ROTA is calculated by: Profits Before Interest and Tax (PBIT) / Total Assets (TA)
PBIT = operating profits of the firm before interest and tax is deducted. So this is operating revenues less operating expenses (including direct and indirect)
TA = current plus noncurrent assets
In reviewing the commentary around ROTA there are two schools of thought to which short assets to include in the total assets figure. In particular, only those current assets for which a charge in the use of funds is made in their acquisition. For example, inventory purchased through “free” creditor lines of credit would not be included. Where as inventory purchased through interest bearing overdrafts would.
This difference in approach would result in the former approach producing, all other things being equal, a higher return as the denominator to the fraction is a smaller figure.
We feel that this would be a rather misleading approach as the source of asset funding should be inclusive of all sources as this is a reflection of how effective management are in their sourcing of funds. For example, a firm that was able to better utilize noninterest bearing funding is generating a more positive return for its shareholders when compared to another firm utilizing interest bearing funds.
So the key components used in this measure of management performance are total costs (excluding interest incurred), total income (excluding interest received) over total assets employed.
Below are statements of financial performance and position with the same format and figures we used when looking at ROE in our previous tutorial. The ROTA figure is always expressed as a percentage and as we have mentioned already it is a key measure in how efficient management are in the deployment of the firm’s assets and the return therefore generated.
Operating Sales  1,120,000 
Operating Expenses  1,008,000 
PBIT  112,000 
Less: Interest Expense  20,000 
PBT  92,000 
Less: Income Tax  32,000 
PAT  60,000 
Less: Dividends Declared  24,000 
Net Profit  36,000 
Owners Equity  360,000 
Current Assets  320,000 
Less: Current Liabilities  240,000 
Working Capital  80,000 
NonCurrent Assets  480,000 
NonCurrent Liabilities  200,000 
Net Assets  360,000 
PBIT = Profit Before Interest and Tax
PBT = Profit Before Tax
PAT = Profit After Tax
ROTA  PBIT  112,000  14.0%  
Total Assets  800,000 
When compared to the ROE we calculated with the same figures, being 16.4%, the ROTA 14.0% reflects the leverage that owners achieve through the use of debt. A modest 2 percentage points can make a significant difference as the scale of the business increases.
Of course like any analysis the figure calculated and the conclusions drawn from it must be analyzed within context. The context in this sense means looking at both the longitudinal data series of the firm itself and the crosssectional comparison with other firms within the sector and other comparable sectors. At the moment 14.0% means little to us in how well this firm’s management is performing.
And of course these comparisons are set within the context of the general economic conditions of the economy and the sector itself. One would expect, ceteris paribus, that as economic conditions improve so would returns on assets and equity. While as conditions deteriorate returns would track down in the same manner.
The performance of management, which this is a key measure of, is compared against what targets have been set and how the performance compared against similar firms and over previous years. Without this type of context performance is very difficult to measure and the figure itself means little. One only needs to see this in the media on a daily basis when a particular company’s profit is reported as $xxx million; often with inference of price gouging or monopolistic power or some stakeholder group demanding a greater slice of the action, for example employees. But the profit figure initself means little when used in isolation. Is the $xxx million a growing or shrinking figure? Does it reflect a 50% ROTA or a 1% ROTA? How are comparable firms in the sector performing? Which profit was reported? A highly leveraged firm could well have a much better PBIT compared to a firm carrying little debt.
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Back in November 2014 we provided an overview of ROE and also provided an online calculator to help you with the calculation. In this new post we expand on this material and in particular introduce the measure of ROTA (to be covered in next weeks tutorial).
These two measures provide a means analyzing the business from the perspective of the total capital employed in the business to generate the results that it does. While the second looks at the reward for the owners, with the equity placed into the business what return are the shareholders being rewarded with.
In the first of two tutorials on this material we work through examples to show how the performance measures are calculated and, more importantly, what do the measures mean and how should be used in business analysis.
Set out below is the source figures for the calculation of the ROE. The figure is always expressed as a percentage and reflects the return being generated from the funds shareholders have invested in the business through capital directly paid in and profits reinvested.
Operating Sales  1,120,000 
Operating Expenses  1,008,000 
PBIT  112,000 
Less: Interest Expense  20,000 
PBT  92,000 
Less: Income Tax  32,000 
PAT  60,000 
Less: Dividends Declared  24,000 
Net Profit  36,000 
Owners Equity  360,000 
Current Assets  320,000 
Less: Current Liabilities  240,000 
Working Capital  80,000 
NonCurrent Assets  480,000 
NonCurrent Liabilities  200,000 
Net Assets  360,000 
PBIT = Profit Before Interest and Tax
PBT = Profit Before Tax
PAT = Profit After Tax
ROE  PAT  60,000  16.6%  
Owners Equity  36,000 
Out of the two measures, ROE and ROTA, the former is perhaps one of the most important figures in the assessment of investment return and in particular for publicly listed firms their respective share price. Other than a boasting figure for executives around lunches and a key driver of performance related bonuses, for the company itself it strengthens its ability to attract and retain capital funding. And, all other things being equal, should also attract cheaper debt financing.
With the ability to attract and hold equity and debt funding a business then has the means to utilize this capital through which it can then grow its revenues and profits. As long as the executive is able to continue or improve its efficiency in the utilization of this additional funding the returns to shareholders, in particular with increased leverage through greater debt funding, will improve and grow.
Like many of these measures of financial efficiency it cannot only be applied at the individual company or business level but also to the wider economy. The efficiency in which a country can utilize its capital, physical, human and money, is reflected in its economic growth and strength. You will find over history those countries that have been able to gain the greatest leverage in deployment of capital has been able to grow in economic and political power. Where as those countries that have been wasteful in this deployment of economic resource, and often despite the bounty of it, have suffered lower levels of employment, standards of living, political stability and wider geopolitical influence.
Next week we will be looking at ROTA and how this measure complements the ROE and the efficiency in capital deployment. As always we welcome any feedback you have about our site. Please provide comment below or use the Contact Us page.
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The formula for the net profit margin is:
Net Profit Margin = (Net Profit/Revenue) x 100
As an example, if Company Z has $200,000 net profit and $2,000,000, then the net profit margin will be 10%.
