned over through the revenue of a business( sales or service).

Asset Turn over ratio = Total Revenue/ Average total assets

We take the average total assets due to the fact that the total assets can increase (or decrease) through out the course of the running financial year. For calculating average total assets, we find the average of the beginning and ending balance of the total assets. It will be more clear in the example given to illustrate the idea.

Now we know that the basic accounting equation is
                                                                          ASSETS = LIABILITIES + EQUITY

                                                               OR      ASSETS= TOTAL INVESTMENT
So the asset turn over ratio can also be seen as how many times the total investment is turned over in order to milk out profits.

Therefore

                ASSETS TURN OVER RATIO = TOTAL INVESTMENT TURN OVER RATIO

FINANCIAL LEVARAGE

As you can see, Financial leverage in the du pont formula is given as the ratio of Average total assets and the shareholder's equity,

And we know that the basic accounting equation  is

                                                                          ASSETS = LIABILITIES + EQUITY

                                                         Financial Leverage = Average total Assets/ Equity
           
                                                                                         = ( LIABILITIES + EQUITY )/ EQUITY

Which means financial leverage gives an idea of how much the business is jacked up with liabilites.
The more the liability, the more the leverage is.

DU PONT ANALYSYS

Let us recap the du pont formula

      ROE = NET PROFIT MARGIN X  ASSET TURN OVER RATIO X  FINANCIAL LEVERAGE

Now let us continue with an example to understand how du pont formula is used to analyse the perfomance of a business, from an owners perspective.

John invests 10000 in a bakery and buys raw material, display racks, baking machinery for 8000 and is left with cash of 2000.

For the first year,
                          the Cost of raw materials = 7500
                                          Other expenses = 2000
                                      and Sales revenue = 10000

From the above we can see that

                               The net profit margin  = Net profit/ Total Revenue
                                                                    = (10000-9500)/10000 =5%
                                                          ROE = Net profit/Equity
                                                                   = (10000-9500)/10000= 5%

Now in the 5th year of business, John had invested an additional amount of 10000 into the business over the years, he had purchased additional equipment, employed a salesperson, introduced new items, increased the efficiency of baking . He could increase the sales revenue to 20000, but the raw material cost and other expenses also increased to 13500 and 3500 respectively, for the 5th year.

For the 5th year John calculated
                               The net profit margin  = Net profit/ Total Revenue
                                                                   = (20000-17000)/20000 =15%
                                                        ROE = Net profit/Equity
                                                                  = (20000-17000)/20000 =15%

As he completed 5 years of business, John learned that he could not increase the ROE beyond 15% while, another bakery in the same area had an ROE of 25%. On studying the methods of the other bakery, John came to know that the sales revenue of the other bakery was 25000, with the same investment of 20000. In order to increase the sales revenue, John tied up with a local supermarket for selling his items.

 In the 6th year, raw material costs increased to 16750, and other expenses to 4500. But the sales revenue increased to 25000.

he calculated
                               The net profit margin  = Net profit/ Net revenue
                                                                   = (25000-21250)/25000 =15%
                                                          ROE = Net profit/Equity
                                                                   = (25000-21250)/20000 =18.75%

At the end of 6th year,John learned two important lessons

1. He could not increase the net profit margin easily. He knew that the industrial standard for net profit margin is around 15%. He had to find another way to increase the ROE.

2. By increasing the sales revenue with respect to the investment, he could increase the ROE even when the net proft margin remained the same. This lead him to asset turnover ratio. Total revenue/ Total Investment is nothing but the asset turn over ratio as we had seen earlier.

in the 6th year

                              Asset Turn over ratio = Total revenue/ Avg Total Assets
                                                                 = Total revenue/ Total Investment
                                                                 = 25000/ 20000 = 1.25
So John understood that by turning over the assets which is equal to the total investment, by 1.25 times in the 6th year, he could increase the ROE to 18.75%.

Now John knew that he cannot increase the net profit margin farther than 15%, without compromising on the quality of raw materials or the methods of preparation or by reducing any other costs as he was already running a lean business. So he has to revert back to the method of further increasing the turnover ratio by increasing the sales revenue. The only way to do that was to go for home delivery. But for that, he would need to buy a delivery van. And a delivery van would require an investment of another 10000. But he could only put up that amount by taking a loan. So in the 7th year, John went for a loan of 10000, with an interest expense of 1000 per annum.

This increased the sales revenue to 40000, with a commensurate increase in raw materials to 25000 and other expense to 9000 and interest expense of 1000.
       
he calculated for the 7th year
                           
                               The net profit margin  = Net profit/ Total revenue
                                                                   = (40000-35000)/40000 =12.5%
                                                        ROE = Net profit/Equity
                                                                  = (40000-35000)/20000 = 25%
                                Asset Turn over ratio = Total revenue/ Avg Total Assets
                                                                   = Total revenue/ Total Investment
                                                                   = 40000/ 30000 = 1.33

                                        Leverage Ratio  = Avg total Assets/ Equity
                                                                  = Total Investment/ Equity
                                                                  = 30000/20000 = 1.5

                                DUPONT Analysis

                                                        ROE = Net profit Margin X Turn over ratio X Leverage
                                                                 = 12.5 X 1.33 X 1.5
                                                                 = 25

So from 7 years of John's bakery business, we can learn the following

1. ROE will be equal to Net Profit Margin, if a business could turn the investment only one time, ie the turn over ratio=1, and if there is no leverage.

