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CHAPTER 0

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.
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.

CHAPTER 1

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 articleson 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
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 linkto see the offer documents that have been issued
over the past few years.
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.
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
BSEor NSEwebsites (in their respective corporate announcement sections)
and the company’s website.

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.

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.

CHAPTER 2

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

Key constituents of an annual report


Director’s report: The director’s report comprises 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.

Management discussion and analysis (MD&A): More often than not,


the MD&A starts off with the management giving its view on the economy.
It is then followed by a perspective on the sector in which the company is
present. Any major changes like inflation, government policies, competition,
tax structures, amongst others are highlighted and discussed in this report.
It also includes the business strategy the management intends to follow.
Details regarding different segments are provided in this section.
The company also gives a brief SWOT (strength, weakness, opportunity,
and threat) analysis and business outlook for the coming fiscal.
This can aid the shareholder to understand what major changes are likely
to affect the company going forward. However, as mentioned earlier, an
investor should not blindly believe what the management has to say.
While it tends to paint a rosy picture, one needs to judge the sanity behind
the rationale.
Report on corporate governance: The report on corporate governance
covers all aspects that are essential to the shareholder of a company and are
not part of the daily operations of the company. It includes details regarding
the directors and management of a company. These include details such as
their background and their remuneration. This report also provides data
regarding board meetings – how many directors attended the how many
meetings. It also provides general shareholder information such
as correspondence details, details of annual general meetings, dividend
payment details, stock performance, details of registrar and transfer agents
and the shareholding pattern.

Financial statements and schedules: Finally, we arrive at the crux


of the annual report, the financial statements. Financial statements, as you
are aware, provide details regarding the operational performance of a
company during the reporting period. In addition, it also depicts the
financial strength of a company. The key constituents of the financial
statement include the profit and loss account, the balance sheet, the
cash flow statement and the schedules.
In the next article, we shall briefly take a look at the key constituents
of the financial statements. Thereafter, we will go through each of the
statements in further detail

CHAPTER 3
In this article, we shall go through the key constituents of the financial
statements - profit and loss account, balance sheet and cash flow statement.
Key financial statements
Profit & Loss account: The profit and loss account (P&L) shows a company’s
performance over a specific time frame, usually a financial year or a period of 12
months. In India, most companies follow a April to March financial year (as in April
2008 to March 2009 will be one financial year). The P&L account is also known as
the income statement. It presents information relating to a company’s
revenues, manufacturing costs, sales and general expenses, interest and
depreciation charges, tax costs, other income, net profits, and dividends.
A typical P&L statement is as hereunder (Source: Britannia).

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.

Sourced from Britannia Industries’ FY08 annual report

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 above-mentioned activities cover
most of the integral cash transactions of a company. As such, the cash flow statement
allows investors to understand how a particular company’s business is running,
how it has raised capital and how it is being spent.
A cash flow statement is typically broken into three broader parts:
Cash (used in)/ generated from operations
Net cash used in investing activities
Net cash from financing activities
An example of a cash flow statement is displayed below.

Sourced from Britannia Industries’ FY08 annual report

In the next article, we shall start our detailed discussion on the P&L statement
and its key constituents.
CHAPTER 4

In the previous article, we had taken a brief look at the key financial statements
that are found in a company’s annual report. In today’s article, we will take a look how
one should view and analyse the key revenue constituents of a profit and loss account (P&L).
Core vs non-core A handful of companies report the ‘total income’ earned by them
within a year as ‘sales’. We believe one should always take into consideration a

company’s integral earnings (core operations) as sales and not the income that is
generated from other operations. The latter could include items such income from
sale of scrap, income from interest and dividends, forex gains, profit on sale of assets,
export incentives, job charges, and miscellaneous receipts, amongst others.
While these items may not be a significant part of the total income, we believe it is
a good practice to follow, apart from knowing the precise figures. In fact, it would be
even better if one could further bifurcate such earnings under two heads – other
operating income and other income. Details regarding total income are found in
respective schedules.
Segment and region wise Revenues are generated from sales of goods or
services. However, for companies which have presence in various businesses,
a good practice would be to study the change in segment wise/ product wise /
businesswise revenues on a year on year basis. One can also take a look how the
income from each business segment (as a percentage of net sales) has changed
over the years. This gives a good judgment in knowing how a company’s
segments or businesses have been performing over a particular time frame.

