Professional Documents
Culture Documents
2013
Table of Contents
Preface
13
15
17
20
23
25
27
29
32
35
37
39
42
45
47
49
51
55
58
59
61
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Preface
While the future is unfolding at a gradual pace or so it seems, we wonder how fast we have traveled
the distance since the beginning of 2008, when the skies above the stock markets were blue, and
investors thought that the tree called stock markets could grow to touch the sky. It has never
happened this way in the past. And this time was no different.
As far as the corporate world is concerned, there has been a sea change in the attitude of companies
and their managements. While not many of them (companies) were talking about any business
concerns then (January 2008 and before), disclosures are flooding in these days - disclosures relating
to hidden losses, pledged shares, cash that never was, cooked up books, and many like these.
Another contrast can be seen in the behaviour of stock prices to bad news. While such ill doings
were not given any air and were casually passed off in the heydays of 2008 and before, these days
even a hint of negative news sets a company's stock to plummet.
One of Warren Buffett's famous quotes is - "I never attempt to make money on the stock market. I
buy on the assumption that they could close the market the next day and not reopen it for five years."
Imagine if that actually happened. And that too in the first week of January 2008! Most of us would
have loved it considering that it was the peak of the bull-run.
Or to put things in a different perspective, imagine if there was a lock in period on every stock
purchase - say, a five year lock-in period. A greater proportion of us would have been wiser in our
stock picking.
Coming back to the earlier point about the change in attitudes, with the occurrence of the slowdown,
investors' focus is expected to shift on companies' long term performance rather than short-term
performance. As such, the managements and their long term plans would be looked at with more
detail.
We hope this brings about a change in investors' approach towards investing. The lost art of carefully
studying a stock before making the purchase, we believe, needs to make comeback. Understanding
the nuances of profit and loss accounts, balance sheets, and cash flow statements has always been
pertinent, more now than ever before.
So, let's begin the journey to educate ourselves towards a fruitful investing experience. In a series of
articles following this, we will try to bring to you the basics of investing by acting as guideposts to
unraveling the mystery behind the financial statements.
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While soft qualitative metrics like corporate governance and management quality will continue to be
clouded under subjectivity, our effort will be to arm you with a better understanding of the ways
companies can be researched.
Happy Investing!
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Equitymaster database: You can also visit Equitymaster's database by clicking on this link.
Here you will be able to view information relating to companies' historical numbers and
business profile. You will also be able to view reports on key sectors.
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3. Report on corporate governance: The report on corporate governance covers all aspects
that are essential to the shareholder of a company and are not part of the daily operations of
the company. It includes details regarding the directors and management of a company.
These include details such as their background and their remuneration. This report also
provides data regarding board meetings - how many directors attended the how many
meetings. It also provides general shareholder information such as correspondence details,
details of annual general meetings, dividend payment details, stock performance, details of
registrar and transfer agents and the shareholding pattern.
4. Financial statements and schedules: Finally, we arrive at the crux of the annual report, the
financial statements. Financial statements, as you are aware, provide details regarding the
operational performance of a company during the reporting period. In addition, it also depicts
the financial strength of a company. The key constituents of the financial statement include
the profit and loss account, the balance sheet, the cash flow statement and the schedules.
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The balance sheet: The balance sheet gives a snapshot of a company's financial strength. The
statement shows what a company owns or controls (assets) and what it owes (liabilities plus equity).
In accounting terminology, the balance sheet is broken into two parts - 'Sources of funds' and
'Application of funds'. 'Sources of funds' indicate the total value of financing that a company has
done, while 'Application of funds' indicates the areas the company has utilised these funds.
As such, sources of funds = application of funds.
Put in other words, assets = liabilities + equity.
As we are aware, every company has limited resources. What differentiates a good company from an
average one is the way in which it utilises such resources.
A typical balance sheet statement is displayed below.
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12,096 Total
12,096
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Another way a company can diversify itself is by having presence across geographies. An investor
can study a company's revenue pattern (from each zone, region or country) over the years.
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Companies having transnational presence have the option of focusing on the high growth areas or
areas that are relatively resilient to an economic slowdown. In addition, if its operations in a certain
country/region are witnessing a problem, it could curb the fall in revenue by focusing on operations
in other countries/regions.
Seasonal and cyclical businesses
The revenue volatility would remain high for companies that are present in seasonal or cyclical
businesses, especially if viewed on a quarterly basis. A seasonal business is a business for which
certain seasons of the year are far more profitable than others. These include businesses such as
seeds and fertilizers (harvest season), hotels (vacation), air conditioners (summer season), rain coats
and umbrellas (monsoon season), amongst others. On the other hand, a cyclical business is largely
dependent on economic cycles. A classic example for the same would be the cement business,
wherein there is a high correlation between the GDP growth and the growth in cement consumption.
As such, we would recommend investors to look at performance of such companies over the long
run.
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the breakup of the various cost heads of Indian food major, Britannia Industries. We have compared
each cost head to the respective year's sales figure also shown the change in expenses in absolute
terms and in terms of percentage (of sales).