2. Even if there is no leverage, the ROE can be increased by turning over, the total investment, more than one time with the same profit margin.

3. Leverage is the most tricky one here. First of all, all loans have interest, and this additional expense will bear on the profit margin.

 Secondly, the leverage increases the total investment, which would decrease the turn over ratio, if the sales revenue does not increase, commensurately. In other words, if the additional fund brought in by taking a loan is put idle, the sale revenue won't increase, on the top of it, the Total Revenur/assets will decrease, which will bring down the turn over ratio. The leverage multiplier won't be enough to jack up the ROE. This will be more clear in John's example.

In the 7th year John had brought in additional 10000 from a loan.

                           The Leverage = Total investment/ Equity
                                                  = 30000/20000
                                                  =1.5

Imagine if John went crazy and put all the 10000 loan fund in a safe deposit box, keeping it idle. He would not be able to purchase the delivery van. The sales revenue would remain same as that of the 6th year at 25000. The Raw material costs would be same as 16750, and other expense 4500. On top of it he would have to incur an interest expense of 1000.

              The Net profit Margin = Net Profit/Total Revenue
                                                  = (25000-22250)/25000
                                                  = 11%
                                 The ROE  = Net Profit/Equity
                                                  = (25000-22250)/20000
                                                  = 13.75%
Had he not taken the loan the ROE would be 18.75%

In order to see what really went wrong, we need to see the du pont analysis

                The Turn over ratio  = Total Revenue/ Avg Total assets
                                                 = Total Revenue/ Total investment
                                                 = 25000/ 30000
                                                 = 0.83
Dupont Analysis

                                The ROE  = Net Profit Margin X Turn Over Ration X Leverage
                                                 = 11 X 0.83 X 1.5
                                                 = 13.75%
                                         
So what we learn from all this is that even though the company is leveraged, it may not produce decent ROE, if the fund from the leverage loan, is not utilized efficiently.

CONCLUSION

Du Pont analysis gives precious insight to the efficiency of  capital management and operational performance of a business, from an investor/ owners perspective. It allows us, not only to compare how leverage is used to enhance the profit of a company, but also to individually compare the net profit margin and the turn over ratio with other competitors in the industry. It allows us to judge if the capital structure justifies, the operational requirement of funds in a business.





               
                       


Wednesday, 11 January 2017

ESOP Accounting Case study of Dabur Limited

Please see the post titled Warrants and Employee Stock Options to understand the basic concepts

Note that I have changed certain notations used in my previous post on warrants and employee stock options, in order to conform to those used in the Consolidated Financial Statements of Dabur Limited. For this case study, I have used the statements for 2011-12

Terms changed

1. Paid in Capital in Excess of Par          to Share Premium
2. Common Stock                                  to Total Shares Issued for ESOP
3. Paid in Capital-ESOP                         to ESOP Scheme Outstanding


I don't need to emphasize the need for ESOP schemes in a growing company. But as we will see, ESOPs incur a cost on the company, specifically on it's shareholders. The following is disclosed in the 2011-12 report of the company.

1. Number of Options granted                    : 1557412
2. Pricing formula : Each option carries the right to the holder to apply for one equity share of the           Company at par/discount to market value.
3. Options vested                                      : 1377056
4. Options exercised                                  : 1377056
5. Total number of shares arising as a result of exercise of option
                                                                : 1377056
6. Options lapsed/cancelled                         : 1520376
7. Variation in terms of options                   : None
8. Money realized by exercise of options      : Rs. 672721/-
9. Total number of options in force              : 18287210


The fair value of the options under intrinsic value method is 111.90 as mentioned in the AR. Fair value under this method is the difference between the exercise price and the market price of the share at that time. We can also use the Black scholes Model for evaluating the options.

The formula used for recording the cost of the options based on the intrinsic value method  in the balance sheet is as follows

The maximum of

1.  (Fair value of options   MINUS  a percentage of market price of the shares) x no of options granted.
2.  (Fairvalue of options X no of options granted) MINUS (a percentage of total empoyee compensation for that year)
3. Zero.

So when the options are granted, they are recorded using the above formula, as per indian accounting standards. From the balance sheet, we can find that the options granted in the year 2011-12, is recorded at a cost of 928 lacs. And we can find that the cancelled options is recorded at a total of 802 lacs.

Options are a liability to the company. But they are also long term liabilities. The opposite entry will naturally be a capitalised expense, which will be amortized over the life of the options.

The following is the journal entry for granting options

Deferred  ESOP Scheme Outstanding expense           928
ESOP Scheme Outstanding liability                                                   928

As you can see, the expense for the liability is deferred, which makes it a capitalized asset. This asset can be found under non current assets in the balance sheet. The entry for cancelled options is as follows.

Deferred  ESOP Scheme Outstanding expense                                    802
ESOP Scheme Outstanding liability                          802                              

This capitalised asset, needs to be amortized over the life of the options. The balance in the Deferred  ESOP Scheme Outstanding expense  account at the beginning  is Rs 8295 lacs. the amortization entry is as follows.