A more detailed analysis of the above example is as follows:
Let’s assume that Company Z has published the latest income statement (or profit and loss account) which is as follows:
200x 
200x1 

Revenue  $2,000,000  $1,500,000 
Cost of Sales  $(1,200,000)  $(850,000) 
Gross Profit  $800,000  $650,000 
Admin Expenses  $(300,000)  $(150,000) 
Profit Before Tax  $500,000  $500,000 
Tax  $(100,000)  $(100,000) 
Profit After Tax  $400,000  $400,000 
The example above shows that while the profit after tax (which is also the total profit that is available for distribution to shareholders) remained stable during these two years, the net profit margin decreased.
Calculating the net profit margin for these two years gives:
200x: Net profit Margin = (400,000/2,000,000)%= 20%
200x1: Net Profit Margin = ($400,000/1,500,000)%=27%
It is clear from the above example that while revenue increased during the second year, the net profit and therefore the net profit margin decreased. Net Profit Margin effectively shows if a company is able to control it’s costs in order to translate the revenue generated into distributable profits.
Therefore, while revenue is very important, so are the costs and not only the cost of sales but also the administrative expenses and the finance costs.
Net Profit Margin is one of the most widely used ratios by both analysts and investors. However, judgement should be exercised when comparing two potential investments or when comparing and judging the performance of two companies that operate in different industries.
As an example, companies that operate in competitive markets often try to grab additional market share by reducing their prices, at least for the short term. In addition, new companies might have increased interest expenses due to capital raised which should cause the net profit margin to decrease.
At the same time, increased net profit margin does not necessarily mean increased distributions since companies might choose to retain the profits.
It’s not that uncommon for a company to have one or more exceptional items on the income statement. As an example, an exceptional item might be an impairment, a restructure expense or a decommission cost.
Therefore, it might be useful to omit these exceptional items in order to maintain comparability.
As already mentioned above, net profit margin shows the ability of a company to “translate” the income into profits. Therefore, if a company is making losses, then the net profit margin does not have a meaning.
Both net profit margin and gross profit margin are very useful and widely used ratios. However, there are quite different. Analyzing a company by calculating and using the gross profit margin, we effectively try to understand if the company is able to increase costs while controlling the costs that can be directly attributed to the manufacturing the delivery of a product.
However, the net profit margin allows us to see the bigger picture by incorporating not only the cost of sales but also other expenses such as payroll, other admin expenses, finance costs and the taxes paid.
At the same time, while net profit margin includes more costs, it also includes more costs that are subject to judgement and can therefore change from company to company. As an example, depreciation policy varies from company to company and net profit margin can be subject to costs that could be described as more judgmental.
The calculator below can be used to find the net profit margin of a company. Simply enter the net profit and the revenue in the boxes!
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Return on Assets is calculated by dividing the net profit for the year to the total assets that a company has. The Return on Assets Ratio (ROA) is expressed as a percentage. The net profit is a figure found in the profit and loss account (income statement) while the total assets is recorded in the balance sheet.
In addition, Return on Assets can be also calculated by taking the average assets (average of opening and closing) but for companies with fairly stable assets, this version should produce consistent results. Furthermore, there are analysts that prefer to ignore (or better to add back) the interest expense since the interest is effectively the cost of raising the capital in order to acquire the costs.
In summary, the Return on Assets Ratio can be calculated as follows:
Return on Assets: (Net Profit/Total Assets)%
The table below includes details for two companies with different numbers. We will use these two companies in order to calculate both versions of the return on assets ratio (with interest and without).
Company A  Company B  
Net Profit  $4,000,000  Net Profit  $3,000,000 
Interest Expense  $(250,000)  Interest Expense  $(100,000) 
Total Assets  $15,000,000  Total Assets  $8,000,000 
Company A: Using the first version (ignoring the interest expense), the Return on Assets Ratio is : $4,000,000/15,000,000 or around 27%. However, adding back the interest expense slightly increases ROA to 28% ($4,250,000/$15,000,000).
Company B: Using the simpler formula, ROA is 38% ($3,000,000/$8,000,000) while by using the second version ROA becomes 39% ($3,100,000/8,000,000)
The examples above, show that while the first company has higher net profit, it also uses significantly higher assets to generate these profits and therefore, the return on assets ratio is lower. All things being equal, increasing the total assets for Company B and matching them to the assets that Company A has would allow it to generate more profits than company A.
In other words, the example above shows that company B is more efficiently using its’ resources and is able to generate more cents of profits per cent of assets.
Comparing the Return on Assets for one company with the Return on Assets for another company is useful but also certain difficulties. Each company is unique and has a different structure. In addition, a company that operates in the manufacturing sector for example might be more asset intensive and might have a higher asset base compared to a company that is providing services (as an example a marketing company).
Therefore, the Return on Assets Ratio should be ideally used to compare companies that operate in the same industries or be used to understand if a company is improving based on historical information.
The calculator below can be used to produce the ROA ratio. Simply input the net income and total assets for the company you want to calculate the Return on Assets for.
]]>There is more than one formula that you can use to calculate the debtor days. To be more specific, the first version of the debtor days calculates the debtor days ratio by dividing the trade debtor (not the whole debtor balance, just the trade debtors) with the credit sales and multiplying the result with 365 (number of days in a year).
Debtor Days= (Trade Debtors/Credit Sales)*365
However, the above formula assumes that information about the credit sales will be available to you. Most of the times, such information is not available in the financial statements. Therefore, if you are an analyst or if you don’t have access to the credit sales figure, an alternative is the following formula:
Debtor Days Ratio = (Trade Debtors/Revenue)*365
As you can imagine, the second ratio will give you a smaller number of days that a company needs to turn its’ sales into cash. The reason for that is that the second formula includes cash sales and not just credit sales, since it includes the total revenue figure and not just credit sales.
Finally, you will also see the debtor days ratio being calculating the average of the opening and the closing debtors for the year.
The table below includes details for the two hypothetical companies. Company A has managed to generate more sales. However, it also has a larger trade debtors figure.