FY07
FY08
Amount % of sales
21,993
100.0%
Change
Amount % of sales
25,848
100.0%
Amount % of sales
17.5%
14,004
63.7%
15,553
60.2%
11.1%
-3.5%
767
3.5%
905
3.5%
18.1%
0.0%
1,357
6.2%
1,798
7.0%
32.5%
0.8%
4,578
20.8%
5,274
20.4%
15.2%
-0.4%
20,705
94.1%
23,531
91.0%
13.6%
-3.1%
During FY07, raw material costs firmed nearly 64% of sales. However, during FY08, raw material
costs increased by 11.1% YoY in absolute terms, but as a percentage of sales, it dropped by 3.5%
YoY. Further, employee costs increased by 18.1% YoY in absolute terms during FY08, but when
compared to sales, these remained flat at 3.5%. On the other hand, advertising costs increased by
32.5% YoY in absolute terms during FY08.
As raw material form a major part of Britannia's expenses, a slower increase in their cost (as
compared to sales) has helped the company boost its margins by 3.1% YoY. Similarly due to lower
other expenses, the company was marginally able to improve its operating margins. However, as
advertising costs do not form a big part of the company's expenses, when compared to sales, these
increased by a mere 0.8% YoY.
Likewise, if you can follow this method for companies over a long run, it would help you analyse
and view the trend expenses over a long period.
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To give an idea of how margins differ within each industry, we can take a look at the table below.
Sector
Engineering
Cement
Retail*
Pharma
FMCG$
IT
Telecom
Hotels
Power
Automobiles#
Steel^
Construction
From the above table, we can notice that broadly, sectors such as telecom and IT earn the highest
operating margins, while sectors such as auto and FMCG garner the lowest margins.
The telecom industry garners one of the highest margins mainly on account of the advantage of
operating leverage. As telecom companies need a selected amount of mobile subscriptions (in turn,
revenues) to cover its costs of networks, licences and spectrum, any subscriber additions above that
level will largely translate as profit for the company.
On the other hand, the auto industry garners one of the lowest margins mainly on account of stiff
competition and high dependence on raw material costs (in turn, realisations). An auto manufacturer
may not be in a position to pass on the rise in raw material cost to its customers to the full extent as it
would end up its car sales as customers would choose a cheaper alternative (stiff competition). For
these reasons, the auto industry remains a high-volume, low-margin business. Similar would be the
case for FMCG companies.
An example of a low-volume, high margin business would be that of software products or heavy
engineering. As software companies develop products in-house, they are able to earn higher margins
on their sales. But when compared to IT services, the revenue is relatively much lower. Similarly for
engineering companies, when the component of pure engineering is high on a particular project, the
company tends to earn higher margins (on that particular project) as opposed to pure construction or
project activities.
It may be noted that these differences are largely intra-industry and not inter-industry.
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Conclusion
We hope that you may have got a better understanding of operating margins and their key
determinants after reading this article. As we mention time and again, we recommend investors to
study and analyse operating performance of companies from a long term perspective.
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Year
FY08
FY09
FY10
FY11
FY12
FY13
FY14
Value of asset
10,000,000
9,000,000
8,000,000
7,000,000
6,000,000
5,000,000
4,000,000
Depreciation amount
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
FY15
FY16
FY17
FY18
3,000,000
2,000,000
1,000,000
0
1,000,000
1,000,000
1,000,000
-
Under the written down value (WDV) method, companies depreciate the value of assets using a fixed
percentage on the written down value. The written down value is the original cost less the depreciation
value till the end of the previous year. As such, this results in higher depreciation during the earlier life
of the asset and lesser depreciation in the later years. An example of the same is shown below:
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A company buys an asset worth Rs 10 m in FY08. It will depreciate the value of the asset by 15% each
year (on the written down value).
Year
WDV of asset
Depreciation amount
FY08
10,000,000
1,500,000
FY09
8,500,000
1,275,000
FY10
7,225,000
1,083,750
FY11
6,141,250
921,188
FY12
5,220,063
783,009
FY13
4,437,053
665,558
FY14
3,771,495
565,724
FY15
3,205,771
480,866
FY16
2,724,905
408,736
FY17
2,316,169
347,425
FY18
1,968,744
295,312
The main difference between both these methods is the actual amount of depreciation per year.
However, it may be noted that the total depreciation costs (over the life of the asset) will be the same
using either of the methods.
Coming to the point of how much depreciation a company charges, it mainly depends on the type of
asset. As mentioned earlier, depreciation is charged on assets due to reasons such as obsolesce, wear and
tear, amongst others. Fixed assets such as software and computers would be depreciated at the highest
rate as they tend to get obsolete rapidly due to technology upgrades and updates. Plant and machinery
would attract a lower depreciation rate due to their longer life. It may be noted that companies do
mention the depreciation rates they take on their fixed assets in their annual reports.
Another point to be noted is that some companies show depreciation costs as part of operating expenses.
However, it does not form part of the core operations of a company. As such, it would be a better
method to calculate depreciation separately (after calculating the operating income) and not as part of
the operating expenses.
Interest costs: Interest costs are the compensation that a company pays to banks or lenders for using
borrowed money. These costs are usually expressed as an annual percentage of the principal, also known
as the interest rate. As you may be aware, interest rate is dependent of variety of factors such as the
credit risk of the company, time value of money, the prevailing global interest and inflation rates.
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Any investor would prefer a company which is debt free. But that does not make companies that have a
certain amount of debt a bad investment. If a company is easily able to cover its interest costs within a
particular period, it could be a safe bet. How can we know that? This is where the interest coverage ratio
comes in. The interest coverage ratio is used to determine how comfortably a company is placed in
terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings
before interest and taxes (EBIT) by its interest expense for a given period.