Amortization Expense                                              3037
Deferred  ESOP Scheme Outstanding expense                                    3037

The balance in the ESOP Scheme Outstanding liability account is Rs 11681 lacs at the beginning. This was accumulated over time, This liability gets reduced only when the options gets exercised.

The total no of options exercised is 1377056. An equivalent amount of share is issued in leu of the options exercised ie 1377056. The value of the options exercised is 1219 lacs, which is calculated using the formula mentioned above that conforms to Indian Accounting standards. The weighted average exercise price (per option) is Rs 50.90. So the company should receive a cash of
1377056 X 50.90 = 700.9 lacs from the employees for exercising the options. But it has received only
Rs 672721/- in total, which is only Rs 0.48/- per options. I don't know the terms and conditions of ESOP scheme at Dabur Limited, but this seems an excess amount of compensation to the employees, especially to the promoters, who are also directors on the board.

For the year 2011-12, the average price of shares was Rs 100/-. The total benefit for the employees under ESOP scheme = (100 X 1377056)-672721=13.7 crore. This is in additional to all other salaries and remunerations.


The journal entry for options exercise is as follows

Cash                                                                        7
PL Account                                                              7
ESOP Scheme Outstanding liability                           1219
Total Shares issued for ESOP                                                                14
Share Premium                                                                                  1219

For the company there was also a transition adjustment of 79 lacs in the ESOP Scheme Outstanding liability account. This is a one time compliance adjustment and can be ignored.

The summary of the ESOP Scheme Outstanding Liability account is as follows

                                          ESOP Scheme Outstanding
Previous Year Balance 11681
Addition during this year 928
Allotted during this year -1219
Cancellation during this  year -802
Transition Adjustment -79
End of Year Balance 10509

The Summary of Deferred  ESOP Scheme Outstanding expense account is as follows

                                    ESOP Scheme Outstanding expense account

Previous Year Balance 8295
Addition during the year  928
Less : Cancelled during the year  -802
Less: Amortised during the year -3037
End of Year Balance 5384

The issue of 14 lac shares is financed partly from PL account and partly with cash received from employees. The irony is that even the par value of Rs 1 per share is not paid for by the employees and had to be partly financed from PL Account.

The liability of ESOP Scheme Outstanding is reduced by 1219 lac and the shareholder's equity of share premium is increased by the same amount. This equity is created from charging the profit of the company regularly through amortization. This is equivalent to siphoning retained profits (surplus) to create the liability first, and then the equity, as the options are exercised. 

Thursday, 17 November 2016

How and why the change in inventory is adjusted to the net income in the indirect method for cash flow from operations

Let us start with the net income of a company.

Net income = Total Revenue - Cost of Goods sold (COGS)- Other Costs of revenue - Other expenses 

Net income = Total Revenue - COGS- All other Expenses ( Equation 1)

Now we all know that 

COGS = Beginning Inventory + Purchases- Ending Inventory


From here onward we will always assume that there has been a decrease of inventory at the end of the year. 

Re Arranging the above equation

COGS = Purchases + Decrease in Inventory

COGS = Cash Purchases + Credit Purchases + Decrease in Inventory  (Equation 2)


If you look at Equation 1, we have arrived at net income from the following three figures. 

1. Total Revenue 

2. COGS

3. All other Expenses

All these three figures have non cash computations in them, due to the nature of accrual accounting. But in this topic, we have to be concerned only about COGS.

 Coming back to Equation 2, we can see that there are two components of COGS which are non cash.

1. Credit Purchases

2. Decrease in Inventory

These two needs to be re adjusted to the net income inorder to eliminate the non cash components of COGS. As we can see in Equation 1, COGS is subtracted from the Total Revenue to arrive at the net income figure. And from Equation two, we can see that, Credit purchases and Decrease inventory both needs to be added back to the net income, in order to eliminate the non cash components of COGS, which inturn is subtracted from Total Revenue to arrive at Net Income figure.

     Note that Cash purchases need not be adjusted at all to the net income figure.

If you are familiar with indirect method, all the increase in Accounts Payables, are already added back to net income to arrive at operating cash flow, inorder to eliminate the non cash expenses which are represented by the accounts payables. Along with this, the Purchase Payables are also automatically added back to net income, which represents the adjustment of credit purchases. This is done as a separate step in the indirect method. 

 Thus we don't need to adjust credit purchases again, separately, from the net income figure. 

This leaves us with the decrease in inventory figure. In order to eliminate this non cash expense component of the COGS ( as COGS is an expense which is subtracted from the Total Revenue),
we add it back to the net income figure to arrive at Operating Cash flow.


On the other hand if there is an increase in inventory, we intuitively subtract it from the net income figure. 












Wednesday, 29 June 2016

COGS, Calculation, Explanation, Formula all in a simple illustration.

The gross profit is simply Sales minus the Cost of the goods sold. It’s quite logical, if you think about it. So you need the Cost of Goods Sold figure (COGS), for a period, to find out the gross profit for that period. How to calculate the COGS if you don't have a computer to do it for you, is what we need to find out.