Companies enter new businesses for two main


reasons –to diversify their revenue streams and
de-risk their business from a presence in a
single segment. Further it also helps to
capitalise on the opportunities in fast growing
segments. A classic example would be
ITC Limited’s entrance into other business
(hotels, agri, non-FMCG, papers, etc.) Over time, this move has helped it reduce
dependence on its cigarettes business. The adjacent chart shows gives an idea
as to how the scenario has changed for the company over the past few years.
Another way a company can diversify itself is by having presence across
geographies. An investor can study a company’s revenue pattern (from each zone,
region or country) over the years. Companies having transnational presence have
the option of focusing on the high growth areas or areas that are relatively resilient
to an economic slowdown. In addition, if its operations in a certain country/region
are witnessing a problem, it could curb the fall in revenue by focusing on operations
in other countries/regions.
Seasonal and cyclical businesses The revenue volatility would remain high for
companies that are present in seasonal or cyclical businesses, especially if viewed
on a quarterly basis. A seasonal business is a business for which certain seasons of the
year are far more profitable than others. These include businesses such as seeds

and fertilizers (harvest season), hotels (vacation), air conditioners (summer season),
rain coats and umbrellas (monsoon season), amongst others. On the other hand, a
cyclical business is largely dependent on economic cycles. A classic example for the
same would be the cement business, wherein there is a high correlation between the
GDP growth and the growth in cement consumption.
As such, we would recommend investors to look at performance of such
companies over the long run.
In the next article, we shall take a look at the key expenditure constituents of
a P&L. It would be advisable for investors to not look at the P&L revenue constituents
on a standalone basis but to review the same in relation with the expenditure
constituents to gauge the overall impact.

CHAPTER 5

In the previous articleof this series, we had a brief look at how one could
analyse a company’s income over a particular period. In today’s article, we will take
a look at the key expenditure constituents (operating costs) of a company and how
one could view and analyse these over a particular period.
Operating expenses can be broadly segregated into cost of goods sold
(COGS) and selling, general and administrative expenses (SG&A).
COGS: COGS are direct costs that a company incurs for producing or providing a
product or service. These costs are directly attributable to the production of
goods or services. For example, 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 the breakup of the various cost
heads of Indian food major, Britannia Industries. We have compared each cost head to
the respective year’s sales figure also shown the change in expenses in absolute terms
and in terms of percentage (of sales).
Britannia Industries (Rs m)
FY07 FY08 Change
Items Amount % of Amount % of Amount % of
sales sales sales
Net Sales 21,993 100.0% 25,848 100.0% 17.5%
Expenditure
Consumption of Raw 14,004 63.7% 15,553 60.2% 11.1% -3.5%
Materials (i)
Employee costs (ii) 767 3.5% 905 3.5% 18.1% 0.0%
Advertising costs (iii) 1,357 6.2% 1,798 7.0% 32.5% 0.8%
Other expenditure (iv) 4,578 20.8% 5,274 20.4% 15.2% -0.4%
Total operating expenses 20,705 94.1% 23,531 91.0% 13.6% -3.1%
(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.
In the next article of this series, we will take a detailed look at interest
and depreciation costs and how one should analyse them .

CHAPTER 6

In the previous article of this series on investing, we had briefly looked


at how one could analyse a company’s expenses over a particular period. In today’s
article, we will 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.
To give an idea of how margins differ within each industry, we can take a look
at the table below.