For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20
m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the
greater are the risks.
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Net profit margin is a measurement of what proportion of a company's revenue is leftover after paying
for costs of production / services and costs such as depreciation on assets and finances its takes to run or
expand the company. A higher net profit margin allows the company to pay out higher amounts of
dividends or plough back higher amount of money back into the business. Net profit margin is
calculated by dividing the net profits (for a particular period) by the net sales of that respective period.
Net profit margins = (Profit before tax- Tax)/ Net sales * 100
Appropriation: A company can do two things with the profits that it earns. It can either invest it back
into the company (into reserves and surplus) and/or pay out the amount as dividend. In addition, the tax
on dividends is also included here. To get a better understanding of how this functions, we can take a
look at the image below.
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Assuming a company's stock is trading at a price of Rs 100 and during FY09 it has paid a dividend of Rs
5 per share in total. This stock would be having a dividend yield of 5% at the current price. Assuming
that the company is growing steadily and is expected to pay dividends in the coming year, the investor
could have surety of earning at least a 5% return on his investment.
However, it may be noted that you should not purely go out and buy a stock which has a high dividend
yield. It is very important for you to study the company before deciding to purchase a high dividend
yield stock. It could be possible that a company may not be in a position to pay dividends or it might pay
lower dividend in the future (as compared to earlier years) due to various reasons an unprecedented
loss, higher capex requirements, diversification into newer areas, amongst others.
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Reserves and surplus, as the name suggests, are the accumulated profits that a company has earned and
retained overtime. Retained profits are the profits that are left after paying the dividends to the
shareholders. When a company reinvests money back into itself, the reserves and surplus account will
expand. Its complementary effect will be seen in the assets side.
The reserves and surplus account is made up of different reserves such as 'General Reserve', 'Profit and
loss reserve', amongst others. This also includes a reserve which is called the 'Share premium account'.
When a company issues shares, the instrument would have to carry a denomination, called as the face
value. For example, let us assume that the face value of a company's shares is Rs 10 per share. It fixes
the issue price at Rs 100 per share. Now, out of each share that is issued, Rs 10 will go in the share
capital account (as explained above) and the balance Rs 90 will go to the 'Share premium account'.
Loans and borrowings is the other major component of the 'Sources of funds' side. When a company is
in need of capital (for any purpose), but is not able to generate enough internally, it would look to
borrow funds. These could vary from meeting capital expenditure requirements to meeting working
capital requirement, amongst others.
Loans can be of various types. They could be short term (working capital loans) or long term (term
loans) in nature. You would also find terms such as 'secured loans' and 'unsecured loans' in companies'
annual reports. Secured loans are loans that are secured by collateral to reduce the risk associated with
lending.
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Gross block is the total value of all of the assets that a company owns. The value is determined by the
amount it cost to acquire these assets. Any addition made to this gross block is what companies call as
'capital expenditure' or 'capex'. Deletions and other adjustments are largely on account of sale of fixed
assets. As companies buy and sell assets on a regular basis, the gross block figures change every year.
In Nestle's case, gross block as 31st December 2008 (being a calendar year ending company) stood at Rs
14 bn. At the end of CY07, i.e. as on 31st December 2007, the company has a gross block of Rs 11.8 bn.
As such, we can see that the company incurred a capex of about Rs 2.4 bn (not including asset deletions
and adjustments), which was largely expended towards plant & machinery (Rs 1.9 bn) and buildings (Rs
412 m).
Now, on subtracting the depreciation amount from the gross block, we get what we call as the 'net
block'. From the above table we see a figure of Rs 5.8 bn, which is the total accumulated depreciation as
of 31st December 2007 (or at the end of CY07). This increased to Rs 6.5 bn by the end of CY08. If we
take the difference of the two figures we get an amount of Rs 738 m. It may be noted that this includes
the accumulated depreciation amount of those assets that have been sold during the year. On adding the
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amount back, the total would go up to Rs 925 m (including the impairment loss on fixed assets). An
impairment loss is a nonrecurring charge that is taken to write down an asset with an overstated book
value. As such, the actual amount that was added to the accumulated depreciation figure during the year
stands at Rs 923 m. This has also been reported in its profit and loss account during the year.
You will also find the term capital work-in-progress (CWIP) in companies' balance sheets. This is
usually mentioned below the net block. In simple terms, CWIP is work that has not been completed but
has already incurred a capital investment. For example - a building under construction, purchase of plant
and machinery but not yet commissioned or capital advances. This amount (CWIP), when added to the
net block amount gives the total fixed assets of a company for a year. In case of Nestle, during CY08 it
had a net block of Rs 8.6 bn.
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It may be noted that one could also calculate inventory turnover by dividing the inventory by the cost of
goods sold (COGS) during the year. The reason we can calculate it with COGS is because the
inventories are valued at cost and not on sale prices.
Another popular metric that is used is that of 'inventory days'. This is calculated as follows:
Inventory days = 365/ Inventory turnover
or
Inventory days = 365/ (Sales/inventory)
As such, Inventory days = Inventory/Sales *365
While inventory turnover measures the number of times (on an average) the inventory is sold during the
period, inventory days is a ratio which indicates the number of days it takes a company to sell its
inventory. That is the reason for the division of 365/inventory turnover.
