If the change is zero or negative, then you will get a score of zero. So by doing this, you're trying to identify firms who's profitability is improving. So the first three scores, what do they represent? First represents level of profitability. Second represents level of cash flows. Third represents change in profitability. Now, with this background, let's move to the fourth score. Now, fourth score will require some kind of a background. This is called accrual. Now, what is this accrual? This started from a research from Richard Sloan. It's a famous paper about accrual anomaly. Now, he pointed out that if profits are driven by accruals. What is accrual? We just discussed while discussing CFO. Accrual means that part of revenue which the form has not received in cash. Think about any kind of a dealer who sells items on credit. Now, in the income statement moment, the sale transaction is consummated. The moment legal obligation arises at that time only, the buyer is bound to pay, the seller is bound to supply. The moment that legal obligation arises on both the parties, this is recorded as a sales. Once it recorded as sale, it will come into income statement, and then you'll deduct expenses, and then it adds to your profitability. But cash has not moved. There is a possibility that the party which owes you money may not pay up, right? There is also a possibility that a firm which wants to show high profits fictitiously generates these kind of sales by book entries. Because ultimately, for a cash sale you ought to cash in the balance sheet. But for accrual, all that you have to show is you owe money, somebody else owes money to you. So I'm not saying it's very easy to do, but there have been instances where people have recorded fictitious income. So accrual could be a tool to record fictitious income. So that is why it's very important to distinguish between what's [INAUDIBLE] is cash earning and accrual earning is different. So what they showed is if a firm's earning is driven by cash from operations, then such earnings growth is more sustainable than firms whose earnings are driven by accrual items. He also showed that market fails to distinguish between these two immediately. Ultimately, market figures out, but a clever fundamental analyst who can distinguish between accrual earnings and cash earnings has some strategy to make money. We are going to talk about this loans accrual anomaly also. That's one of the strategies that we are going to discuss. But in Piotroski's trading strategy, accrual is one component of the final F score. So now, with this background, how to calculate accrual? Very simple. You have your ROA measure, you have your CFO measure. The difference between the two is accrual. Yeah, the background setting was too long, but the ultimate result is very straightforward and simple. Just deduct CFO from ROA. Think about it. What is ROA? Total income. CFO, cash flow from your business. The difference is what? Accrual. So you get this number and then scale it by assets. We are looking at scaled accrual and then we are seeing whether it is positive or negative. If it is positive, give a score of one, and if it is not positive, give a score of zero. In other words, what we did was we just subtracted CFO from ROA. And if a ROA is higher than CFO, then it is a positive accrual. And if it's ROA is less than CFO, then it's a negative accrual. Now, you have a quiz. What I said about accrual, is that correct? Think in terms of economic logic. It could be correct, I´m not saying it's wrong. Where I said if accrual is positive, give a score of one. If accrual is negative, give a score of zero. Is that right from an economic logic point of view? Think about it. Many of you would have guessed it right, it is wrong. Why? High accrual is a bad thing. This is what I'm telling you. Let's not do anything mechanically. Let's try to understand the economic meaning of this. So if you have positive accrual, it is not good. What did Sloan show? Funds which have high accrual, their income is not sustainable. Do we want to invest in such companies or avoid such companies? We want to award such companies. So the real way of doing this is positive accruals, give a score of zero. Not positive accruals, or negative accruals. I'm sorry, it's not approvals, it's accruals, a-c-c. Then you get a score of one. So we want firms with less accrual, not more accruals. Now, tell me one thing. How is it possible that a firm will have no accrual at all or a negative accrual? How is it possible? It's possible, right? If you have some receivable from last year, and if you receive this year, and you will receive all your receivables this year, your total cash will be higher than your income. That's possible. That's a good scenario to be in. Now, why Piotroski's so much obsessed about cash in this F score? You may be wondering. Is it not a normal business practice to give your items on credit. What's wrong with accrual? You have to remember an important point here. We are looking at firms which are distressed. We are looking at firms, many of which are on the verge of bankruptcy. There's serious liquidity problems. This is what a lot of classical economists pointed out, right? They said these firms earning high returns is nothing magic, nothing great, because they are high risk firms. I told you right at the beginning itself. If reaching between destination A and B takes two hours, and you tell me you reached the two, you covered the distance in one hour by doubling the speed, there's nothing great. Good that you survived, but then, the chance of an accident also is high. It's possible to imagine a scenario where there could happen an accident. By taking that risk, you covered the distance quickly. There is nothing magic going on here, right? So similarly, high BM farms, if you think they that they're all high risky farms, they may not survive. Then if by investing in some of these high BM farms, even if you have made money, doesn't mean that this is a replicate, all right? Yeah, you are lucky not to get stuck in stocks, which ultimately went bankrupt. But some other person may invest in stocks, or at some other time, these firm will go bankrupt. Then you may lose all your money. So what Piotroski score is