Sector Operating margin range


Engineering 10% to 20%
Cement 13% to 33%
Retail* 7% to 11%
Pharma 10% to 24%
FMCG$ 13% to 15%
IT 26% to 30%
Telecom 27% to 37%
Hotels 18% to 40%
Power 15% to 20%
Automobiles# 8% to 16%
Steel^ 9% to 28%
Construction 12% to 23%

Source: CMIE, Equitymaster Research; * Trading companies; ^ Finished steel; # Including 2- and 4- wheeler manufacturers;

$ Non-food items

From the above table, we can notice that broadly, sectors such as telecom and
IT earn the highest operating margins, while sectors such as auto and FMCG garner
the lowest margins.
The telecom industry garners one of the highest margins mainly on account
of the advantage of operating leverage. As telecom companies need a selected amount

of mobile subscriptions (in turn, revenues) to cover its costs of networks, licences
and spectrum, any subscriber additions above that level will largely translate as profit
for the company.
On the other hand, the auto industry garners one of the lowest margins mainly
on account of stiff competition and high dependence on raw material costs
(in turn, realisations). An auto manufacturer may not be in a position to pass on the rise
in raw material cost to its customers to the full extent as it would end up its car sales
as customers would choose a cheaper alternative (stiff competition). For these reasons,
the auto industry remains a high-volume, low-margin business. Similar would be the case
for FMCG companies.
An example of a low-volume, high margin business would be that of software
products or heavy engineering. As software companies develop products in-house,
they are able to earn higher margins on their sales. But when compared to IT services,
the revenue is relatively much lower. Similarly for engineering companies,
when the component of pure engineering is high on a particular project,
the company tends to earn higher margins (on that particular project) as opposed
to pure construction or project activities.
It may be noted that these differences are largely intra-industry and not
inter-industry.
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. In the next article of this series, we shall take a
look at interest and depreciation costs and how one could view them.

CHAPTER 7

In the previous article of this series, we had discussed how operating margins
vary from one sector to another. In today’s article, we will take a look at the items that
come below operating profits- depreciation and interest.
Depreciation: Overtime, assets lose their productive capacity due to reasons such as
wear and tear, obsolescence, amongst others. As s result, their values deplete.
Companies need to account for this depletion in value. This amount is called
depreciation expense. Depreciation can also be viewed as matching the use of an
asset to the income that it helped the company generate. It may be noted that
it only represents the deterioration in value. As such, this expense is not a direct
cash expense.

Depreciation can be accounted in broadly two methods – straight line and


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

Year Value of asset Depreciation amount


FY08 10,000,000 1,000,000
FY09 9,000,000 1,000,000
FY10 8,000,000 1,000,000
FY11 7,000,000 1,000,000
FY12 6,000,000 1,000,000
FY13 5,000,000 1,000,000
FY14 4,000,000 1,000,000
FY15 3,000,000 1,000,000
FY16 2,000,000 1,000,000
FY17 1,000,000 1,000,000
FY18 0 -

Under the written down value (WDV) method, companies depreciate the
value of assets using a fixed percentage on the written down value. The written down
value is the original cost less the depreciation value till the end of the previous year.
As such, this results in higher depreciation during the earlier life of the asset and
lesser depreciation in the later years. An example of the same is shown below:
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.
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.

CHAPTER 8

In the previous article of this series, we had discussed about


depreciation and interest expenses. In today’s article, we will take a look at the items
that come below these – taxes, net 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.
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.


CHAPTER 9

In the previous article of this series, we had discussed about items that are
found at the bottom of the profit and loss account - taxes, net profits and appropriation.
In this article, we shall discuss about dividends and its impact on investors.
There are two ways in which an investor can profit from his investment in stocks.
One, through stock price appreciation, which we know can remain depressed for a
long duration even if the fundamentals of the underlying company are strong
enough. Another way to profit from an investment in a stock is through dividends.
Dividends, unlike stock prices, do not depend on the whims and the fancies
of the investor community at large. If the business is performing well and generating
cash in excess of what is required for growth, dividends are paid out irrespective of the
stock price movement.
As mentioned in the earlier article, a company can do two things with the profits
that it earns. It can either invest it back into the company (into reserves and surplus)
and/or pay out the amount as dividend. As such, dividend payout depends a lot on the
cash (after meeting its capital expenditure and working capital requirements) a
company generates during a year.
It quite often happens that many companies will not need to reinvest much
into the business (in spite of having high return on investments), purely because they
don’t see the need for it. A classic example would be of companies from the FMCG sector.
The FMCG sector is a slow yet steady growing industry. Most of the companies garner
high return on their investments in this sector. But yet they choose to pay out huge
dividends due to the sector's slow growing nature as capex requirements are on the
lower side.
Now if we compare this to say a fast growing industry such as telecom, the
situation is quite different. We shall explain this with the help of an example.
Telecom major, Bharti Airtel recently announced its maiden dividend of Rs 2 per share.
It may be noted that this was after being listed for seven years. The reason for not
paying dividends all these years, as attributed by its management, was the huge
capital expenditure programme to spread its wings across the entire country.
So, what has made the company announce a dividend this time around?
Crossing the peak capex requirement, the management has indicated.
Do all dividend paying companies make a good investment? The answer
is understandably no. This is where the aspect of 'dividend yield' comes into picture.
Dividend yield is calculated by dividing the amount paid out as dividend within a year
by the company's share price. An example will help in understanding this better.
Assuming a company's stock is trading at a price of Rs 100 and during FY09
it has paid a dividend 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.