Before we move on to the next current asset, we would like to mention that it would only make sense for
one to compare this parameter between companies that are present in the same or similar businesses.
What are sundry debtors?
In simple terms, debtors are persons who owe money to the company. Typically, such debts are on
goods and services that are sold on credit. Sundry debtors can also be termed as 'accounts receivable'.
The reason sundry debtors are recorded as assets to a company is because the money belongs to the
company, which it expects to receive within a short period.
From an investor's perspective, it would help to analyse the speed at which a company is able to collect
the money from its debtors. If a company's collection period is long or is expanding, it is not a good
sign. Apart from meeting daily expenses, a company would also prefer having low debtor days
(mentioned below) to avoid the risk of defaults.
Similar to inventory days, there is a ratio which helps in analysing the number of days it takes a
company to collect payments from its debtors. This ratio is termed as 'debtor days'. The formula for the
same is:
Debtor days = Debtors/Sales * 365
Let us take up an example to understand this further. At the end of CY08, sundry debtors on Nestle's
books stood at Rs 455.9 m. The company had reported net sales of Rs 43,242.5 m. As such, by using the
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above formula, the outcome is 3.8 days. This means that the company is able to collect its payments
within an average period of 3.8 days, which is a very low period.
Let's compare this to an engineering company such as Punj Lloyd. At the end of FY09, the receivables
on the company's books stood at Rs 26.7 bn, while it reported a topline (net sales) of Rs 119.1 bn. As
such, the company had average receivable days of 81.8 days during the year.
We would like to reiterate that these figures (inventory days and debtor days) should be compared to
companies within a particular sector. Comparing companies across industries would throw up different
numbers, purely due to the nature of the respective businesses.
What are cash and cash equivalents?
As you may be aware, cash and cash equivalents are the most liquid assets found in any company's
balance sheet. As an investor, you must have heard experts recommend investing in cash rich companies
(especially in recent times). Why would this be the case? This is simply because it would allow
companies to meet expenses in a downturn when the business is slow.
Cash does not only offer protection against difficult times, but also gives companies more options for
future growth. Companies could grow by acquiring companies. If they do not find a company that meets
their criteria, they could pay their shareholders through dividends.
However, a big cash balance is not always a good sign. What would be an optimum cash balance that a
company must have depends from sector to sector. Sometimes, it differs between companies within a
particular sector.
One could analyse cash levels as a percentage of sales. We ran a query on CMIE Prowess to study some
of these figures between companies that form part of the BSE-IT and BSE-FMCG indices.
During the last five years, the average cash balance as a percentage of sales (standalone figures) stood at
about 4% for companies that form part of the BSE-FMCG Index. On comparing the same parameter on
companies that form part of the BSE-IT Index, the figure stood at an average of 24%.
For instance, during the period between CY99 to CY04, Nestle maintained cash to sales average of
0.4%. During the last four years it has increased to an average of 2.4%. During CY08, the company's
cash balance stood at 4.5% of its full year net sales.
What are loans and advances?
Loans and advances include various items such as advance to suppliers and vendors (in accounting
terminology it is known as 'advances recoverable'), advance tax payments (income tax, wealth and
fringe benefit tax), loans to employees, deposits, balance with customs, amongst others.
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These ratios indicate the short-term liquidity of the company. The higher the ratio, stronger is the short
term liquidity position of the company. If the ratio is 1 or higher, it means that the company has enough
cash and liquid assets to cover its short-term debt obligations. If a company's creditors exceed the
debtors it is possible that it could run into trouble paying back creditors in the short term. However, it
may be noted that it is not always necessary that a company having a ratio of less than 1 (or indirectly
current liabilities are more than current assets) is not in a strong position.
At the end of FY09, the current liabilities on Hero Honda's books stood at Rs 15.5 bn, while its current
assets totaled to Rs 10.1 bn. The current ratio in this case is 0.65. This is one strong advantage for the
company as it is able to generate cash so quickly. This is the case as its customers (two-wheeler owners)
usually pay upfront. Indirectly, as the company has higher creditor days, it means that it is actually
receiving cash for products even before it is making payments to its creditors.
Working capital
Working capital is calculated by subtracting current assets by current liabilities. As indicated above, the
rule of thumb is that positive working capital means that a company is able to pay off its short-term
liabilities.
What is the average amount of working capital needed by a company is calculated by dividing the net
working capital figure by net sales of a particular year. It may be noted that this is an average figure and
as such only gives an indication.
'Working capital turnover' is a ratio that helps in knowing how many days it takes a company to convert
its working capital into revenue. The faster a company is able to do so, the better it is. The formula for
the same is:
Working capital turnover = (Average Working Capital/ Net sales) * 365
When utilizing this ratio, it is important for one to see the long term pattern of the company. More
important is how it fares when compared to its peer group.
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You may also notice investments termed 'investment property' annual reports of in some companies.
This is nothing but an investment in land or buildings which are not intended to be used or occupied by
the investee. Such an investment is considered as a long term investment.
Quoted and unquoted investments:
Quoted investments are investments whose value is easily assessable. Investment in the stock of
companies which are listed on stock exchanges would be the best example of quoted investments. This
is because market prices give these instruments a readily assessable value. Investment in mutual funds
would also classify as a quoted investment. On the other hand, un-quoted investments are investments
which do not have a readily available price. Many a times you will find that companies have invested in
stocks that are not listed on any stock exchange. For such kind of investments, other means are used to
determine fair value.