The first thing to come in mind is to take all the sales receipts and invoices for the period for which you need to find the COGS. Then, find out which all items were sold out. Find the cost of the individual items, from the purchase register. Then calculate the cost of all the items sold. This will be your COGS for that period. By now you can see that it's not that simple at all. But, fortunately, there is another way.

Imagine that you are an accountant recruit at a retail firm. On the first day of your employment, you are asked to calculate the stock (inventory) at the warehouse of the retail firm.  After a day of grueling work, you arrive at an inventory figure, which represents the inventory at the end of the day at the warehouse. Let’s say that it is I1 (Inventory on day 1 at your job). You note it down and soon forget it. 

A few months go by. You are busy at your job. Suddenly your boss asks how much is the COGS for the sales done, from your beginning of your joining date. You scroll through the various registers and find out that there has been lots of purchase of goods, since your date of joining. An the firm has also had a good period, with a lot of sales.  You think of calculating the cost of each items sold, and after sometime, conclude, that it’s quite cumbersome. So you think that you need to find another way.

Then you remember the inventory value I1 (Inventory on day 1 at your job), which you had jotted down on the first day at the firm. 

You know that the inventory values must have been quite changed from the beginning inventory figure I1, due to purchases and sales of goods, that have happened after you started working in the firm.  So you wonder what changes must have happened to I1 , to arrive at the present inventory. You spend almost a day to calculate the present inventory figure, which is  I2 (inventory on the day you are asked to calculate COGS).

You know that purchases increase the  inventory, and sales (measured in COGS) decreases the inventory.  If there were no sales, then I1 + Purchases would have been, the total goods available for sale from day 1 to the present day.  But the sales did happen, and the total goods available for sale must have got reduced by the sale of goods (measured in COGS).  So, the present inventory I2, would be

                    I1 + Purchases-COGS.

This whole story of inventory change can be represented in the equation

                    I2= I1 + Purchases-COGS
OR              COGS= I1- I2+ Purchases

Now you got an easy method to calculate COGS, and you don’t waste any time. So you immediately begin calculating the  the COGS for the period starting from the day of your joining to the day at which you were asked to find COGS.

When the boss asks you the next time, to calculate the COGS for the current financial year, you know that the formula for COGS, you arrived earlier can be used that time too. You can modify your formula and finally arrive at the general formula, which  used world over, for calculating COGS.

                   COGS= I(Beginning)- I(Ending)+ Purchases



Wednesday, 17 September 2014

Very basic, simple and elaborate tutorial for Futures Contracts, Open Interest and Volume relationship



INTRO

          Futures Contracts in its simplest form are formed between two parties. A buyer and a seller. To explain why people engage in these kind of contracts can be best explained with examples

EASY EXAMPLES

Chicken farmer example

          You are planning to start a chicken farm. After asking around, you find that Red Rooster Chicken is the one which you need to farm as this breed is a local favorite.  After calculating the cost of procurement of chicks, and all other costs, you find out that the cost of farming, fully grown Red Rooster Chicken is  $3 per chicken. And you know that the market price for Red Rooster Chicken is $5 per chicken. And you can produce only 1000 chicken at a time, which  will take 3 months to mature, enough to be sold. After elaborate analysis, you calculate that you can sell the whole lot of  Red Rooster Chicken for a profit of $2000. So you invest in the farm and procure chicks. And then you hear the news.

              Another brand of chicken, Black Rooster Chicken has come to town, and people have started liking it. As the price for both the brands are the same, you start to panic. If the demand for Red Rooster dips in the next 3 months, the market price for Red Rooster may fall. So you start searching for buyers in advance.

            As it turns out, there happens to be a buyer who believes that he can buy your whole lot of Red rooster Chicken when they mature, at $5 per chicken and supply to the next town super market for $8 ( which he of course doesn't tell you ). He believes that after $1 per chicken, cost of transportation and storage, he still can have a profit of $2000 for the whole lot. So both of you enter into a contract, which is a futures contract in its simplest form.

             The contract stipulates that, no matter what the market price is, after 3 months, you should sell your whole lot of chicken (1000 Nos) for $5 per chicken, and no matter what the market price is, after 3 months, the buyer should buy your whole lot of chicken (1000 Nos) for $5 per chicken.

               After 3 months the story can end in two different ways.

Climax No 1:
           
          What you feared, happened. Market price for Red Rooster Chicken plummeted to $2 per chicken. But the buyer had to buy the whole lot of chicken for $5. You pocketed a profit of $2000 as you had hoped for. What happened to the buyer is another story.

Climax No 2: 

             The Black Rooster Chicken lasted only for a few weeks. And the Red Rooster Chicken gained in market price to $10, in 3 months time. But, you had to sell your whole lot for $5 per chicken as the contract stipulated.  Had the buyer not entered into a contract with you, he would have had to buy the chicken from the local market for $10. And you pocketed a profit of $2000 only.

Hedging

                But you had always known that both scenarios would have worked out. You just wanted to remove the risk of a falling market price. You didn't hope for an exorbitant profit, if the market price gained to $10. This strategy of minimizing the risk is called hedging. You can also see that the buyer also hedged his risk of an unexpected gain in the market price.

