ABC of Investing

Introduction to the 'Investing: Back to Basics' Series
2013
Table of Contents
Preface
Where To Gather Information From?
Key Constituents Of An Annual Report
Introduction To Financial Statements
Gauging A Company's Revenues
13
Analysing Companies' Operating Expenses
15
Discussion On Operating Margins
17
Discussion On Depreciation & Interest Charges
20
Key Items Below The Profit Before Tax Level
23
Dividends, Payout Ratios And Their Importance
25
Introduction To Balance Sheets
27
Discussion On Fixed Assets
29
Current Assets - What Are They?
32
Current Liabilities, Working Capital And Related Ratios
35
Dissecting The Investments On Books
37
Financial Statements: Key Ratios
39
What Are Cash Flows From Operations?
42
Discussion On Cash Flow From Investing Activities
45
Relation Between Capital Structure And Cashflows
47
Key Ratios Related To The Cashflow Statement
49
Understanding The Profit & Loss Statement Of Banks/ Financial institutions
51
Key Ratios Associated With Banks' P&L Statements
55
Making Sense Of A Bank's Balance Sheet
58
Making Sense Of A Bank's Balance Sheet - II
59
Key Ratios Related To Banks' Balance Sheets
61
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Preface
While the future is unfolding at a gradual pace or so it seems, we wonder how fast we have traveled
the distance since the beginning of 2008, when the skies above the stock markets were blue, and
investors thought that the tree called stock markets could grow to touch the sky. It has never
happened this way in the past. And this time was no different.
As far as the corporate world is concerned, there has been a sea change in the attitude of companies
and their managements. While not many of them (companies) were talking about any business
concerns then (January 2008 and before), disclosures are flooding in these days - disclosures relating
to hidden losses, pledged shares, cash that never was, cooked up books, and many like these.
Another contrast can be seen in the behaviour of stock prices to bad news. While such ill doings
were not given any air and were casually passed off in the heydays of 2008 and before, these days
even a hint of negative news sets a company's stock to plummet.
One of Warren Buffett's famous quotes is - "I never attempt to make money on the stock market. I
buy on the assumption that they could close the market the next day and not reopen it for five years."
Imagine if that actually happened. And that too in the first week of January 2008! Most of us would
have loved it considering that it was the peak of the bull-run.
Or to put things in a different perspective, imagine if there was a lock in period on every stock
purchase - say, a five year lock-in period. A greater proportion of us would have been wiser in our
stock picking.
Coming back to the earlier point about the change in attitudes, with the occurrence of the slowdown,
investors' focus is expected to shift on companies' long term performance rather than short-term
performance. As such, the managements and their long term plans would be looked at with more
detail.
We hope this brings about a change in investors' approach towards investing. The lost art of carefully
studying a stock before making the purchase, we believe, needs to make comeback. Understanding
the nuances of profit and loss accounts, balance sheets, and cash flow statements has always been
pertinent, more now than ever before.
So, let's begin the journey to educate ourselves towards a fruitful investing experience. In a series of
articles following this, we will try to bring to you the basics of investing by acting as guideposts to
unraveling the mystery behind the financial statements.
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2013
While soft qualitative metrics like corporate governance and management quality will continue to be
clouded under subjectivity, our effort will be to arm you with a better understanding of the ways
companies can be researched.
Happy Investing!
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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 from
facts 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.
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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 attain
those 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 from
this 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 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.
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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 transactions
during 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 abovementioned 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.
Source: Annual report & BSE
Another way a company can diversify itself is by having presence across geographies. An investor
can study a company's revenue pattern (from each zone, region or country) over the years.
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Companies having transnational presence have the option of focusing on the high growth areas or
areas that are relatively resilient to an economic slowdown. In addition, if its operations in a certain
country/region are witnessing a problem, it could curb the fall in revenue by focusing on operations
in other countries/regions.
Seasonal and cyclical businesses
The revenue volatility would remain high for companies that are present in seasonal or cyclical
businesses, especially if viewed on a quarterly basis. A seasonal business is a business for which
certain seasons of the year are far more profitable than others. These include businesses such as
seeds and fertilizers (harvest season), hotels (vacation), air conditioners (summer season), rain coats
and umbrellas (monsoon season), amongst others. On the other hand, a cyclical business is largely
dependent on economic cycles. A classic example for the same would be the cement business,
wherein there is a high correlation between the GDP growth and the growth in cement consumption.
As such, we would recommend investors to look at performance of such companies over the long
run.
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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 they
are 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. 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, 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)

Items
Net Sales
Expenditure
Consumption of Raw Materials (i)
FY07
FY08
Amount % of sales
21,993
100.0%
Change
Amount % of sales
25,848
100.0%
Amount % of sales
17.5%
14,004
63.7%
15,553
60.2%
11.1%
-3.5%
767
3.5%
905
3.5%
18.1%
0.0%
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%
20,705
94.1%
23,531
91.0%
13.6%
-3.1%
Employee costs (ii)
Total operating expenses

(i + ii+ iii +iv)
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 deducting
its 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
Engineering
Cement
Retail*
Pharma
FMCG$
IT
Telecom
Hotels
Power
Automobiles#
Steel^
Construction
Operating margin range

10% to 20%
13% to 33%
7% to 11%
10% to 24%
13% to 15%
26% to 30%
27% to 37%
18% to 40%
15% to 20%
8% to 16%
9% to 28%
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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Discussion On Depreciation & Interest