CHAPTER 10

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 past few articles of this series, we discussed about the
various aspects of a profit and loss account, right from the topline till the appropriation
items. In the next few articles, 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.
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.
In the next article of this series, we will take a look at the key constituents
of the ‘Application of funds’ head.

CHAPTER 11

In the previous article of this series, we took a look at one of the components
of a balance sheet - ‘Source of funds’ and what its key constituents are. In the next
few articles, 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.
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 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.

CHAPTER 12

In the previous article of this series, we discussed one of the components


of the 'Application of funds' side of the balance sheet - Fixed assets. In this article
we shall take a look at another component - current assets.
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.

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 above formula, the outcome is 3 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-FMCGIndex. 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.
In the next article, we shall take a look at current liabilities and also briefly
glance through the topic of working capital. To read the previous articles in this
series, click on 'Investing: Back to basics'.

CHAPTER 13

In the previous article of this series, we discussed one of the components


of the 'Application of funds' side of the balance sheet - current assets. In this article we
shall take a look at another component - current liabilities and will also discuss about
working capital.
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
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.
In the next article, we shall discuss about investments and the different
types of investments found in companies' balance sheets. To read the previous articles
in this series, click on 'Investing: Back to basics'.

CHAPTER 14

In the previous article of this series, we discussed about current liabilities and
working capital. In this article, we shall conclude our discussion about the components
that make up a balance sheet by taking up the topic of 'investments' and the different
types of investments found in companies' balance sheets.
As defined in Accounting Standard 13 (AS-13) - "Investments are assets held
by an enterprise for earning income by way of dividends, interest, and rentals, for
capital appreciation, or for other benefits to the investing enterprise. Assets held as
stock-in-trade are not 'investments'."
Some of the investments found in companies' balance sheets include stocks,
bonds, mutual funds and investments made towards their subsidiaries or
associate companies.
Broadly investments can be categorised into four categories. They are as follows:
Current and long-term investments
Quoted and unquoted investments
Current and long-term investments: On a broader basis, investments are
classified as long-term and short terms investments. Current investments are
investments that are not intended to be held on for more than a year from the
date of purchase. An example of the same would be an investment in a liquid fund.
On the other hand, AS-13 states that an investment other than a current
investment is termed as a long term investment.
In the financial statements, current investments are valued at the lower of
cost and fair value. However, in the case of long term assets, it should be valued
at cost. However, it is mandatory for companies to make a provision for diminution
in value if there is a decline in the value of the investment. AS-13 has defined
fair value as - "Fair value is the amount for which an asset could be exchanged
between a knowledgeable, willing buyer and a knowledgeable, willing seller in
an arm's length transaction. Under appropriate circumstances, market value or net
realisable value provides an evidence of fair value." Apart from the actual cost of
the asset, the cost of an investment also includes acquisition charges such as brokerage,
fees and duties.
Further, as values of investments fluctuate from time to time, companies
need account for the same in their books (profit and loss account). It is
mandatory for companies to report the aggregate amount of quoted and
unquoted investments. They should also give the aggregate market value of
quoted investments as on the date of reporting.