Other takeways
           
1. Now you can understand that a futures contract  always has a buyer and a seller on both sides of the contract.

2. The current market  price of a commodity or any goods or any securities for which the contract is written between two parties is called the spot price. In the previous example, the spot price at the time of investment was $5, then in scenario 1, it decreased to $2, and in scenario 3, it increased to $10.

3. You entered the futures contract believing that the prices would. You would profit only if the price of the chicken falls below $5 after 3 months. If it goes up to $10 you still will have to sell at $5. People who agree to sell a commodity at the contract price, who take positions in a contract believing that the spot price will fall in the future are called the Shorters. The buyer has agreed to buy the chicken at $5 believing that the prices would go up. If it falls below $5 after 3 months, he still will have to buy at $5, thus incurring a loss. People who agree to buy a commodity at the contract price, who take positions in a contract believing that the spot price will go up in the future are called the Longers.
         
Example of a simple currency futures contract          

        Suppose you  would like to purchase a software from an Indian company and sell it to a company in the US. The  company in the US has agreed to buy the software from you for $115000/-. The cost of the software is Rs 6 million in India, which at the current rate ( Rs 60/ Dollar) is $100000/-. The Indian company has agreed to deliver the software at the end of 3 months from now. If the deal works out, you can pocket $15000/- in 3 months.

        But, you very well know that the US dollar to Indian Rupee rate is prone to wild fluctuations. And according to your knowledge, the Indian  Rupee might appreciate against Dollar in 3 months time to Rs 50 per Dollar. Which means for each Indian Rupee, you have to pay 2 cents, 3 months later. After calculating, you find out that, you may have to pay $120000/- for the same software, 3 months later, as the Indian company accepts payment only in Indian Rupee.

        After working out the profit in the deal, you come to the conclusion that, you will lose $5000/-, if the Indian currency appreciates against the dollar as you expect. You wish that the currency rate of Rs 60/ dollar remains the same.

        After asking around, you find out there are some of your Indian friends, who believe that Indian currency will actually depreciate against dollar to Rs 70/Dollar. And they are all worried because they all have Indian currencies with them, which will depreciate. It so happens that one of your friends have Rs 6 million with him, which at current rate is worth $100000/-.  If the indian currency deprecates to Rs 70/ dollar his Rs 6 million will be worth only $85700/-, 3 months later.  So you convince him to enter into a contract, which will be profitable for him if his prediction come true.

        The contract is simple. You are ready to sell $100000 to him for Rs 6 million in Indian Rupee at the rate of Rs 60 per dollar, 3 months from now, no matter what the currency rate is, after 3 months. If his prediction comes true, then after 3 months, the exchange rate will be Rs 70/Dollar. But he will still get $100000/- for his Rs 6 million after, 3 months.

       But you also know that your risk is eliminated, because you believe that the currency rate will appreciate to Rs 50/dollar. But even if that happens, you still can get Rs 6 million for $100000/- at the end of 3 months. And you can buy that software from India for $100000/- and can re sell it for $ 115000/-

        Now, here we have to understand that, there is a buyer and seller in this contract. Are you a buyer or a seller? It depends on the contract. In this contract, you are willing to buy Indian Rupee at Rs 60/- dollar in the future. And your Indian friend is willing to sell Indian Rupee for Rs 60/dollar. So here, you are the buyer and he is the seller.

        Even if the Indian Rupee appreciates to Rs 50/Dollar, 3 months later, you can still buy the Indian rupee for a lower cost of Rs 60 per dollar.   And if the Indian Rupee depreciates to Rs 70/Dollar, 3 months later, your friend can  still sell the Indian rupee for a higher value of Rs 60 per dollar. In this case you are protecting the value of your dollar, and he is protecting the value of his rupee.

        If you think carefully, either the buyer or the seller will lose money if the currency rate changes. If the  Indian Rupee appreciates to Rs 50 per Dollar after 3 months, your friend still has sell you his Rupee at Rs 60 per Dollar. That means, he is buying your dollar at Rs 10 higher than he normally has to pay. And if the Indian Rupee depreciates to Rs 70 per Dollar after 3 months, you are selling a  dollar for Rs 60, whereas you could have got Rs 70/-.

        It can also be said that, you are taking a  long position on Indian Rupee, as you hope to buy an appreciated  Indian rupee for a higher value. Your friend is taking a short position on Indian Rupee, as he hopes to sell a depreciated  Indian rupee for a higher value.

FUTURES  IN A MODERN STOCK MARKET

       If you are a newbie in futures trading in a stock market, you must have wondered what happens behind the curtain of a futures market.

Market Maker

         If you know anything about shares, you must know that shares are pieces of ownership of a company distributed among various people. Those who have a good amount of these shares, can actually control a company by using their voting power.

          These days all the allotted shares are held in a de materialised account. Just like cash held in electronic form. Just like banks, there are stock exchanges that gives you a venue to trade your stocks. They create a market, where other people with their stocks, arrive and trade. They are the market makers.

Futures 

          Before going through the definition of futures, you have to understand two kinds of prices.

