discussion on key financial ratios

Discussion on key financial ratiosIn the previous article of this series, we concluded our discussion about the components that make up a balance sheet. In this article of this series, we shall go though some of the key financial ratios associated with the profit and loss account and the balance sheet.

Some of the key financial ratios are:

*Return on equity (ROE)

*Return on capital employed (ROCE)

*Return on invested capital (ROIC)

*Return on total assets (ROA)

*Asset Turnover

*Debt to equity ratio (D/E)

*Interest coverage ratio

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 utilised 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.

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 utilised 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 generating. 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 ₹10 billion on its books. At the end of the year, the company recorded a topline of ₹25 billion. That means the company has an asset turnover of 2.5. This indirectly

gives an indication that the company would be able to increase its revenues by ₹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 ₹100 million and is paying an interest of ₹20 million, its interest coverage ratio would be 6 (₹100 million + ₹20 million / ₹20 million). 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.

This article is authored by Equitymaster.com, India’s leading independent equity research initiative

Disclaimer: The opinions expressed by Equitymaster are theirs alone and do not reflect the opinions of The Hindu Business Line or any employee thereof. The Hindu Business Line is not responsible for the accuracy of any of the information within the article.

(This article was published on June 24, 2014)

Dissecting the investments on booksInvesting Back to Basics - Series

In the previous article of this series, we discussed about current liabilities and working capital. In this article, we shall conclude our discussion about the components that make up a balance sheet by taking up the topic of 'investments' and the different types of investments found in companies' balance sheets.

As defined in Accounting Standard 13 (AS-13) - "Investments are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets held as stock-in-trade are not 'investments'."

Some of the investments found in companies' balance sheets include stocks, bonds, mutual funds and investments made towards their subsidiaries or associate companies.

Broadly investments can be categorised into four categories. They are as follows:

*Current and long-term investments

*Quoted and unquoted investments

Current and long-term investments:

On a broader basis, investments are classified as long-term and short terms investments. Current investments are investments that are not intended to be held on for more than a year from the date of purchase. An example of the same would be an investment in a liquid fund. On the other hand, AS-13 states that an investment other than a current investment is termed as a long term investment.

In the financial statements, current investments are valued at the lower of cost and fair value. However, in the case of long term assets, it should be valued at cost. However, it is mandatory for companies to make a provision for diminution in value if there is a decline in the value of the investment. AS-13 has defined fair value as - "Fair value is

the amount for which an asset could be exchanged between a knowledgeable, willing buyer and a knowledgeable, willing seller in an arm's length transaction.

Under appropriate circumstances, market value or net realisable value provides an evidence of fair value." Apart from the actual cost of the asset, the cost of an investment also includes acquisition charges such as brokerage, fees and duties.

Further, as values of investments fluctuate from time to time, companies need account for the same in their books (profit and loss account). It is mandatory for companies to report the aggregate amount of quoted and unquoted investments. They should also give the aggregate market value of quoted investments as on the date of reporting.

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 time 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.

In the next article, we shall take a look at some of the key ratios associated with the profit and loss account and the balance sheet.

This article is authored by Equitymaster.com, India’s leading independent equity research initiative Disclaimer: The opinions expressed by Equitymaster are theirs alone and do not reflect the opinions of The Hindu Business Line or any employee thereof. The Hindu Business Line is not responsible for the accuracy of any of the information within the article.

(This article was published on May 31, 2014)

Discussion on depreciation & interest charges

In the previous article of this series, we had discussed how operating margins vary from one sector to another. In today's article, we will take a look at the items that come below operating profits - depreciation and interest.

Depreciation: Overtime, assets lose their productive capacity due to reasons such as wear and tear, obsolescence, among others. As a result, their values deplete. Companies need to account for this depletion in value. This amount is called depreciation expense. Depreciation can also be viewed as matching the use of an asset to the income that it helped the company generate. It may be noted that it only represents the deterioration in value. As such, this expense is not a direct cash expense.

