abc of investing

8/20/2019 ABC of Investing

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Introduction to the 'Investing: Back to Basics' Series2013

Table of Contents

Preface Where To Gather Information From?

Key Constituents Of An Annual Report

Introduction To Financial Statements

Gauging A Company's Revenues

Analysing Companies' Operating Expenses

Discussion On Operating Margins

Discussion On Depreciation & Interest Charges

Key Items Below The Profit Before Tax Level

Dividends, Payout Ratios And Their Importance

Introduction To Balance Sheets

Discussion On Fixed Assets

Current Assets - What Are They?

Current Liabilities, Working Capital And Related Ratios

Dissecting The Investments On Books

Financial Statements: Key Ratios

What Are Cash Flows From Operations?

Discussion On Cash Flow From Investing Activities

Relation Between Capital Structure And Cashflows

Key Ratios Related To The Cashflow Statement

Understanding The Profit & Loss Statement Of Banks/ Financial institutions

Key Ratios Associated With Banks' P&L Statements

Making Sense Of A Bank's Balance Sheet

Making Sense Of A Bank's Balance Sheet - II

Key Ratios Related To Banks' Balance Sheets

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© Equitymaster Agora Research Private Limited

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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!

It's Not Just About Picking The Right Stocks...

Take a look at the pyramid alongside...

This simple structure holds the secret to investingsuccess!

That's right! You could read a dozen books on how topick the right stocks, and yet never really create solid

wealth from your portfolio.

And most of the times, the reason has something to do with this pyramid.

So, what's this all about? Find out all about this simple yet powerful investmentrule here...

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Where To Gather Information From?

In your investment career, you must have received stock tips and recommendations from your

brokers, friends and family. Many a times, on asking the rationale behind the same, the person giving

the recommendation would state the source of the tip as some 'reliable' source. Investors make

decisions based on certain factual information. Subsequently, they make future assumptions based on

and in support of those facts. As such, knowing how an industry and a company functions is very

important. In addition, it is equally important for one to gain such information from proper and

reliable sources.

In the second part of this series of articles on educating you on the basics of investing in stocks, we

present herewith a basic idea of where you can go about looking for information on companies you

wish to invest in.

Sources of information on companies

1. Offer documents: For a novice investor, it is always recommended that he should

understand a sector before jumping into understanding the working of a particular company.

One of the best sources for understanding a particular sector or industry is the offer document

of the company, if one can get hold to one. Every company which gets listed first needs to

file an offer document with the Securities & Exchange Board of India (SEBI). Apart fromfacts and figures about the company and its promoters, this document also contains

information relating to the working of the industry (the company is involved in).

One may refer to this link to see the offer documents that have been issued over the past few

years.

2. Annual reports: In case of a company for which you cannot get hold of the offer document

given that the company has been listed on the stock exchanges for long, the annual report

comes in handy. The director's report and the management discussion and analysis (MD&A)

sections of an annual report provide good information related to the company and industry.

However, as compared to the offer document, this information is usually related to the past

year and the management's views on the outlook for the next year. It may be noted that one

should not blindly take the management's views into consideration as more often than not, it

tends to paint a rosy picture. In the next article of this series, we shall take a deeper look into

the constituents of an annual report.

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3. BSE/NSE announcements and company press releases: We at Equitymaster have always

believed in attaining information straight from a company rather than from a third party.

Even if an investor gets some 'inside information' on a particular company, how factual and

accurate it is, is something that cannot be determined. Apart from annual reports (which are

published on an annual basis), it is the official company documents such as press releases,

announcements and presentations which are released in regular intervals. The source for such

information is the BSE or NSE websites (in their respective corporate announcement

sections) and the company's website.

4. Business dailies and other media: Newspapers and news channel are a great medium for

gaining updates on companies. Interviews with managements provide good information on

the company's views, plans and strategies. However, information divulged from sources who

do not wish to be named can be dicey. Reporters and journalists may get such news printed as

they try to snoop around and find out stories relating to a particular company. But there have

been a handful of cases wherein companies (on whom the news has been reported) have

made announcements stating that the information is speculative or not true. As such, it would

only be possible for an investor to judge the piece of news / information provided he is well

acquainted with the company and its working.

