Sharekhan - Fundamental Analysis

2 3Which Company? Which Company?

Which Company?

Preface...........................................................................................4

Introduction: The Importance of Information.............................11

Fundamental Analysis: The Search for Intrinsic Value................19

CONTENTS

PART I : ECONOMIC ANALYSIS: 13

Politico-Economic Analysis................................................25

The Economic Cycle.............................................................34

Industry Analysis..................................................................38

THE MANAGEMENT ……………………………………………..50

THE COMPANY …………………………………………..............59

THE ANNUAL REPORT ………………………………………….63

A.The Director's Report …………………………………...64

B.The Auditor's Report ……………………………………66

C. Financial Statements …………………………………….70

D. Schedules and Notes to the Accounts ………………....82

RATIOS…………………………………………………………........86

A. Market Value ………………………………………........89

B. Earnings …………………………………………............94

C. Profitability …………………………………..................98

D. Liquidity …………………………………………..........104

E. Leverage ……………………………………..................112

F. Debt Service Capacity ……………..............................117

G. Asset-Management/Efficiency ……………………......121

H. Margins …………………………................................127

CASH FLOW ………………………………….............................135

Conclusion …………………………………..................................140

Fundamental Analysis: Quick Check List ……………………….142

PART II : INDUSTRY ANALYSIS: 37

PART III : COMPANY ANALYSIS: 48

to make him more wealthy then heever dreamed possible. The possibil-ity of this spurs him on. With thegrowth of IT Shares, Azim Premji ofWipro was for a brief period the sec-ond richest man in the world (afterBuffetting Warren Buffett for thatposition) and Infosys ChairmanNarayanamurthy of Infosys was, atone time, worth in excess of Rs.14000 crores. Prices of IT stockplummeted. Others not heard ofhave also moved tohuge highs.

During the lasttwo decades themanner of tradinghas changed - fromtraditional shopfloor (trading ring)to screen-based trad-ing with brokerslinked to the major stock exchanges.Most shares are now dematerialized- making sales/ purchases and trans-fers easy. Payment for shares sold, ismade within a few days.

Information has exploded. Atone time there was dearth. Now it islike a tornado. There are very goodreports on companies. There areprobing analysis done on perform-ance. There are studied forecastsmade. There are intelligent conclu-sions made. The information isthere. It can be accessed. The

investor must access it and havingaccessed it, he must, manage theinformation. In terms of investors the largest

investor segment is FinancialInstitutions and Mutual Funds.Foreign Institutional Investors (FIIs)and Non Resident Indians have asignificant presence. They accounttoday for a significant amount of theinvestments made in the market. Inthe end of July 2005 foreign institu-

tion investors byinvesting a littleover half a billiondollars raised thestock index bynearly 300 points.The Indian marketis, inspite of all thisstill rumour andinsider driven. Even

after the many scams shares, con-tinue to bought on the basis of tips,and for the short term. The averageinvestor does little or no research(even though more information thanhe can handle is available) andmakes his purchase or sale decisionon the strength of an article that hemay have read or a conversationwith a friend. This is usually becausethe average investor is unclear onhow to analyze companies and notequipped to arrive at an investmentdecision. Consequently, he buys and

5Preface4 Preface

Which Company?

he Indian capital market isvibrant and alive. Itsgrowth in the last twodecades has been phenom-

enal. In 1983, the market capitaliza-tion of the shares quoted in theBombay Stock exchange amountedto a mere $7 billion. It grew to $65billion in 1992, to $220 billion byApril 2000 and it is, at the end of2003, estimated at $432 billion.India ranks 7th in price index and4th in total return index.

The ride has been tumultuous.The interest and growth of the mar-ket began with the FERA dilutioni.e. when foreign companies dilutedtheir interest. The interest grew withspeculators and others entering thearena. Though one may question themeans, individuals such as the lateHarshad Mehta must be recognizedas individuals who did much to cre-

ate an awareness of the market andmake the average Indian Ram andSita invest in shares. The reformsfollowing the liberalization and theentering into this market of ForeignInstitutional Investors and MutualFunds coupled with scams anddownturns forced the individualinvestor out of the market. Thebursting of the dotcom bubble andthe Ketan Parekh scam punctuatedthe average investors' fears. It isinteresting to note that the individ-

ual who is investing in the thirdquarter 2003 boom in the markets isthe young investor - investors whohad not lost monies in the HarshadMehta or Ketan Parekh scams.

And yet, the investor dreamseven after he has been mauled. Thisis because man is essentially both anoptimist and a risktaker. The mar-ket excites him because of its ability

T

PrefaceRaghu Palat

““Fundamentalanalysis is forthe rational

man.

6 7Preface Preface

decision after careful thought andeliberation. Hegel once said, "Tothose who look upon the worldrationally, the world in its turn pres-ents a rational aspect".Fundamental analysis is for therational man.

This book is for the investor - behe or she an executive, a housewife,a professional, a student or a selfemployed person. My aim is tointroduce you to the world of infor-mation and analysis and to showyou how one can arrive at a buy orsell decision. By doing so I seek todiscourage you from acting onrumours or on tips and encourageyou to go by hard facts.

However, the investor must bewarned that the world is constantlychanging as a consequence of whichthe new situations arise which theinvestor must monitor.Consequently there is no fixed for-mula that will give one "wealthbeyond belief". If such a formulaexisted I wouldn't be writing thisbook. I would be out there in themarket accumulating that wealth.Analysis and information give onethe basis for a logical decision.There are other factors, especiallythe human factor, that are some-times not logical and cannot be pre-dicted.

To select the most promising

shares the investor faces obstacles.The first is in the assessment - thehuman fallibility factor. The secondis from the nature of the competi-tion. The third is from sheer perver-sity - the failure of the market to belogical. The investor may be wrongin his estimate of the future or evenif he is right the current price mayalready reflect what he is anticipat-ing. The point I am trying to stressthat in the end, the manner theprices of shares moved depend on ahost of factors. Yet the basic issueremains. The share must have value.Its fundamentals must be good. Itsmanagement must be competent.This book, which is aimed at youthe investor, will introduce you tothe world of fundamental analysisand guide you through the factorsthat you should look at before youbuy any shares.

The art of successful investmentlies in the choice of those industriesthat are most likely to grow in thefuture and then in identifying themost promising companies in theseindustries. There are however pit-falls in the approach and one mustbe careful. It must however beremembered that:

“The obvious prospects forphysical growth in a business do nottranslate into obvious profits forinvestors.”

Which Company?

sells with inadequate informationand often suffers needless losses. Atno time was this more evident thanin the first four months of 1992 andlater in 2000 when even prices of the"dogs" doubled. It was a period notdissimilar to Wall Street in the midsixties which Mr. Harold Q Masureloquently described in his book,“The Broker" In the super heatedeconomy of the late sixties there wasan illusion of endless prosperity. OnWall Street the bullswere rampant. Privatecompanies were goingpublic at arbitraryprices that generatedhuge profits for thepromoters. Mutualfunds were plungingrecklessly into newuntested issues.Glamour Stockssoared to premiumsthat discounted not only the futurebut the next millennium. Money, itseemed was spermatic.Properlyinvested in the womb of Wall Street,it would produce wildly proliferat-ing offspring. Thousands of newcomers opened accounts. Brokeragefirms expanded with quixotic opti-mism."

As I write this preface, the mar-ket after many years of lying downis sitting up. The rumour mill is

churning out figures with gay aban-don. "the market will grow to 8500by September 2005". Another says,"the market will rise to 10000 byMarch 2006. These are numbers'taken out of a hat'. They have nologic. They have no credibility. Yet,there are so many gullible investorswho, fueled by greed, buy and thenlive to regret it. Human nature hasnot changed.

I'd like you to dwell a momenton a thought byHarold Masur. Hesays, "Bargains areavailable during timesof extreme pessimism.Trouble is, when theso-called experts arewringing their hands,nobody has thecourage to buy".Rothschild echoed thiswhen he said, "Buy

when there is blood on the streets."J.P. Morgan when asked once by

an investor on his view of the mar-ket is said to have stated: "It willfluctuate." Some will rise while oth-ers will fall. The aim of the investormust be to buy when the price is lowand to sell when it is high.

Fundamental analysis is not forspeculators. It is for those who areprepared to study and analyze acompany; for those who arrive at a

“Buy when there

is blood onthe streets

Rothschild

“

8 9Preface Preface

investor to invest in stocks that havevalue; that have good fundamentals.Santayana once said, "Those whodo not remember the past are con-demned to return to it." BenjaminGraham added to this by saying,"To invest intelligently in securitiesone should be forearmed with anadequate knowledge of how the var-ious types of stocks have behavedunder varying conditions - some ofwhich one is likely to meet again inone's experience." This bookattempts to arm you.

Which Company?

“The experts do not havedependable ways of concentratingon the most promising companies inthe most promising industries.”

There could also be imbalanceson account of political happenings,speculations, demand and a host ofother reasons. Further, as AdamSmith said, "Even if, by some magic,you knew the future growth rate ofthe little darling you just discovered,you do not really know how themarket will capitalize that growth.Sometimes the market will paytwenty times earnings for companygrowing at an annual compoundedrate of 30 percent; sometimes it willpay sixty times earnings for thesame company. Sometime the mar-ket goes on a growth binge, espe-cially when bonds and the moretraditional securities do not seem tooffer intriguing alternatives. Atother times the alternatives areenticing enough to draw away someof the money that goes into pursu-ing growth. It all depends in the psy-chological climate of the time."

This is why he also said, "Youcan have no preconceived ideas.There are fundamentals in the mar-ket place, but the unexplored area isthe emotional area. All the chartsand breadth indicators and technicalpalavers are the statisticiansattempts to describe an emotional

state." This is why finance theory does

not support the belief that the fun-damental approach, or for that mat-ter any other approach be ittechnical analysis, random walk,etc. can consistently outperform themarket. However, fundamentalanalysis gives you a fighting chanceand it is because of this that I urgeyou to be familiar with it and prac-tice it when you go out to do battle.

I'd like to leave you with anobservation made by the thenFinance Minister, Mr. YashwantSinha on May 4, 2000 after offeringcertain tax sops at the budget ses-sion. He said, "I can appreciate amarket responding to fundamentals,but a market which responds torumours is irresponsible and silly.The BSE (Bombay Stock Exchange)is being driven by rumours, they willhave to behave more responsibly."

Benjamin Graham adds, "Theinvestors' chief problem is likely tobe himself. More money has beenmade and kept by ordinary peoplewho were temperamently wellsuited for the investment processthan by those who lacked this qual-ity even though they had extensiveknowledge of finance, accountingand stock market lore."

In summary the purpose of thisbook is to help you the individual

10

Which Company?

11The importance of information

This booklet is distributed as part of the Sharekhan First step to Investing Program. This booklet is meant for private circulation only and is not meant for sale.

This document is prepared for assistance only and is not intended to be and must alonenot be taken as the basis for an investment decision.

Theimportance ofinformation

Introduction to Fundamental Analysis

12 13The importance of information The importance of information

sense. As Gustave Le Bon observedin his "Psychologic des toules", thecrowd acts with a single-mindedpurpose and not very rationally.According to him the most strikingpeculiarity of a crowd is that "who-ever be the individuals that com-pose it, however like or unlike betheir mode of life, their occupa-tions, their characterof their intelligence,the fact that they havebeen transformed intoa crowd puts them inpossession of a sort ofcollective mind whichmakes them feel,think, and act in amanner different fromthat in which eachindividual of them would feel,think, and act were he in a state ofisolation." Le Bon speaks of thecrowd being in a state of hypnotizedfascination and the rational investorbecoming mindless in the sense thathe surrenders his rational thinkingmind to the domination of themood of the moment. The crowd inlate 1999 and early 2000 every-where and in India in 1992 acted onimpulse, on expectations and hopeand on hearsay fueled by greed. Theindex bloated like a balloon andlike a balloon it burst. It had to.Unfortunately at times such as these

the ones that lose are the smallinvestors who do not have their eyeon the market at all times nor dothey have the contacts/they wherewithal to know what is likely to behappening to the market.