Depreciation can be accounted in broadly two methods – straight line and written down value. The straight line value method divides the cost of an asset equally over its lifetime. An example will help us understand the process better. Suppose a company buys an equipment worth Rs. 10 m in FY08, and it expects it to have a lifeline of 10 years, the depreciation rate would be 10 per cent, that is, Rs. 1 m (Rs 10 m * 10%). As such, the company will show depreciation charge (for that asset) as Rs. 1 m each year.

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:

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).

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.

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 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.



(This article was published on April 11, 2014)

Discussion on operating margins In the previous article of this series on investing, we had briefly looked at how one could analyse a company’s expenses over a particular period. In this article we discuss operating margins, which is the residual profit a company has after deducting its operating expenses from sales.

Before we go into the details, we should take a look at the expense components that determine a company’s operating margin. These include variable expenses, semi-variable expenses and fixed costs. Variable expenses are expenses that change in proportion with sales or business activity. Fixed costs are expenses that a company incurs regardless of the business activity. Semi-variable expenses are a mixture of fixed and variable components. For most manufacturing companies, costs are fixed until production is at a certain level. If production exceeds that level, costs tend to become variable.

Example of fixed costs include interest costs, salaries (office employees) and electricity (office), amongst others. Examples of variable costs are raw materials, sales and marketing costs, amongst others. A common example of a semi-variable cost is that of wages. A company needs to pay its labourers a fixed amount even if there is very little production or no production activity taking place. However, if and when production

activity accelerates, the staff may tend to work overtime. Subsequently, they will get paid for the same. The overtime wages, in this case, is the semi-variable cost.

Operating margin: It is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production. A healthy operating margin is required for a company to be able to pay for its fixed costs. The higher the margin, the better it is for the company as it indicates its operating efficiency. Operating margin is calculated by subtracting the operating expenses from sales, and then dividing the balance by the sales figure. The formula is shown below -

Operating margins = (Net sales - Total operating expenses)/ Net sales * 100

Now that we have a basic idea of what an operating margin is, we take a look at some factors that determine a company's or an industry's operating margin.

It may be noted that operating margins differ for each industry. The reasons behind the same are many. Some of them may include the regulatory nature of the business, the intensity of competition, the phase of the industry (life cycle), segmental presence within an industry (niche businesses), geographical presence, brand power, bargaining power of buyers and suppliers, raw material procuring policies and their impact on realisations, amongst others. Many a time these factors coincide and complement each other. It may be noted that operating margins differ for companies within a particular industry. This is basically what ascertains the leaders from the inefficient players.

To give an idea of how margins differ within each industry, we can take a look at the table below.

Sector Operating margin range

Engineering 10% to 20%

Cement 13% to 33%

Retail* 7% to 11%

Pharma 10% to 24%

FMCG$ 13% to 15%

IT 26% to 30%

Telecom 27% to 37%

Hotels 18% to 40%

Power 15% to 20%

Automobiles# 8% to 16%

Steel^ 9% to 28%

Construction 12% to 23%

Source: CMIE, Equitymaster Research; * Trading companies;

^ Finished steel; # Including 2- and 4- wheeler manufacturers;

$ Non-food items

From the table we 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 select 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.

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 that investors study and analyse the operating performance of companies from a long term perspective. In the next article of this series, we shall take a look at interest and depreciation costs and how one could view them.




Take advice with a pinch of saltIncentives play a big role in what sells. Be wary of professional advice when it is especially good for the advisor

Of the many causes of human misjudgement, Charlie Munger finds incentives one of the most difficult to understand. In other words, why do we do what we do? Why are we tempted to do certain things while refraining from others? Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the same time avoiding or reducing pain. In any given circumstance, we assess the risks and the associated rewards and respond in a way that seems to best serve us. With this premise, it is imperative to understand the role of incentives and disincentives in changing cognition and behaviour.

