[MUSIC] Learning outcomes. After watching this video, you will be able to calculate the value of accruals. [MUSIC] >> All right, guys. So, we are so far seeing the whole concept of accrual and why theoretically this is supposed to work. Now let's get into the actual formula. So this is it. This is the formula that Sloan uses to identify accruals. It looks complicated on the face of it, but it's very, very simple and straightforward. If you really understand what's going on here, so accruals, let's start from the first part of the formula. So how do you calculate accrual? So first for you to do is Delta C, what is this Delta C? Go back to your accounting class, you'll learn that, you know there are current assets and current liabilities, right? Just pause for a while and think, what are current assets? Do you get it? Yeah, so current assets are those which are easily convertible into cash within a quick time. Usually people say within a year. But the spirit of the human is there. They are convertible into cash quickly. So that's the idea. So delta current assets, so change in current assets. Now, remember, what are we up to? We are trying to calculate this accrual company. How much is the accrual earnings of a farm in a year, right? So why should we take this delta current assets? If you think properly, think of a seller who has sold something and has not received cash. Now what happens? How is such a transaction recorded? Such a transaction is recorded as a receivable from that buyer, right? So if you record something as a receivable from a buyer, so what happens your current assets go up. Remember, current asset consist of what? Cash, receivables, stock, and so on, and so forth. So any increase in current assets is an increase in accruals, right? So the sale, which is not a cash transaction, increases your income. But at the same time it doesn't contribute to your cash. So that is why Delta CA, an increase in current assets is considered as increasing accrual. It is not considered, it is an increasing accrual. So first calculate that. So how do you calculate? Take this year's balance sheet, take the previous year's balance sheet, and just take the difference, calculate the difference. So, the first component is Delta C. So this is basically the difference between all current assets of this year and last year. However, you have to subtract change in cash from them, okay? Change in cash from change in current assets, why? Because increase in cash is not accruals. Increase in cash is cash. So when you calculated increasing current assets you would have also taken cash into account, right? So if that same sale is because of cash or within three months if the buyer pays cash, then that should not be considered. So, basically, this part is increasing current assets net of increasing cash. In other words, all that you have to do is calculate change in all current assets other than cash. That's what this part means. Now let's go to the second part. There are some terms which you may not be familiar, but you would understand the spirit of this formula. Basically all that we are trying to understand is, what is the change in operating income caused by accruals? That's all. Now, ignore the negative sign for a while, what are we trying to calculate here? Delta current liabilities. [COUGH] CL stands for current liabilities. Now, increasing current liabilities, does it increase accruals or does it reduce accruals? Why don't you think about this for a bit? You can pause this video here and think about this. The question is, increasing current liabilities, does it increase accruals or does it reduce accruals? You thought about it, many of you have got it, but let me explain for those of you still thinking. What is this current liability? Current liability is something that you owe to your supplier, right? Suppose you buy something on credit. It could be raw material. It could be any purchases that you make on credit. So you record the moment you make this purchase, right? But then, the actual payment may be delayed. It may be a practice in your industry to pay off, let's say, three months or six months. Now, in such a situation, how do you record this transaction? You will record this transaction as a purchase, which is an expense, but at the same time in your balance sheet, what you do is show it as? Yes. Sundry creditors, bills payable, in different names, in different countries. That doesn't matter, the spirit is that whenever you buy something on credit, when there is no cash flow involved. So there is an increase in current liability. Now, what does this increase in current liability to do, what does it do to your accruals? So the way you able to think about it is suppose you have paid this in cash, then your cash earnings would have come down, right? Suppose you are paid this in cash. Now what is happening is, you're not paid it in cash. So there is a cash saving. Let me give you a concrete example. I think then it'll be clear. Suppose, let's take a guess, there is a purchase of 300. And you sold this for, let's say, 150, right? Now, imagine that this entire 150 comes in cash. Okay? Now, just for the sake of simplicity, assume that there are no other expenses and you make a profit of 50. I'm just making it too simple just for the sake of understanding. Of course, you will have other expenses, closing stock, and so on, and so forth, but let's take this example. Now, in this case, what is the cash you will have? So you started with, let's say, cash of, say whatever, you started with the cash of 100, let's say, right? Now, you're paid nothing, but your receipts are 150, right? So your cash earnings in this case is going to be how much? Yes, the cash earning is going to be You know, I gave that pause for you to think. You know whenever I ask a question, I'll pause for a few seconds so that you can think. Otherwise, you can also mute this video and, sorry not mute, pause this video and see this. Think yourself. So what happens? The accounting profit is 50. But the cash you'll have, imagine you started with 0, forget about 100, how much cash you will have? You will have a cash of 150, right? So what did this credit transaction do? It increased your cash earnings. In other words, it reduced your accruals. So cash earnings is 150, right? Because you had 150 in cash, you paid nothing. You have cash earnings of 150, your accrual earnings is 50. Right? So if you're to calculate this number from this number, what you have to do? You have to subtract 100 from this number. That is what we are trying to do here. Right? So, when you subtract 100, so you will actually arrive at the accrual number. So we are trying to calculate what is the part of the earnings, which is driven by accruals, right? So that is why current liability is subtracted. Very, very straightforward, where there is no rocket science going on here. So subtract increase in current liabilities, now what's this animal doing, Delta STD? Now, this is not usual, you will not have it in every company, suppose there has been an increase in short-term debt, which is not used for our operational purpose. A lot of times you, for financing activities, you raise money for some kind of investment which is not related to your normal operating activities, that should not be considered as a part of current liabilities, that's all. I know you are subtracting this, and then this is Delta TP, Delta TP is Delta tax payable. So, in this short-term liabilities on the count of tax payable also should be excluded, right? Because it's not a part of your normal operations. So, first calculate this part and calculate this part. So, once both of them are done, and the final part is this depreciation. Now, I'm sure you're going through depreciation in your accounting module, right? So pause for a while and think about it. So what does depreciation do? Is there any outflow of cash involved in depreciation? No, so there is no outflow of cash. All that we are doing is we have an asset, we have its use for life. We are writing off the desert or its useful life? That's all that is going on in depreciation. So, but then in your income statement, let's go back to this example, suppose there is depreciation here, so that depreciation saved 30 here, so that is considered as an expense. So in this case, if there is 30 depreciation, now your profit will be how much? Your accrual profit falls to 20, why? Because of this depreciation, if we take 30 rupees as depreciation in this case. Instead of 50 accrual profit it becomes 20, because this 30 is considered as expensive, which is not actually cash expense. There is no cash overflow. Therefore, that also has to be subtracted. So, then you will actually get what is the actual accrual component of values, so what do you do? First step, calculate increase in current assets, net of cash. That's the first step. So that will give you what is the increase in accruals. Subtract increase in current liabilities, net of increase in debt, which is used for financing activities. They're also increasing tax payable. So that will give you that component of cash earnings that needs to be subtracted from here. And finally, deduct depreciation, because there is no cash outflow there, it's purely an accounting entry. So the balance that you get is the accrual component. So this is the first step in arriving at this formula for trading on this strategy.