Let us examine what happenedin the last twelve years. In 1992investors were buying on the flimsi-

est of reasons believ-ing there is no end tothe boom. I remem-ber a person advisingme to buy the sharesof a certain company.This was at the timenot a very wellknown company. Iasked him for someinformation - what

did the company do? Who were itsdirectors? How had it performed inthe last three years? He did notknow nor did he care. He hadreceived a tip that the price woulddouble and was passing it on.Another share that must be men-tioned was Karnataka Ball Bearings- a company whose share was lan-guishing in the low 20s. Sparked bya rumor that Harshad Mehta wasbuying the share price rose 60. then68 and went upto 180 all in matterof 10 days. It was then heard thatthe rumor about Harshad Mehta'sinterest in the share was false. The

Which Company?

he market, says Mr.Johnson in Adamsmith's The MoneyGame, is like a beautiful

woman- endlessly fascinating end-lessly complex, always changingalways mystifying. I have beenabsorbed and immersed since 1924and I know this is no science. It isan art. Now we have computers andall sorts of statistics but the marketis still the same and understandingthe market is still no easier. It is per-sonal intuition, sensing patterns ofbehavior. There is always some-thing unknown, undiscerned. Themarket is fascinating and addictiveand once you have entered it" it isfoolish to think that you can with-draw from the exchange after youhave tasted the sweetness of thehoney", De La Vega commented inthe seventeenth century.

The magic of the market is thepromise of great wealth. WarrenBuffett became several years ago theSecond richest man in the world.His net worth was estimated byForbes in September 2003 at 436billion. The wealth is entirely fromthe market - by managing an invest-ing company called Hathaway. Hebelieves in value investing - in fun-damental analysis. It is the promiseof great wealth, of emulating per-sons like Buffett and his gurus

Benjamin Graham and BernardBaruch that spurs investors on. Thislure was demonstrated in India in1992, at the end of the millennium(in the first 4 months of 2000) andfrom the end of the second quarterof 2003 when prices soared. Themanner in which these speculativedrives occur are similar and hap-pens with amazing frequency andregularity. This is not restricted toshares either. The tulip mania inHolland in the seventeenth centurysent their prices soaring. In 1992the rush to buy shares in India wasso great that ancestral land andfamily jewels were sold or pawnedin the overpowering, overwhelminggreed for riches. For a time pricesrose and then the bubble burst. Thisoccurred again in early 2000 wheninformation technology share pricesrose to phenomenal heights. Manyshrewd promoters changed thenames of their companies to"infotech" or added the word"infotech" to its name and made akilling in the market. The law ofgravity has to prevail and theirprices fell in March and April 2000dramatically supporting the truththat prices of companies will fall orrise to their true level in time. Theprices of shares rose at this time asthe crowd had taken over and therewas no place then for logic or good

T

“The crowdacts with a

single-mindedpurpose

Gustave Le BonVice-chairman, Fidelity

“


successful stock pickers of all time.He evolved a theory called the Zulutheory which submits that one mustknow all about the company andthe industry and any other factorthat may affect the company's per-formance. His argument was thatone could never lose if one has thisinformation. If the company is like-ly to do badly, one can sell and thenbuy shares to cover this when theprice falls, and vice versa. This is thephilosophy of professional and suc-cessful investors - informed invest-ing. And this is the foremost tenet offundamental analysis. As AdamSmith says, "There is no substitutefor information. The market is not aroulette wheel. Good research andgood ideas are the one absolutenecessity in the market place."

Fundamental analysis demands,nay insists, on information about acompany. It requires subjecting acompany's performance and itsfinancial statements to the mostpiercing scrutiny as well as theanalysis of the economy and theindustry in which the companyoperates. And the fundamentalistmakes his buy or sell decision on thebasis of his interpretation of theinformation that he receives, hisanalysis, and on the strength of hisexperience and investment maturi-ty.

All information is important andcan be grouped under the followingclassifications: a) Information about the economy. b) Information about governmentpolicy; taxation, levies, duties andothers. c) Information about the industry inwhich the company operates. d) Information about the company -its management, its performance, itssales and its products including itsperformance in relation to othersimilar companies. e) Information about consumer out-look, fashions and spending.

In India we are fortunate thatthere is greater awareness of theneed for information today thanever before and this need is beingaddressed by the media, researchersand professional investment con-sultants are addressing that need.

Internet The internet is a tremendous sourceof information. It can tell you aboutthe economy, company results, pro-files and a host of other informa-tion. Now you can even buy and sellshares instantly on the "net".

Media There are several investment andbusiness focused magazines, papersand directories that are available

Which Company?

share price plunged to 50 in 4 days.The original rumor raised its head.The price rose again to 120. Therumor was again condemned asfalse and the price fell. At that timeI spoke with a person intimatelyconnected with the Company. Hetold me that the Company was sickand that there was no activity. Itwas on the verge of being closeddown. The price had risen on theflimsiest of excuses and the crowdcomprising of otherwise intelligent,logical and rational human beingsacted irrationally and illogically. Alot of persons did make money onthe stock - but most lost, havingbought it with no other informationthat the rumor that Harshad Mehtawas buying the share. One wouldhave thought one learns. Not so. History repeats itself. At the end ofthe last century Indian shares espe-cially those related to InformationTechnology (IT) such as Wipro,Infosys (lovingly called Infy) andSatyam (Sify) began to be quoted inAmerica in the NASDAQ. With therise in NASDAQ, these sharesbegan rising and a wave feelingtook over that software is the newmantra and that the shares of all ITcompanies can only go one way -up. This began an upward move-ment that gained momentum everyday till prices became unreal. The

wise began to exit and as this tookroot prices began to fall. This had asnowballing effect and soon priceshad fallen by a half or over that.Then later when the dotcom boomoccurred, shares were priced on"stickiness of eyeballs". It is impos-sible to get more esoteric. Later in2000 people began buying sharesthat Ketan Parekh was purportedlybuying. The question that begas ananswer is “Will they never learn?”The answer probably is that man'sgreed is bottomless.

In 2003, prices have again begunmoving upwards. The sensex brokethrough the 5000 barrier and thereare some who claim that it willreach 6000 in six months/ one year/very soon. Many buy on the"strength" of these predictionswhich are all they are - predictions,hopes, expectations. Nothingbacked by logic or sense.

Fundamental analysis submitsthat no one should purchase a shareon a whim. Investment in shares isserious business and all aspects andfactors, however minor, must beanalyzed and considered. The bil-lionaire Jean Paul Getty, until hisdeath the richest man in the world,once said, "No one should buywithout knowing as much as possi-ble about the company that issuesit". Jim Slater was one of the most


share.These are the major sources of

information. One must train oneselfto listen and absorb informationthat is received. One should analyzeand interpret the information todetermine the profitable course ofaction to be taken. This is the essen-tial governing principle of funda-mental analysis - action only afterreceiving and analyzing informa-tion.

It is also extremely importantthat one acts swiftly on the informa-tion received as the person whoreceives it first will often be the per-son to profit most from it. That iswhat Rothschild did.

18 June 1815, was a date thatwill be remembered as the day whenone of the most decisive battles inEurope was fought - the day theDuke of Wellington pitted his75,000 English troops against the100,000 soldiers of Napoleon. Thebattle was momentous as the futureof Europe and the EuropeanColonies around the world restedon its outcome.

Investors in London were con-cerned and worried. As the Germanarmy under Marshal Von Blucherhad not joined his English allies atthe time the battle began, there wasconcern that he would be too late asa consequence of which Englandwould lose the battle. The British

East India Company's trade withIndia and China was threatened.There was fear that its allies mightdesert England. The future of theEnglish Empire was at stake.

Investors awaited news, NathanRothschild of the House ofRothschild, a leading merchantbanker, aware of the importance ofinformation, had invested a consid-erable sum to develop a privateintelligence system. This was wellknown. It was also well known thatRothschild had invested heavily onan English victory. As soon as thewar was over, Rothschild's agentsdispatched to him carrier pigeonswith the result of the war in code.When they arrived, well before theofficial dispatches, Rothschildbegan to sell every thing he owned.In the belief that the English hadlost, investors panicked and beganto sell. The market collapsed. In thedepressed market, Rothschildstepped in and with his agentsbought and bought. Within hoursthe news of Wellington's victorysent the market booming. By thismanouvre, Rothschild earned onemillion pounds, a fabulous amountat that time and it is this that ledhim to state, “the best time to buy iswhen blood is running in thestreets”.

Which Company?

today that discuss the economy,industries and individual compa-nies. These contain articles of a highstandard that analyze industries andcompanies in depth. They also con-tain knowledgeable articles on tax,investment strategies, finance andallied subjects.

I would insist that the seriousinvestor should read at least onegood financial paper every day andtwo magazines a month. This oughtto keep him well informed.

Investment NewslettersThere are several professionalinvestment managers and expertswho publish investment informa-tion. This is extremely useful as theyare often very up to date and con-tain information not generally avail-able to the investor.

Insiders Insiders are persons who work for acompany or who have intimatedealings with a company and haveaccess to, or are aware of informa-tion that is not generally known.This could be information on theperformance of the company orrights or bonus issues or some otherrelevant news. As the information isnot known to all, the investor mustact fast if he wishes to make akilling. The Securities Exchange

Board of India (SEBI) has publishedregulations prohibiting insider trad-ing. I would also caution againstinsider trading; apart from the factthat it is against SEBI rules and thelaw, it is fraught with other risks.Edwin Leferre, in his book,Reminiscences of a Stockbrokeralso warned against it saying, "WallStreet professionals know that act-ing on inside tips will break a manmore quickly than famine, pesti-lence, crop failure, political read-justments or what may be callednormal accidents."

Seminars and Lectures byinvestment expertsExcellent seminars and lecture arebeing held in the country. These areconducted by eminent individualsand one can pick up a lot of infor-mation attending these lectures.These may be on how an industry isdoing, their view of an industry andthe like. One can even sharethoughts with those they meet. Thiscan result in forming opinions.Acting on these opinions could beprofitable.