The power of incentives

There is this interesting case of the logistics services major FedEx Corporation. The integrity of the FedEx system required that all packages be shifted rapidly among airplanes in one central airport each night. And the system had no integrity for the customers if the night work shift couldn’t accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right thing. They tried moral persuasion. They tried everything in the world without luck.

Finally, somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was not maximised billable hours of employee service but fault-free, rapid performance of a particular task. So, maybe if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And that solution worked just perfectly. This is a classical case of the power of incentives and how they can be used to produce desirable behavioural changes.

The abuse of incentives

One of the most important consequences of incentives is what Munger calls “incentive-caused bias”. The following example explains it.

Early in the history of Xerox, Joseph Wilson, who was then in the Government, had to go back to Xerox because he couldn’t understand why its new machine was selling so poorly in relation to its older and inferior model. When he got back to Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse incentive to push the inferior machine on customers. An incentive-caused bias can tempt people into immoral behaviour, like the salesmen at Xerox who harmed customers in order to maximise their sales commissions.

Incentives and mutual funds

The story of mutual funds in India is quite similar to that of the Xerox case. Mutual funds that offer the maximum commission to distributors are the best sold funds. Also, consider your own stockbrokers. There will seldom not be one who will not lure you to trade too often. And seldom will a management consultant’s report not end with advice on these lines: “This problem needs more management consulting services.” Such behavioural bias exists in most places and situations.

And human nature, bedevilled by incentive-caused bias, can inflict a lot of harm.

For you investors, we believe it is important to understand the motives and incentives of people and organisations you’re dealing and investing with.

Everyone - ranging from the company you’re investing in, to your stockbroker, your mutual fund agent and your equity advisor (yes, even we) — must pass your scrutiny. Widespread incentive-caused bias requires that one should often distrust, or take with a pinch of salt, the advice of one’s professional advisor. The general antidotes here are: Fear professional advice when it is especially good for the advisor; learn and use the basic elements of your advisor’s trade as you deal with your advisor; double-check, disbelieve, or replace much of what you’re told, to the degree that seems appropriate after objective thought.

(This article is authored by Equitymaster.com, India’s leading independent equity research initiative)

(This article was published on January 26, 2014)

Some doubt is in orderHow open are you to hearing negative things about stocks that you are very optimistic about?

Doesn’t our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion?

It surely does, and at times to our own disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must have developed in humans from their non-human ancestors.

He asserts that it would be suicidal for a prey animal threatened by a predator to take a long time to decide what to do. The development of this tendency has come as a survival tactic in times of stress and confusion.

Much of religious propaganda has, in fact, taken advantage of this tendency. How otherwise would you explain the immense faith displayed by people in religious decrees that will otherwise find difficulty to get past the check-post of logic?

So the evolutionary justification of this tendency is reasonable. But the problem with any kind of psychological tendency or mental programming is that it doesn’t work well in all situations.

A person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly the opposite.

Doubt-avoidance

Have you observed the doubt-avoidance tendency manifesting itself in the stock markets? The answer is a loud ‘yes’ in our view. How often do you trade on impulse? How open are you to hear negative things about stocks that you are very optimistic about?

When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising.

The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided.

Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity.

Without any exaggeration, we strongly believe that if you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor.


(This article was published on February 9, 2014)

Investing basics: Key constituents of an annual report

An annual report is probably among the most viewed company publications. It is the most comprehensive means of communication between a company and its shareholders. It is a report that each company must provide to each of its shareholder at the end of the financial year. To put it differently, it is a report that each shareholder must read.

But what is its use if one does not understand or refer to it?

As a shareholder of a company, you need to know its performance over the past financial year and the management's view on the same. You also need to know what is

the company's future plan and strategies. As a shareholder, you need to know what does the management intends to do to attain those targets.

In the third part of this series, we present to you a brief on what the key constituents of an annual report are.

Key constituents of an Annual Report

Director's report: The director's report comprises the events that take place in the reporting period. This includes a summary of financials, analysis of operational performance, details of new ventures and business, performance of subsidiaries, details of change in share capital, and details of dividends. In short, shareholders can get a gist of the fiscal year from this section.