Charges
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, 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
FY08
FY09
FY10
FY11
FY12
FY13
FY14
Value of asset
10,000,000
9,000,000
8,000,000
7,000,000
6,000,000
5,000,000
4,000,000
Depreciation amount
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
FY15
FY16
FY17
FY18
3,000,000
2,000,000
1,000,000
0
1,000,000
1,000,000
1,000,000
-
Under the written down value (WDV) method, companies depreciate the value of assets using a fixed
percentage on the written down value. The written down value is the original cost less the depreciation
value till the end of the previous year. As such, this results in higher depreciation during the earlier life
of the asset and lesser depreciation in the later years. An example of the same is shown below:
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A company buys an asset worth Rs 10 m in FY08. It will depreciate the value of the asset by 15% each
year (on the written down value).
Year
WDV of asset
Depreciation amount
FY08
10,000,000
1,500,000
FY09
8,500,000
1,275,000
FY10
7,225,000
1,083,750
FY11
6,141,250
921,188
FY12
5,220,063
783,009
FY13
4,437,053
665,558
FY14
3,771,495
565,724
FY15
3,205,771
480,866
FY16
2,724,905
408,736
FY17
2,316,169
347,425
FY18
1,968,744
295,312
The main difference between both these methods is the actual amount of depreciation per year.
However, it may be noted that the total depreciation costs (over the life of the asset) will be the same
using either of the methods.
Coming to the point of how much depreciation a company charges, it mainly depends on the type of
asset. As mentioned earlier, depreciation is charged on assets due to reasons such as obsolesce, wear and
tear, amongst others. Fixed assets such as software and computers would be depreciated at the highest
rate as they tend to get obsolete rapidly due to technology upgrades and updates. Plant and machinery
would attract a lower depreciation rate due to their longer life. It may be noted that companies do
mention the depreciation rates they take on their fixed assets in their annual reports.
Another point to be noted is that some companies show depreciation costs as part of operating expenses.
However, it does not form part of the core operations of a company. As such, it would be a better
method to calculate depreciation separately (after calculating the operating income) and not as part of
the operating expenses.
Interest costs: Interest costs are the compensation that a company pays to banks or lenders for using
borrowed money. These costs are usually expressed as an annual percentage of the principal, also known
as the interest rate. As you may be aware, interest rate is dependent of variety of factors such as the
credit risk of the company, time value of money, the prevailing global interest and inflation rates.
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Any investor would prefer a company which is debt free. But that does not make companies that have a
certain amount of debt a bad investment. If a company is easily able to cover its interest costs within a
particular period, it could be a safe bet. How can we know that? This is where the interest coverage ratio
comes in. The interest coverage ratio is used to determine how comfortably a company is placed in
terms of payment of interest on outstanding debt. It is calculated by dividing a company's earnings
before interest and taxes (EBIT) by its interest expense for a given period.
For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20
m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the
greater are the risks.
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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

Importance
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.
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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 broken
into 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 this
topic 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 will
expand. Its complementary effect will be seen in the assets side.
The reserves and surplus account is made up of different reserves such as 'General Reserve', 'Profit and
loss reserve', amongst others. This also includes a reserve which is called the 'Share premium account'.
When a company issues shares, the instrument would have to carry a denomination, called as the face
value. For example, let us assume that the face value of a company's shares is Rs 10 per share. It fixes
the issue price at Rs 100 per share. Now, out of each share that is issued, Rs 10 will go in the share
capital account (as explained above) and the balance Rs 90 will go to the 'Share premium account'.
Loans and borrowings is the other major component of the 'Sources of funds' side. When a company is
in need of capital (for any purpose), but is not able to generate enough internally, it would look to
borrow funds. These could vary from meeting capital expenditure requirements to meeting working
capital requirement, amongst others.
Loans can be of various types. They could be short term (working capital loans) or long term (term
loans) in nature. You would also find terms such as 'secured loans' and 'unsecured loans' in companies'
annual reports. Secured loans are loans that are secured by collateral to reduce the risk associated with
lending.
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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. In
due 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 receivables
on the company's books stood at Rs 26.7 bn, while it reported a topline (net sales) of Rs 119.1 bn. As
such, the company had average receivable days of 81.8 days during the year.
We would like to reiterate that these figures (inventory days and debtor days) should be compared to
companies within a particular sector. Comparing companies across industries would throw up different
numbers, purely due to the nature of the respective businesses.
What are cash and cash equivalents?
As you may be aware, cash and cash equivalents are the most liquid assets found in any company's
balance sheet. As an investor, you must have heard experts recommend investing in cash rich companies
(especially in recent times). Why would this be the case? This is simply because it would allow
companies to meet expenses in a downturn when the business is slow.
Cash does not only offer protection against difficult times, but also gives companies more options for
future growth. Companies could grow by acquiring companies. If they do not find a company that meets
their criteria, they could pay their shareholders through dividends.
However, a big cash balance is not always a good sign. What would be an optimum cash balance that a
company must have depends from sector to sector. Sometimes, it differs between companies within a
particular sector.
One could analyse cash levels as a percentage of sales. We ran a query on CMIE Prowess to study some
of these figures between companies that form part of the BSE-IT and BSE-FMCG indices.
During the last five years, the average cash balance as a percentage of sales (standalone figures) stood at
about 4% for companies that form part of the BSE-FMCG Index. On comparing the same parameter on
companies that form part of the BSE-IT Index, the figure stood at an average of 24%.
For instance, during the period between CY99 to CY04, Nestle maintained cash to sales average of
0.4%. During the last four years it has increased to an average of 2.4%. During CY08, the company's
cash balance stood at 4.5% of its full year net sales.
What are loans and advances?
Loans and advances include various items such as advance to suppliers and vendors (in accounting
terminology it is known as 'advances recoverable'), advance tax payments (income tax, wealth and
fringe benefit tax), loans to employees, deposits, balance with customs, amongst others.
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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 able to collect its payments within an average period of 3.8 days. But on the other
hand it takes nearly 42 days to pay off its creditors. This indirectly indicates that the company has a very
strong bargaining power, both against its vendors and debtors.
To assess how comfortable a company is in terms of meeting its short term liabilities, we can use ratios
such as the current ratio and the quick ratio. Current ratio is calculated by dividing current assets by
liabilities. As such:
Current ratio = Current Assets / Current Liabilities
Quick ratio on the other hand is calculated by dividing current assets minus inventories by current
liabilities. Therefore:
Quick ratio = (Current Assets Inventories)/ Current Liabilities
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These ratios indicate the short-term liquidity of the company. The higher the ratio, stronger is the short
term liquidity position of the company. If the ratio is 1 or higher, it means that the company has enough
cash and liquid assets to cover its short-term debt obligations. If a company's creditors exceed the
debtors it is possible that it could run into trouble paying back creditors in the short term. However, it
may be noted that it is not always necessary that a company having a ratio of less than 1 (or indirectly
current liabilities are more than current assets) is not in a strong position.
At the end of FY09, the current liabilities on Hero Honda's books stood at Rs 15.5 bn, while its current
assets totaled to Rs 10.1 bn. The current ratio in this case is 0.65. This is one strong advantage for the
company as it is able to generate cash so quickly. This is the case as its customers (two-wheeler owners)
usually pay upfront. Indirectly, as the company has higher creditor days, it means that it is actually
receiving cash for products even before it is making payments to its creditors.
Working capital
Working capital is calculated by subtracting current assets by current liabilities. As indicated above, the
rule of thumb is that positive working capital means that a company is able to pay off its short-term
liabilities.
What is the average amount of working capital needed by a company is calculated by dividing the net
working capital figure by net sales of a particular year. It may be noted that this is an average figure and
as such only gives an indication.
'Working capital turnover' is a ratio that helps in knowing how many days it takes a company to convert
its working capital into revenue. The faster a company is able to do so, the better it is. The formula for
the same is:
Working capital turnover = (Average Working Capital/ Net sales) * 365
When utilizing this ratio, it is important for one to see the long term pattern of the company. More
important is how it fares when compared to its peer group.
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Dissecting The Investments On Books