StockbrokersStockbrokers are always in touchwith companies and are normallyaware of their performance andother factors affecting the price of a

19Fundamental analysis18 Fundamental analysis

Which Company?

undamental analysis isbased on the premise thatevery share has a certainintrinsic value at a period

of time. This intrinsic value changesfrom time to time as a consequenceof both internal and external fac-tors. The theory of fundamentalanalysis submits that one shouldpurchase a share when it is availablebelow its intrinsic value and sell itwhen it rises above its intrinsicvalue. When the market value ofshare is below its intrinsic value it isunder valued, whereas if the marketvalue of a share is above its intrinsicvalue it is over valued.Fundamentalists thus seek to pur-chase underpriced shares and selloverpriced ones. They believe thatalthough the market price may devi-ate from the intrinsic value in theshort term, in the long term the

market price will be equal to theintrinsic value. Calculation of Intrinsic value How does one calculate the intrinsicvalue of a share? Let us assume thatone expects a return of 20% on aninvestment every year for 3 years.Let us also assume that the compa-ny would pay dividends of 20%,25% and 30% on its Rs.10 share.The dividend received on a sharewould therefore be Rs.2.00 in thefirst year, Rs.2.50 in the second,and Rs.3.00 in the third. Let us alsoassume that the share can be sold atRs.200 at the end of 3 years. Theintrinsic value of the share will be:

2 + 2.5 + 3 + 200 = Rs.120.88 1.2 (1.2)2 (1.2)3

The logic is to discount the dividendreceived and anticipated to be

received infuture yearsand thee x p e c t e dprice at afuture datewith thereturn ory i e l dexpec t ed .Since theprice at thatfuture date

F

WHAT IS INTRINSIC VALUE AND HOW IS IT DETERMINED?What is the intrinsic value of a share? How is itdetermined? Fundamental analysis propoundsthat the intrinsic value is, and has to be, based onthe benefits that accrue to investors in the share.As the return to shareholders is in the form of div-idends, under strict fundamental analysis, thepresent value of future, dividends discounted onthe basis of its perceived safety or risk is its intrin-sic value. The intrinsic value is based on the divi-dend because that is what a shareholder orinvestor receives from a company, and not on theearnings per share of the company. This distinction is very important.

ANALYSISThe Search for Intrinsic Value

fundamental


Which Company?

lows depending on its financialstrength and stage of growth.Blue Chip2+ 2.5 + 3 + 200 = Rs.133.63 1.16 (1.16)2 (1.16)3

Mature Share 2+ 2.5 + 3 + 200 = Rs.130.28 1.17 (1.17)2 (1.17)3

Growing Company 2+ 2.5 + 3 + 200 = Rs.127.04 1.18 (1.18)2 (1.18)3

New Company 2+ 2.5 + 3 + 200 = Rs.123.91 1.19 (1.19)2 (1.19)3

It would be noted that the safer theshare, the higher its intrinsic value.

There is however one factor thatis assumed or estimated and that isthe price at the end of three years.The most reasonable method (eventhough this is arguable), in my opin-ion is basing the price on a priceearnings multiple.

The price earnings multiple orP/E of a share is its market pricedivided by its earnings per share. Ifa company has earned Rs.7 pershare in the current year represent-ing a growth of 20% and if it is con-servatively believed that the earn-ings per share (EPS) will grow 15%

every year.

EPS at the end of: Year 1 will be Rs.7.70

Year 2 will be Rs.8.47

Year 3 will be Rs.9.32

If it is believed that a reasonable P/Efor a company of such a size in thatindustry should be 15, the marketprice at the end of 3 years would be9.32 x 15 = Rs.139.80.

Let us now look at a real exam-ple. On 31 May 2000 the price ofthe shares of a company wasRs.465. The company declared adividend of 65% for the year endedMarch 31 2000, and an earningsper share of Rs.13.3. If we assumethat this dividend will remain con-stant, and that a P/E of 20 is reason-able, the intrinsic value of the com-pany's share should be Rs.266.

If the company's earnings growat 20% per year the EPS at the endof 3 years would be Rs.22.98 (13.3x 1.20 x 1.20 x 1.20). On thatassumption, the price at the end of3 years would be Rs.459.60 (EPS xP/E of 20). Based on an expectedreturn of 20% the intrinsic valuetoday will therefore be: 6.5+ 6.5 + 6.5+ 459.60= Rs.279.66 1.20(1.20)2 (1.20)3

is also considered, the possibility ofcapital appreciation is consideredand this is why this method of arriv-ing at the intrinsic value is consid-ered the most balanced and fair.

If the market price of the share isbelow Rs.120.88 then the share isbelow its intrinsic value and there-fore well worth purchasing. If, onthe other hand, the market price ishigher, it is a sell signal and theshare should be sold.

Considerations It must be noted that the intrinsicvalue of a share can and will be dif-ferent for different individuals. If, inregard to the above mentionedinvestment another individual(Kumar) expects a return of 16%whereas a third individual (Nair)expects a return of 25% the intrin-sic value (assuming the dividendsand the sale value at the end of 3years will remain the same will be):

Intrinsic value for Kumar

2+ 2.5 + 3 + 200 = Rs.133.63 1.16 (1.16)2 (1.16)3

Intrinsic value for Nair

2+ 2.5 + 3 + 200 = Rs.107.14 1.25 (1.25)2 (1.25)3

Thus if the market price isRs.120.88, the first individual (letus call him Siddarth) will hold ontothe share whereas Nair would sellthe share and Kumar would pur-chase it.

In short, the intrinsic value of ashare will vary from individual toindividual and will be dependantboth on that individual's ability tobear risks and the return that indi-vidual expects.

It is prudent and logical toremove this anomaly. The returnexpected should be the return onecan expect from an alternate, rea-sonably safe investment in that mar-ket. This rate should be bolstered bya risk factor as the return is greaterfrom riskier investments. A verysafe investment (blue chip) will havea risk rate of 0. A mature near bluechip share will have a risk rate of 1.

A growing company will haverisk rate of 2. A risky new companywill have a risk rate of 3. If it isassumed that the return one canexpect from a unreasonably safeinvestment (an investment say withthe Unit Trust of India) is 16% andthe dividend expected is Rs.2 in thefirst year, Rs.2.5 in the second yearand Rs.3 in the third year and theanticipated sale price is expected tobe Rs.200, the intrinsic value of theshare of the company will be as fol-


Which Company?

market price, therefore, at everypoint in time represents the latestposition at all times. The efficientmarket theory submits it is not pos-sible to make profits looking at olddata or by studying the patterns ofprevious price changes. It assumesthat all foreseeable events havealready been built into the currentmarket price. Thus, to work out thelikely futureprice at afuture date inorder todetermine theshare's pres-ent intrinsicvalue, funda-m e n t a l i s t sdevote timeand effort toascertain the effect of various hap-penings (present and future) on theprofitability of the company and itslikely results. This must also includethe possibility of the company issu-ing bonus shares or offering rightsshares.

The most important factor infundamental analysis is information

- information about the economy,the industry and the company itself- any information that can affect thegrowth and profitability of the com-pany and it is because of this funda-mental analysis is broken into threedistinct parts:

1.The economy,2.The industry within which the

c o m p a n yo p e r a t e s ,and 3.The com-pany.

T h einformationhas to beinterpretedand ana-lyzed and

the intrinsic value of the sharedetermined. This intrinsic valuemust, then, be compared against themarket value the fundamentalistssay, and only then can an invest-ment decision be taken.

1.THE ECONOMY

2.THE INDUSTRY WITHIN WHICH THECOMPANY OPERATES, AND

3.THE COMPANY

3 Distinct parts of fundamental analysis

The company's share price atRs.465 was nearly 67% above itsintrinsic value and on the basis ofthis submission should be sold.

The price of a 100% export ori-ented unit on 31 May 2000 was160. Its profit in the year to 31March 2000 had grown by 60% toRs.17.88 crore. Its earnings pershare at Rs.10.26 was an improve-ment of 23%. If we assume that inthe next 2 years its EPs will grow by20%, the EPS at the end of 2 yearswould be Rs.14.77. At a P/E of 15,its market price at the end of 2 yearswould be Rs.221.55. In 2000, thecompany paid a dividend of 25%.On the assumption that the dividendof 25% will be maintained in 2001,and that it will rise to 30% in 2002,its intrinsic value on an expectedreturn of 20% would be :

2.5 + 3.0 + 221.55 = Rs.158.02 1.2 (1.2)2

Its intrinsic value of Rs.158.02 wasvery close to the market value ofRs.160. If however, one expects areturn of 25% as that export orient-ed unit is a relatively new company,the intrinsic value would be:

2.5 + 3.0 + 221.55 = Rs.145.71 1.25 (1.2)2

At an expected return of 25% themarket value of Rs.160 was higherthan the intrinsic value of Rs.145.71and the share should be sold.

The subjective assumptionsmade in arriving at the intrinsicvalue results in the intrinsic value ofa share being different for differentindividuals. In the example detailedabove, the intrinsic value of thatcompany share would be Rs.158.02for an investor who expects a returnof 20% whereas it would beRs.145.71 for an individual expect-ing a return of 25%. The otherassumptions too are subjective, i.e.the expected price at the end of aperiod, and the anticipated divi-dends during the period.

This method, however, isextremely logical. It considers hedividends that will be paid and thelikely capital appreciation that willtake place.

Efficient Market Theory Fundamental analysts often use theefficient market theory in determin-ing the intrinsic price of a share.This theory submits that in an effi-cient market all investors receiveinformation instantly and that it isunderstood and analyzed by all themarket players and is immediatelyreflected in the market prices. The

25Politico-economic analysis24

Which Company?

ANALYSIS

Politico-Economic

PART I- CHAPTER ONE

ANALYSISEconomic

PART I

27Politico-economic analysis26 Politico-economic analysis

Which Company?

USSR was one of India's biggestpurchasers. When that enormouscountry broke up into theConfederation of IndependentStates, Indian exports declined andthis affected the profitability ofcompanies who had to search forother markets. Wars have a similareffect. The war in Croatia, inKosovo, in Africa, the Gulf war andother wars have had an effect onexports of goods. The tragedy of9/11 (September 9 when two planescrashed into the World TradeCenter at New York), affected theentire world. Many industries areyet to fully recover. Similarly theSARS epidemic that affected SouthEast Asia affected trade andtourism.

The other gnawing politicalissue that has been a thorn in India'sback is the Pakistan issue. The dete-rioration in our relationship culmi-nated in 1999 in the war in Kargil.Earlier we have fought several warson Kashmir and other issues. In2005 there has been an improve-ment in the relationship. One won-ders whether this thorn will cease tobe a thorn in time. The deteriora-tion in our relationship culminatedin 1999 in the war in Kargil. Earlierwe have fought several wars onKashmir and other issues. Warspush up inflation and demand

declines. It is estimated that theGulf War cost India $1.5 billion onaccount of higher prices of petrole-um products, opportunity costs andfall in exports. The defence budgetis enormous. This money couldhave been spent elsewhere for thedevelopment of the country. Otherexamples include Sri Lanka, EastEurope and other troubled coun-tries. These countries were oncethriving. No longer. Let us take theexample of Sri Lanka. It is a beauti-ful island and was considered a par-adise for tourists - a pearl in theocean. The country is in the grips ofa civil war. The northern part of thecountry, which was once thriving, isin the hands of Tamil guerillas andthere is no industry and little eco-nomic activity. Idi Amin in the sev-enties by expelling Asians fromUganda did that country's economyirreparable harm. In 1997-98, dueto the elections and then the bomb-ing of the American embassy, theeconomy of Kenya tailspinned tonegative growth. Then a few yearslater as the economy was recover-ing, the Mombasa bombings againset it back.

In conclusion, the political sta-bility of a country is of paramountimportance. No industry or compa-ny can grow and prosper in themidst of political turmoil.

wise man once said, "Noman is an island". Noperson can work and livein isolation. External

forces are constantly influencing anindividual's actions and affectinghim. Similarly, no industry or com-pany can exist in isolation. It mayhave splendid managers and atremendous product. However, itssales and its costs are affected byfactors, some of which are beyondits control - the world economy,price inflation, taxes and a host ofothers. It is important, therefore, tohave an appreciation of the politico-economic factors that affect anindustry and a company.

The political equation A stable political environment is

necessary for steady, balancedgrowth. If a country is ruled by astable government which takes deci-sions for the long-term developmentof the country, industry and compa-nies will prosper. On the otherhand, instability causes insecurity,especially if there is the possibilityof a government being ousted andreplaced by another that holds dia-metrically different political andeconomic beliefs.