Company A  Company B  
Revenue  $5,000,000  $3,000,00 
Trade Debtors  $350,000  $150,000 
The debtor days ratio for first company is as follows:
Debtor Days Ratio : (350,000/5,000,000)*365= around 26 days
However, the debtor days for the second company is:
Debtor Days Ratio : (150,000/3,000,000)*365= around 18 days
What the example above shows is that Company A suffers from a higher number of days that it takes its’ customers to pay for the amounts invoiced. On average, it takes around 8 more days for customers of Company A to pay the amounts outstanding compared to the clients that the company A has.
There are several implication for this which are further analyzed below the most important is that Company A shows a greater ability to collect cash and increase its’ working capital which can be used for the day to day operations.
There are many useful things that the debtor days ratio can show. In particular, by calculating, analyzing and interpreting the debtor days ratio, you can gain insight about:
At the same time, it is worth noting that each company has a different client portfolio and different agreements with its’ clients in place. Similarly, different companies from different industries will have significantly different debtor days ratio. Therefore, the specifics of the company and also the industry that a company operates in should be taken into account when comparing more than one company at the same time.
The calculator below is very straightforward so please fill in the boxes and you will get the debtor days!
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The formula that is used to calculate the Inventory Turnover Ratio is quite simple. The formula is:
Inventory Turnover Ratio: Cost of Sales/Average Inventory for the Year
Where Average Inventory for the year is: (Opening Inventory + Closing Inventory)/2
If the stock levels do not drastically change year one year, it’s also possible not to use the average inventory levels and just use the final closing stock balance.
In addition, it’s also possible to use specific costs that are included in the stock line item in order to further refine the ratio and make it more accurate. As an example, certain overhead costs such as labor can be excluded since they are allocated to stock as needed while raw materials for example are actually purchased by the company.
The table below summarises the information we need in order to calculate the inventory turnover ratio for two hypothetical companies, Company A and Company B.
Company A 
Company B 

Cost of Goods Sold 
$5,000,000 
$8,500,000 
Average Inventory 
$650,000 
$2,500,00 
Inventory Turnover Ratio 
7.7 
3.4 
Company A is smaller than Company B both in terms of year end stock levels but also in terms of cost of sales. However, the Inventory Turnover Ratio is lower for Company B (Cost of Goods Sold/Average Inventory).
As explained in the introduction above, the inventory turnover ratio shows how many times stock is sold or replaced during the year.
Therefore, it’s reasonable to assume that the higher the inventory turnover ratio the better. The reason for this is that a higher ratio is correlated to higher sales and also lower (always comparatively) lower year end stock levels.
At the same time, having unusually high inventory turnover ratio can be also associated with a couple of negative points. For example, high stock turnover can mean that the company might be having difficulties in keeping a certain level of stock level at all times which leaves it open to price fluctuations of its stock.
As a result of that, the first company will have a lower inventory turnover ratio compared to the second company. It’s therefore advisable to benchmark each company against other comparable companies.
In order to use the online calculator below, just fill in the cost of goods sold (or as it’s also called cost of sales) and the average inventory figure.
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It therefore shows how much profit (attributable to the shareholders) in dollars (or any other currency) can be distributed to the shareholders for every dollar of common stock.
The formula to calculate the return on equity ratio is very simple. You will need two numbers, the net income available for distribution to the shareholders which can be found on the income statement and the shareholders equity which can be found on the balance sheet – statement of financial position.
The formula is: ( Net Income/Common Stock Equity)%
It is worth pointing out that in order to calculate ROE, the net income is after deducting any dividend that needs to be paid out to investors that hold redeemable preference shares. However, these dividends are already deducted before arriving to the net income, since redeemable preference is debt and the “dividend” is included in the finance expense line (on the profit and loss statement).
The following example will help us calculate and understand the return on equity ratio. It’s a straightforward scenario for two different companies that have a different capitalization and different income.
[table id=21/]
Company A has a lower net income but also a significantly lower equity. At the same time, Company B has a higher net income but a significantly higher shareholders’ equity figure.
Therefore, the return on equity ratio for company A (2,000,000/15,000,000) is 13% while the ROE for Company B is 10% (5,000,000/50,000,000).
Based on the example above, we can see that while Company B has a higher net income, ROE takes into account the “size” of equity too.
As a result, ROE for company A is higher than for Company B. This means that Company A has managed to generate more profit per dollar of equity than Company B.
Investors usually follow company that have a high ROE because it shows that the company is able to potentially pay out high dividend. However, high ROE and does not necessarily mean high dividends too. In other words, a company might be able to generate high profits compared to the equity funds used, but it might be choosing to either retaining them or reinvesting them instead of distributing them.
Another point that is worth noting is that ROE can be manipulated by raising debt instead of capital. If a company used more debt, then the shareholders’ equity will be lower and therefore the ROE (return on equity) will be higher. However, higher debt also means higher interest expense (among other things).
Finally, a variation of the Return on Equity is the Return on Common Equity which excluded preference shares (both the dividend paid to preference shares but also the funds raised by issuing preference shares).
The online calculator below can be used to calculate the return on equity. Just fill in the blanks!
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Creditor Days Ratio is used together with other ratios such as the accounts receivable days, the inventory turnover ratio in order to monitor the working capital.
The Creditor Days ratio can be calculated as follows:
Creditor Days Ratio = (Trade Creditors/Credit Purchases)*365
However, if information for the credit purchases is not be available, you can also use the formula below that will produce comparable results:
Creditor Days Ratio = (Trade Creditors/Cost of Sales)*365
You might be wondering what is the difference between these two formulas. Credit purchases should be included within the cost of sales. However, cost of sales will also include cash purchases. Therefore, including cash purchases too, the creditors days ratio will appear lower than it actually is.
In addition, there are analysts and accountants that prefer to also include purchases that not just from the cost of sales line but also from financial statements line items such as admin expenses. The reason for that is that if you make a purchase that does not directly relate to stock (such as stationery for example), using only the cost of sales effectively ignores these purchases, Therefore, if your income statement does not only include cost of sales but also other lines where purchases are included, make sure you add these too in order to calculate the creditor days ratio (or DPO as it’s also called).
Let’s assume that we have two different companies (Company A and Company B). Company A is larger with company B and has a greater trade creditors at the year end but it also has a larger cost of sales balance.