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.
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You may also notice investments termed 'investment property' annual reports of in some companies.
This is nothing but an investment in land or buildings which are not intended to be used or occupied by
the investee. Such an investment is considered as a long term investment.
Quoted and unquoted investments:
Quoted investments are investments whose value is easily assessable. Investment in the stock of
companies which are listed on stock exchanges would be the best example of quoted investments. This
is because market prices give these instruments a readily assessable value. Investment in mutual funds
would also classify as a quoted investment. On the other hand, un-quoted investments are investments
which do not have a readily available price. Many a times you will find that companies have invested in
stocks that are not listed on any stock exchange. For such kind of investments, other means are used to
determine fair value.
It may be noted that some companies also report investments as trade and non-trade investments. Also,
an investor may get confused as to why certain investments are shown in a company's standalone
statement, but are missing from its consolidated balance sheet. The answer lies in the fact that a
company's consolidated numbers include those of its subsidiaries and associate companies, the latter
companies do not appear separately as investments in the balance sheet.
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Financial Statements: Key Ratios

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 utilized the shareholders funds. It is calculated by dividing the 'profit
after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the
company. The result of this calculation should be multiplied into 100.
Return on equity = profit after tax / shareholders funds * 100
One could also take the average equity capital i.e. the average equity of a particular financial year and its
preceding financial year. The ratio is also known as the return on net worth (RONW).
It is important to note that this ratio should be compared within companies of a particular industry or
intra-industry rather than inter-industry. This exercise helps in knowing which companies have better
operating efficiencies and consequently, which managements have been utilising their shareholders'
funds more efficiently. An inter-industry comparison does not really make sense as characteristics of
different industries vary.
Return on capital employed (ROCE) - Capital employed in simple terms is the value of all assets
employed in a business. It can be calculated in two ways -from the 'Application of funds' side and the
'Sources of funds' side of the balance sheet. In case of the former, capital employed would the total
assets minus the current liabilities. For the latter, one can simply add the shareholders funds and the loan
funds.
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ROCE is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed. As
such,
ROCE = EBIT / Capital employed * 100
This ratio helps in assessing the returns that a company realises from the capital employed by it. In other
words, it represents the efficiency with which capital is being utilized to generate revenue.
Return on invested capital (ROIC) - ROIC shows the returns that a company earns on the capital that
is actually invested in the business. It is an important tool which helps in determining how well a
company's management is able to allocate capital into its operations for future growth. It is calculated as:
ROIC = (EBIT)*(1 - effective tax rate) / (Capital employed - cash in hand) * 100
As we can see form the above ratio, after reducing the tax from the earnings before interest and tax
figure (EBIT), we divide the result by the capital employed (net of the idle cash on hand). The reason we
take the EBIT figure is because it includes the PAT and depreciation (which is a non-cash expense).
Surplus cash is subtracted from the total capital employed is because it is not actually employed in the
business.
Return on total assets (ROA) - ROA is another ratio which helps in indicating the management
efficiency. This ratio gives an idea as to how efficiently a company's management is using its assets to
earn the profits it is generation. It is calculated by dividing the profit after tax by the total assets as at the
end of that year/period. As such,
ROA = Profit after tax / total assets * 100
It measures how profitably the assets of the company have been utilised. Companies with high asset
base in capital-intensive industry such as fertilisers and steel tend to have a lower ROA than companies
selling branded products such as toothpaste and soaps, which may have a lower asset base. As such, it is
important for one to compare the ROAs of companies involved in similar businesses/ industries.
Asset turnover - The asset turnover ratio indicates how well the company is sweating its assets. In other
words, it shows how much many rupees a company generates with every rupee invested in assets. This
ratio is a measure of how efficiently the company has been in generating sales from the assets at its
disposal. It is calculated by dividing the sales by the total assets.
Asset turnover = Sales / Assets
Let us take up an example to understand this well. Suppose company 'A' has assets worth Rs 10 bn on its
books. At the end of the year, the company recorded a topline of Rs 25 bn. That means the company has
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an asset turnover of 2.5. This indirectly gives an indication that the company would be able to increase
its revenues by Rs 2.5 with every rupee invested in as assets.
Naturally, the higher the assets turnover, the better it is for a company. However, it largely depends on
the strategy a company is following. It is likely that a company with lower margins and higher volumes
will have a higher asset turnover than a company involved in a low volume - high margin business.
Debt/Equity ratio - This ratio indicates how much the company is leveraged (in debt) by comparing
what is owed to what is owned. As mentioned in the earlier part of this series, a company can broadly
have two sources for employing funds into its business - from the owners and from third parties, i.e. loan
funds.
As such, to get an idea as to how much of the funds employed into a business is in the form of loans, we
use the debt to equity ratio. It is calculated by dividing the debt by the shareholders funds (or equity). As
such,
Debt to equity ratio = Debt on books / Shareholders funds (Equity)
This ratio is probably one of the most observed ratios as it indicates the extent to which a company's
management is willing to fund its operation with debt. Naturally, a high debt to equity ratio is
considered bad for a company as it would have to pay the necessary interest on the borrowings.
But that does not make companies that have a certain amount of debt a bad investment. If a company is
easily able to cover its interest costs within a particular period, it could be a safe bet. For the same, one
should also gauge at the interest coverage ratio.
Interest coverage ratio - The interest coverage ratio is used to determine how comfortably a company
is placed in terms of payment of interest on outstanding debt. It is calculated by dividing a company's
earnings before interest and taxes (EBIT) by its interest expense for a given period. As such,
Interest coverage ratio = EBIT/ Interest expense
For example, if a company has a profit before tax (PBT) of Rs 100 m and is paying an interest of Rs 20
m, its interest coverage ratio would be 6 (Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the
greater are the risks.
We hope that the series of articles so far would have helped you analyse companies' numbers better. In
the next article of this series, we shall take up the topic of cash flows.
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What Are Cash Flows From Operations?