5. 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.

http://www.bseindia.com/http://www.bseindia.com/http://www.nseindia.com/http://www.nseindia.com/http://www.equitymaster.com/research-it?utm_source=B2B-Guide&utm_medium=pdf&utm_campaign=guide&utm_content=B2B-Guidehttp://www.equitymaster.com/research-it?utm_source=B2B-Guide&utm_medium=pdf&utm_campaign=guide&utm_content=B2B-Guidehttp://www.equitymaster.com/research-it?utm_source=B2B-Guide&utm_medium=pdf&utm_campaign=guide&utm_content=B2B-Guidehttp://www.equitymaster.com/research-it?utm_source=B2B-Guide&utm_medium=pdf&utm_campaign=guide&utm_content=B2B-Guidehttp://www.nseindia.com/http://www.bseindia.com/


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Key Constituents Of An Annual Report

An annual report is probably amongst 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 attainthose targets.

Below are the key constituents of an annual report:

Key constituents of an annual report

1. Director's report: The director's report comprises of 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 fromthis section.

2. 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 thecoming 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.


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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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Introduction To Financial Statements

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.

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.

A typical P&L statement is as hereunder (Source: Britannia).

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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.

A typical balance sheet statement is displayed below.


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Reworked FY08 balance sheet to simplify the understanding

Total Assets Rs m Total liabilities Rs m

Net fixed assets 2,507 Current liabilities 3,477

Inventories 3,808 Shareholders' funds 7,558

Deferred tax asset (net) 24 Loan funds 1,061

Current assets 5,525

Miscellaneous exp 232

Total 12,096 Total 12,096

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 transactionsduring a particular time frame.

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

An example of a cash flow statement is displayed below.


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Gauging A Company's Revenues

We will now take a look 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 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 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 time frame.

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

Limited'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 adjacent chart shows 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 investorcan study a company's revenue pattern (from each zone, region or country) over the years.

Source: Annual report & BSE

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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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Analysing Companies' Operating Expenses

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,

costs 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 theyare related to the manufacturing process. To give a similar type of example for a service company,

like 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. Thiscalculation 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, the 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 costs 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 help of an example to understand this point better. Below we have

given


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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).

Britannia Industries (Rs m) FY07 FY08 Change

Items Amount % of sales Amount % of sales Amount % of sales

Net Sales 21,993 100.0% 25,848 100.0% 17.5%

Expenditure

Consumption of Raw Materials (i) 14,004 63.7% 15,553 60.2% 11.1% -3.5%

Employee costs (ii) 767 3.5% 905 3.5% 18.1% 0.0%

Advertising costs (iii) 1,357 6.2% 1,798 7.0% 32.5% 0.8%Other expenditure (iv) 4,578 20.8% 5,274 20.4% 15.2% -0.4%

Total operating expenses

(i + ii+ iii +iv) 20,705 94.1% 23,531 91.0% 13.6% -3.1%

Source: Britannia FY08 annual report

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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Discussion On Operating Margins

We will now discuss the operating margins, which is a residual profit a company has after deductingits operating expenses from sales.

Before we go further into details, we should broadly take a look at the various 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 the 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 of the

manufacturing companies, costs are fixed until production is at a certain level. If production exceeds

that level, the costs tend to become variable.

Example of fixed costs include interest costs, salaries (office employees), electricity (office),

amongst others. Examples of variable costs are raw materials, sales and marketing costs, amongst

others. A very 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 leftover 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 shall 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

various. 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 times, 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.


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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 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 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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Introduction to the 'Investing: Back to Basics' SeriesSep, 2013

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Discussion On Depreciation & Interest

ChargesWe 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, amongst others. As s 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% i.e. Rs 1 m (Rs 10 m *

10%). As such, the company will show depreciation charge (for that asset) as Rs 1 m each year.