The table below summarizes the specifics for the two companies but briefly, using the formula above, the creditor days ratio or else, the days payable outstanding ratio, is 36.5 days for Company A and 29 Days for Company B.
This is calculated by dividing the trade creditors by the cost of sales and multiplying the result with 365 which is the number of days in a financial year.
Company A 
Company B 

Trade Creditors 
$600,000 
$800,000 
Cost of Sales 
$6,000,000 
$10,000,000 
Creditors Days Ratio (DPO) 
36.5 Days 
29 Days 
While Company B has a higher trade creditors at the year end, it also has a higher cost of sales. As a result, Company B has a smaller Creditor Days Ratio or Days Payable Outstanding Ratio.
The creditor days ratio for company B is 29 days and 36.5 days for company A. So what does that mean in practice? It means that company B takes a shorter period of time to repay its suppliers. In particular, it takes on average a slightly more than a week less to pay the invoices for purchases made.
While you might think that this is a good thing, that’s not always the case. In order to maintain, a healthy working capital, companies need to reduce the days it takes for clients to pay any amounts due but at the same time this can by achieved by delaying payments to suppliers.
However, as you might be able to guess, delaying payments it not something that your suppliers will be particularly happy about! It’s therefore important to be able to keep a balance between increasing the time it takes your company to pay invoices due (by improving credit terms for example) but at the same time maintaining good relationships with your suppliers.
The online calculator below can help you calculate the days Payable Outstanding ratio by simply filling the boxes with the trade creditors and the cost of sales figures.
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The internal rate of return is the discount rate which makes the costs to undertake a project equal the profits that this project will generate. In other words, the internal rate of return is the discount rate that gives a zero net present value.
The idea is that if the cost of capital which is also the interest rate that a company pays to borrow money is less than the internal rate of return, then the project can be accepted.
As noted above, if the internal rate of return is lower than the cost of capital then the project should be rejected since it costs more money for the company to invest in this project than the return that the project is expected to bring.
We will use one example in order to illustrate how the internal rate of return can be calculated and the approach is. Let’s say that company A uses the internal rate of return to evaluate investment opportunities and make a decision regarding the profitability and viability of a project.
There is one potential project that Company A wishes to appraise with the following characteristics:
An initial investment of $50,000 is required during the first year.
The project will last for four years and the cash inflows during these four years will be:
The company has a cost of capital of 15% and wishes to appraise this project and decide whether to proceed or not.
There are two different approaches that can be followed to calculate the internal rate of return.
From the IRR definition, we know that the IRR is the discount rate that makes the present value of the cash flows become $nil. We can therefore use a trial and error approach and start increasing the discount rates until we get to a present value that is $nil.
The following table illustrates the calculations.
[table id=19 /]
As we can see from this table, a discount rate of 19% gives around $500 NPV while a 20% discount rate gives a $462 NPV. We can therefore understand that the IRR is somewhere in the middle or around 19.5%.
There is another approach we can use to calculate the internal rate of return (IRR) and involves a formula (see below). The idea is that we use two different discount rates for which one will give a positive net present value and another that we believe will result in a negative net present value. It might sound complicated but follow the example below which should help you understand what are the steps you should follow.
IRR= Ra + (NPVa/(NPVaNPVb))*(RbRa)
where
Ra is the discount rate that gives the positive net present value, NPVa is the positive NPV, NPVb is the negative NPV and Rb is the discount rate that gives the negative NPV.
Let’s proceed with a table that can illustrate what’s written above in an easier to follow way:
[table id=20 /]
The table is part of the first table and we can see that a 10% discount rate gives a positive NPV and a 20% gives a negative NPV. We can therefore use the formula above and calculate IRR as:
IRR= 10+(11,242/(11,242+462))*(2010)=19.6%
As you can see both methods will give the same IRR (more or less) but most people prefer to calculate IRR by using the second approach since it involves less calculations.
The internal rate of return is a very robust capital appraisal method but there are certain limitations. For example:
There are however certain advantages that IRR has which make it one of the most preferred capital appraisal methods.
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By doing that, we can calculate the payback period or the time that it takes for a project to break even by correctly accounting for the fact that having $1 now does not have the same value as having $1 in 5 years from now.
As explained above, the discounted payback period is used to calculate the time that it takes for a project to bring in enough profits to cover the initial investment (and other subsequent costs) or put it differently, how many years it takes to break even and recoup the initial investment.
Trying to give a single formula will complicate things but an example will help us understand how the payback period is calculated. Let’s assume that company ABC has the option to invest in a project that will initially cost $20,000. The project will run for 4 years and will bring the following profits during each one of these four years.
Year 1 = $7,000
Year 2= $9,000
Year 3= $4,000
Year 4= $12,000
The company believes that the cost of capital that should be used to discount these cash flows is 10% since that’s the interest rate the bank charges Company ABC for the loan facility.
Company ABC uses the discounted payback period method (among other methods) to rank potential projects and choose the ones that will be undertaken.
Using the example explained above, we will need to perform the following steps to calculate the discounted payback period.
–First Step: Calculate the discounted cash flow for each period by using the following formula :
Discounted Cash flows = (Cash flows)/ (1+r)^n
where r is the cost of capital or 10% and n is the time (for this example we have 4 years so n spans from zero to four).
–Second Step: Calculate the cumulative discounted cash flows until we get a cumulative cash flow number that is greater than zero
–Third Step: When we get the first positive number we know that the project has started bringing profits so the discounted payback period can be now calculated. What we need to do is workout how many months from this last period we need to add in order for the project to make zero profit (neither a loss nor a profit).
Let’s see the above steps by using the example already provided.
[table id=18 /]
What we can see from the table above is that during the last period the cumulative cash flows become positive. We therefore know that the discounted payback period is somewhere between the third and the fourth period.
In order to find exactly what’s the discounted payback period is, we do the following simple math:
Discounted Cash flows for Last period = $8,196
Cumulative Cash flows for last period with negative number = $3,193
We will need the following number of months from the last period to break even:
Number of months = (3,193)/(8,196/12)= around 5 months. The discounted payback period is therefore 3 years and 5 months.
As already noted, the difference between the discounted payback period method and the simple payback method is the fact that we can discount the cash flows and account for the time value of money which as explained above is the fact that having one dollar today is not the same as having one dollar in one year from now.