What is a cash flow statement?
In simple terms, a cash flow statement indicates how (and how much of) cash has left or entered a
company during a particular time period. It helps the investor assess the ability of a company to generate
cash.
Broadly, there are three ways a company can generate and use its cash. This is in fact how a cash flow
statement is arranged. The first and most obvious way a company can earn money (or even lose) is
through its basic business operations. The second way is through borrowing and repaying loans or by
raising capital (through issuing shares and debentures). The third way is by selling or purchasing assets
and investments. A cash flow statement is thus typically broken into three parts:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
These three aspects need to be looked at individually as they are all important to a firm. We shall discuss
these topics one by one with the help of a few examples.
Cash flow from operations
As per Accounting Standard 3 (or AS3), "Operating activities are the principal revenue-producing
activities of the enterprise and other activities that are not investing or financing activities."
As the name suggests, this head shows the amount of money the company makes (or loses) through its
operations. However, it must be noted that only the "core" operations must be taken into consideration.
A cash flow statement begins with the profit before tax (PBT) figure. This is because this figure takes
into consideration the revenues and expenses related it's a company's operations. This figure also
includes depreciation and interest costs. However, PBT should be adjusted for non-cash items (such as
depreciation) and financing expenses (such as interest costs), amongst others. The reason depreciation
expenses are added back is that there is no actual outgo of cash. It is just an accounting entry that is
recorded to recognise the cost of the asset over a period of time.
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After making these adjustments, we arrive at a figure which is termed as the 'operating profit before
working capital changes'.
Working capital is again, a part of the company's core operations. As such, any changes in the same
needs to be accounted for. After arriving at the 'operating profit before working capital changes' figure
one must account for:
The decrease/ (increase) in sundry debtors
The decrease/ (increase) in inventories
The increase / (decrease) in sundry creditors
It helps in knowing how a company has unblocked or blocked a certain amount towards meeting its
working capital requirements. It does the same by blocking less cash in current assets or by increasing
its current liabilities. When the reverse takes place, it means that more money has been blocked in
meeting working capital requirements.
Nestle's CY08 cash flow statement
Source: Company's CY08 annual report
Let us take up an example to understand this well. Above, we have displayed Nestle's CY08 cash flow
statement. After making the necessary adjustments, Nestle's 'operating profits before working capital
changes' stood at Rs 8.7 bn at the end of 2008. However, as we move further down, we can see that the
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company's 'cash generated from operations' is higher. The difference between the two figures is Rs 550
m (Rs 9258.8 - Rs 8709.5 m). This means that the company was able to improve its working capital
position over the year. In fact, it was able to unblock funds to the tune of Rs 550 m during CY08 as
compared to the previous year. After we arrive at the 'cash generated from operations figure' we need to
deduct the direct taxes.
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Discussion On Cash Flow From Investing

Activities
Cash flow from investing activities
As per Account Standard 3 (or AS3), "Investing activities are the acquisition and disposal of long-term
assets and other investments not included in cash equivalents."
Cash transactions used for acquiring assets which help in generation of future income fall under this
category. This disclosure is quite necessary for an investor. This is because it gives an idea as to how
much expenditure has been made towards acquiring resources intended for future income generation.
The amount of money received from sale of such investments is recorded here as well.
Payments- towards acquiring fixed assets fall under this category. This also includes intangible assets. In
fact, this would probably be the most common entry found under this head. Costs on capitalised research
and development and self-constructed assets would also fall under this category.
Further, cash receipts and payments towards acquiring or selling shares of others enterprises need to be
shown here as well. These include investments in shares and also acquisition and investments in
subsidiaries and joint ventures. Instruments such as warrants and debt instruments of other enterprises
are included here.
It must be noted that instruments considered as cash equivalents or even those held for dealing or trading
purposes should not be a part this head.
A company needs to record the income - in the form of interest and dividends - that is derived from such
instruments as well. However, their classification depends on the business of the company. For a
financial enterprise, this would be routine activity. As such it would be recorded as a cash flow from
operations. However, such income for a non-financial company would fall under cash flow from
investing activities. At the same time, interest payments (outflow) would be classified as cash flows
from financing activities.
Let us take up an example to understand this well. Shown below is the 'cash flow from investing
activities' portion of Bharti Airtel's FY09 cash flow statement.
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Source: Company's FY09 Annual Report; Figures in Rs '000
As you can see, there are some figures which are in brackets. This indicates that the money is going out
of the company. On the other hand, the amounts which are not in brackets indicate the inflow of money.
It must be noted that the figures in the above image are in Rs '000 (thousand).
As such, during FY09, Bharti Airtel invested about Rs 137 bn on fixed assets. The same figure during
the previous year stood at Rs 136 bn. Further, during FY09 Bharti Airtel purchased investments of about
Rs 394 bn. During the same year, it sold investment worth about Rs 421 bn.
The other transactions can be viewed in a similar manner. On adding up all the figures, the total comes
up to about Rs 152 bn. This means that Bharti Airtel invested Rs 152 bn in items that fall under the
category of 'investing activities'.
In many cases, companies may have negative overall cash flow during a particular period. However, on
looking at the numbers in detail, one may notice that this may be the case despite a positive cash
generation at the operating level. In such cases it is likely that the overall cash flow position is negative
on the back of higher investments. This may not particularly be a bad news for the company.
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Relation Between Capital Structure And