Management discussion and analysis (MD&A): More often than not, the MD&A starts off with the management giving its view on the economy. It is then followed by a perspective on the sector in which the company is present. Any major changes like inflation, government policies, competition, tax structures, amongst others are highlighted and discussed in this report. It also includes the business strategy the management intends to follow. Details regarding different segments are provided in this section. The company also gives a brief SWOT (strength, weakness, opportunity, and threat) analysis and business outlook for the coming fiscal.

This can aid the shareholder to understand what major changes are likely to affect the company going forward. However, as mentioned earlier, an investor should not blindly believe what the management has to say. While it tends to paint a rosy picture, one needs to judge the sanity behind the rationale.

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.

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.

In the next article, we shall briefly take a look at the key constituents of the financial statements. Thereafter, we will go through each of the statements in further detail.


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Introduction to financial statementsAs we had discussed in the previous article of this series on investing basics, financial statements are among the most important sections of an annual report. For a novice investor, reading and understanding a company's financial statement is quite intimidating at first sight. However, to study and make good investing decisions, it is necessary for one to understand the same.

In this article, we shall go through the key constituents of the financial statements - profit and loss account, balance sheet and cash flow statement.

Key financial statements

Profit & Loss account: The profit and loss account (P&L) shows a company's performance over a specific time frame, usually a financial year or a period of 12 months. In India, most companies follow a April to March financial year (as in April 2008 to March 2009 will be one financial year). The P&L account is also known as the income statement. It presents information relating to a company's revenues, manufacturing costs, sales and general expenses, interest and depreciation charges, tax costs, other income, net profits, and dividends.

(For a typical P&L statement refer image. P&L statement sourced from Britannia Industries' FY08 annual report. )

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.

Cash flow statement

Put in simple terms, a cash flow statement shows the amount of cash and cash equivalents that enter and leave a company. Just as the P&L statement, the cash flow statement shows cash transactions during a particular time frame.

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A company can generate or lose cash through its normal operations. Further, it can raise or payback cash through financing activities. In addition, it can use cash for investing in assets or receive cash through sales of assets or through dividends. Being the various aspects of any business, these above-mentioned activities cover most of the integral cash transactions of a company. As such, the cash flow statement allows investors to understand how a particular company's business is running, how it has raised capital and how it is being spent.

A cash flow statement is typically broken into three broader parts:

Cash (used in)/ generated from operations

Net cash used in investing activities

Net cash from financing activities

(For an example of a cash flow statement refer image. Sourced from Britannia Industries' FY08 annual report)

In the next article, we shall start our detailed discussion on the P&L statement and its key constituents.



Gauging a company's revenuesIn the previous article, we had taken a brief look at the key financial statements that are found in a company's annual report.

In today's article, we will take a look at how one should view and analyse the key revenue constituents of a profit and loss account (P&L).

Core vs non-core

A handful of companies report the 'total income' earned by them within a year as 'sales'. We believe one should always take into consideration a company's integral earnings (core operations) as sales and not the income that is generated from other operations. The latter could include items such income from sale of scrap, income from interest and dividends, forex gains, profit on sale of assets, export incentives, job charges, and miscellaneous receipts, amongst others.

While these items may not be a significant part of the total income, we believe it is a good practice to follow, apart from knowing the precise figures. In fact, it would be

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even better if one could further bifurcate such earnings under two heads - other operating income and other income. Details regarding total income are found in respective schedules.

Segment and region-wise

Revenues are generated from sales of goods or services. However, for companies which have presence in various businesses, a good practice would be to study the change in segment-wise/ product-wise / businesswise revenues on a year on year basis. One can also take a look at how the income from each business segment (as a percentage of net sales) has changed over the years. This gives a good judgment in knowing how a company's segments or businesses have been performing over a particular timeframe.