India has gone through a fairlydifficult period. There had been ter-rible political instability after the

ouster of Mr. Narasimha Rao fromthe Prime Ministership. Successiveelections held did not give any sin-gle political party a clear majorityand mandate. As a result there werecoalitions of unlikes. These led toconsiderable jockeying for powerand led to the breakup of the gov-ernments and fresh elections.

There has also been much grandstanding such as the Mandal recom-mendations in order to capturevotes. These led to riots. There wereother religious and ethnic issuesthat also led to violence such as theBabri Masjid/Ram Janmabhoomiissue. All these shook the confi-dence of the developed world in thesecurity and stability of India.Tourism fell.

Foreign Direct Investment fell.Investments were held back. Thesehad an adverse impact on the devel-opment of the economy. In recenttimes this scenario has changed.

The Government, even though acoalition has been stable. Its policieshave beren positive and the econo-my has been doing well. There arepredictions that by 2050, Indiawould be one of the three mostpowerful nations in the world. Thishas led to renewed interest in Indiaand investors are back.

International events too impactindustries and companies. The

A


Which Company?

imports more expensive and if acompany is dependent on imports,margins can get reduced. On theother hand, a devaluation in thecountry to which one exportswould make the company's prod-ucts more expensive and this canadversely impact sales. A method bywhich foreign exchange risks can behedged is by entering into forwardcontracts, i.e. advance purchase orsale of foreign exchange therebycrystallizing the exposure.

In India our currency has beenappreciating against the dollar.Thus, the threat investors or recipi-ents of dollars face is that the rupeesthat they finally receive is less thanthat they expected. This is an aboutturn from the situation earlier. As aconsequence many have begunquoting in rupees.

Restrictive Practices Restrictive practices or cartels

imposed by countries can affectcompanies and industries. TheUnited States of America hasrestrictions regarding the imports ofa variety of articles such as textiles.

Licenses are given and amountsthat may be imported from compa-nies and countries are clearlydetailed. Similarly, India has a num-ber of restrictions on what may beimported and at what rate of duty.

To an extent this determines theprices at which goods can be sold. Ifthe domestic industry is to be sup-ported, the duties levied may beincreased resulting in importsbecoming unattractive.

During the last two years Indiancustoms duties have been reduceddrastically. Imports are consequent-ly much cheaper and this has affect-ed several industries.

When viewing a company, it isimportant to see how sensitive it isto governmental policies andrestrictive practices.

Foreign Debt and the Balanceof TradeForeign debt, especially if it is verylarge, can be a tremendous burdenon an economy. India pays around$ 5 billion a year in principal repay-ments and interest payments. This isno small sum. This has been theprice the country has had to pay dueto our imports being far in excess ofexports and an adverse balance ofpayments. At the time the countrydid borrow, it had no alternative.

In 1991, at the time of devalua-tion, India had only enough foreignexchange to finance the imports offew weeks. It is to reverse this thatthe government did borrow fromthe World Bank and devalue thecurrency.

Foreign Exchange Reserves A country needs foreign exchangereserves to meet its commitments,pay for its imports and service for-eign debts. Without foreignexchange, a country would not beable to import materials or goodsfor its development and there is alsoa loss of international confidence insuch a country. In 1991, India wasforced to devalue the rupee as ourforeign exchange reserves were, at$532 million very low, barelyenough for few weeks imports. Thecrisis was averted at that time by anIMF loan, the pledging of gold, andthe devaluation of the rupee.

Several North American bankshad to write off large loansadvanced to South American coun-tries when these countries wereunable to make repayments. CertainAfrican countries too have very lowforeign exchange reserves.

Companies exporting to suchcountries have to be careful as theimporting companies may not beable to pay for their purchasesbecause the country does not haveadequate foreign exchange. I knowof an Indian company which hadexported machines to an Africancompany a few years ago. Theimporting company paid the moneyto its bank. It lies there still. The

payment could not be sent to Indiaas the central bank refused the for-eign exchange to make the pay-ment. Following the liberalizationmoves initiated by the NarasimhaRao Government and endorsed/sup-ported by successive governments,India had by 31 December 1999foreign investments in excess of $28billion. In May 2000, the foreignexchange reserves had swelled toover $38.4 billion - a far cry fromthe $500 million of reserves in1991. In 2003, the reserves are inexcess of $100 billion.

The problem the Reserve Bankof India now faces is managing thehuge reserves. In order to discour-age short term flows, the ReserveBank has lowered interest rates andeven mandated that the interestpaid should not exceed 25 basispoints over LIBOR on foreign cur-rency funds and Non- residentdeposits.

Foreign Exchange Risk This is a real risk and one must becognizant of the effect of a revalua-tion or devaluation of the currencyeither in the home country or in thecountry the company deals in.

A devaluation in the home coun-try would make the company'sproducts more attractive in othercountries. It would also make


Which Company?

Taxation The level of taxation in a countryhas a direct effect on the economy.If tax rates are low, people havemore disposable income. In addi-tion they have an incentive to workharder and earn more. And anincentive to invest. This is good forthe economy. It is interesting tonote that in every economy there isa level between 35% to 55% wheretax collection will be the highest.While the tax rates may go up, col-lection will decline. This is whythere it has been argued that therates in India must be lowered.

Government Policy Government policy has a directimpact on the economy. A govern-ment that is perceived to be pro-industry will attract investment.The liberalization policies of theNarsimha Rao government excitedthe developed world and foreigncompanies grew keen to invest inIndia and increase their existingstakes in their Indian ventures. Theinitiative of the former BJP govern-ment in improving the infrastruc-ture grabbed the attention of for-eign investors. The present govern-ment continues to focus on infra-structure as it is realized progress ata decent rate would not be possiblewithout infrastructure.

Domestic Savings and itsUtilizationIf utilized productively, domesticsavings can accelerate economicgrowth. India has one of the largestrate of savings (22%). In USA, it isonly 2% whereas in Japan it is ashigh as 23%. Japan's growth wason account of its domestic savingsinvested profitably and efficiently.Although India's savings are high,these savings have not been investedeither wisely or well. Consequently,there has been little growth. It is tobe remembered that all investmentsare born out of savings. Borrowedfunds invested have to be returned.Investments from savings leads togreater consumption in the future.This has been recognized by theGovernment and it was in order todivert savings to industry the 1992Finance Act stipulated that produc-tive assets of individuals (shares,debentures, etc.) would not be liablefor wealth tax.

The Infrastructure The development of an economy isdependent on its infrastructure.Industry needs electricity to manu-facture and roads to transportgoods. Bad infrastructure leads toinefficiencies, poor productivity,wastage and delays. This is possiblythe reason why the 1993 budget lay

A permanent solution will resultonly when the inflow of foreign cur-rency exceeds the outflow and it ison account of this that tourism,exports and exchange earning/sav-ing industries are encouraged.

Inflation Inflation has an enormous effect

in the economy. Within the countryit erodes purchasing power. As aconsequence, demand falls. If therate of inflation in the country fromwhich a company imports is highthen the cost of production in thatcountry will automatically go up.

This might reduce the cost com-petitiveness of the product finallymanufactured. Conversely, if therate of inflation in the country towhich one exports is high, the prod-ucts become more attractive result-ing in increased sales.

The USA and Europe have fairlylow inflation rates (below 2%). InIndia, inflation has been fallingsteadily in recent times. It is current-ly estimated between 3.7% and 4%.In South America, at one time, itwas over 1000%. Money there hadno real value. Ironically, SouthAmerican exports become attractiveon account of galloping inflationand the consequent devaluation oftheir currency which makes theirproducts cheaper in the internation-

al markets. Low inflation within a country

indicates stability and domesticcompanies and industries prosper atsuch times.

The Threat of Nationalization The threat of nationalization is areal threat in many countries - thefear that a company may becomenationalized.

With very few exceptions,nationalized companies are histori-cally less efficient than their privatesector counterparts. If one isdependent on a company for certainsupplies, nationalization couldresult in supplies becoming erratic.In addition, the fear of nationaliza-tion chokes private investment andthere could be a flight of capital toother countries.

Interest Rates A low interest rate stimulatesinvestment and industry.Conversely, high interest rates resultin higher cost of production andlower consumption. When the costof money is high, a company's com-petitiveness decreases. In India, the government, throughthe Reserve Bank, has been success-ful in lowering interest rates.Increasing competition amongbanks has also helped.

33The economic cycle32 Politico-economic analysis

Which Company?

CYCLEEconomic

PART I- CHAPTER TWO

The

so much emphasis, and offered somany benefits, to infrastructuralindustries, such as power and trans-portation. In recent years there hasbeen greater emphasis. Flyovershave been built, national highwaysare being widened and made betterand the improvements made incommunications is awesome.

Budgetary Deficit A budgetary deficit occurs whengovernmental expenditure exceedsits income. Expenditure stimulatesthe economy by creating jobs andstimulating demand. However, thiscan also lead to deficit financingand inflation. Both these, if notchecked, can result in spiralingprices. To control and cut deficitsgovernments normally cut govern-mental expenditure. This wouldalso result in a fall in money supplyand a consequent fall in demandwhich will check inflation.

All developing economies sufferfrom budget deficits as governmentsspend to improve the infrastructure- build roads, power stations andthe like. India is no exception.

Budget deficits have been high. Thegovernment has, to reduce inflationconsciously cut expenditure downand it has reduced from a high ofaround 15% few years ago to a lit-tle over 7% today.MonsoonsThe Indian economy is an agrarianone and it is therefore extremelydependent on the monsoon.Economic activity often comes to astand still in late March and earlyApril as people wait to see whetherthe monsoon is likely to be good ornot.

Employment High employment is required toachieve a good growth in nationalincome. As the population growthis faster than the economic growthunemployment is increasing. This isnot good for the economy.

35The economic cycle34 The economic cycle

Which Company?

in fully, profits begin to grow at ahigher proportionate rate. Moreand more new companies arefloated to meet the increasingdemand in the economy. In India2003 could be seen as a year ofrecovery. All the attributes of arecovery are evident in the economy.

Boom In the boom phase, demand reachesan all time high. Investment is alsohigh. Interest rates are low.Gradually as time goes on, supplybegins to exceed the demand. Pricesthat had been rising begin to stabi-lize and even fall. There is anincrease in demand. Then as theboom period matures prices begin torise again.

Recession The economy slowly begins todownturn. Demand starts falling.Interest rates and inflation Demandstarts falling. Interest rates andinflation are high. Companies startfinding it difficult to sell their goods.The economy slowly begins todownturn. Demand starts falling.Interest rates and inflation begin toincrease. Companies start finding itdifficult to sell their goods. Indiawent through a terrible recession for4 years from 1996.

The Investment Decision Investors should attempt to deter-mine the stage of the economic cyclethe country is in. They should investat the end of a depression when theeconomy begins to recover.Investors should disinvest either justbefore or during the boom, or, at theworst, just after the boom.Investment and disinvestmentsmade at these times will earn theinvestor greater benefits.