Cashflows
Cash flow from financing activities
As per Account Standard 3 (or AS3), "Financing activities are activities that result in changes in the
size and composition of the owners' capital (including preference share capital in the case of a
company) and borrowings of the enterprise. "
As you must be aware, a balance sheet is broadly made up of two components. One side shows what a
company owns or controls (assets) and the other, what it owes (liabilities plus equity). In accounting
terminology, it is termed as 'Application of funds' and 'Sources of funds'. 'Sources of funds' indicate the
total value of financing that a company has done. 'Application of funds' displays how a company has
utilised these funds.
As such, one can say that 'cash from financing activities' is related to the 'Sources of funds' aspect of the
balance sheet. This is where a company reports whether it took in money or paid out money to finance
its activities.
Whenever a company changes the size or the structure of its 'Sources of funds', it is recorded under this
cash flow head. As such, any increase in debt, be it long term or short term is recorded here. Similarly,
transactions relating to repayments are also shown under this head.
Interest costs relating to loans taken form a part of 'cash flow from financing activities' as well. This is
because it is considered as the cost of obtaining financial resources or returns on investments.
Moving on, details relating to funds raised by issuance of more shares are recorded here as well. This
may include proceeds from issuance of shares though preferential allotments, QIPs, amongst others. It
would also include increase in share capital through issuance of ESOPs. Cash transactions relating to
repurchase or buyback of shares are shown under this head as well. The cash flow from financing
activities also includes outflow of cash in the form of dividends. As dividend can be considered as a cost
for obtaining financial services, it is required to be shown here.
Unlike the 'cash flow from operations', a positive cash flow from financing activities would not
necessarily be a good thing. A positive cash flow from financing activities indicates that a company has
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taken on more debt or is diluting equity by issuing more shares. This is not necessarily something that
would make an investor happy. Similarly a negative cash flow would not also be harmful as it could
mean that a company is paying out dividend (cash outflow).
Let us take up an example to understand this well. Shown below is the 'cash flow from financing
activities' portion of Britannia's FY09 cash flow statement.
Source: Company's FY09 Annual Report; Figures in Rs '000
As you can see, there are some figures which are in brackets. This indicates that the money is going out
of the company. On the other hand, the amounts which are not in brackets indicate the inflow of money.
It must be noted that the figures in the above image are in Rs '000 (thousand).
During FY09, Britannia's cash outflow from financing activities stood at Rs 1.1 bn. This negative cash
flow from financing activities is largely due to repayment of unsecured loans (Rs 3.1 bn). However, the
company has also received certain funds from borrowings. The net figure however stands at a negative
figure of Rs 396 m (Rs 3,063 m - 2,337 m - 330 m), indicating that the amount that was repaid was
higher. In addition, due to interest payment and dividend payment (including the dividend tax), the
overall net cash flow from financing activities increased to Rs 1.1 bn.
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Key Ratios Related To The Cashflow

Statement
It is very common that investors give more focus and attention to balance sheets and profit and loss
statements. More often than not, novice investors may ignore a company's cash flow statement on
account of its relatively complex nature. This is true, when compared to the other two financial
statements - balance sheet and profit and loss account.
In the last few articles, we have tried to educate readers about the basics of a cash flow statement. Since
we have completed our discussion about some of the technical terms that are found in the cash flow
statement, we shall discuss some of the key ratios associated with it.
A cash flow statement is probably the most useful tool for judging or testing a company's liquidity
position. In addition, it can also help in testing a company's financial health.
We are not implying that the ratios which we discussed earlier related to the other two statements are not
useful. All ratios have different usages in terms of testing a company's financial performance.
Free cash flow per share (FCF/ Share): Free Cash Flow (FCF) is the cash earned by the company that
can be actually distributed to the shareholders. It signals a company's ability to repay debt, pay
dividends and buy back stock - all important undertakings from an investor's point of view.
FCF takes into account not only the earnings of the company but also the past (depreciation) and present
capital expenditures and investment in working capital. Growing free cash flows are frequently a
prelude to increased earnings. Companies that experience surging FCF due to revenue growth,
efficiency improvements, cost reductions can reward investors in the future. Better free cash flows are
therefore a reason for the investment community to cherish.
On the other hand, an insufficient FCF for earnings growth can force a company to boost its debt levels.
Even worse, a company without enough FCF may not have the liquidity to stay in business
An in-depth methodology would be to adjust a company's increase or decrease in net working capital
(current assets less current liabilities) to the above figure. Free cash flow increases if the company
manages to improve efficiency and consequently reduce the required working capital. This ratio implies
the amount of free cash available per share. It is calculated as follows:
FCF = Net Profit + Depreciation - Capital expenditure - Changes in working capital
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Therefore, FCF/share = (Net Profit + Depreciation - Capital expenditure - Changes in working capital) \
Shares outstanding
Price to free cash flow (P/FCF) is a valuation method which allows one to compare the FCF generated
per share to its share price. The higher the result, the more expensive is the stock.
Operating cash flow ratio (OCF): OCF is calculated by dividing the cash flow from operations by the
current liabilities. This ratio helps in knowing how well short term liabilities of a company are covered
by the cash flow from operations. Short term liabilities in this case would be current liabilities.
As such, operating cash flow = cash flow from operations / current liabilities
You may have by now guessed that this ratio helps in ascertaining a company's liquidity position. But so
are ratios such as the current ratio and the quick ratio, you may ask. The OCF ratio helps in assessing
whether a company's operating cash flow generations are enough to cover its current liabilities. If the
ratio falls below 1.0, it means that the company is not generating enough cash to meet its short term
liabilities. In order to judge whether a company's OCF is out of line, one should look at comparable
ratios for the company's industry peers.
Capital expenditure ratio: This ratio helps in ascertaining how much operating cash flow a company
generates as compared to the capital expenditure it incurs. It would always be better to look at the
numbers for a particular period as compared to a single or particular year.
It is calculated by dividing the cash flow from operations by the capital expenditure. Therefore:
Capital expenditure ratio = cash flow from operations / capital expenditure
This ratio measures the capital available for internal reinvestment and for payments on existing debt. If
the ratio exceeds 1.0, it indicates that the company has enough funds to meet its capex requirements. As
such, higher the value, the more spare cash the company has to service and repay debt. One will usually
find lower ratios in fast growing companies on the back of high capital investments.
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Understanding The Profit & Loss Statement