It may be noted that some companies also report investments as trade and non-trade investments. Also,
an investor may get confused as to why certain investments are shown in a company's standalone
statement, but are missing from its consolidated balance sheet. The answer lies in the fact that a
company's consolidated numbers include those of its subsidiaries and associate companies, the latter
companies do not appear separately as investments in the balance sheet.
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Asset Turnover
Return on equity (ROE) - ROE is probably the most important ratio in the investing world. It helps in
measuring the efficiency with which a company utilises the equity capital. ROE reflects the efficiency
with which the management has utilized the shareholders funds. It is calculated by dividing the 'profit
after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the
company. The result of this calculation should be multiplied into 100.
Return on equity = profit after tax / shareholders funds * 100
One could also take the average equity capital i.e. the average equity of a particular financial year and its
preceding financial year. The ratio is also known as the return on net worth (RONW).
It is important to note that this ratio should be compared within companies of a particular industry or
intra-industry rather than inter-industry. This exercise helps in knowing which companies have better
operating efficiencies and consequently, which managements have been utilising their shareholders'
funds more efficiently. An inter-industry comparison does not really make sense as characteristics of
different industries vary.
Return on capital employed (ROCE) - Capital employed in simple terms is the value of all assets
employed in a business. It can be calculated in two ways -from the 'Application of funds' side and the
'Sources of funds' side of the balance sheet. In case of the former, capital employed would the total
assets minus the current liabilities. For the latter, one can simply add the shareholders funds and the loan
funds.
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ROCE is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed. As
such,
ROCE = EBIT / Capital employed * 100
This ratio helps in assessing the returns that a company realises from the capital employed by it. In other
words, it represents the efficiency with which capital is being utilized to generate revenue.
Return on invested capital (ROIC) - ROIC shows the returns that a company earns on the capital that
is actually invested in the business. It is an important tool which helps in determining how well a
company's management is able to allocate capital into its operations for future growth. It is calculated as:
ROIC = (EBIT)*(1 - effective tax rate) / (Capital employed - cash in hand) * 100
As we can see form the above ratio, after reducing the tax from the earnings before interest and tax
figure (EBIT), we divide the result by the capital employed (net of the idle cash on hand). The reason we
take the EBIT figure is because it includes the PAT and depreciation (which is a non-cash expense).
Surplus cash is subtracted from the total capital employed is because it is not actually employed in the
business.
Return on total assets (ROA) - ROA is another ratio which helps in indicating the management
efficiency. This ratio gives an idea as to how efficiently a company's management is using its assets to
earn the profits it is generation. It is calculated by dividing the profit after tax by the total assets as at the
end of that year/period. As such,
ROA = Profit after tax / total assets * 100
It measures how profitably the assets of the company have been utilised. Companies with high asset
base in capital-intensive industry such as fertilisers and steel tend to have a lower ROA than companies
selling branded products such as toothpaste and soaps, which may have a lower asset base. As such, it is
important for one to compare the ROAs of companies involved in similar businesses/ industries.
Asset turnover - The asset turnover ratio indicates how well the company is sweating its assets. In other
words, it shows how much many rupees a company generates with every rupee invested in assets. This
ratio is a measure of how efficiently the company has been in generating sales from the assets at its
disposal. It is calculated by dividing the sales by the total assets.
Asset turnover = Sales / Assets
Let us take up an example to understand this well. Suppose company 'A' has assets worth Rs 10 bn on its
books. At the end of the year, the company recorded a topline of Rs 25 bn. That means the company has
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an asset turnover of 2.5. This indirectly gives an indication that the company would be able to increase
its revenues by Rs 2.5 with every rupee invested in as assets.
Naturally, the higher the assets turnover, the better it is for a company. However, it largely depends on
the strategy a company is following. It is likely that a company with lower margins and higher volumes
will have a higher asset turnover than a company involved in a low volume - high margin business.
Debt/Equity ratio - This ratio indicates how much the company is leveraged (in debt) by comparing
what is owed to what is owned. As mentioned in the earlier part of this series, a company can broadly
have two sources for employing funds into its business - from the owners and from third parties, i.e. loan
funds.
As such, to get an idea as to how much of the funds employed into a business is in the form of loans, we
use the debt to equity ratio. It is calculated by dividing the debt by the shareholders funds (or equity). As
such,
Debt to equity ratio = Debt on books / Shareholders funds (Equity)
This ratio is probably one of the most observed ratios as it indicates the extent to which a company's
management is willing to fund its operation with debt. Naturally, a high debt to equity ratio is
considered bad for a company as it would have to pay the necessary interest on the borrowings.
But that does not make companies that have a certain amount of debt a bad investment. If a company is
easily able to cover its interest costs within a particular period, it could be a safe bet. For the same, one
should also gauge at the interest coverage ratio.
Interest coverage ratio - The interest coverage ratio is used to determine how comfortably a company
is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's
earnings before interest and taxes (EBIT) by its interest expense for a given period. As such,
Interest coverage ratio = EBIT/ Interest expense
For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20
m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the
greater are the risks.
We hope that the series of articles so far would have helped you analyse companies' numbers better. In
the next article of this series, we shall take up the topic of cash flows.