It must however be noted thatthere is no rule or law that statesthat a recession would last a certainnumber of years, or that a boomwould be for a definite period oftime. Hence the length of previouscycles should not be used as a meas-ure to forecast the length of an exist-ing cycle. An investor should also beaware that government policy orother events can reverse a stage andit is therefore imperative thatinvestors analyze the impact of gov-ernment and political decisions onthe economy before making the finalinvestment decision. JosephSchumpeter once said, “Cycles arenot, like tonsils, separable thingsthat might be treated by themselvesbut are, like the beat of the heart, ofthe essence of organism that dis-plays them.”

ountries go through thebusiness or economiccycle and the stage of thecycle at which a country

is in has a direct impact both onindustry and individual companies.It affects investment decisions,employment, demand and the prof-itability of companies. While someindustries such as shipping or con-sumer durable goods are greatlyaffected by the business cycle, otherssuch as the food or health industryare not affected to the same extent.This is because in regard to certainproducts consumers can postponetheir purchase decisions, whereas incertain others they cannot.

The four stages of an economiccycle are:

Depression Recovery Boom Recession

Depression At the time of depression,demand is low and falling.Inflation is high and so areinterest rates. Companies,crippled by high borrowingand falling sales, are forcedto curtail production, closedown plants built at times

of higher demand, and let workersgo.

The United States went througha depression in the late seventies.The economy recovered and theeighties was a period of boom.Another downturn occurred in thelate eighties and early nineties, espe-cially after the Gulf War. The recov-ery of the US economy and that ofthe rest of Western Europe beganagain in 1993. Later the US againwent through a period of depressionat the turn of the millennium. Indiatoo went through a difficult periodand it began its recovery in 2002.

Recovery During this phase, the economybegins to recover. Investment beginsanew and the demand grows.Companies begin to post profits.Conspicuous spending begins onceagain. Once the recovery stage sets

C

The four stages of an economic cycle are:

37Industry analysis36 Industry analysis

Which Company?

he importance ofindustry analysis is nowdawning on the Indianinvestor as never before.

Previously, investors purchasedshares of companies without con-cerning themselves about the indus-try it operated in. And they couldget away with it three decades ago.This was because India was a sell-ers' market at that time and prod-ucts produced were certain to besold, often at a premium. Thosehappy days are over.

Now, there is intense competi-tion. Consumers have now becomequality, cost and fashion conscious.Foreign goods are easily availableand Indian goods have to competewith these. There are great techno-logical advances and "state of theart" equipment becomes obsolete ina few years. If not months. In thelate 1970s and early 1980s, moviecameras and projectors were prizedpossessions. With the advent of thevideo camera in the mid 80s theybecame obsolete. In 1988, laptopcomputers were the "in" thing.Everyone raved about the inventionand how technology could com-press a huge computer into such asmall box. These early models didnot have a hard disk but two fixeddisk drives. A few months later harddisks were incorporated, initially

having a capacity of 20 megabytes.The memory was then increased to40 megabytes. In eighteen months,the laptop became obsolete with thecreation of the notebook. Thesenotebooks, some having a capacityof as much as 120 megabytes, arestill not the last word in compressedcomputing. The palm tops havenow arrived. Mobile phones todayhave computing capabilities. Onereally and honestly does not knowwhat will be next.

I have used these examples toillustrate how technologicaladvances make a highly regardedproduct obsolete. In the same way,technological advances in oneindustry can affect another indus-try. The jute industry went intodecline when alternate and cheaperpacking materials began to be used.The popularity of cotton clothes inthe West affected the manmade(synthetic) textile industry. Aninvestor must therefore examine theindustry in which a company oper-ates because this can have a tremen-dous effect on its results, and evenits existence. A company's manage-ment may be superior, its balancesheet strong and its reputation envi-able. However, the company maynot have diversified and the indus-try within which it operates may bein a depression. This can result in a

T

ANALYSISIndustry

PART II


Which Company?

tionally readable magazine.However, it did not have thefinance needed in those critical ini-tial years to keep it afloat and hadto fold up. Had it, at that time, hadthe finance it needed it may havesurvived and thrived.

In short, at this stage investorstake a high risk in the hope of greatreward should the product succeed.

The Expansion or GrowthStage Once the industry has establisheditself it enters a growth stage. As theindustry grows, many new compa-nies enter the industry.

At this stage, investors can gethigh reward at low risk sincedemand outstrips supply. In 2000, agood example was the Indian soft-ware industry.

In 2003, the BPO industry isarguably in the growth stage. Themobile phone industry is also in thegrowth stage - with newer modelsand newer entrants.

The growth stage also witnessesproduct improvements by compa-nies that have survived the firststage. In fact, such companies areoften able to even lower their prices.Investors are more keen to invest atthis time as companies would havedemonstrated their ability to sur-vive.

The Stabilization or MaturityStageAfter the halcyon days of growth,an industry matures and stabilizes.Rewards are low and so too is therisk. Growth is moderate. Thoughsales may increase, they do so at aslower rate than before. Productsare more standardized and lessinnovative and there are severalcompetitors.

The refrigerator industry inIndia is a mature industry. Growthis slow. It is for the time seeing safe.Investors can invest in these indus-tries for comfort and averagereturns. They must be aware thoughthat should there be a downturn inthe economy and a fall in consumerdemand, growth and returns can benegative.

The Decline or Sunset StageFinally, the industry declines. Thisoccurs when its products are nolonger popular. This may be onaccount of several factors such as achange in social habits The film andvideo industries , for example havesuffered on account of cable andsatellite television, changes in laws,and increase in prices. The risk atthis time is high but the returns arelow, even negative.

The various stages can belikened to the four stages in the life

tremendous decline in revenues andeven threaten the viability of thecompany.

Cycle The first step in industry is to deter-mine the cycle it is in, or the stage ofmaturity of the industry. All indus-tries evolve through the followingstages:

1.Entrepreneurial, sunrise or nas-cent stage2.Expansion or growth stage3.Stabilization, stagnation or matu-rity stage, and4.Decline or sunset stage

The Entrepreneurial or NascentStage

At the first stage, the industry isnew and it can take some time for itto properly establish itself. In theearly days, it may actually makelosses. At this time there may alsonot be many companies in theindustry. It must be noted that thefirst 5 to 10 years are the most crit-ical period. At this time, companieshave the greatest chance of failing.It takes time to establish companiesand new products. There may belosses and the need for large injec-tions of capital.

If a company or an industry isnot nurturedor husbandedat this stage, itcan collapse.

A goodjournalist Iknow began abusiness mag-azine. Hisintention wasto start a mag-azine editedby journalistswithout inter-ference fromi n d u s t r i a lmagnates orpoliticians. Itwas excep-

The life cycle of an industry can be illustrated in an inverted "S" curve as illus-trated above.

(1) Entrepreneurial of nascent stage (2) Expansion or growth stage (3) Stabilization or maturity stage (4) Decline

LIFE CYCLE OF AN INDUSTRY


Which Company?

sider is the level of competitionamong various companies in anindustry. Competition within anindustry initially leads to efficiency,product improvements and innova-tion. As competition increases evenmore, cut throat price wars set inresulting in lower margins, smallerprofits and, finally some companiesbegin to make losses. The moreinefficient companies even closedown.

To properly understand thisphenomenon, it is to be appreciatedthat if the return is high, newcomerswill invest in the industry and therewill be an inflow of funds. Existingcompanies may also increase theircapacity. However, if the returnsare low, or lower than that whichcan be obtained elsewhere, thereverse will occur. Funds will not beinvested and there will be an out-flow. In short high returns attractcompetition and vice versa.However, competition in the formof new companies do not bacterial-ly multiply just because the returnsare high.

There are competitive forces andit is these competitive forces thatdetermine the extent of the inflowof funds, the return on investmentand the ability of companies to sus-tain these returns. These competi-tive forces are: barriers to entry, the

threat of substitution, bargainingpower of the buyers, bargainingpower of the suppliers, and therivalry among competitors.

1.BARRIER TO ENTRY New entrants increase the capacityin an industry and the inflow offunds. The question that arises ishow easy is it to enter an industry ?There are some barriers to entry:

a) Economies of scale: In someindustries it may not be economicalto set up small capacities. This isespecially true if comparativelylarge units are already in existenceproducing a vast quantity. Theproducts produced by such estab-lished giants will be markedlycheaper.

b) Product differentiation: A com-pany whose products have productdifferentiation has greater stayingpower. The product differentiationmay be because of its name orbecause of the quality of its prod-ucts - Mercedes Benz cars; NationalVCRs or Reebok shoes.

People are prepared to pay morefor the product and consequentlythe products are at a premium . It issafe usually to invest in such com-panies as there will always be ademand.

cycle of a human being - childhood,adulthood, middle age and old age.Investors should begin to purchaseshares when an industry is at theend of the entrepreneurial or nas-cent stage and during its growthstage, and should begin to disinvestwhen at its mature stage.

The Industry vis-à-vis theEconomy Investors must ascertain how anindustry reacts to changes in theeconomy. Some industries do notperform well during a recession,others exhibit less buoyancy duringa boom. On the other hand, certainindustries are unaffected in adepression or a boom. What are themajor classifications?

1. Industries that are generally unaf-fected during economic changes arethe evergeen industries. These areindustries that produce goods indi-viduals need, like the food oragrobased industries (dairy prod-ucts, etc.).

2. Then there are the volatile cycli-cal industries which do extremelywell when the economy is doingwell and do badly when depressionsets in. The prime examples aredurable goods, consumer goodssuch as textiles and shipping.

During hard times individuals post-pone the purchase of consumergoods until better days.

3. Interest sensitive industries arethose that are affected by interestrates. When interest rates are high,industries such as real estate andbanking fare poorly.

4. Growth industries are thosewhose growth is higher than otherindustries and growth occurs eventhough the economy may be suffer-ing a setback.

What should Investors do? Investors should determine how anindustry is affected by changes inthe economy and movements ininterest rates. If the economy ismoving towards a recession,investors should disinvest theirholdings in cyclical industries andswitch to growth or evergreenindustries. If interest rates are likelyto fall, investors should considerinvestment in real estate or con-struction companies. If, on theother hand, the economy is on theupturn, investment in consumer anddurable goods industries are likelyto be profitable.

Competition Another factor that one must con-


Which Company?

i) Cost of capacity additions: If thecost of capacity additions are high,there will be fewer competitorsentering the industry.

j) International cartels: There maybe international cartels that make itunprofitable for new entrants.

2.THE THREAT OF SUBSTITUTIONNew inventions are always takingplace and new and better productsreplace existing ones.

An industry that can be replacedby substitutes or is threatened bysubstitutes is normally an industryone must be careful of investing in.An industry where this occurs con-stantly is the packaging industry -bottles replaced by cans, cansreplaced by plastic bottles, and thelike.

To ward off the threat of substi-tution, companies often have tospend large sums of money inadvertising and promotion. Theindustries that have to worry mostare those where the substitutes areeither cheaper or better, or are pro-duced by industries earning highprofits. It should be noted that sub-stitutes limit the potential returns ofa company.

3.BARGAINING POWER OFTHE BUYERS In an industry where buyers havecontrol, i.e. in a buyer's market,buyers are constantly forcing pricesdown, demanding better services orhigher quality and this often erodesprofitability. The factors one shouldcheck are whether: a)A particular buyer buys most ofthe products (large purchase vol-umes). If such buyers withdrawtheir patronage, they can destroy anindustry. They can also force pricesdown. b)Buyers can play one companyagainst another to bring pricesdown.

One should also be aware that: If sellers face large switching

costs, the buyer's power isenhanced. This is especially true ifthe switching costs for buyers arelow.

If buyers have achieved partialbackward integration, sellers face athreat as they may become fullyintegrated.

If buyers are well informed abouttrends and details they are in a bet-ter position vis-à-vis sellers as theycan ensure they do not pay morethan they need to.