Of Banks/ Financial Institutions
In the previous topic of this guide, we had discussed some of the key ratios relating to the cash flow
statement. With that, we concluded our discussion on financial statements. However, we have till now
discussed the financial statement for non-financial companies. Non-financial companies include firms
involved in manufacturing and providing services.
However, financial statements of financial firms such as banks are very different. In the next few
articles, we will talk about the financial statements for such firms. On the back of banking regulations,
banks' accounts are presented in a different manner. As such, one needs to analyze the same in a
different manner.
Before we get into a detailed discussion, we think it would be better to start right at the basics. For this,
we will see the difference between the financial statements of a financial organization and a nonfinancial organization.
Profit and Loss account
Let's start with the profit and loss account. A non-financial company, say a manufacturing company,
derives revenues from product sales. The expenses for the company would include that of raw materials,
labour, power and fuel, salaries and wages, administrative costs, amongst others.
For a bank it is quite different. The basic function of a bank is to accept deposits and give out loans. On
the loans that it gives out, it charges an interest rate. This interest earned is the key revenue source for a
bank. This term is known as 'interest income'.
Apart from interest income from loans advanced, it also earns interest from certain investments that it
makes. In addition, a bank is also required to keep a certain amount of its cash reserves with the RBI.
However, it must be noted that a bank's interest income from investments depends upon some key
factors like monetary policies (Cash reserve ratio and statutory liquidity ratio limits) and credit demand.
Cash reserve ratio (CRR) is a certain percentage of deposits which a bank is mandated to maintain with
the RBI. Statutory liquidity ratio (SLR) is the second part of regulatory requirement, which requires
banks to invest in G-Secs. The bank's revenues are basically derived from the interest it earns from the
loans it gives out as well as from the fixed income investments it makes. If credit demand is lower, the
bank increases the quantum of investments.
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Apart from interest income being the key revenue source for a bank, it also earns income in the form of
fees that it charges for the various services it provides. These services include processing fees for loans
and forex transactions, amongst others. It is believed that banks derive nearly 50% of revenues from this
stream in developed economies. In India, the story is very different. This stream of revenues contributes
about 15% to the overall revenues.
Now that we have covered the income part of the profit and loss account, we shall move on to the
expenditure aspect of the same. The key expense of a bank is interest on deposits that are made with it.
These could be in the form of term (fixed) or savings bank account deposits. The second biggest expense
head for a bank would be its operating expenses. This head would include all operational costs, which
even non-financial companies expend. Some of include employee costs, advertisement and publicity
costs, administrative costs, rent, lighting and stationary.
Under expenses, there is also an item called 'provisions and contingencies' that is included. In the
simplest terms, these are liabilities that are of uncertain timing or amount. This includes provisions for
unrecoverable assets. In accounting terms, such provisions are called as 'Provisions for Non-performing
assets (NPAs)'. Apart from NPAs, these provisions also include provision for tax and also depreciation
in the value of investments.
After removing these heads from the income generated, we simply arrive at the profits figure. The
process of appropriation thereafter is similar to that of non-financial companies.
We shall take up an example to understand this. Displayed below is the profit and loss account of HDFC
Bank.
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Source: HDFC Bank's FY09 annual report.
The total income generated by the bank during FY09 was Rs 198 bn. Of this, interest income was Rs
163 bn. The balance was contributed by other income.
Out of the Rs 163 bn of interest income, HDFC Bank earned about Rs 121 bn from interest on loans
advanced/ bills. The income from investments during the year stood at Rs 40 bn, while interest from the
balance with RBI and other inter-bank funds stood at Rs 2 bn.
During FY09, HDFC Bank earned revenues of Rs 34 bn as other income. The largest contributor here
was fee income (Commission, exchange and brokerage) to the tune of Rs 26 bn. This translates as 13%
of the total income during the year. Other major contributors were profit on sale of investments and
exchange transactions.
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Moving on to the bank's expense account. The total interest expended stood at Rs 89 bn. The interest on
deposits stood at Rs 80 bn , while interest on borrowings from other sources such as the RBI and other
bank borrowings stood at Rs 6 bn. Operating expenses during the year stood at Rs 56 bn. The major
contributor to this head was employee costs (Rs 23 bn). Provision and contingencies amount stood at Rs
29 bn.
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Key Ratios Associated With Banks' P&L

Statements
As a bank's accounts are very different from that of a manufacturing firm, it would be necessary for an
investor to understand some of the key performance ratios. As you must be aware, analysis of a bank's
accounts differs significantly from any other company due to their structure and operating systems.
Those key operating and financial ratios, which one would normally evaluate before investing in
company, may not hold true for a bank. Some of these key ratios are:
Net interest margin (NIM)
Operating profit margin (OPM)
Cost to income ratio
Other income to total income ratio
Net interest margin (NIM): Just as we calculate and measure performances of non-financial companies
on the basis of their operating performance (EBITDA margins), the performance of banks is largely
dependent on the NIM for the year. The difference between interest income and interest expense is
known as net interest income. It is the income, which the bank earns from its core business of lending.
As such, NIM is the net interest income earned by the bank on its average earning assets. These assets
comprises of advances, investments, balance with the RBI and money at call. As such it is calculated as,
NIM = (Interest income - interest expenses) / average earnings assets
Operating profit margin (OPM): A bank's operating profit is calculated after deducting operating
expenses from the net interest income. Operating expenses for a bank would mainly be more of
administrative expenses. The main expense heads would include salaries, marketing and advertising and
rent, amongst others. Operating margins are profits earned by the bank on its total interest income. As
such,
OPM = (Net interest income (NII) - operating expenses) / total interest income
Cost to income ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part
of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its
return on equity. Salaries, branch rationalisation and technology upgradation account for a major part of
operating expenses for new generation banks. Even though these expenses result in higher cost to
income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as
a proportion of operating profit including non-interest income (fee based income).
Cost to income ratio = Operating expenses / (NII + non-interest income)
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Other income to total income: Fee based income accounts for a major portion of a bank's other
income. A bank generates higher fee income through innovative products and adapting the technology
for sustained service levels. This stream of revenue is not depended on the bank's capital adequacy and
consequently, the potential to generate the income is immense. The higher ratio indicates increasing
proportion of fee-based income. The ratio is also influenced by gains on government securities, which
fluctuates depending on interest rate movement in the economy.
Let's take up an example to understand this well. Below, we have displayed HDFC Bank's FY09 profit
and loss account. We shall calculate the above mentioned ratios for the bank.
Source: HDFC Banks FY09 annual report.
We will first calculate HDFC Bank's NIM for the year FY09. As mentioned above, for calculating
NIM, one needs to divide the net interest income by the average earning assets.
Or, NIM = (Interest income - interest expenses) / average earnings assets
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The interest income during FY09 stood at Rs 163 bn. The interest expended during the year was Rs 89
bn. Therefore the net interest income is Rs 74 bn (Rs 163 - Rs 89 bn).
Average earnings assets for the bank for the year stood at Rs 1,753 bn. It is calculated by adding the
cash and balances with Reserve Bank of India (Rs 135 bn), balances with banks and money at call and
short notice (Rs 40 bn), investments (Rs 587 bn) and advances (Rs 990 bn).
Therefore the NIM for the year FY09 was 4.2% (Rs 74 bn / Rs 1,753 bn)
Now moving on to the OPM for HDFC Bank - Net interest income for the year stood at Rs 74 bn. The
operating expenses for the year were about Rs 56 bn. Total interest income for the year was Rs 163 bn.
Therefore, the OPM for the year stood at,
OPM = (Net interest income (NII) - operating expenses) / total interest income
= Rs 74 bn - Rs 56 bn / Rs 163 bn. This is equal to about 11%.
Moving on the cost to income ratio for HDFC Bank - As mentioned above, it is calculated by operating
expenses by the total of the net interest income and the non-interest income.
Or, Cost to income ratio = Operating expenses / (NII + non-interest income)
Operating expenses for the bank during the year stood at Rs 56 bn. Non-interest income, which is
basically the other income, stood at Rs 36 bn. NII, as calculated above, was Rs 74 bn. Putting all this
together, we get the following:
= Rs 56 bn / (Rs 74 bn + 36 bn)
= 50.9%. The cost to income ratio stood at almost 51% for the year FY09.
The last ratio is the other income to total income ratio. It is a very straight forward ratio. The other
income for the year FY09 stood at Rs 34 bn. The total income for the year was about Rs 198 bn.
Therefore HDFC Bank's other income to total income ratio for the year FY09 was about 17%.
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Making Sense Of A Bank's Balance Sheet