1. Spot price

             It is the current price of the underlying stock on which the futures is based on. Every futures have their own underlying stocks. The relation between the futures and the underlying stocks will become apparent when you read on

2. Futures price

             It is the price of the position you hold. How this price is arrived at will also be apparetn when you read on.

 What are futures.
   
            A futures is a contract between the market maker and the traders. The contract stipulates that the market maker will ensure that, the difference between the spot price of the under lying stock and the price of the futures held by traders will be settled on a daily basis between the buyer/seller and the market maker. 

         This is the most important thing to understand. There is no contract between a buyer and a seller. There isn't any physical delivery of the underlying stock between the seller and the buyer as seen in the chicken farmer example. When a buyer buys futures, it becomes a long position, and when a seller sells futures, it becomes a short position. Each positions are unique. You can sell your long position or buy your short position at anytime, given there is a buyer or a seller for your positions.  Daily settlement of the difference between the spot price of the underlying stock and the futures price is undertaken by the Market make only.

            To understand how the futures is settled, you have to read on.

Derivatives

         Now you can understand why futures contract are called derivative. Its because  the settlement is done depending on the difference between the futures price and the spot price.

Longers and Shorters
  
          People who believe that the spot price would go up are called Longers, and their futures position is called a long position.

         People who believe that the spot price would go down are called Shorters, and their futures position  is called a Short position.

Bid price and Ask price and Spread

          Bid price is the price at which a buyer puts up a buy order. Ask price is the price at which a seller puts up his sell order. The difference between the bid and the ask price is called the spread.

Futures Pricing

       The pricing of the futures of a stock, has nothing to do with the pricing of the underlying stock. ie if futures of the stock of a company XYZ is priced $222, when the price of the stock is $220, the futures pricing has nothing to do with either the underlying stock of the company, or with anything else.

         Futures pricing, simply depends on the price arrived by a buyer and a seller. The buyer and the seller arrives at a price to make a profit. The price of the futures of a stock, which is displayed on a computer screen, can either be the last traded price, or the average price or anything else. It is normally the Last Traded Price.

         Last traded price is the price at which the last trade has happened between a buyer and a seller. When the next trade happens at a different price, that price becomes the last traded price.

Why not trade stocks only

         Why trade such complicated instruments. Why not buy some stock if you believe that it will go up in price. This is where the margin plays a role. Every market maker provides margins for a futures trader.

         If you wish to buy 1000 nos of $100 shares of XYZ corp, you will have to put up $100000. Now if your exchange gives you a margin of 1:100 for the futures of the same XYZ corp, then you can buy futures. You know that the lot size for the futures of XYZ corp, is 1000 nos per lot. You can buy 1 lot ie 1000 nos of $100 futures of XYZ corp for $1000 only. This is what is meant by a margin of 1:100. You need to put up 1/100th of the value of the futures. And you can have the same profit if price of the underlying stock goes up. This is because the futures price more or less follows the spot price. Why so? Follow on.

Why does the futures price closely follow the underlying stock price

          You visit your broker's office. You see that the stock of XYZ corp is trading at $100. Since you are very clever, and since you have read this blog, you decide to buy 1 lot of XYZ corp futures. You know that 1 lot has 1000 nos of XYZ corp futures. And you see that the Last traded price is $102. But since you have read in this blog, that the price of the futures is determined only by the buyer and the seller, you decide to put a buy order for 1 lot of XYZ corp at $20. The broker looks at you as if you don't know anything. Then a message in the screen reports that $20 is no allowed, the maximum deviation from the last traded price, is 20%. So you modify your buy order to $80. Now you find out that the nearest seller is at $106.

        Now you understand an important principle of the futures trading. At any time, a trader will assume that the probability of the price of the underlying stock, at the expiry date of the futures is around the current price of that stock, most of the time.

         Traders always believe that the stock price will ( in the worst case) hover around the current spot price.. This is because, the expiry date for a stock futures contract is normally a short period, most of the time, 1 month. So if the trend of the stock is upward, a Longer(buyer) will naturally assume the spot price to go up, and in the worst case to stay the same,  And a Shorter will believe that the price of the stock will decrease towards the expiry date or in the worst case will remain the same.

         Normally people do not think that anything exceptionally good or bad will happen to the underlying stock. This shortsightedness is what allows the futures price to follow the underlying stock.

         Now when you put the buy order at $80, the Shorters will think that if they sold you at $80, and in the worst case, if the spot price remains the same, then he will lose $20. So he will always try to sell you at a price above $100, which is the spot price of the underlying stock.

         Since you finally understood this principle, you increase your buy order to $100. You are sure a seller would agree to sell you at this price. But no one is willing to sell you at this price. This is because the general market is in an uptrend. So the Shorters would like to sell you at a price above $100, just in case, the stock moves up. Now you understand that why the Last traded price was at $102. So you increase the price to $101. Suddenly a seller matches your bid price and the trade happens at $101. And the last traded price resets to $101.

Daily settlement and Margin calls 

          This is a bit complicated. You may have to read this section many times to understand the process.

Leverage

         If you have gone through the chicken farmer example, you must have seen that both farmer and the buyer, have to honor the contract at the expiry date of the contract. And mainly these kind of contracts are tailor made for hedging purposes.