Apart from that, these two methods are exactly the same and have the same advantages and disadvantages.
In line with the advantages of the simple payback period, the discounted payback period has the following advantages:
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The Payback Period method is mainly an initial screening capital appraisal method and should not be used as the only method to make investment decisions. The reasons for that are explained below but for now, let’s see how the payback period is calculated and a couple of examples.
The payback period has two different formulas which are used depending on whether your cash flows are stable and equal throughout the duration of the project. What that means is that if you have a project with the same cash inflows during all periods, then the first formula can be used. On the other hand, if your cash flows are not the same, then the second approach is used.
First of all, if the project yield equal cash inflows for all the years that it will last, then the formula is simply:
Payback Period = (Investment at Period 0)/(Cash Inflow per period)
Remember that the payback period calculates the time it takes to break even (in years, months or anything you are using to count the periods). For example, if you have a project that will initially cost you $10,000 and you know that it will bring $5,000 per year, then the payback period is 2 years (see table below).
[table id=14 /]
In the real world, you will rarely find a project that will bring the same amount of revenue throughout its duration. You will therefore find it useful to know how to calculate the payback period for more complex scenarios. An example might help:
The initial investment is again $10,000 but the cash inflows are not the same for none of the three periods. The first year the project will generate $3,000, the second $6,000 and the third $2,000.
You might have noticed that we will manage to break even somewhere within the third year. So the payback period is not exactly 3 years but it’s 2.5 years.
[table id=15 /]
We will use two more examples to illustrate why the payback period should not be the only method that you will use to appraise a project. It can be used as an initial screening process but it’s not advised to be used on it’s own. The internal rate of return or the net present value methods will give you a more robust analysis.
We have the following scenario: An initial $10,000 investment is required which will bring $3,000 in the first year, $7,000 in the second year and $200 residual cash inflows per year for three more years. It’s clear that the the payback period is 2 years.
[table id=12 /]
Now let’s see another example that can help us understand what’s the biggest disadvantage of the payback period when it’s used to rank investments (from the most attractive to the least attractive). The initial investment in the example below are the same. The annual income generated differs and the payback period is 3 years and 2 months.
It’s clear that if we had to use the payback period to choose one of the these investments, we would pick the first since it has a lower payback period. However, having a second look can reveal that the second investment might take more time to break even but the total present value is higher.
It will generate a total of $11,000 profit compared to the $600 profit that the first investment will generate.
[table id=13 /]
It should be clear by now that the payback period method is not the most robust capital appraisal technique and should not be used on it’s own. The internal rate of return or even the accounting rate of return should be used to supplement your analysis.
In particular, the internal rate of return answers a different question (the cost of capital that is required to break even) but it takes into account the time value of money and it also takes into account the whole duration of the project and does not stop when the project has generated enough profits to help us break even.
However, while the payback period definitely has disadvantages, it also has some advantages which can be summarized as:
A summary of the disadvantages of the payback period is as follows:
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Shareholder funds are not interest bearing but they dilute the ownership of the company. In addition, investors expect some kind of return on their investment which usually takes the form of dividends.
On the other hand, debt does not dilute the ownership but it requires interest payments. In addition, debt holders come first when a company is being liquidated. Finally, debt usually requires a fixed or floating charge.
There are two different formulas that can be used. Both of them are valid and as long as there is consistency, the results from your analysis should be comparable.
The first formula includes the interest bearing debt in the numerator and the share capital plus the retained earning in the denominator. So, the first formula for the gearing ratio is:
Gearing Ratio (%) = (Interest Bearing Short and Long Term Debt/Share Capital+Retained Earnings) *100%
The second formula that can be used to calculate the gearing ratio is pretty much the same apart from the fact that the debt that is included in the numerator is also added in the denominator.
In other words, the formula is:
Gearing Ratio (%) = (Interest Bearing Debt)/(Share Capital + Retained Earnings+Interest Bearing Debt)
Where interest bearing debt one should include bank loans, overdraft facilities, loan notes issues and other forms of debt that has been issued.
In order to understand the gearing ratio, two examples will be used.
Company A has a $1,000,000 bank loan that is due in 5 years. In addition, the shareholders funds as per the latest statement of financial position appear to be $750,000. Similar companies in the industry usually have a gearing ratio of 40% to 50%.
Using the above formulas (the first one), we can calculate the gearing ratio for this company which is 75% (1,000,000/750,000). Apart from analyzing the historical data for the same company, it’s also useful to compare the results with similar companies in the sector. The reason for that is that different sectors have different characteristics.
For this example, we can see that Company A has higher gearing since other companies in this sector have around 50% financial gearing.
Company B operates in the same sector with Company A. Company B has a $500,00 bank loan and $1,500,000 shareholder funds. Therefore, we can calculate the gearing ratio which is 33.33%.
While for simplicity, we don’t use historical information for Company A and B, we can say that both companies could improve their financial leverage.
For example, Company A is highly geared with the gearing ratio being higher than the industry average by 25%. At the same time, company B has a significantly lower than the industry financial leverage.
So what does that mean? For company A, a high gearing ratio means that the company will have to pay interest on an annual basis (higher than what’s normally paid by same companies in the sector), adhere to bank covenants and risk breaking these covenants when the financial results are not so good. Of course, all of the above are not ideal for a company.
Increased gearing ratios are risky and when a company is unable to repay it’s debt, it can lead to bankruptcy.
At the same time, Company B has a very low gearing ratio when compared to other similar companies in the same industry. This is also not ideal since the cost of debt is lower than the cost of equity.
The cost of debt is cheaper because as already mentioned, debt holders are more secured then shareholders (in the event of a liquidation). Of course, as we saw from the first example, that does not mean that companies should only raise debt. This is also risky and can lead to unpleasant events.
Companies should find a balance that is in line with the needs of the company, the ability to raise debt or capital (creditworthiness), the needs and desires of its shareholders and also in line with the industry and market standards.
As explained above, there are reasons for which a company might want to increase the gearing ratio. There are different ways to achieve that:
Similarly, there are situations where a company might have to or want to lower the financial gearing which can be done by:
Finally, a gearing ratio online calculator is included below which can be used to calculate the financial gearing of a company using the first formula (debt/equity).