A balance sheet of a manufacturing firm is broadly divided into two parts - 'Sources of funds' and
'Application of funds'. For a bank these are termed as 'Capital and liabilities' and 'Assets' respectively.
We shall first discuss the 'Capital and liabilities' portion of the balance sheet.
Capital and Liabilities
The 'capital and liabilities' head, as the name suggests is made up of the three portions - the net worth,
which is the 'capital' and the 'reserve and surplus', the liabilities, which is the money that a bank owes.
This money is in the form of 'deposits and borrowings'. The third portion is the 'other liabilities and
provisions'.
Net worth: Net worth is made up of the 'share capital' and the 'reserves and surplus'. While the net
worth of banks is quite similar to that of a non-financial institution, there are some balances that a bank
needs to maintain in its balance sheet, which one will not find in a non-financial institution. One such
reserve is the 'statutory reserve', which is not a free reserve for the bank. Unlike this there are free
reserves that banks maintain, but their proportions are quite subjective as they differ from bank to bank.
Such reserves include 'Investment Reserve Account' and 'Foreign Currency Translation Account'.
Liabilities: As it is a bank's business to raise funds and lend the same, the debt to equity ratio is
typically 10 to 20 times, much higher than that of non-financial firms. Banks also need funds for
investing. The liabilities are usually in various forms. They can either be deposits or borrowings.
Deposits are again broadly of three kinds - demand deposits (current accounts), savings bank deposits
(saving accounts) and term deposits (fixed deposits).
As compared to the interest paid on fixed deposits (term deposits), the interest offered on demand and
savings bank deposits (popularly known as CASA or current account and savings accounts) is very low.
As such, when banks mention that they are trying to increase the share of low cost funds, it means that
they are trying to garner more funds in the form of CASA. This would eventually help them improve
their net interest margins (NIMs).
As for borrowings, they are somewhat similar to the debt that non-financial companies take. Apart from
deposits, banks can also borrow funds through loans from other sources. These can include the Reserve
Bank of India (RBI) as well as other institutions and agencies, be it domestic or foreign.
Other liabilities and provisions: This head is similar to that of a 'current liabilities' portion of a nonfinancial company. The items can fall under this head are the short term obligations of a bank during a
particular year. The items that can fall under this category include bills payable, interest accrued,
provision for dividend, contingent provisions etc.
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Making Sense Of A Bank's Balance Sheet- II