Year Value of asset Depreciation amount

FY08 10,000,000 1,000,000

FY09 9,000,000 1,000,000

FY10 8,000,000 1,000,000

FY11 7,000,000 1,000,000

FY12 6,000,000 1,000,000

FY13 5,000,000 1,000,000

FY14 4,000,000 1,000,000

FY15 3,000,000 1,000,000

FY16 2,000,000 1,000,000

FY17 1,000,000 1,000,000FY18 0 -

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 3,771,495 565,724FY15 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 ofasset. 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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Key Items Below The Profit Before Tax Level

We will now take a look at the items that come below these – taxes, net profits 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% (A surcharge of 10% 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

profits, 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, amongst

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, amongst others.

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 profits: After deducting the taxes from the 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 earning per share or the EPS is attained by dividing the net profits by the shares

outstanding.

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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.

Source: Britannia FY08 annual report.



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Dividends, Payout Ratios And Their

ImportanceThere 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 payout 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.

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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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Introduction To Balance Sheets

A lot of emphasis was given on companies' revenues and profits during the high growth phase (FY04 to

FY08) as virtually every company was growing at a strong pace. However, with the events that occurred

in the past 18 months, the focus on the relatively ignored part of the annual report, the balance sheet, has

increased. And in the process it has made many investors realise the need of a good balance sheet.

In the next few topics, we will touch upon few of the key constituents of a balance sheet.

What is a balance sheet?

A 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). The balance sheet is brokeninto two parts - 'Sources of funds' and 'Application of funds' - as they are called in accounting

terminology. We shall first look into the key constituents of the head 'sources of funds', after which we

will cover the head 'application of funds'.

Sources of Funds

'Sources of funds' indicates the total financing that a company has done. In simple terms it shows how a

company has got the funds which it has used to purchase its assets. As such, Total assets = Shareholders'

equity + total liabilities It may be noted that in the above ratio, total liabilities includes loans and current

liabilities. As current liabilities are found on the lower side of the balance sheet, we will touch up on thistopic in the next few articles.

Shareholders equity - To put in the simplest form, equity is that portion of the balance sheet which

purely belongs to the shareholders. An easy way to calculate it is by using the above formula.

Shareholder's equity = Total assets - total liabilities

Shareholder's equity represents the total capital received from investors, plus the accumulated earnings

which are displayed in the form of reserves and surplus.

As such, Shareholders' equity = Share capital + reserves and surplus

Share capital represents the funds that are raised by issuing shares. On multiplying the face value of a

share by the number of issued, subscribed and fully paid, we get the value of share capital. The reason a

company's share capital remains constant for years is on account of non-issuance of additional shares.

When a company issues more number of shares, the effect needs to be seen in the share capital.



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The picture displayed below will help us understand this better.

Sourced from Nestle's CY08 annual report

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 willexpand. 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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Discussion On Fixed Assets

In the next few topics, we will take a look at the other component of the balance sheet - 'Application of

funds' and some of its key constituents. As mentioned earlier, 'Sources of funds' indicates the total

financing that a company has done. In simple terms it shows how a company has got the funds which it

has used to purchase its assets.

As such, Total assets = Shareholders' equity + total liabilities

Assets in simple terms are resources owned by a company that help in generating cash flows. In broader

terms, assets are of two types – Tangible and intangible. Tangible assets are assets that have a physical

form. In short they can be seen or touched. Such assets include fixed assets and current assets. Intangible

assets on the other hand are assets that have an economic value to an organisation but do not have a

physical nature. A classic example of an intangible asset would be brand value. Some other examples

that can be included in this list are goodwill, software and technical know-how.

In today's article, we will focus mainly on fixed assets. In the next few articles, we will take a look at the

other components of 'Application of funds' – current assets, current liabilities, investments and

miscellaneous items.

What are fixed assets?

Fixed assets are assets that help companies reap economic benefits over a period of time. Assets such as

land, building, plant and machinery are all fixed assets. The general consensus is that fixed assets cannot

be liquidated easily. This is quite apparent when compared to current assets such as cash and bank

account and inventories, which can be liquated or converted into cash relatively easily. It may be noted

that intangible assets can also be part of this head as they benefit companies over a long period of time.