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These three aspects need to be looked at individually as they are all important to a firm. We shall discuss
these topics one by one with the help of a few examples.
Cash flow from operations
As per Accounting Standard 3 (or AS3), "Operating activities are the principal revenue-producing
activities of the enterprise and other activities that are not investing or financing activities."
As the name suggests, this head shows the amount of money the company makes (or loses) through its
operations. However, it must be noted that only the "core" operations must be taken into consideration.
A cash flow statement begins with the profit before tax (PBT) figure. This is because this figure takes
into consideration the revenues and expenses related it's a company's operations. This figure also
includes depreciation and interest costs. However, PBT should be adjusted for non-cash items (such as
depreciation) and financing expenses (such as interest costs), amongst others. The reason depreciation
expenses are added back is that there is no actual outgo of cash. It is just an accounting entry that is
recorded to recognise the cost of the asset over a period of time.
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After making these adjustments, we arrive at a figure which is termed as the 'operating profit before
working capital changes'.
Working capital is again, a part of the company's core operations. As such, any changes in the same
needs to be accounted for. After arriving at the 'operating profit before working capital changes' figure
one must account for:
It helps in knowing how a company has unblocked or blocked a certain amount towards meeting its
working capital requirements. It does the same by blocking less cash in current assets or by increasing
its current liabilities. When the reverse takes place, it means that more money has been blocked in
meeting working capital requirements.
Nestle's CY08 cash flow statement
Let us take up an example to understand this well. Above, we have displayed Nestle's CY08 cash flow
statement. After making the necessary adjustments, Nestle's 'operating profits before working capital
changes' stood at Rs 8.7 bn at the end of 2008. However, as we move further down, we can see that the
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company's 'cash generated from operations' is higher. The difference between the two figures is Rs 550
m (Rs 9258.8 - Rs 8709.5 m). This means that the company was able to improve its working capital
position over the year. In fact, it was able to unblock funds to the tune of Rs 550 m during CY08 as
compared to the previous year. After we arrive at the 'cash generated from operations figure' we need to
deduct the direct taxes.
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As you can see, there are some figures which are in brackets. This indicates that the money is going out
of the company. On the other hand, the amounts which are not in brackets indicate the inflow of money.
It must be noted that the figures in the above image are in Rs '000 (thousand).
As such, during FY09, Bharti Airtel invested about Rs 137 bn on fixed assets. The same figure during
the previous year stood at Rs 136 bn. Further, during FY09 Bharti Airtel purchased investments of about
Rs 394 bn. During the same year, it sold investment worth about Rs 421 bn.
The other transactions can be viewed in a similar manner. On adding up all the figures, the total comes
up to about Rs 152 bn. This means that Bharti Airtel invested Rs 152 bn in items that fall under the
category of 'investing activities'.
In many cases, companies may have negative overall cash flow during a particular period. However, on
looking at the numbers in detail, one may notice that this may be the case despite a positive cash
generation at the operating level. In such cases it is likely that the overall cash flow position is negative
on the back of higher investments. This may not particularly be a bad news for the company.
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taken on more debt or is diluting equity by issuing more shares. This is not necessarily something that
would make an investor happy. Similarly a negative cash flow would not also be harmful as it could
mean that a company is paying out dividend (cash outflow).
Let us take up an example to understand this well. Shown below is the 'cash flow from financing
activities' portion of Britannia's FY09 cash flow statement.
As you can see, there are some figures which are in brackets. This indicates that the money is going out
of the company. On the other hand, the amounts which are not in brackets indicate the inflow of money.
It must be noted that the figures in the above image are in Rs '000 (thousand).
During FY09, Britannia's cash outflow from financing activities stood at Rs 1.1 bn. This negative cash
flow from financing activities is largely due to repayment of unsecured loans (Rs 3.1 bn). However, the
company has also received certain funds from borrowings. The net figure however stands at a negative
figure of Rs 396 m (Rs 3,063 m - 2,337 m - 330 m), indicating that the amount that was repaid was
higher. In addition, due to interest payment and dividend payment (including the dividend tax), the
overall net cash flow from financing activities increased to Rs 1.1 bn.
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Therefore, FCF/share = (Net Profit + Depreciation - Capital expenditure - Changes in working capital) \
Shares outstanding
Price to free cash flow (P/FCF) is a valuation method which allows one to compare the FCF generated
per share to its share price. The higher the result, the more expensive is the stock.
Operating cash flow ratio (OCF): OCF is calculated by dividing the cash flow from operations by the
current liabilities. This ratio helps in knowing how well short term liabilities of a company are covered
by the cash flow from operations. Short term liabilities in this case would be current liabilities.
As such, operating cash flow = cash flow from operations / current liabilities
You may have by now guessed that this ratio helps in ascertaining a company's liquidity position. But so
are ratios such as the current ratio and the quick ratio, you may ask. The OCF ratio helps in assessing
whether a company's operating cash flow generations are enough to cover its current liabilities. If the
ratio falls below 1.0, it means that the company is not generating enough cash to meet its short term
liabilities. In order to judge whether a company's OCF is out of line, one should look at comparable
ratios for the company's industry peers.
Capital expenditure ratio: This ratio helps in ascertaining how much operating cash flow a company
generates as compared to the capital expenditure it incurs. It would always be better to look at the
numbers for a particular period as compared to a single or particular year.