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Both the International Accounting Standards and the Local GAAP (US or UK) do not provide a clear and concise definition for finance leases. Instead, they use a set of criteria or rules that guide users and help us distinguish what should be recognized as an finance or as an operating lease.
Specifically, the criteria that are used are the following:
From above criteria, it’s obvious that using the substance over form, the accounting standards require that the assets leased should be treated based on the economic reality rather than based on the current legal status.
In other words, if you expect that the leased asset will be transferred to your company or will be acquired by your company for a price that is significantly lower than the market value, then it should be recognized as a finance lease. The accounting treatment of the finance leases is significantly different from the accounting treatment of an operating lease since operating leases are effectively kept off balance sheet while finance leases are recognized as a normal asset owned by the company.
For example, Company XYZ signs a lease for a piece of machinery which says that:
Let’s say that the remaining useful life of the asset is estimated to be 62 months or 5 years and 2 months and the current market price is $410,000. Therefore, based on the above criteria, the lease is a finance lease since the present value of the lease payments is basically the same as the fair value of the asset and the lease term is the more or less the same as the useful life of the asset.
In line with the finance leases, there is no definition for an operating lease. Instead, the accounting standards say that if a lease is not a finance lease, then it has to be an operating lease.
As an example, Company A leases a printer for 1 year and the monthly payments are agreed to be $100. Similar printers are expected to last for 3 years and their price is around $300. Therefore, since the asset will have another 67% of its useful life remaining when the lease is over and the payments that will be made constitute a portion of the fair value of the asset, then the lease is an operating lease and should be treated as such.
The accounting standards try to avoid having companies selling and leasing back assets while keeping them off balance sheet. However, leasing an asset (even with a finance lease) can have significant benefits.
Operating leases also have significant advantages. For example:
Accrual Concept of Accounting vs Accruals
First of all, we should distinguish the accrual concept of accounting and the accruals, accounts that are included in the statement of financial position or under US or UK GAAP, the Balance Sheet.
Under IFRS or the Generally Accepted Accounting Principles (Practice of the UK) Frameworks, accounts should be prepared on an accruals basis.
In other words, revenue should be recognized when earned and expenses should be recognized when incurred. Cash Receipts and Cash Payments are irrelevant.
Accrual Accounts on the other hand are liability accounts that are included under the current or the non current liabilities section found on the balance Sheet. They, of course, derive from the fact that the accounts are prepared using the Accruals Concept of Accounting but they are not “directly” related to that.
So we established that the financial statements should be prepared on an accruals basis and not on a cash basis. This is of course applies for everything apart from the cash flow statement (which is prepared on a cash basis).
So what do we mean by saying accrual concept of accounting? For revenue, we should recognize all the sales that were made during the year even if there was no actual cash inflow. If we make a cash sale, then we post the following journal:
Debit Cash
Credit Revenue
However, if we make a sale on credit, then revenue is should be also recognized and the following entry is posted:
Debit Accounts Receivable
Credit Revenue
Similarly, expenses are recognized in the period incurred regardless of when the cash outflow actually happened. In other words, if we incur expenses and pay with cash, then the following entry is posted:
Debit Admin Expenses (for example)
Credit Cash
However, if the invoice is not yet paid, then the entry posted is the following:
Debit Admin Expenses (for example)
Credit Accounts Payable
Company XYZ has 31 December year end. Company XYZ sold shoes worth of $500,000 on the 10th of December to an important client. The shoes have been produced and have been already received by the client. The agreement was that 50% of the shoes would be paid when the were delivered and 50% after 6 months. The good were delivered on the 20th of December.
Answer: Company XYZ should recognize the sale made (fully) since the sale is complete, the goods are delivered and risks and rewards have been passed on to the supplier.
Therefore, the doubly entry is the following;
Debit Cash $250,000
Debit Accounts Receivable $250,000
Credit Revenue $500,000
Company XYZ made also signed a contract with an other client that shoes worth of $1,000,000 would be produced and delivered during a two year period. The full amount was paid when the contract was signed.
As at the year end, Company XYZ has delivered shoes worth of $400,000.
Answer: Since the company has completed 40% of the order, the double entry should be the following:
Debit Cash $1,000,000
Credit Revenue $400,000
Credit Deferred Revenue $600,000
The concept is the same for expenses. Using the accrual concept of accounting, if the cost has been incurred during the year, it needs to be recognized even if no or if part of the payment has been made.
]]>The difference between the current ratio and the quick ratio is that the quick ratio only includes cash, marketable securities (which are easily convertible into cash) and accounts receivable. As explained above, it therefore excludes the stock or inventory.
Therefore, in order to get the quick ratio, you will need to use the following formula:
Quick Ratio (or Acid Test Ratio)= (Cash + Accounts Receivable + Marketable Securities)/Current Liabilities
You can also use the following formula provided that the current assets only include the current assets as per the equation above plus stock:
Quick Ratio (or Acid Test Ratio)= (Current AssetsStock)/Current Liabilities
Let’s say for example, that company A has the following :
Therefore, the quick ratio is : (1,500,000+ 500,000)/1,000,000= 2
The quick ratio assesses whether a company will be able to cover its current liabilities from its current assets as they are falling due. Therefore, if you want to analyze the quick ratio, the following apply:
If the quick ratio is higher than 1 (ideally as high as possible), the company appears to be able to repay its current liabilities as they are falling due.
If the quick ratio is lower than 1, then the company might be unable to repay some of its current liabilities and the company might face liquidity squeeze.
The calculator below will help you find the quick ratio by taking the current assets less the inventory and dividing it by the current liabilities. To be more precise and as explained above, the quick ratio only includes cash, marketable securities and accounts receivable. However, most companies only have the above assets plus stock. Therefore, by taking the total current assets and deducting the stock, we get the same figure.
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It might be easier to just start with the formula of the break even point. First of all, the break even point is the point where you make no profit but you also incur no losses. In other words, it’s the point where the total profit that a product generates equals the total fixed costs. So, the break even formula is:
Break Even Point= (Fixed Costs)/(Sales PriceVariable Costs)
As explained above, the break even point is calculated by divided the total fixed cost by the contribution of each unit. By saying contribution, we mean the revenue per unit less the variable costs per unit. In terms of analyzing or explaining the break even point, a high break even point or in other words a large number of units necessary to cover the fixed costs can mean either that the contribution is low (low price per unit or low margins) or the fixed costs are high.