Companies enter new businesses for two main reasons -to diversify their revenue streams and de-risk their business from a presence in a single segment. Further it also helps to capitalise on the opportunities in fast growing segments. A classic example would be ITC Ltd's entrance into other business (hotels, agri, non-FMCG, papers, etc.) Over time, this move has helped it reduce dependence on its cigarettes business. The chart gives an idea as to how the scenario has changed for the company over the past few years.

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. 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.

In the next article, we shall take a look at the key expenditure constituents of a P&L. It would be advisable for investors to not look at the P&L revenue constituents on a standalone basis but to review the same in relation with the expenditure constituents to gauge the overall impact.



Analysing companies’ operating expenses In the previous article of this series, we had a brief look at how one could analyse a company’s income over a particular period. In today’s article, we will take a look at the key expenditure constituents (operating costs) of a company and how one could view and analyse these over a particular period.

Operating expenses can be broadly segregated into cost of goods sold (COGS) and selling, general and administrative expenses (SG&A).

COGS: COGS are direct costs that a company incurs for producing or providing a product or service. These costs are directly attributable to the production of goods or services.

For example, the cost of items such as flour, sugar, fats and oils (various raw materials), laminations rolls (packaging material), amongst others will be the COGS for a biscuit manufacturer.

In addition to these expenses, costs such as power and fuel, wages, rent (of manufacturing unit), repair and maintenance (plant and machinery), amongst others, will also be a part of COGS as they are related to the manufacturing process. To give a similar type of example for a service company, such as an IT firm, costs of software development will be its COGS. This will include costs of the software developers.

A common method to calculate COGS is shown below.

COGS = Opening stock of inventory + purchase of goods – closing stock of inventory

COGS can be calculated by adding the opening stock of inventory with the total amount of goods purchased in a particular period and subsequently, deducting the ending inventory from it. This calculation gives the total amount of inventory or, more specifically, the cost of this inventory, sold by the company during the period.

For example, if a company starts with Rs. 10 m worth of inventory, makes Rs. 2 m in purchases and ends the period with Rs. 8 m in inventory, its cost of goods for the period would be Rs. 4 m (Rs 10 m +Rs. 2 m – Rs. 8 m).

SG&A: The SG&A head includes costs that are not part of the manufacturing process. As such, this category includes the cost of items such as marketing, salaries, electricity (office), travel, advertisement, office maintenance, rent (office), auditor costs, and distribution charges, amongst others. To take forward the example of the biscuit


manufacturer, advertising costs, cost of distribution, the cost of labour used to sell the biscuits would all be part of SG&A. For an IT firm, SG&A costs would include cost of salaried employees which form part of the sales, marketing and admin teams.

How could one analyse operating costs?

For analysing operating expenses, a common method is to compare each cost head to the sales of a particular period. We shall take the help of an example to understand this point better. Below we have given the break-up 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).

During FY07, raw material costs firmed nearly 64 per cent of sales. However, during FY08, raw material costs increased by 11.1 per cent YoY in absolute terms, but as a percentage of sales, it dropped by 3.5 per cent YoY. Further, employee costs increased by 18.1 per cent YoY in absolute terms during FY08, but when compared to sales, these remained flat at 3.5 per cent. On the other hand, advertising costs increased by 32.5 per cent YoY in absolute terms during FY08.

As raw material forms 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 per cent 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 per cent 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.

In the next article of this series, we will take a detailed look at interest and depreciation costs and how one should analyse them.

This article is authored by Equitymaster.com, an independent equity research initiative.


Dividends, payout ratios and their importanceIn the previous article of this series, we had discussed about items that are found at the bottom of the profit and loss account - taxes, net profits and appropriation.

In this article, we shall discuss about dividends and its impact on investors.

http://www.thehindubusinessline.com/features/investment-world/beyond-stocks/key-items-below-the-profit-before-tax-level/article5951121.ece

There are two ways in which an investor can profit from his investment in stocks. One, through stock price appreciation, which we know can remain depressed for a long duration even if the fundamentals of the underlying company are strong enough. Another way to profit from an investment in a stock is through dividends.