You may also notice investments termed 'investment property' annual reports
of in some companies. This is nothing but an investment in land or buildings which
are not intended to be used or occupied by the investee. Such an investment is
considered as a long term investment.
Quoted and unquoted investments: Quoted investments are investments whose
value is easily assessable. Investment in the stock of companies which are listed on
stock exchanges would be the best example of quoted investments. This is because
market prices give these instruments a readily assessable value. Investment in
mutual funds would also classify as a quoted investment. On the other hand,
un-quoted investments are investments which do not have a readily available price.
Many a 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.
In the next article, we shall take a look at some of the key ratios associated
with the profit and loss account and the balance sheet. To read the previous articles
in this series, click on ‘Investing: Back to basics’.
CHAPTER 15

In the previous article of this series, we concluded our discussion about


the components that make up a balance sheet. In this article of this series, we
shall go though some of the key financial ratios associated with the profit and
loss account and the balance sheet.
Some of the key financial ratios are:
Return on equity (ROE)
Return on capital employed (ROCE)
Return on invested capital (ROIC)
Return on total assets (ROA)
Asset Turnover
Debt to equity ratio (D/E)
Interest coverage ratio

Return on equity (ROE) – ROE is probably the


most important ratio in the investing world. It helps in measuring the efficiency with
which a company utilises the equity capital. ROE reflects the efficiency with
which the management has 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.
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 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. To read the previous articles in this series, click on
‘Investing: Back to basics’.

CHAPTER 16

In the previous article of this series, we took a look at some of the key
financial ratios associated with the profit and loss account and the balance sheet.
In today’s article, we shall take a look at the cash flow statement.
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.
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 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.
In the next article of this series, we shall discuss one of the other two heads
cash flow from investing activities. To read the previous articles of this series,
click on 'Investing: Back to basics'.
CHAPTER 17

In the previous article of this series, we had taken a look at one of the
components of cash flow statement - cash flow from operations. In this article,
we shall discuss one of the other components of the cash flow statement -
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.

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.
In the next article of this series, we will look at the third component of the
cash flow statement, cash flow from financing activities. To read the previous
articles of this series, click on 'Investing: Back to basics'.

CHAPTER 18

In the previous article of this series, we had taken a look at one of the
components of cash flow statement - cash flow from investing activities. In this
article, we shall discuss the last component of the cash flow statement -
cash flow from financing activities. 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 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.
In the next article of this series, we shall look at some of the key ratios relating
to cash flow statements. To read the previous articles of this series,
click on 'Investing: Back to basics'.

CHAPTER 19

In the previous article of this series, we had taken a look at one of the
components of cash flow statement - cash flow from financing activities. In this
article, we shall discuss some of the key ratios relating to the cash flow 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 too 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
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.
To read the previous articles of this series, click on ‘Investing: Back to basics’.

CHAPTER 20

In the previous article of this series, 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 non-financial 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.
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.

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.
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.
In the next article of this series, we shall continue our discussion on the
financial statements of banks. To read the previous articles of this series, click on
‘Investing: Back to basics’.

CHAPTER 21

In the previous article of this series, we initiated our discussion on the


financial statements of banks. We discussed how different is a profit and loss statement
of a financial company as against that of a non-financial company. In this article,
we shall discuss some of the key ratios related to a bank's profit and loss statement.
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)
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 Bank’s 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
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%.
In the next article of this series, we shall continue our discussion on the
financial statements of banks. To read the previous articles of this series, click on
'Investing: Back to basics'.

CHAPTER 22

In the previous article of this series, we discussed some of the key ratios related
to a bank’s profit and loss account. We shall take forward our discussion on how the
accounts of financial organisations are different as compared to those of
non-manufacturing organisations. In this article, we will discuss a bank’s other
financial statement, the 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 non-financial 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.
In the next article of this series, we shall continue our discussion on the financial statements of
banks. To read the previous articles of this series, click on
'Investing: Back to basics'.
CHAPTER 23

In the previous article of this series, we discussed the 'Capital and Liabilities'
portion of a financial firm's balance sheet. In this article, 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).
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.
In the next article of this series, we shall continue our discussion on the
financial statements of banks. To read the previous articles of this series, click on
'Investing: Back to basics'.