For example, if your company is thinking of launching a new product that will have $500,000 fixed costs while the sale price for one unit is $10 and the variable costs (such as materials and supplies) will be $5, then the break even point will be:
$500,000/($10$5) or 100,000 units. In other words, using this example, you will have to product and sell 100,000 units to break even.
A second example might be more illustrative. Let’s say that you have two products that you can develop. However, you can not develop both products at the same time. You need to choose either Product A or Product B.
Product A has these characteristics:
Product B has :
The break even point for product A is : (5,000/0.5) or 10,00 units to break even. The break even point for product B is : (20,000/2) or 10,000.
So which product would you choose to develop? You will need exactly the same amount of sales to break even for both products and product B has a higher contribution as well.
There is definitely more than one factor that I would take into account such as the reliability of the information that I am using to perform my analysis but me, being a risk averse, I would choose product A. The reason? If I lose, I will only lose $5,000. The second scenario is a bit more risky due to the high fixed costs. Of course, this is a matter of preference and the way people assess and perceive risk.
A simple calculator to help you find out how many units of a product you will need to sell to break even. Break Even analysis is a straightforward approach to help you understand if the product you are developing is likely to be successful and if you will be able to cover the fixed costs by using the projected sales that you will be able to make.
The only inputs you need are the revenue per unit, the variable cost per unit and the total fixed cost attributed to the development of this product.
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The current ratio formula is very straightforward. The numerator includes the current assets and the denominator the current liabilities. Therefore, the current ratio formula is:
Current Ratio= Current Assets/Current Liabilities
Examples of current assets that are included are cash and cash equivalents, accounts receivable and stock (or inventory). On the other hand, current liabilities include your trade creditors (or accounts payable), your shortterm debt (shortterm bank loans, overdraft facilities) and other liabilities that are expected to fall due within the next financial year.
As noted above, the current ratio shows whether a company is able to repay the current liabilities as they are falling due. In other words, if the current ratio is higher than 1, then the company is believed to be in a better shape to repay the current liabilities from its current assets. Preferably, a company should have a current ratio higher than 1.5 but comparing this ratio with the industry which the company operates in or with other similar companies is considered more appropriate. Furthermore, when analyzing the a company, it’s suggested to compare the current position with historical data. Preferably, you use a 35 years horizon which will enable you to add comparability and identify trends.
A current ratio that is lower than 1 means that the company risks being unable to pay its current liabilities as they are falling due. In other words, it might be the case that the company will be unable to pay its suppliers or the shortterm loan and the consequences might not be pleasant.
Example 1: Company A has $500,000 cash and $200,000 stock while the accounts payable is $1,000,000. Now let’s assume that the full $700,000 balance that represents the current assets can be recovered in a short period. The above example company will be unable to pay part (or $300,000) of its suppliers.
Example 2: Let’s say that we have two companies. Company A has $1,000,000 current assets and $500,000 current liabilities. Company B operates in the same industry and has $2,000,000 current assets and $3,000,000 current liabilities.
The current ratio for Company A is 2 (1,000,000/500,000) and the current ratio for company B is 0.67. Therefore, company A seems to be able to cover its current liabilities by utilizing its current assets and there is also a 500,000 headroom. On the other hand, company B might face difficulties repaying all its current liabilities since the current assets are not enough.
The calculator that you will find below calculates the current ratio by dividing the current assets with the current liabilities. Current assets include all assets that are due within the next financial year such as cash and cash equivalents, inventory, accounts receivable and prepaid expenses. Current Liabilities include liabilities such as accounts payable, accruals and shortterm debt.
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Apart from the fact that gross profit is widely used, it’s also a very straightforward figure or ratio to calculate since the only numbers that are used are the revenue and the cost of sales, both obtained from the income statement.
As explained above, the gross profit is calculated by deducting the cost of sales from the revenue or the sales that a company has generated in a financial year. In other words, the gross profit formula can be calculated as :
Gross Profit= Revenue – Sales
However, the gross profit margin is presented as a percentage and it tries to add comparability and correct for the fact that different companies have different sales figures. A comparison of the gross profit and the gross profit margin is provided below but for now, the gross profit margin formula is:
Gross Profit Margin= (RevenueCost of Sales)/(Revenue) * 100%
We will use an example to help you understand how the gross profit and the gross profit margin are calculated and how you can analyze and interpret the results.
Let’s assume that we have two companies. Company A is bigger than Company B. In particular, Company A was able to generate $20m of sales and the cost of sales were $15m. On the other hand, Company B was able to generate $5 of sales and the cost of sales were $2.5m.
Using the formulas above, for company A the gross profit and the gross profit margin are:
Gross Profit= $20$15=$5m
Gross Profit Margin= ((2015)/20)*100%=25%
For company B, the results are:
Gross Profit= $5m$2.5=$2.5
Gross Profit Margin= (($5m$2.5)/$5)*100%=50%
What the above example shows, is that the gross profit can be used to help us understand how a company is doing in terms of revenue generation over time and within the same industry. However, it has a weak point when used for companies of different sizes. For this reason, it’s a good idea to use both the gross profit and the gross profit margin. For the example above, company B has lower gross profit but higher margin. In other words, while Company B is smaller, it performed better in terms of cost control.
So we established that to get more information, we should be using both financial ratios. But what information do we get by calculating the gross profit and the gross profit margin?
As explained above, the information you will get is pretty much the same for both ratios. However, the margin tries to correct for the “size issue”. In other words, you can analyze these two financial ratios and understand:
1. Whether a company is having steady revenue growth. In particular, by calculating these two ratios for more than one year (maybe a fiveyear horizon will enhance your analysis) and especially by diving into the different revenue streams (such as clothes department, shoes department etc.), you will be able to understand if the company is growing and if the sales are increasing.
2.Apart from the sales increase, you will also be able to understand if the company is able to control its costs and increase profitability. Increasing sales is definitely something that all companies want. On the other hand, if you increase sales by 10% and cost of sales increase by 20%, then the net result is definitely not good.