doing is trying to identify good firms among them. Please note this. By good firm, I mean, these are firms which may survive. So that is why cash flow is important. If you're on the verge of bankruptcy, then it is very, very important that you have positive cash flows. Because that can save you from bankruptcy in a lot of cases. That is why Piotroski emphasizes so much on cash flows. If you see the four profitability measures, the first four profitability measures, two of them depend on cash flows, and two of them are onearnings. Now, let's take a hypothetical example and see how do we get these numbers. It's very simple. You've already gone through an accounting module, but let's do this. So think of a proforma income statement. On the right-hand side, you have all revenues. This could be left-hand side in some countries. Ultimately, you should get the spirit of this. Suppose you have a revenue of 100, whichever currency it is. Then you have an expense of 50, so your net profit is 50. So assume that all this is from ordinary course of business. There is nothing extraordinary going on. So this is your ROA, right? So how do you calculate your first measure? Your numerator is this. You get the asset number from balance sheet. On the right-hand side, you have assets. On the left-hand side, you have capital and liabilities. Of course, the balance sheet should tally, Accounting 101. So again, this could be written. Sometimes in some countries, assets may come on this side and liabilities may go on the other side you. You could just get the spirit, that's more important. Of course, the real life balance sheet will have like 10,000 assets, but I'm not getting into that. You just have to get the spirit of the score. So go to balance sheet and get the value of assets. Important thing to note is beginning of the year, not the end of the year. So basically, beginning of the year means last year's assets, end of the year last year. Nobody prepares a balance sheet as the beginning of [INAUDIBLE]. So if this is for Year 1, this should be for Year 0. Get that clearly. Why? Because Year 1 assets are influenced by what is going on here. Please understand this. This profit will come into capital and add to your total liabilities, and it'll also come into cash or receivables, so on and so forth. You would have seen all this in your accounting course, right? Now, pick up these number assets. Pick up this profit. Just do 50 by 1,000, that's all. There's no magic here. And 50 by 1,000 is positive, you get a score of 1. What if this will be minus? Minus would have come here. What if this was a loss? Then give it a score of zero. So that's your first company. Second company does what? Cash flow from operations. Where do we get it from? You have a work cash flow statement. So in cash flow statement, you have cash flow from operations, cash flow from financing, cash flow from investing. Now, again, you can take a standard accounting course to know the difference between the three. But right now, we are interested in cash flow from operations. Pick up this number. So here, they're not cooked up, our number 10. It could be 10 million, 10 billion, whatever, based on whatever you have in mind. But more important is the sign. It's positive, right? So pick up this number, 10. Scale it by, guess. Simple, straightforward. Again, the same asset beginning of there. Again and again, I want to emphasize, this is not current year. This is last year's assets, right? You'll learn cash flow will influence this year's assets. So do 10 by 1,000. Is it positive? Yes, it is positive, and hence you give us quota of 1 for this company. Now, what is a third component? Third component is delta ROA. Now, for that, you need to know last year's numbers, last year's ROA by assets. Let's assume, last year the profit was, say, 30, and the asset was, say, it was 1,000 last year, also. It is 30 by 1,000. This year, it is 50 by 1,000. 50 by 1,000 is, of course, more than 30 by 1,000. Therefore, delta ROA is increasing. So if delta ROA is increasing, what do you do? Give a score of 1. So this particular firm has, so far, got three out of three. Amazing. It's a very rare phenomena, by the way. Why? Again, go back. We are looking at distressed firms. Okay, what is the final company? Now, by now, you should know that the fourth one, which is accrual, is just the difference between ROA and CFO. So ROA is 50, CFO is 10, so accrual is positive. So if accrual is positive, what will you do? Will you give a score of one? Does this formula get a score of four out of four in profitability? No. Accrual positive is not a good thing. Remember this. So accrual positive will get a score of zero. So among the first four profitability measure, this firm gets three out of four. So that's how you calculate the first four components of Piotroski's measure. So these are based on profitability. So once we are done with profitability, we now move on to capital structure measure. Now, profitability measures tell you about the current health of the firm in terms of whether it's making money or losing money, whether its profitability is increasing or decreasing. We should also know about the capital structure. Why should we know about capital structure? Again, pause for a while and guess. Think about this. If a firm is financed heavily by debt, that too short-term debt, then there is a higher probability of a bankruptcy. Why did I say short-term debt more than long-term debt? Because short-term creditors can claim their money at any time, because the maturity is very short. So they'll come knocking to your doors within next three months, six months, any day. And suppose you do not have enough of influence, the firm maybe under. So it's very important to know how the firm is financed. Or this capital part, which I have capital and this part, the liabilities. By capital, I mean liquidity capital, by the way. So how these liabilities are financed, how they are structured. What proportion is outside liability to inside capital? These are very, very important to know the chances of a firm's survival. See, what is the big risk for us that this firm may go downward? If they go down, your equity is going to become zero, all your money is gone. Remember, if you lose 95%