If a product represents a signifi-cant portion of the buyers' cost,

c) Capital requirement: Easy entryindustries require little capital andtechnological expertise. As a conse-quence, there are a multitude ofcompetitors, intense competition,low margins and high costs.

On the other hand, capital inten-sive industries with a large capitalbase and high fixed cost structurehave few competitors as entry is dif-ficult. The automobile industry is aprime example of such an industry.Its high fixed costs have to be serv-iced and a fall in sales can result ina more than proportionate fall inprofits. Large investments and a bigcapital base will be barriers toentry.

d)Switching costs: Another barrierto entry could be the cost of switch-ing from one supplier's product toanother. This may include employeerestraining costs, cost of equipmentand the likes. If the switching costsare high, new entrants have to offera tremendous improvement for thebuyer to switch.

A prime example is computers.A company may be using aHoneywell computer. If it wishes tochange to an IBM computer, all theterminals, the unit and even thesoftware would have to be changed.

e)Access to distribution channels:

Difficulty in securing access to dis-tribution channels can be a barrierto entry, especially if existing firmsalready have strong and establishedchannels.

f) Cost disadvantages independentof scale: This barrier occurs whenestablished firms have advantagesnew entrants cannot replicate.These include:

Proprietary product technology Favorable access to raw materials Government subsidies Long learning curve.

A prime example is Coca Cola.The company has proprietary prod-uct technology. Similar cold drinksare available but it is not easy for acompetition to compete with it.

g)Government policy: Governmentpolicy can limit fresh entrants to anindustry, usually by not issuinglicenses. Till about the mid-1980s,the Indian motor car industry wasthe monopoly of two companies.Even though others sought licensesthere were not given.

h)Expected retaliation: The expect-ed retaliation by existing competi-tors can also be a barrier to poten-tial entrants, especially if existingcompetitors aggressively try to keepthe new entrants out.


Which Company?

of the other by price cuts orimproved service. g)Rivalry increases if the stakes(profits) are high. h)Firms will compete with oneanother intensely if the costs of exitare great, i.e. the payment of gratu-ity, unfunded provident fund, pen-sion liabilities, and such like. Insuch a situation, companies wouldprefer remaining in business even ifmargins are low and little or noprofits are being made. Companiesalso tend to remain in business atlow margins if there are strategicinterrelationships between the com-pany and others in the group; due togovernment restrictions (the gov-ernment may not allow a companyto close down); or in case the man-agement does not wish to closedown the company out of pride oremployee commitment. If exit barriers are high, excesscapacity can not be shut down andcompanies lose their competitiveedges; profitability is eroded.If exit

barriers are high the return is lowbut risky. If exit barriers are low thereturn is low but stable. On theother hand, if entry barriers are lowthe returns are high but stable. Highentry barriers have high, riskyreturns.

Selecting an IndustryWhen choosing an industry, itwould be prudent for the investor tobear in mind or determine the fol-lowing details: 1.Invest in an industry at thegrowth stage.2. The faster the growth of a com-pany or industry, the better. Indiansoftware industry, for example, wasgrowing at a rate of more than 50per cent per annum at the dawn ofthe new millennium.3. It is safer to invest in industriesthat are not subject to governmentalcontrols and are globally competi-tive. 4. Cyclical industries should beavoided if possible unless one is

High Low

Entry Barriers Return high but risky Return high but stable

Exit Barriers Return low but risky Return low and stable

buyers would strongly attempt toreduce prices.

If a product is standard and undif-ferentiated, the buyer's bargainingpower is enhanced.

If the buyer's profits are low, thebuyer will try to reduce prices asmuch as possible.

In short, an industry that is dic-tated by buyers is usually weak andits profitability is under constantthreat.

4.BARGAINING POWER FORTHE SUPPLIERS An industry unduly controlled by itssuppliers is also under threat. Thisoccurs when:

a) The suppliers have a monopoly,or if there are few suppliers. b) Suppliers control an essentialitem. c) Demand for the product exceedssupply. d) The supplier supplies to variouscompanies. e) The switching costs are high. f) The supplier's product does nothave a substitute. g) The supplier's product is animportant input for the buyer'sbusiness. h) The buyer is not important to thesupplier. i) The supplier's product is unique.

5.RIVALRY AMONG COMPETI-TORS Rivalry among competitors cancause an industry great harm. Thisoccurs mainly by price cuts, heavyadvertising, additional high costservices or offers, and the like. Thisrivalry occurs mainly when: a) There are many competitors andsupply exceeds demand. Companiesresort to price cuts and advertiseheavily in order to attract customersfor their goods. b) The industry growth is slow andcompanies are competing with eachother for a greater market share. c) The economy is in a recession andcompanies cut the price of theirproducts and offer better service tostimulate demand. d) There is lack of differentiationbetween the product of one compa-ny and that of another. In such cases, the buyer makes hischoice on the basis of price or serv-ice. e) In some industries economies ofscale will necessitate large additionsto existing capacities in a company.The increase in production couldresult in over capacity & price cut-ting. f) Competitors may have very dif-ferent strategies in selling theirgoods and in competing they maybe continuously trying to stay ahead

47Company analysis46 Industry analysis

Which Company?

ANALYSISCompany

PART III

investing in them at the time theindustry is prospering. 5. Export oriented industries arepresently in a favorable positiondue to various incentives and gov-ernment encouragement. On theother hand, import substitutioncompanies are presently not doingvery well due to relaxations andlower duties on imports. 6. It is important to check whetheran industry is right for investment

at a particular time. There are sun-rise and sunset industries. There arecapital intensive and labour inten-sive industries. Each industry goesthrough a life cycle. Investmentsshould be at the growth stage of anindustry and disinvestments at thematurity or stagnation stage beforedecline sets in.

49The management48 Company analysis

Which Company?

ManagementCHAPTER FOUR

The

At the final stage of fundamentalanalysis, the investor analyzes thecompany. This analysis has twothrusts:

How has the company performedvis-à-vis other similar companiesand

How has the company performedin comparison to earlier years

It is imperative that one completesthe politico economic analysis andthe industry analysis before a com-pany is analyzed because the com-pany's performance at a period oftime is to an extent a reflection ofthe economy, the political situationand the industry.

What does one look at when analyz-ing a company? There is, in myview, no point or issue too small tobe ignored. Everything matters. As Ihad mentioned earlier, the billion-aire Jean Paul Getty, one of the mostsuccessful stock market operators ofall time, said, "Do not buy stockuntil you know all about it".

The different issues regarding acompany that should be examinedare:

The Management The Company The Annual Report Ratios Cash flow

51The management50 The management

Which Company?

ity is due to Rahul Bajaj, and theReliance Empire due entirely to oneman. Dhirubhai Ambani. There areseveral others such as Azim Premjiand Wipro, Narayanamurthy andInfosys and HDFC and DeepakParekh. In India management can be broadlydivided in two types:

Family Management Professional Management

Family management Family managed companies arethose that have at the helm a mem-ber of the controlling family. TheChairman or the Chief ExecutiveOfficer is usually a member of the"ruling" family and the Board ofDirectors are peopled either bymembers of the family or theirfriends and "rubber stamps". This isnecessarily bad. It is just that all pol-icy is determined by the controllingfamily and some of the policies maynot necessarily always be in theshareholders' best interest.

I remember a few years agoKirloskar Pneumatics was quotingat Rs.36 per share. At that timeKirloskar Tractors was not doingwell. The controlling family mergedthe two companies and the price ofKirloskar Pneumatic fell to aroundRs.10. It was probably good for the

family and for the shareholders ofKirloskar Tractors but the mergerwas disastrous for the shareholdersof Kirloskar Pneumatics. In short,decisions are often made with fam-ily interests in view and employeesare often treated as paid servants ofthe family even though they may besenior managers. For instance, inone company I know the HumanResources Manager is also involvedin hiring maids and houseboys forhis Chairman's house and he buysthe vegetables too. The New Delhimanager, whenever his "Seth" visitsthat city is expected to be at thecompany house every morning at 7a.m. when the Chairman wakes up,and can only leave his master's pres-ence after he retires for the night. Iwas witness to an incident atBombay airport many years ago.The head of a large business housewas going on a trip. The chief exec-utives of his many companies hadcome to see him off. These gentle-men were well known individuals,captains of industry in their ownright and respected for their achieve-ments and accomplishments. Theseleaders bent double and touchedtheir leader's feet when he left, andthree of them were actually olderthan their master. Possibly, this mayhave been done as a sign of respectlike a student touching his teacher's

he single most importantfactor one should con-sider when investing in acompany and one often

never considered is its management.It is upon the quality, competenceand vision of the management thatthe future of company rests.

A good, competent managementcan make a company grow while aweak, inefficient management candestroy a thriving company.Corporate history is riddled withexamples. Chrysler was an ailinggiant in the early eighties, Iacoccaturned thec o m p a n yround withtough compe-tent manage-ment. In thefirst quarter of 1993, the big blue -IBM - dismissed its, Chief ExecutiveOfficer Akers who was blamed forthe company's dismal performance.Lou Gerstiner who was at one timePresident of American Express andlater took charge of R.J.R. Nabiscowas invited to become the ChiefExecutive Officer of IBM. Mr.Gerstner had earlier been successfulin reducing quite drastically andvery impressively the liabilities thathad arisen on account of the lever-aged buy out of R.J.R. Nabisco. Itwas this success that was instrumen-

tal in his getting the top job at IBMSimilarly, the main reason attrib-

uted for the collapse in the seventiesof Penn Central, the largest railwayin the United States, was that it washeaded by Stuart Saunders who wasa lawyer and possessed little under-standing of what was involved inrunning a large railway network.Indian corporate history also hasmany such examples.

Metal Box was a name knownand respected, the bluest of bluechips. After a series of occurrencesincluding a diversification that went

wrong, thec o m p a n ywas forcedto close allits facto-ries.

Killick Nixon was one of themost respected names in WesternIndia. No longer.

On the other hand, there arenumerous success stories, of pros-perity that resulted due to the fore-sight and vision of management.Haksar diversified ITC into hotels(the WelcomGroup chain); his suc-cessor diversified into agro basedindustries.

These have been successes Thesuccess of Videocon could probablybe attributed to Venugopal Dhoot,Bajaj Auto's growth and profitabil-

T

Management is the single most important factor toconsider in a company. Upon its quality rests the

future of the company.

Fundamental Analysis Primer


Which Company?

Professional Management Professionally managed companiesare those that are managed byemployees. In such companies, thechief executive officer often does noteven have a financial stake in thecompany. He is at the helm ofaffairs because of his ability andexperience.

The professional manager is acareer employee and he remains atthe seat of power so long as he meetshis targets. Consequently, he isalways result-oriented and his aim isoften short term - the meeting of theannual budget. He is not necessarilyinfluenced by loyalty to the com-pany. As a professional he is usuallyaware of the latest trends in man-agement philosophy and tries tointroduce these. He tries to run hiscompany like a lean, effectivemachine striving for increased effi-ciency and productivity. As a conse-quence, professionally managedcompanies are usually well organ-ized, growth oriented and good per-formers. The companies that comereadily to mind are ITC, Infosys,HDFC and Hindustan Lever.

However, there is often a lack oflong term commitment and some-times a lack of loyalty. This isbecause the professional managerhas to step down in time, to retire,and he cannot therefore enjoy the

fruit of his labour for ever. Nor willhis sons succeed him although somemay try to see that his happens. It ispossible Darbari Seth's son willbecome Chairman of TataChemicals. One must also not forgetthat the professional manager is amercenary. He sell his services to thehighest bidder, and such individualsare consequently not usually knowfor their loyalty.