Few more examples of the same would be trademarks, designs and patents.

Assets overtime lose their productive capacity due to reasons such as wear and tear, obsolescence,

amongst others. As a result, their values deplete. Companies need to account for this depletion in value

on a yearly basis. This amount is called as a 'depreciation expense' and is shown in the profit and loss

account. It may be noted that it only represents deterioration in value and is not a direct cash expense. Indue course of time, assets lose their value on account of depreciation on a year on year basis. As such,

these amounts are accumulated and are reduced from cost of the asset.

Let us take up an example to understand the concept better. Below is the fixed assets schedule from

Nestle's annual report for CY08. We can see three columns – gross block, depreciation and net block.

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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).

Sourced from Nestle's CY08 annual report

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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Current Assets - What Are They?

As compared to fixed assets, which are relatively more difficult to liquidate, current assets are easier to

convert into cash. The reason why fixed assets are less liquid in nature is because of their influence on a

company. The usage of current assets on a company is more short term in nature (usually a period of one

year) as against that of a fixed asset. Current assets are assets that are used to fund day to day operations

and pay ongoing expenses of a company.

The most common current assets include sundry debtors, inventories, cash and bank balances, loans and

advances, amongst others. We shall briefly discuss some of the key current assets one by one.

What are inventories?

Inventories are goods that are in different stages of production and have not yet been sold. As such, they

could be finished or semi-finished products. As you may be already aware, goods when manufactured

go through various processes - from being a raw material to a semi-finished good (work-in-progress) to

a finished good. Inventories would also include packaging material. Many a times, you may also find an

entry such as good-in-transit under inventories. These are goods that have departed from the dispatch

point but have not yet arrived at the delivery point.

An interesting tool that would help understand and analyse the inventory position of a company is

'Inventory turnover'.

Inventory turnover is calculated by dividing the sales by the inventory of a particular period (usually a

year).

As such, Inventory turnover = Net sales/ inventory

Let us explain this with the help of an example. FMCG major Nestle had inventories worth Rs 4.4 bn at

the end of CY08, i.e. 31st December 2007. The company reported a topline (net sales) of Rs 42.2 bn. As

such, the company had an inventory turnover of 9.6 times. This means that, the company will be able to

sell the current level of inventory nearly 9.6 times each year. The higher the inventory turnover ratio, the

better it is for a company.

Let us take an example. Suppose company XYZ reported a topline of Rs 5 bn and had an inventory of

Rs 15 bn. This means that if company XYZ maintains the level of inventory throughout the year, it will

take nearly three years to clear the inventory level it currently has. This indirectly indicates that the

inventory management has been poor as the company's management has locked in a lot of funds towards

inventories.

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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 receivableson 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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Current Liabilities, Working Capital And

Related Ratios

As compared to long term liabilities (debt), current liabilities are obligations that are due within a period

of one year. The concept of current liabilities is similar to that of current assets. As companies buy

goods and services on credit from their vendors and suppliers, the latter becomes their creditors. As such

'sundry creditors' are bills that are due to creditors and suppliers within a short period of time. It also

includes provisions made for a particular year. It usually includes payment of dividends, interest and

taxes. Other current liabilities include loans and advances from customers as well. These are basically

payments that a company receives in advance. The higher the amount of loans and advances, the better it

is for a company as it is able to fund its operations without being charged any interest on the funds.

Moving on, to know the average number of days at which a company meets its short term liabilities, one

calculates the creditor days. The formula for the same is similar to that of debtor days.

Creditor days = Sundry creditors/sales * 365

Let us take up an example to understand this well. As of 31st December 2008, the sundry creditors on

Nestle's books were Rs 5 bn. During CY08 the company recorded sales of Rs 43 bn. As such on using

the above-mentioned formula, the result is 42 days. This means that the company takes nearly 42 days to

pay off its creditors.

In the previous article of this series, we calculated Nestle's average debtor days as 3.8 days. This means

that the company is a

abc of investing

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