It is calculated by dividing the cash flow from operations by the capital expenditure. Therefore:
Capital expenditure ratio = cash flow from operations / capital expenditure
This ratio measures the capital available for internal reinvestment and for payments on existing debt. If
the ratio exceeds 1.0, it indicates that the company has enough funds to meet its capex requirements. As
such, higher the value, the more spare cash the company has to service and repay debt. One will usually
find lower ratios in fast growing companies on the back of high capital investments.
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Apart from interest income being the key revenue source for a bank, it also earns income in the form of
fees that it charges for the various services it provides. These services include processing fees for loans
and forex transactions, amongst others. It is believed that banks derive nearly 50% of revenues from this
stream in developed economies. In India, the story is very different. This stream of revenues contributes
about 15% to the overall revenues.
Now that we have covered the income part of the profit and loss account, we shall move on to the
expenditure aspect of the same. The key expense of a bank is interest on deposits that are made with it.
These could be in the form of term (fixed) or savings bank account deposits. The second biggest expense
head for a bank would be its operating expenses. This head would include all operational costs, which
even non-financial companies expend. Some of include employee costs, advertisement and publicity
costs, administrative costs, rent, lighting and stationary.
Under expenses, there is also an item called 'provisions and contingencies' that is included. In the
simplest terms, these are liabilities that are of uncertain timing or amount. This includes provisions for
unrecoverable assets. In accounting terms, such provisions are called as 'Provisions for Non-performing
assets (NPAs)'. Apart from NPAs, these provisions also include provision for tax and also depreciation
in the value of investments.
After removing these heads from the income generated, we simply arrive at the profits figure. The
process of appropriation thereafter is similar to that of non-financial companies.
We shall take up an example to understand this. Displayed below is the profit and loss account of HDFC
Bank.
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The total income generated by the bank during FY09 was Rs 198 bn. Of this, interest income was Rs
163 bn. The balance was contributed by other income.
Out of the Rs 163 bn of interest income, HDFC Bank earned about Rs 121 bn from interest on loans
advanced/ bills. The income from investments during the year stood at Rs 40 bn, while interest from the
balance with RBI and other inter-bank funds stood at Rs 2 bn.
During FY09, HDFC Bank earned revenues of Rs 34 bn as other income. The largest contributor here
was fee income (Commission, exchange and brokerage) to the tune of Rs 26 bn. This translates as 13%
of the total income during the year. Other major contributors were profit on sale of investments and
exchange transactions.
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Moving on to the bank's expense account. The total interest expended stood at Rs 89 bn. The interest on
deposits stood at Rs 80 bn , while interest on borrowings from other sources such as the RBI and other
bank borrowings stood at Rs 6 bn. Operating expenses during the year stood at Rs 56 bn. The major
contributor to this head was employee costs (Rs 23 bn). Provision and contingencies amount stood at Rs
29 bn.
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Net interest margin (NIM): Just as we calculate and measure performances of non-financial companies
on the basis of their operating performance (EBITDA margins), the performance of banks is largely
dependent on the NIM for the year. The difference between interest income and interest expense is
known as net interest income. It is the income, which the bank earns from its core business of lending.
As such, NIM is the net interest income earned by the bank on its average earning assets. These assets
comprises of advances, investments, balance with the RBI and money at call. As such it is calculated as,
NIM = (Interest income - interest expenses) / average earnings assets
Operating profit margin (OPM): A bank's operating profit is calculated after deducting operating
expenses from the net interest income. Operating expenses for a bank would mainly be more of
administrative expenses. The main expense heads would include salaries, marketing and advertising and
rent, amongst others. Operating margins are profits earned by the bank on its total interest income. As
such,
OPM = (Net interest income (NII) - operating expenses) / total interest income
Cost to income ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part
of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its
return on equity. Salaries, branch rationalisation and technology upgradation account for a major part of
operating expenses for new generation banks. Even though these expenses result in higher cost to
income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as
a proportion of operating profit including non-interest income (fee based income).
Cost to income ratio = Operating expenses / (NII + non-interest income)
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Other income to total income: Fee based income accounts for a major portion of a bank's other
income. A bank generates higher fee income through innovative products and adapting the technology
for sustained service levels. This stream of revenue is not depended on the bank's capital adequacy and
consequently, the potential to generate the income is immense. The higher ratio indicates increasing
proportion of fee-based income. The ratio is also influenced by gains on government securities, which
fluctuates depending on interest rate movement in the economy.
Let's take up an example to understand this well. Below, we have displayed HDFC Bank's FY09 profit
and loss account. We shall calculate the above mentioned ratios for the bank.
We will first calculate HDFC Bank's NIM for the year FY09. As mentioned above, for calculating
NIM, one needs to divide the net interest income by the average earning assets.
Or, NIM = (Interest income - interest expenses) / average earnings assets
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The interest income during FY09 stood at Rs 163 bn. The interest expended during the year was Rs 89
bn. Therefore the net interest income is Rs 74 bn (Rs 163 - Rs 89 bn).
Average earnings assets for the bank for the year stood at Rs 1,753 bn. It is calculated by adding the
cash and balances with Reserve Bank of India (Rs 135 bn), balances with banks and money at call and
short notice (Rs 40 bn), investments (Rs 587 bn) and advances (Rs 990 bn).