CHAPTER 24
In the previous few articles of this series, we discussed the
two key sections - the 'Capital and Liabilities' and ‘Assets’ - of a
financial firm’s balance sheet. Prior to that we discussed the ‘Profit
and loss statement’ of a financial firm and some of the key ratios
related to it. In this article, we shall 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.
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


met 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

Key banking ratios-II: PSUs vs private BANKING SECTOR QUOTES

In one of our recent articles, we discussed about some of the key ratios relating to a bank's balance sheet
statement. Just to brush up our readers, some of the ratios that were discussed included:
 Credit to deposit ratio
 Capital adequacy ratio
 Non-performing asset ratio
 Provision coverage ratio
 Return on assets ratio
We thought it would be an interesting idea to look and compare these numbers for the leading private (HDFC
Bank, ICICI Bank and Axis Bank) and public sector (SBI, Punjab National Bank and Bank of Baroda) banks. In
addition, we will also see how the same ratios have changed over the past few years.
Credit to deposit 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.
Source Data: Equitymaster research
If we see the following chart, ICICI Bank distinctly stands out from its peers. A strong reason for the same would
be its aggressive nature. Further, PSU banks and Axis Bank have seen their ratios increase gradually over the
years. The credit to deposit ratio of HDFC Bank on the other hand, has been fairly stable.
Capital adequacy ratio: 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.
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.
Considering that the Indian banking sector has been growing at a strong pace, all the leading banks, both private
and public have been expanding operations at a strong pace. As such, their CAR ratios are well above the
prescribed limit of 9%. Private banks such as HDFC Bank, Axis Bank and ICICI Bank have in fact increased their
CAR over the past four to five years.

Source Data: Equitymaster research


As for the public banks, SBI and Punjab National Bank (PNB) have seen their CAR steadily expand over the
past few years as well. However, this ratio for Bank of Baroda has been fairly stable.
Non-performing asset 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.
Source Data: Equitymaster research
The NPA ratio is one of the most important ratios in the banking sector. It helps identify the quality of assets that
a bank possesses. If we look at the chart below, we can clearly see a differentiation between India’s largest
banks. A bank such as ICICI Bank would garner one of the highest NPA ratio amongst private banks on the back
of its aggressive nature. As the banks lends out strongly to customers, the chances of them defaulting also rises.
Plus, considering that private banks charge higher interest costs would only make things more difficult for its
customers. At the same time, the NPA ratio of a relatively much conservative bank such as HDFC Bank would
remain low. It is clearly evident from the above chart. The marginal spurt in this ratio during FY09 is due to its
acquisition of Centurion Bank of Punjab.
Further, Axis Bank has done well in the recent past to bring down its NPA ratio. So is the case for Bank of
Baroda (BoB). PNB has done well to keep its NPA levels low as well. As for India’s largest bank SBI, its NPAs
are relatively much higher than that of its PSU peers. This can also be attributed to its aggressive period over the
past few years.
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).

Source Data: Equitymaster research


On observing the above chart, we can notice that private banks such as HDFC Bank & ICICI Bank as also PNB
and Bank of Baroda have been quite conservative when it comes to covering their NPAs. Axis Bank on the other
hand has been extra conservative in the past few years. This explains the reason for the sharp improvement in
the NPA ratio as well. The same can however, not be said about SBI, which is the only large bank which has
seen its provision coverage ratio deteriorate over the past four years.
Return on assets ratio: Returns on asset (ROA) 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.

Source Data: Equitymaster research


While HDFC Bank has done well to maintain its ROAs over the past few years, that of ICIC Bank has been
gradually on a decline. The other banks, has however done well to improve their return ratio over the past few
years.
Conclusion
Looking at the above mentioned parameters, it would be quite easy to differentiate the aggressive banks from
the conservative ones. During good times and bad, banks such as HDFC Bank have managed to keep things
under control. Relatively aggressive banks such as ICICI Bank and SBI have been facing some problems.
Further, PNB, Axis Bank and Bank of Baroda have done well to improve their asset quality, return ratios over the
past few years as well.
It is recommended that you must not be prejudiced towards investing in stocks of only public or only private
sector banks. It is important to study various parameters related to financial statements of banks, compare them
to the peer group and also make sure that the stocks you pick meet your valuation criteria.