       But stock market futures contracts are made mostly for speculative purposes, though some traders may use it for hedging. Most of the traders  are attracted to futures because of the leverage these kind of instruments give.

        Leverage is the ability of a trader to buy and sell an instrument with an amount which is smaller than the actual value of the trade. With a little money you can trade large amount of instruments and can make potentially huge profits (or losses).

          Since huge leverages are used, if a stock is going down the drain, a person who has taken a trade against the trend of the underlying stock might lose large amount of money, if he holds a futures contract till its expiry. By the time, the contracts expire, the trader who has taken a position against the trend, will find his account burned.

         As you have read in the beginning, all the settlements on a daily basis is done by the market maker. Which means, the market maker has to credit money to a trader who has mad a profit, and debit money from a trader, who has made a loss. When a Longer guy takes a long position on an underlying stock which is plummeting, then he will have to give huge amount of money to the Market maker. There is a possibility of someone absconding without paying his liabilities, or huge litigation costs for the brokers or the exchange.

             In order to make settlements on a daily basis, and for protecting the recovery of losses, the exchanges have put in place two mechanisms; Margin Money and Daily Settlement.

Margin Money

            As you have read, the market maker debits money from the  losers account and also credits the profits in the gainers account. So the distribute profit and losses. They also take commission from both the buyer and the seller for each trade. They also need to minimize risk of non payment of liabilities. In order to make payments for profits and retrieve the losses, the market makers pools money from the traders. Every trader has to pay some margin money to the market maker, if he wishes to buy or sell futures. This money is a fraction of the actual value of futures traded. The margin money is set by the market maker almost daily and depends upon the following.

1. What is the volatility of the underlying stock. If the stock plummets, then the market maker's only option to retrieve money from a buyer is to debit money from the margin money he has put up.

2. What is the liquidity of the futures. If the number of buyer and trader for a futures is low, then if a fall out happens, a buyer cannot exit his trade, or if the stock sky rockets, then the seller also might not be able to cover his position.

3. Various other things.

Daily settlement 

Consider the following example

           A longer has taken a long position by buying into a contract at a price of $102. He pays the margin money set by the Market maker, which is $10000. He has taken 10 lots of 100 nos each. The underlying stock price at that time is $100. All of a sudden, some bad news circulates about the company, and the stock starts to move down. After a few days, the futures price also moves down to $80. Now the longer panics and tries to exit. He puts up a sell order for $80. But the nearest buyer is at $77. So he modifies the sell order to $77 and the trade happens. But now the now the longer owes the Market Maker $25*1000, ie $25000. The longer is unable to pay such a huge sum to the market maker.

            So instead of allowing the longer and the shorter to hold the contract until it expires, without making any payments, the market maker decides to settle the contract on a daily basis. The basic idea is to settle whatever the difference between the spot price and the contract price on a daily basis when the market closes.

            Continuing with the example, suppose there is only 30 days for the futures to expire, The contract price on the day 1, is $102.  Suppose the closing price of the futures (The last traded price at the end of the day) is $100. And  the closing price of the underlying stock price is $98. Then,the maker maker takes, the difference of the contract price and the closing price of the futures . In this case it is $102-$100= $2. If buyer had exited the trade at the end of the day at the closing price of the futures, that is, at $100, he would have incurred a loss of $2*1000=$2000. So the market maker debits the loss ( which he might have incurred had he exited ), from the buyer's account,

            This is done by a simple method. The exchange sells the long position of the longer  at the closing price of $100 and buys the short position of the shorter at the same closing price. So when the market closes, the contract is settled, and the buyer and the seller no longer holds any contract. The loss incurred by the buyer,$2000 is debited from his margin money and credited to the seller. But on the next day morning, a new contract is created between the buyer and the seller for $100.

              So in effect, the contract is reset to $100 and the difference is settled with both the buyer and  seller. This goes on till the expiry, if the buyer and the seller chooses not to liquidate their position. There must be other buyers and sellers in the market, who have traded futures at different prices, but their futures are also settled and reset at the closing price of the futures.

            Remember, The futures prices are reset at the previous closing price of the futures and not the previous closing price of the underlying stock. But the futures price is settled at the price of the underlying stock at the time of the expiry. Please read on to know how this is done.

Margin Call

              Continuing with the previous example. What happens when the price of the futures falls to a closing price $80 in a days time,  and the buyer couldn't exit his long position at $77 only.  In that case, even if the market maker resets the prices, the buyer has payed only a margin of $10000. The market maker has to debit $102-$80=$22, loss per futures, ie $22*1000=$22000, from the buyers account, in order to reset the prices.

             So the market maker makes a margin call. The market maker demands $12000 or more from the buyer, if he wishes to trade again in the futures market at all. If he doesn't pay up the margin money called, then the market maker retrieves the money by either selling his other assets or through litigation. He will also be banned from the futures market.

              If the price starts plummeting at a very high rate, then the market maker might sell the long positions, without asking the buyers, and then make the margin call. This is applicable to the sellers as well, if the prices sky rocket.

Settlement at the time of expiry

            If you have read the daily settlement section, you must have understood that, the prices are reset every morning to the previous day closing prices. So you can only imagine that, the price of the futures you have held till expiry,  will also be reset to the previous day closing price, at the day of expiry .