Dividends, unlike stock prices, do not depend on the whims and the fancies of the investor community at large. If the business is performing well and generating cash in excess of what is required for growth, dividends are paid out irrespective of the stock price movement.

As mentioned in the earlier article, 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. As such, dividend payout depends a lot on the cash (after meeting its capital expenditure and working capital requirements) a company generates during a year.

It quite often happens that many companies will not need to reinvest much into the business (in spite of having high return on investments), purely because they don't see the need for it. A classic example would be of companies from the FMCG sector.

The FMCG sector is a slow yet steady growing industry. Most of the companies garner high return on their investments in this sector. But yet they choose to pay out huge dividends due to the sector's slow growing nature as capex requirements are on the lower side.

Now if we compare this to say a fast growing industry such as telecom, the situation is quite different. We shall explain this with the help of an example. Telecom major, Bharti Airtel recently announced its maiden dividend of Rs. 2 per share. It may be noted that this was after being listed for seven years.

The reason for not paying dividends all these years, as attributed by its management, was the huge capital expenditure programme to spread its wings across the entire country.

So, what has made the company announce a dividend this time around? Crossing the peak capex requirement, the management has indicated.

Do all dividend paying companies make a good investment?

The answer is understandably no. This is where the aspect of 'dividend yield' comes into picture. Dividend yield is calculated by dividing the amount paid out as dividend within a year by the company's share price. An example will help in understanding this better.

Assuming a company's stock is trading at a price of Rs. 100 and during FY09, it has paid a dividend ofRs. 5 per share in total. This stock would be having a dividend yield of 5 per cent 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 per cent 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.

This article is authored by Equitymaster.com , India’s leading independent equity research initiative


Key items below the profit before tax levelIn the previous article of this series, we had discussed about depreciation and interest expenses. In today's article, we will take a look at the items that come below these – taxes, net profit and appropriation.

Taxes: There are different types of taxes that a company pays. The ones that are commonly found in annual reports are current income-tax, fringe benefit tax, wealth tax and deferred income-tax.

Corporate income-tax is the tax which a company pays on the profits it makes. Currently, the domestic corporate income-tax rate stands at 30 per cent (A surcharge of 10 per cent of the income-tax is levied, if the taxable income exceeds Rs. 1 m). It may be noted that the tax structure for foreign companies operating in India is different.

After adding other income and deducting the interest and depreciation charges from the operating profit, we arrive at a number which is known as the profit before tax (PBT).

On dividing the current income-tax (for the particular year) by the PBT (also known as the net taxable income) we get a figure which is called the 'effective tax rate'.

Fringe benefit tax is the tax which a company pays on certain benefits which its employees get. This includes items such as employee stock options (ESOPs), expenses on travel, entertainment, among others. It may be noted that the employer needs to cover the cost of these items for them to be accounted as a fringe benefits.

Wealth tax is levied on the benefits derived from ownership of certain non-productive assets that a company owns. As such, assets like shares, debentures, bank deposits and investments in mutual funds, being productive assets, are exempt from wealth tax. Non-productive assets include jewellery, bullion, motorcars, aircraft and urban land.

The need for deferred tax accounting arises because companies often postpone or pre-pay taxes on profits pertaining to a particular period. It may be noted that when a


company reports its profits/losses, it is not necessary that they match the profits the taxman lays claim to.

As such, if a company prepays taxes relating to the future years, it will show up as deferred tax assets in the profit and loss account. Similarly, if a company creates a provision for deferred tax liability, it shows that it has postponed part of the tax of that period's transactions to the future.

Net profit: After deducting the taxes from PBT, we arrive at the profit after tax, which is also called the net profit. One can say that the net profit is probably one of the most sought after figures in the analyst community. It is the figure that each analyst tries to derive using all the knowledge he or she possesses. After all, the earnings per share or the EPS is attained by dividing the net profits by the shares outstanding.

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 amount of dividend 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 table.




discussion on key financial ratios

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