Companies are now to promoteor create commitment offeringemployees stock options. Thesedevolve on employees after a speci-fied period of service and are givento them on performance. Theemployee thus becomes a partowner and becomes thus involved inthe profitability of the enterprise.Additionally as these devolve on theemployee only after a time, he tendsto stay till it does. As these optionsare given, often annually, theemployee remains with the companyfor a significant period of time. It isa win-win situation for both. Thecompany gets the services of a loyalcompetent employee. The employeebuilds his net worth.

In many professionally managedcompanies there is also a lot ofinfighting and corporate politics.This is because managers are con-stantly trying to climb up the corpo-rate ladder and the end is often what

feet, but I do wonder what may haveoccurred if these individuals had nothumiliated themselves with this ges-ture of obeisance. What I am tryingto point out is that in many familyrun companies, employees areexpected to be subservient to thefamily and loyalty to the family isconsidered even more importantthan talent. And often this loyalty isrewarded. If a retainer is ill, he islooked after well and all his medicalexpenses are borne by the family.

When heretires he isgiven a goodpension. Iremember anoccasion when a senior employeedied. His widow was given the com-pany flat, the children were edu-cated and she was even given a job.Few professionally managed ormultinationals would do this.

Mr. T. Thomas, a formerChairman of Hindustan Lever Ltd.,describes the family business struc-ture most eloquently in his memoir,To Challenge and to Change. Hespeaks of an Indian family businesshaving a series of concentric circlesemanating from a core - the corebeing made up of the founder andhis brothers or sons. The next circleis the extended family of cousinsand relatives followed by people

from the same religious or castegroup. The fourth circle comprisesof people from the same region. Mr.Thomas says that to go beyond thiswas "like going out of orbit -unthinkably risky".

There has been some change inthe way family controlled businesseshave been managed. In the begin-ning, these were often orthodox,autocratic, traditional, rigid andaverse to change. This is no longertrue. The sons and the grandsons of

t h efoundingf a t h e r shave beeneducated

at the best business schools in Indiaor abroad and they have beenexposed to modern methods.Consequently, in many family man-aged companies, although the manat the helm is a scion of the family,his subordinates are graduates ofbusiness schools, i.e. professionalmanagers. To an extent this com-bines the best of two worlds andmany such businesses are very suc-cessful. The frustration for the pro-fessional manager in suchcompanies is that he know that hewill never ever run the company.That privilege will always be with amember of the family.

In India there are two main types of management -Family and Professional.



Which Company?

Rs.230. The worthy replied, "Wewill not allow it to". Shares of suchcompanies are speculative sharesand artificially kept at a high price.They must be avoided.

2. Past record of managementAnother point to consider is provencompetence, i.e. the past record ofthe management. How has the man-agement managed the affairs of thecompany during the last few years?Has the company grown? Has itbecome more profitable? Has itgrown more impressively than oth-ers in the same industry?

It is always wise to be a littlewary of new management and newcompanies as they have very highlevel of mortality. Wait until thecompany shows signs of success andthe management proves its compe-tence.

3. How highly is the manage-ment rated by its peers in thesame industry? This is a very telling factor.Competitors are aware of nearly allthe strengths and weaknesses of amanagement and if they hold themanagement in high esteem it istruly worthy of respect. It should beremembered that the regard theindustry has of the management of

a company is usually impartial, fairand correct.

4. How the management fares inadversity? In good times everyone does well.The steel of a management is testedat times of adversity? And during atime of recession or depression, it isimportant to consider how well themanagement did? Did it streamlineits operations? Did it close down itsfactories? Did it (if it could) get ridof employees? Was it able to sell itsproducts? Did the company performbetter than its competitors? Howdid sales fare? A management thatcan steer its company in difficultdays will normally always do well.

5. The depth of knowledge of themanagementIts knowledge of its products, itsmarkets and the industry is of para-mount importance because uponthis can depend the success of acompany. Often the management ofa company that has enjoyed a pre-eminent position sits back thinkingthat it will always be the dominantcompany. In doing so, it loses itstouch with its customers, its marketsand its competitors.

The reality sinks in only when itis too late. The management must be

matters, not the means. Often too,as a consequence, the best persondoes not get the top job; rather, it isthe person who plays the game best.This does not always happen in fam-ily managed companies as one isaware that the mantle of leadershipwill always be worn by the son ordaughter of the house.

What to look forIt would be unfair to state that oneshould invest only in professionallymanaged companies or family man-aged companies. There are wellmanaged, profitable companies inboth categories. There are alsobadly managed companies in bothcategories. What then are the factorsone should look for?

1. Integrity of Management In my opinion, the most importantaspect is the integrity of the manage-ment. This must be beyond ques-tion. It is often stated that adetermined employee can perpetratea fraud, despite good systems andcontrols. Similarly if it so desires,the management can juggle figuresand cause great harm and financialloss to a company (for their ownpersonal gain).

My recommendation wouldtherefore be to leave a company wellalone if you are not too certain of

the integrity of its management. Ihad the privilege once to listen toMr. C.S. Patel who was at one timethe Chief Executive of Unit Trust ofIndia. He recounted an advice hewas given by his mentor, Mr. A.D.Shroff, the erstwhile Chairman ofthe New India Assurance; "If youhave the slightest doubt of manage-ment, do not touch the companywith a pair of tongs". Seldom haveI heard truer words. When, in a con-versation about a company, its man-agement is described colloquially as"chor (thief) management", it is ahint to keep well away from thatcompany.

In this context, one should checkwho the major shareholders of thecompany are. There are some man-agements who have a record ofmanipulating share prices. I wasrecounted a tale wherein a non-Indian journalist asked the scion ofa family managed company how hecould claim that the share price ofhis company would not fall below

Investors must check on integrity ofmanagers, proven competence, how highis it rated by its peers, how did it performat times of adversity, the management'sdepth of knowledge, its innovativeness

and professionalism.



Which Company?

ble, nor would it be fair, to general-ize which is better. An investormust, before he risks his money,decide whether he is comfortablewith the management of a company.

Ultimately, this is what will deter-mine the safety and the fate of themoney that you invest.

in touch with the industry and cus-tomers at all times and be aware ofthe latest techniques and innova-tions. Only then can it progress andkeep ahead. A quick way of check-ing this is to determine what themarket share of the company'sproducts is, and whether the share isgrowing or at least being main-tained.

6.The management must beopen, innovative and must alsohave a strategy:

It must be prepared to changewhen required. It must essentiallyknow where it is going and have aplan of how to get there. It must bereceptive to ideas and be dynamic.

A company that has many layersof management and is top heavytends to be very bureaucratic andponderous. There are "many chiefsand few braves". They do not wantchange and often stand in the way ofchange. Their strategy is usually apersonal one, on how to hold ontotheir jobs.

7 . N o n - p r o f e s s i o n a l i s e dManagementI would not recommend investing ina company that is yet to profession-alize because in such companiesdecisions are made on the whims of

the chief executive and not with thegood of the company in mind. Insuch companies the most competentare not given the position of power.There may be nepotism with thenephews, nieces, cousins and rela-tives of the chief executive holdingpositions not due to proven compe-tence but because of blood ties.

8. Avoid investing in family con-trolled companiesIt would be wise, too, to avoid

investing in family controlled com-panies where there is infightingbecause the companies suffer andthe one who arguably stands to losethe most is the shareholder or theinvestor. In recent years, many suchfamily controlled companies havesplit, the Birlas, the Goenkas, theMafatlals, to name but a few. Theperiod before the split and theperiod soon after are the most unset-tled times. That is the time to keepaway from such companies. Whenthe new management settles down,one can determine whether oneshould invest or not.

In India, most of the larger com-panies are family controlled thoughthey are managed on a day-to-daybasis by professional managers.There are also several professionallymanaged companies. It is not possi-

59The company58 The company

Which Company?

n aspect not necessarilyexamined during ananalysis of fundamentalsis the company. This is

because the company is one's per-ception of the state of a company -it cannot necessarily be supportedby hard facts and figures.

A company may have madelosses consecutively for two years ormore and one may not wish to touchits shares - yet it may be a good com-pany and worth purchasing into.There are several factors one shouldlook at.

1. How a company is perceivedby its competitors?One of the key fac-tors to ascertain ishow a company isperceived by its com-petitors. It is held inhigh regard? TheOscar isHollywood's greatest award, theone most prized by the stars. Why?It is because it represents recogni-tion of an actor/ actress by his/herpeers. A company held in scorn by acompetitor is not worth looking at.

On the other hand, one held inawe must be considered not oncebut several times. Its products maybe far superior. It may be betterorganized. Its management may be

known for its maturity, vision, com-petence and aggressiveness.

The investor must ascertain thereason and then determine whetherthe reason will continue into theforeseeable future.

2. Whether the company is themarket leader in its products orin its segmentAnother aspect that should be ascer-tained is whether the company is themarket leader in its products or inits segment. When you invest inmarket leaders, the risk is less. Theshares of market leaders do not fallas quickly as those of other compa-nies. There is a magic to their name

that would makeindividuals pre-fer to buy theirproducts asopposed to oth-ers.

Let us take areal life example. In the eighties,there was a virtual explosion of con-sumer goods. There were many tel-evision manufacturers. They madesimilar televisions as almost all partswere imported.

However within a decade onlythose that were the market leaderssurvived. The others had died off. Ifone has to purchase an article andhas a choice one would normally

A

The investor must determine the policya company follows and its plans for

growth.


CompanyCHAPTER FIVE

The

61The company60 The company

Which Company?

company is located and where itsfactories are. If the infrastructure isbad, if there is inadequate electricityor water the company could havetremendous problems.

There are many companies inMadhya Pradesh in dire straitsbecause of electricity cuts. Manycannot afford captive power.Transportation is another issue. The

government has recognized this andthere are plans afoot to have super-highways around the country withinthe next ten years.These are the main factors oneshould keep at the back of one'smind while viewing a company.

buy the better one. This is normalhuman behavior and this happens inthe market place too. Consequently,the prices of market leaders fallslower than those of others in thesame industry.

3. Company PoliciesThe policy a company follows isalso of imperative importance.

What is its plans for growth?What is its vision? Every companyhas a life. If it is allowed to live anormal life it will grow upto a pointand then begin to level out and even-tually die. It is at the point of level-ing out that it must be given newlife. This can give it renewed vigourand a new lease of life. A classicexample that comes to mind is ITCLtd. This tobacco giant branchedinto hotels under Haksar and theninto agribusiness under Sapru.Reliance Industries was initially inTextiles. It then saw opportunityand moved into petroleum, intopetro chemicals and refining prod-ucts. It has in 2003 got into mobilephones. Blue Star is a aircondition-

ing company. It had a software divi-sion which was spun off as a sepa-rate company. Since then both thesecompanies have grown.

4. Labour RelationsLabour relations are extremelyimportant. A company that hasmotivated, industrious work forcehas high productivity and practi-cally no disruption of work.

On the other hand, a companythat has bad industrial relations willlose several hundred mandays as aconsequence of strikes and go slows.

In 1992 Bata, the giant shoecompany, was closed due to strikesfor nearly four months and as a con-sequence its results in the year to 31March 1993 were extremely bad. Itis widely believed that the textileindustry died in Mumbai because ofthe militancy of the unions underthe late Datta Samant. It was onaccount of the militancy of thelabour force that many companiesgrew reluctant to invest in statessuch as Kerala and West Bengal. Itis critical, therefore, to ascertainwhere the company's plants and fac-tories are and their record of indus-trial relations.