In this topic, we will discuss the other part of the balance sheet - Assets.
Just to brush up the readers, a balance sheet of a manufacturing firm is divided into two parts - 'Sources
of funds' and 'Application of funds'. For a bank these are termed as 'Capital and liabilities' and 'Assets'
respectively.
Assets
While the 'Capital and Liabilities' is the portion from where the bank sources the money to lend as loans,
the 'Asset's portion indicates where all and how the bank has utilised the money. Apart from advances, a
bank needs to put aside a portion of its assets in various forms. These can be in the form of investments,
deposits with the RBI, cash balances, amongst others. It must be noted that a bank needs to follow
regulations made by India's central bank, the Reserve Bank of India (RBI). We shall discuss these later
on in this article.
Cash and bank balances with the RBI
As the name suggest, this head includes the cash in hand and in ATMs that a bank maintains as well as
the amount of money deposited with the RBI. A bank will need to reserve a certain amount to satisfy
withdrawal demands. The proportion of deposits that a bank needs to keep with the RBI is determined
by the prevailing 'cash reserve ratio' (CRR). As such, CRR is essentially the percentage of cash reserves
to total deposits. The rate of the same is determined by the RBI in its monetary policies.
Balances with Banks and Money at Call and Short notice
This head again has two parts - balance with other banks (which can be in the form of current account or
other deposit accounts) and money at call and short notice. Banks do show these types of balances with
institutions that are in and outside India separately.
These funds are those which banks provide (or take) to (or from) other financial institutions at inter-bank
rates. These types of loans are very short in nature, usually lasting no longer than a week. More often
than not, these funds are used for helping banks meet reserve requirements.
Investments
This head is again divided into two parts - investments in and outside India. Investments in government
securities (G-Secs) take the cake in this head. A bank is required to invest in G-Secs. The amount that
needs to be invested is the dependent on the prevailing statutory liquidity ratio (SLR).
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As mentioned in one of our earlier articles, a bank's revenues are basically derived from the interest it
earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand
is lower, the bank increases the quantum of investments in G-Sec.
The other investment would be somewhat common between all firms. They could include investment in
joint ventures, subsidiaries, bonds and debentures, units, certificate of deposits, amongst others.
Advances
Advance in the simplest term can be defined as loans given to a bank's customers, which could be retail
or corporate clients. The growth in advance, coupled with the prevailing interest rates is what drives the
banks interest income.
Advances are broadly of three types - Bills purchased & discounted, cash credits, overdrafts & loans
repayable on demand and term loans. Term loans, followed by cash credits, overdraft and loans
repayable on demand tend to have a larger share in this head.
Further, banks are also required to show how these assets have been covered. They can be either covered
by tangible assets or bank/government guarantees. Banks also give unsecured loans to their customers.
However, these types of loans would constitute a much less portion (as compared to the secured loans)
of the advance pie.
Banks are also required to broadly show where they have made their advances. While more details can
be sought from various reports, including annual reports, under the advance schedule, they are required
to show what portion is advanced in and outside India. Further bifurcation is made as to how much has
been advanced to the priority sector, public sector, other banks, etc.
Fixed assets and other assets
Fixed assets for a bank would mainly include premises, land, assets on lease and furniture & fixtures.
The 'other assets' portion includes various items such as the interest accrued, advance tax paid, stationary
and stamps, non banking assets acquired in satisfaction of claims, security deposits for commercial and
residential property, deferred tax assets, amongst others.
It must be noted that banks are also required to disclose their contingent liabilities, which as the name
suggests, are possible future liabilities that will only become certain on the occurrence of some future
event. More often than not, liability on account of outstanding forward exchange and derivative
contracts form the majority portion of this.
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Key Ratios Related To Banks' Balance Sheets

We shall now discuss some of the key ratios related to a bank's balance sheet statement.
While the article related to the key 'profit and loss statement' ratios was more to do with the performance
of a bank, the following ratios are more to do with the financial stability of a bank. In addition, we shall
also compare the following ratios of India's largest banks. Some of these key ratios are:
Credit to deposit ratio
Capital adequacy ratio
Non-performing asset ratio
Provision coverage ratio
Return on assets ratio
Credit to deposit ratio (CD ratio): This ratio indicates how much of the advances lent by banks is done
through deposits. It is the proportion of loan-assets created by banks from the deposits received. The
higher the ratio, the higher the loan-assets created from deposits. Deposits would be in the form of
current and saving account as well as term deposits. The outcome of this ratio reflects the ability of the
bank to make optimal use of the available resources.
Capital adequacy ratio (CAR): A bank's capital ratio is the ratio of qualifying capital to risk adjusted
(or weighted) assets. The RBI has set the minimum capital adequacy ratio at 9% for all banks. A ratio
below the minimum indicates that the bank is not adequately capitalized to expand its operations. The
ratio ensures that the bank do not expand their business without having adequate capital.
CAR = Tier I capital + Tier II capital / Risk weighted assets
It must be noted that it would be difficult for an investor to calculate this ratio as banks do not disclose
the details required for calculating the denominator (risk weighted average) of this ratio in detail. As
such, banks provide their CAR from time to time.
Tier I Capital funds include paid-up equity capital, statutory and capital reserves, and perpetual debt
instruments eligible for inclusion in Tier I capital. Tier II capital is the secondary bank capital which
includes items such as undisclosed reserves, general loss reserves, subordinated term debt, amongst
others.
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Non-performing asset (NPA) ratio: The net NPA to loans (advances) ratio is used as a measure of the
overall quality of the bank's loan book. An NPA are those assets for which interest is overdue for more
than 90 days (or 3 months).
Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from
gross NPAs. Higher ratio reflects rising bad quality of loans.
NPA ratio = Net non-performing assets / Loans given
Provision coverage ratio: The key relationship in analysing asset quality of the bank is between the
cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that
indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high
ratio suggests that additional provisions to be made by the bank in the coming years would be relatively
low (if gross non-performing assets do not rise at a faster clip).
Provision coverage ratio = Cumulative provisions / Gross NPAs
Return on assets (ROA): Returns on asset ratio is the net income (profits) generated by the bank on its
total assets (including fixed assets). The higher the proportion of average earnings assets, the better
would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned
by the bank on its total net worth.
ROA = Net profits / Avg. total assets
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ABC of Investing

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ABC of Investing

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Introduction to the 'Investing: Back to Basics' Series

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

Equitymaster Agora Research Private Limited

Introduction to the 'Investing: Back to Basics' Series

Introduction to the 'Investing: Back to Basics' Series

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

Introduction to the 'Investing: Back to Basics' Series

Where To Gather Information From?

Introduction to the 'Investing: Back to Basics' Series

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

Introduction to the 'Investing: Back to Basics' Series

Key Constituents Of An Annual Report

Introduction to the 'Investing: Back to Basics' Series

Introduction to the 'Investing: Back to Basics' Series

Introduction To Financial Statements

Introduction to the 'Investing: Back to Basics' Series

Sourced from Britannia Industries' FY08 annual report

Introduction to the 'Investing: Back to Basics' Series

Sourced from Britannia Industries' FY08 annual report

Introduction to the 'Investing: Back to Basics' Series

Reworked FY08 balance sheet to simplify the understanding

Cash flow statement

Cash (used in)/ generated from operations

Introduction to the 'Investing: Back to Basics' Series

Sourced from Britannia Industries' FY08 annual report

Introduction to the 'Investing: Back to Basics' Series

Gauging A Company's Revenues

Source: Annual report & BSE

Introduction to the 'Investing: Back to Basics' Series

Introduction to the 'Investing: Back to Basics' Series

Analysing Companies' Operating Expenses

Introduction to the 'Investing: Back to Basics' Series

Britannia Industries (Rs m)

Advertising costs (iii)

Other expenditure (iv)

Employee costs (ii)

Total operating expenses

Source: Britannia FY08 annual report

Introduction to the 'Investing: Back to Basics' Series

Discussion On Operating Margins

Introduction to the 'Investing: Back to Basics' Series