Temporal method vs current rate method

One subsidiary, one year, one rate history, six ratios, three ways of expressing them.

How do the ratios change when the rupee falls?

Start with the current-rate column, because it's the calm one. Three ratios are identical to the local figures and two aren't, and the split is exact.

A ratio built from one statement is unchanged. Gross margin takes two income-statement lines, both at ₹84.00, and the rate cancels. The current ratio takes four balance-sheet lines, all at ₹87.00, and the rate cancels. Debt to equity takes three balance-sheet lines and cancels the same way.

A ratio built from two statements is scaled, and you can know the factor in advance. Asset turnover puts revenue at the average rate over assets at the closing rate, so it is multiplied by 84.00 ÷ 87.00 = 0.965517. Return on equity does the same. 16.6667% × 0.965517 = 16.0920%, the figure in the table, to twelve decimal places. Every mixed ratio under the current-rate method equals its local counterpart times the average rate divided by the closing rate. Commit that identity to memory. It lets you convert in your head, and it tells you the sign of the distortion straight away.

Revenue growth is the odd one out, and it's the one that shows up in headlines. Prior-year revenue was translated at ₹80.00, this year's at ₹84.00. Local growth of 11.1111% is reported as 16.6667%, and 5.5556 percentage points of the growth an Indian shareholder reads came from the rupee falling.

Now the temporal column, where nothing is stable. Gross margin rises to 41.1607% because cost of goods sold carries old, cheaper rupees while revenue carries this year's. Asset turnover jumps to 0.816525 times because the denominator shrank. PP&E is frozen at ₹70.00 while revenue moved to ₹84.00. Debt to equity rises to 0.723261 times because the numerator is monetary and moves to ₹87.00 while the equity denominator is held down by frozen non-monetary assets. Return on equity reaches 20.5436%, on a numerator inflated by cheap historical costs and a denominator deflated by them.

What happens when the rupee strengthens instead?

Run the mirror to see that none of this is about the direction of the move. Take the same subsidiary with the rupee strengthening: opening ₹82.00, average ₹78.00, closing ₹77.00, dividend at ₹79.00, closing inventory layer at ₹77.50.

The scaling identity holds in the other direction too: 78.00 ÷ 77.00 = 1.012987, and 16.6667% × 1.012987 = 16.8831%. Gross margin now falls below the local figure, to 39.0705%, because the historical inventory rates are now above the current ones. Reported growth of 8.3333% is below local growth of 11.1111%.

Two things stay true in both directions, and they're the ones to carry with you.

Under the current-rate method the single-statement ratios never move at all, and the mixed ones move by a factor you can compute in one division.

Under the temporal method every ratio moves, the directions differ from each other, and the size depends on how old the fixed assets are. Debt to equity was 25.1799% higher under remeasurement when the rupee fell, and only 9.7387% higher when it rose, on the identical subsidiary. The distortion depends on the gap between the historical rate and the closing rate. That gap is a fact about the company's history. It tells you nothing about this year.

Why one subsidiary looks more profitable one way and more levered the other

You don't have to memorise the grid above. It falls out of a single question you can ask about any line: does this item's rupee value move with the exchange rate?

Under the current-rate method the answer is yes for every asset and every liability, so the entire balance sheet scales together, so every balance-sheet ratio is preserved. The income statement scales together too. Only the seam between the two statements, the average rate against the closing rate, produces any distortion at all.

Under the temporal method the answer splits. Cash, receivables, payables and debt move with the rate. Inventory, plant and the costs that flow from them don't. So the liability side of the balance sheet inflates when the functional currency weakens while the asset side only partly inflates, equity absorbs the difference, and leverage rises. The ₹78.75 crore has no other source.

Why does net income barely change between methods?

Profit takes one more step. Why does net income barely move? Remeasurement improves the operating lines and adds a separate loss below them. Cost of goods sold and depreciation are cheap because they carry old rupees, worth ₹10.05 crore of extra operating profit here. The remeasurement loss of ₹8.80 crore takes most of it back. Net income ends ₹1.25 crore above the translated figure, or 1.9841% higher. Read only the bottom line and you'd conclude the method barely matters.

Net income is where the method matters least. Look at what happens one level up:

Operating profit is 9.97% higher and equity is 20.11% lower, and those two errors point the same way in every ratio built from them. Anything of the form profit over capital is badly wrong under one method or the other, and return on equity is 4.45 percentage points apart on a business that did one year's work.

What does the choice of method do at group level?

At group level the same arithmetic gets diluted and stays material. Bharat Precision's parent-only profit is ₹520.00 crore and its parent-only net worth is ₹2,850.00 crore.

Consolidated profit differs by 0.2144%, which no screen would notice. Consolidated equity differs by 2.4294% and return on equity by 0.4873 percentage points. Several screens would catch that. Total comprehensive income differs by ₹19.95 crore, because under translation the currency movement is real income that bypasses profit, and under remeasurement it has already gone through profit.

The habit to build: when you meet a multinational with an unfamiliar return on equity, find the functional-currency note before you find an explanation.