             Continuing with the earlier example, you had bought the futures at $102. After resetting daily, the price of the futures at the day of expiry is $105, say. And you still are not willing to sell it. At the end of the day of the expiry, the underlying stock closes at $106.

                 Now the market maker has to honor the contract. So it will assign a value of $106 for your futures, which you had bought at $102 at day 1, and credit the margin money and the profit back to your account. As you had paid a margin money of $10000, and your profit is $4*1000, Your account will be credited $14000 minus the transaction costs like brokerage, tax etc. Suppose you had sold the futures ie taken a short position at day 1, at a price of $102. Then also the market maker assigns $106 for your short position and debits the loss of $4*1000 from your account and credits the margin money of $10000. So you will be credited $6000 in you account.

Can you buy and sell between the Day 1 and the expiry date

                  Of course you can. You can buy on Day 3, the long position which the buyer bought at $102. You can buy it at any price the buyer agrees to sell it to you. As usual the price of the long position on Day 3 will also be hovering around the underlying stock price. Say the stock price at Day 3, at the time of trading is $90. The last traded price of futures is say $88. And you put a buy order at $87.Suddenly, the buyer who bought a long position at Day 1 is ready to sell to you at $87. The trade happens. The buyer who sold to you loses $102-$87=$15 per futures in his account ie $15000. Now on Day 6 you can sell it at $95, if there is another buyer available, who is willing to buy your long position a that price. You will make a profit of $8000.

               The mechanism of daily trades are elucidated graphically in coming sessions. So please read on.

  OPEN INTEREST & VOLUME

           Before we begin talking about open interest and volume, let us go through some figures, which illustrate what happens in a futures market place.


                                                                          Snapshot 1



     
                Futures are offered for trading in a series. If they are 1 month futures, then they will be Jan series, Feb series etc. And they all have an expiry date, usually in the last week of the month. Any trader can choose to trade any series, provided there is a trader in the opposite position. If you are a buyer, then there has to be a seller and vice versa. Normally trading volume is highest in the current series. If the day in which you have decided to trade is January, then Jan series will have the maximum volume of trades, then the Feb series and so on. This is because traders do no like to forecast for long term.

Series beginning


               Inorder for trade to begin in a series, two things have to happen.


1. The series has to be opened to the traders by the market maker.
2. There must be matching buy orders and sell orders for trades to be executed.
           
              Snapshot 1 is a snapshot of the futures market for a series, when the series has just been open by the market maker for trading. As you can see, there aren't any orders put up by any trader, yet.


                                                                        Snapshot 2




                             
                 
                    Snapshot 2 is the snapshot of the market when the buy orders and sell orders have been put up by the traders. You can see that, none of the buy orders and sell orders have matched. So no trade has been executed yet.

                                                                       Snapshot 3



In snapshot 3, the arrows represent order matching. Either the buyer or the seller or both relented and the trade is executed
                       
                                                                       Snapshot 4




Open Interest

                     In snapshot 4, you can see that long positions and short positions are formed.  And all the long positions and short positions ate formed in pairs. As you can see from the snapshot, a pair of long and short position is called an open interest. Any two buy order and sell order can be selected for counting an open interest. Normally, open interest, is referred to the total number of pairs of long or short positions that remain open, in a period.


                                                                    
                                                                     Snapshot 5
                                                                       



                                                                       Snapshot 6






Type of trades


                There are for different types of trade.

Type 1 

                This type of trade happens when the price of a standalone buy order is matched with a stand alone sell order.  As you can see in Snapshot 5 and 6, a new open interest is formed in this type of trade.

Type 2

                 This type of trade happens in a existing open interest. When a  Long position is closed against a Short position, type 2 trade happens. It can happen within any two Long and short position. Only condition is that, the price has to be agreed between the buyer and the seller. These kind of trades mostly happen at the time of expiry, though it can happens in any day.

Type 3   

                   This type of trade also happens in a existing open interest.  In order to cover his Short position, a seller might put out a buy order. If it is matched by a seller who doesn't have an existing short position, then this trade happens. As you can see in snapshot 5 and 6, the open interest is not closed in this case, just the sellers are exchanged.

Type 4


                      This type of trade also happens in a existing open interest.  In order to exit his Long position, a buyer might put out a sell order. If it is matched by a buyer who doesn't have an existing long position, then this trade happens. As you can see in snapshot 5 and 6, the open interest is not closed in this case, just the buyers are exchanged.


Volume


                        Volume is the number of trades happened in a period. As you can see all the for types of trades increases the volume, while open interest increases, decreases or remain the same, depending on the type of trade.



The following flow chart brings clarity on the process of trade.

                                                          Flow chart on the order process



                                                                       Snapshot 7



               
                                                                       Snapshot 8



                     Snapshot 7 and 8 happens at the time of expiry of a series. The market maker identifies all the pairs of open interests, and assigns settles each buyer against a seller. It can be any buyer against any seller as shown in Snapshot 7 and 8.

CONCLUSION


                   Futures trading is very popular among stock market, currency and other derivatives traders, because of the leverage, the market makers provides. Any body can make large profits in futures trading, but can give them all up and more, eventually.