3.We talked about the sales increase but you can actually get more information from these two metrics. In particular, the revenue sales depends on the price and the volume. So if you know that the prices are stable (let’s say for example that the industry averages are relatively stable) and you can see that a company has increased its gross profit, then you can assume that it’s attributable to increased volume. This is particularly good because it can mean that the company is able to expand its client base and rely less on specific customers.
4.Similarly, the gross profit and the gross profit margin can help you understand whether specific costs are constantly increasing, pushing the company’s margins lower and lower. To be fair, you will need more information than just that cost of sales figure, but big companies usually include an analysis of the cost of sales in the notes. Similarly, if you are calculating these two figures to for internal analysis (i.e for your company), you probably have access to such information.
There first calculator will help you get the gross profit.
Finally, this calculator will help you derive the gross profit margin. Both calculators should be self explanatory but if you have any questions, feel free to leave a comment.
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Factoring is a contract where a company transfers or sells its accounts receivable balance (the debtors balance) to a factor, usually a specialized factoring provider.
The topic is of particular importance when it comes to the accounting treatment of the transaction and whether the company should keep reporting the accounting receivables or whether they should be removed from the balance sheet. Accounting standards (Both IFRS and GAAP) distinguish two different cases, factoring with recourse and factoring without recourse.
There are two different factoring transactions, a factoring with recourse and factoring without recourse.
Factoring without recourse or the non recourse factoring is the transaction where the rights and the obligations (including the risk of the receivables turning out to be a bad debt) are transferred to the factor.
The difference between the value of the receivables and the amount received is an expense and should be reported on the income statement. The non recourse factoring has increased fees that reflect the transfer of the risk to the factor.
Factoring with recourse has lower fees since the company does not sell the accounts receivable and the risk of the debtors balance turning out to be not receivable remains with the company and is not transferred to the factor.
There are several differences between a loan that a company can take from a bank and a factoring transaction. First of all, the factor will assess the credit worthiness and the recoverability of the accounts receivable. However, for a loan, the bank sets an interest rate that reflects the creditworthiness of the company based on several factors which include the total assets, the debt to equity ratio, the profitability etc.
In addition, when a company takes a loan, the bank will provide the funding providing that a fixed or a floating charge is set as a collateral. The charge (either floating or fixed) is of course enforced only if the loan is considered as non recoverable. However, under a factoring transaction the asset is sold and not secured.
Company A factors $1,000,000 of its accounts receivable to Factors Inc. without recourse. The factor applies 5% interest fee and retains 20% of the receivables which will be paid when the all of the receivables are collected.
Company A will therefore receive in total $1,000,000* (10.05)=$950,000. The company will record $50,000 as an expense on its income statement. The amount that will be received immediately is 75% * 1,000,000=$750,000.
The remaining $200,000 will be recorded as a receivable which will be collected when the factor collects the receivables that have been factored.
The journal entries are therefore as follows:
Debit Factor Loss $50,000
Debit Factor Receivable $200,000
Debit Cash $750,000
Credit Accounts Receivable $1,000,000
We will use the same example as above but $20,000 is the estimated recourse obligation which has been forecast based on the recoverability of the similar debtors balances.
The entries are therefore as follows:
Debit Factor Loss $70,000
Debit Factor Receivable $200,000
Debit Cash $750,000
Credit Accounts Receivable $1,000,000
Credit Recourse Obligation $20,000
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Depreciation is used to spread the cost of the asset over its useful life and to account for the fact that assets become obsolete and need to be replaced as time passes. In other words, companies are not allowed to recognize capital expenditure as an expense and instead, they use a (consistent) depreciation method to gradually include this expense in the income statement.
Both IFRS and GAAP only allow two specific depreciation methods which are:
The declining or the reducing balance depreciation method recognizes that a higher cost should be allocated to the first periods and lower costs are recognized as time passes. The formula that is used to calculate the declining balance depreciation is :
For example, let’s assume that a company bought an asset for $10,000 and the accounting policy allows declining balance depreciation of 10% per year. The depreciation that will be recognized is as follows:
First Year: Opening book value * Depreciation Percentage
Or
$10,000 * 10%=$1000 depreciation and closing carrying value of $10,000$1,000=$9,000
Second Year: Opening Book Value * Percentage or
$9,000 * 10%= $900 depreciation and $8,100 carrying value.
Bear in mind that the scrap value of the asset is ignored when the declining balance method is used.
When the straight line method is used, the scrap value should be deducted from the purchase price. Therefore, the straight line depreciation method formula is as follows:
For example, if a company buys an asset for $10,000 and the asset is expected to be used for four years before it will be sold for $2,000, the depreciation will be :
(10,0002,000)/4=$2,000 per annum.
Tax rules for depreciation are different from the accounting rules. The depreciation tax shield refers to the expense that can be recognized as an allowable tax expense every year. On the other hand, tax rules change and what is allowable or disallowable expenditure depends on the asset and its usage. It is considered as more appropriate not to go into tax details in this tutorial but what is important is that the tax refers to the depreciation that is allowed (usually the declining balance is allowed) for tax purposes.
The journal entries that are posted to account for depreciation are straightforward. The first thing that you should remember is that the cost of an asset that is recorded in the accounting books does not change. Instead, a second account is created which is called accumulated depreciation. The carrying value that is included in the balance sheet is the net result of the cost of the asset and the accumulated depreciation.
Using the first example (the declining balance example), during the first year the following journal entries should be posted:
Debit Depreciation Expense $1,000
Credit Accumulated Depreciation $1,000
The carrying value of the asset will be costaccumulated depreciation or $9,000.
For the second year, the following entries will be posted:
Debit Depreciation Expense $900
Credit Accumulated Depreciation $900
The carrying value will be $10,000 (cost)1,900 (accumulated depreciation)=$8,100
There are no practical differences between the methods that are used to calculate depreciation and amortization. Amortization is used for all intangible assets (patents, brand names, exclusive contracts etc.) while depreciation is used for tangible assets. It is often hard to estimate the useful life of an intangible asset while some assets (such as goodwill) should not be amortized under IFRS, but should be reviewed for impairment instead.
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