Therefore the NIM for the year FY09 was 4.2% (Rs 74 bn / Rs 1,753 bn)
Now moving on to the OPM for HDFC Bank - Net interest income for the year stood at Rs 74 bn. The
operating expenses for the year were about Rs 56 bn. Total interest income for the year was Rs 163 bn.
Therefore, the OPM for the year stood at,
OPM = (Net interest income (NII) - operating expenses) / total interest income
= Rs 74 bn - Rs 56 bn / Rs 163 bn. This is equal to about 11%.
Moving on the cost to income ratio for HDFC Bank - As mentioned above, it is calculated by operating
expenses by the total of the net interest income and the non-interest income.
Or, Cost to income ratio = Operating expenses / (NII + non-interest income)
Operating expenses for the bank during the year stood at Rs 56 bn. Non-interest income, which is
basically the other income, stood at Rs 36 bn. NII, as calculated above, was Rs 74 bn. Putting all this
together, we get the following:
= Rs 56 bn / (Rs 74 bn + 36 bn)
= 50.9%. The cost to income ratio stood at almost 51% for the year FY09.
The last ratio is the other income to total income ratio. It is a very straight forward ratio. The other
income for the year FY09 stood at Rs 34 bn. The total income for the year was about Rs 198 bn.
Therefore HDFC Bank's other income to total income ratio for the year FY09 was about 17%.
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As mentioned in one of our earlier articles, a bank's revenues are basically derived from the interest it
earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand
is lower, the bank increases the quantum of investments in G-Sec.
The other investment would be somewhat common between all firms. They could include investment in
joint ventures, subsidiaries, bonds and debentures, units, certificate of deposits, amongst others.
Advances
Advance in the simplest term can be defined as loans given to a bank's customers, which could be retail
or corporate clients. The growth in advance, coupled with the prevailing interest rates is what drives the
banks interest income.
Advances are broadly of three types - Bills purchased & discounted, cash credits, overdrafts & loans
repayable on demand and term loans. Term loans, followed by cash credits, overdraft and loans
repayable on demand tend to have a larger share in this head.
Further, banks are also required to show how these assets have been covered. They can be either covered
by tangible assets or bank/government guarantees. Banks also give unsecured loans to their customers.
However, these types of loans would constitute a much less portion (as compared to the secured loans)
of the advance pie.
Banks are also required to broadly show where they have made their advances. While more details can
be sought from various reports, including annual reports, under the advance schedule, they are required
to show what portion is advanced in and outside India. Further bifurcation is made as to how much has
been advanced to the priority sector, public sector, other banks, etc.
Fixed assets and other assets
Fixed assets for a bank would mainly include premises, land, assets on lease and furniture & fixtures.
The 'other assets' portion includes various items such as the interest accrued, advance tax paid, stationary
and stamps, non banking assets acquired in satisfaction of claims, security deposits for commercial and
residential property, deferred tax assets, amongst others.
It must be noted that banks are also required to disclose their contingent liabilities, which as the name
suggests, are possible future liabilities that will only become certain on the occurrence of some future
event. More often than not, liability on account of outstanding forward exchange and derivative
contracts form the majority portion of this.
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Credit to deposit ratio (CD ratio): This ratio indicates how much of the advances lent by banks is done
through deposits. It is the proportion of loan-assets created by banks from the deposits received. The
higher the ratio, the higher the loan-assets created from deposits. Deposits would be in the form of
current and saving account as well as term deposits. The outcome of this ratio reflects the ability of the
bank to make optimal use of the available resources.
Capital adequacy ratio (CAR): A bank's capital ratio is the ratio of qualifying capital to risk adjusted
(or weighted) assets. The RBI has set the minimum capital adequacy ratio at 9% for all banks. A ratio
below the minimum indicates that the bank is not adequately capitalized to expand its operations. The
ratio ensures that the bank do not expand their business without having adequate capital.
CAR = Tier I capital + Tier II capital / Risk weighted assets
It must be noted that it would be difficult for an investor to calculate this ratio as banks do not disclose
the details required for calculating the denominator (risk weighted average) of this ratio in detail. As
such, banks provide their CAR from time to time.
Tier I Capital funds include paid-up equity capital, statutory and capital reserves, and perpetual debt
instruments eligible for inclusion in Tier I capital. Tier II capital is the secondary bank capital which
includes items such as undisclosed reserves, general loss reserves, subordinated term debt, amongst
others.
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Non-performing asset (NPA) ratio: The net NPA to loans (advances) ratio is used as a measure of the
overall quality of the bank's loan book. An NPA are those assets for which interest is overdue for more
than 90 days (or 3 months).
Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from
gross NPAs. Higher ratio reflects rising bad quality of loans.
NPA ratio = Net non-performing assets / Loans given
Provision coverage ratio: The key relationship in analysing asset quality of the bank is between the
cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that
indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high
ratio suggests that additional provisions to be made by the bank in the coming years would be relatively
low (if gross non-performing assets do not rise at a faster clip).
Provision coverage ratio = Cumulative provisions / Gross NPAs
Return on assets (ROA): Returns on asset ratio is the net income (profits) generated by the bank on its
total assets (including fixed assets). The higher the proportion of average earnings assets, the better
would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned
by the bank on its total net worth.
ROA = Net profits / Avg. total assets
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