5. Where the company is locatedand where its factories are?One must also consider where the

It is important to check how company isperceived by its competition and

whether it is the market leader in itsproducts or in its segment.


63The annual report62 The annual report

Which Company?

he primary and mostimportant source of infor-mation about a companyis its Annual Report. By

law, this is prepared every year anddistributed to the shareholders.

Annual Reports are usually verywell presented. A tremendousamount of data is given about theperformance of a company over aperiod of time. Multi-colored barand pie charts are presented to illus-trate and explain the growth of thecompany and the manner in whichthe revenues earned have been uti-lized. There are pictures of the fac-tories; of newly acquired machines;of the Chairman cutting a ribbonand of the Board of Directors look-ing responsible.

The average shareholder looksno further. If an Annual Report isimpressive, if the company has madea profit and if a reasonable dividendhas been paid, he is typically contentin the belief that the company is ingood hands.

This must not be the criterion bywhich to judge a company. Theintelligent investor must read theannual report in depth; he must readbetween and beyond the lines; hemust peep behind the figures andfind the truth and only then shouldhe decide whether the company isdoing well or not.

The Annual Report is broken downinto the following specific parts: A.The Director's Report,B.The Auditor's Report, C.The Financial Statements, and D.The Schedules and Notes to theAccounts.

Each of these parts has a purposeand a tale to tell. The tale should beheard.

A.The Director’s Report The Director’s Report is a reportsubmitted by the directors of a com-pany to its shareholders, advisingthem of the performance of the com-pany under their stewardship. It is,in effect, the report they submit tojustify their continued existence andit is because of this that these reportsshould be read with a pinch of salt.After all, if a group of individualshave to present an evaluation oftheir own performance they arebound to highlight their achieve-ments and gloss over their failures.It is natural. It is human nature.Consequently, all these reports arevery well written. Every sentence,

T

The annual report is broken into thedirector’s report, the auditor's report, thefinancial statements and the schedules.


AnnualREPORT

CHAPTER SIX

The


Which Company?

diversification may not suit a com-pany. Similarly, all other issuesraised in the Director’s Reportshould be analyzed. Did the com-pany perform as well as others in thesame industry? Is the finance beingraised the most logical and benefi-cial for the company? It is impera-tive that the investor read betweenthe lines of Director’s Report andfind the answers to these questions.

In short, a Director’s Report is valu-able and if read intelligently can givethe investor a goodgrasp of the work-ings of a com-pany, theproblems it faces,the direction itintends taking,and its future prospects.

B. The Auditor's Report The auditor represents the share-holders and it is his duty to report tothe shareholders and the generalpublic on the stewardship of thecompany by its directors. Auditorsare required to report whether thefinancial statements presented do, infact, present a true and fair view ofthe state of the company.

Investors must remember thatthe auditors are their representativesand that they are required by law to

point out if the financial statementsare not true and fair. They are alsorequired to report any change, suchas a change in accounting principlesor the non provision of charges thatresult in an increase or decrease inprofits. It is really the only impartialreport that a shareholder or investorreceives and this alone should spurone to scrutinize the auditor's reportminutely. Unfortunately, more oftenthan not it is not read.

There can be interesting contra-dictions. It was stated in the

Auditor's Reportof ABC Ltd. forthe year 1999-2000 that, "Asat the year end31st March2000 the accu-

mulated losses exceed the net worthof the Company and the Companyhas suffered cash losses in the finan-cial year ended 31st March 2000 aswell as in the immediately precedingfinancial year. In our opinion, there-fore, the Company is a sick indus-trial company within the meaning ofclause (O) of Section 3(1) of the SickIndustrial Companies (SpecialProvisions) Act 1985". TheDirector’s report however stated,"The financial year under reviewhas not been a favorable year for theCompany as the Computer Industry

The investor must read between andbeyond the lines of an annual report to

determine the state of the companybeing considered.


nay every word, is subjected to themost piercing scrutiny. Every hap-pening of importance is cataloguedand highlighted to convince a casualreader that the company is in goodhands. And there is a tendency tojustify unhappy happenings.Nevertheless, the Director’s Reportprovides an investor valuable infor-mation: 1. It enunciates the opinion of thedirectors on the state of the econ-omy and the political situation vis-à-vis the company. 2. Explains the performance and thefinancial results of the company inthe period under review. This is anextremely important part. Theresults and operations of the variousseparate divisions are usuallydetailed and investors can determinethe reasons for their good or badperformance. 3. The Director’s Report details thecompany's plans for modernization,expansion and diversification.Without these, a company willremain static and eventually decline. 4. Discusses the profit earned in theperiod under review and the divi-dend recommended by the directors.This paragraph should normally beread with sane skepticism, as thedirectors will always argue that theperformance was satisfactory. If

profits have improved it wouldinvariably be because of superiormarketing and hard work in the faceof severe competition. If low,adverse economic conditions areusually at fault.5. Elaborates on the directors' viewsof the company's prospects in thefuture. 6. Discusses plans for new acquisi-tion and investments.

An investor must intelligentlyevaluate the issues raised in aDirector’s Report. Diversification isgood but does it make sense?Industry conditions and the man-agement's knowledge of the busi-ness must be considered. Adiversification that was a disasterwas Burroughs Wellcome's diversi-fication into sport goods - NikeSportswear. So was Metal Box'smove into ball bearings andSpartek's acquisition of NeycerCeramics. The point I am trying tomake is that although companiesmust diversify in order to spread therisks of industrial slumps, every

The annul report is the primary and mostimportant source of information on a

company.



Which Company?

past gratuity liabilities as of 31March 2000 had neither been ascer-tained nor provided for except tothe extent of premiums paid againstan LIC group gratuity policy takenby the trust. (Note 14.)6. Note 16C stated that the rawmaterial consumed had been esti-mated by the management and thishad not been checked by the audi-tors.

The company made a profit ofjust over Rs.1 crore. If the productdevelopment expenses, customerduty and interest and provision forbad debts had been made as isrequired under generally acceptedaccounting principles, the profitwould have turned into a loss.

The point to remember is that attimes accounting principles arechanged, or creative and innovative

Fundamental limited Profit & Loss Account for the year ended 31 March, 2004

2003 2004INCOME

Sales 14,000 17,500Other Income 500 600

14,500 18,100EXPENDITURE

Materials 7,600 9,200

Employment 3,450 3,900Operating & other expenses 1,150 2,100Interest & Finance charges 300 350

Depreciation 80 100

12,580 15,650Profit for the year before tax 1,920 2,450

Taxation 900 1200

1,020 1,250

APPROPRIATIONS 600 700

Dividend 220 400

General reserves 200 400

420 800

BALANCE CARRIED FORWARD 600 450

in general continued to be in the gripof recession. High input costs aswell as resource constraints ham-pered operations. The performanceof your Company must be assessedin the light of these factors. Duringthe year manufacturing operationswere curtailed to achieve cost effec-tiveness. Your directors are confi-dent that the efforts for increasedbusiness volumes and cost controlwill yield better results in the currentyear". The auditors were of theopinion that the company was sickwhereas the directors spoke opti-mistically of their hope that thefuture would be better! I supposethey could not, being directors, stateotherwise.

When reading an Auditor'sReport, the effect of their qualifica-tion may not be apparent. TheAuditor's Report of RoystonElectronics Limited for 1999-2000stated : "In our opinion and to thebest of our information and expla-nation given to us, the said accountssubject to Note No.3 regardingdoubtful debts, No.4 regarding bal-ance confirmations, No.5 on customliability and interests thereon,No.11 on product developmentexpenses, No.14 on gratuity, No.816(C) and 16(F) regarding stocks,give the information in the manneras required by the Companies Act

1956, and give a true and fair view.Let us now look at the specific notesin this case:

1.Note 3 states that no provisionhad been made for doubtful debts. 2. It was noted in Note 4 that bal-ance confirmation of sundrydebtors, sundry creditors and loansand advances had not beenobtained.3. It was stated in Note 5 that cus-toms liability and interest thereonworth Rs.3,14,30,073 against theimported raw materials lying in theICF/Bonded godown as on31.3.2000 had not been provided. 4. Note 11 drew attention to the factthat product development expensesworth Rs.17,44,.049 were beingwritten off over ten years from1999-2000. Rs.2,16,51,023 hadbeen capitalized under this headrelating to the development ofCT142, Digital TV, CFBT whichshall be written off in 10 years com-mencing, 2000-01.5. The company's share towards

The Director’s Report gives investorsinsights into the company.

and enunciates the opinion of the direc-tors on the economy, the industry and

political situation.



Which Company?

accounting practices resorted to bysome companies in order to show abetter result. The effect of thesechanges is at times not detailed inthe notes to the accounts. TheAuditor's Report will always drawthe attention of the reader to thesechanges and the effect that thesehave on the financial statements. It

is for this reason that a careful read-ing of the Auditor's Report is notonly necessary but mandatory for aninvestor.

C.Financial StatementsThe published financial statementsof a company in an Annual Reportconsist of its Balance Sheet as at the

Vasanth Limited had taken a loan of Rs.200 lakh on 1 December 2003 which was repayable on1 April 2004. On 31 March 2004, its Balance Sheet was as follows :

Current assets include cash of Rs.100 lakh to repay the loan . Vasanth Ltd. did repay the loans,as promised on 1 April 2004. Its Balance Sheet after the repayment read:

An investor reviewing the Balance Sheets would be forgiven for drawing two very different con-clusions. At 31 March 2004, Vasanth Limited would be considered a highly leveraged company,one financed by borrowings. On 1 April 2004, on the other hand, it would be concluded that thecompany was very conservative and undercapitalized, as a consequence of which its growthwould be limited.

Vasanth Ltd. Balance Sheet as at 1 April 2004(In Rupees Lakh)

Shareholders' funds 100 70Loan funds — 30

Current liabilities 20 20

120 120

Vasanth Ltd. Balance Sheet as at 31 March 2004 (In Rupees Lakh)

Shareholders' funds 100 70Loan funds 200 30

Current liabilities 20 220

320 320

Balance Sheet Illustration

Fundamental limited (Balance sheet as on 31 MArch, 2003)2003 2004

SOURCES OF FUNDS Shareholder's funds

(a) Capital 1000 1000B) Reserves 800 1650

1800 2650

LOAN FUNDS

(a) Secured Loans 1350 1050(b) Unsecured Loans 650 500

2000 1550

TOTAL 3800 4200

APPLICATION OF FUNDSFixed Assets 3200 3640Investments 400 400

Current Assets :

Trade debtors 600 700

Prepaid Expenses 80 80

Cash & Bank balances 50 100

Other Current Assets 100 150

830 1030

Less :

Current Liabilities and provisions

Trade Creditors 480 710

Accrued Expenses 70 90

Sundry Creditors 80 70

630 870

Net current assets 200 160

TOTAL 3800 4200


Which Company?

shares were often issued to investorsat a price much lower than its realvalue. As a consequence, they wereoversubscribed many times. This isno longer true. As companies arenow free to price their issues as theylike and the office of the controllerof capital issues has been abolished,companies typically price theirshares at what the market can bear.As a consequence the investing pub-lic are no longer applying blindly fornew shares but do so only after acareful analysis.

(iii) Rights issuesCompanies may alsoissue shares to itsshareholders as amatter of right inproportion to theirholding. This wasoften done at a price lower than itsmarket value and shareholdersstood to gain enormously. With thenew-found freedom in respect ofpricing of shares, companies havebegun pricing them nearer theirintrinsic value. Consequently, theseissues have not been particularlyattractive to investors and severalhave failed to be fully subscribed.

(iv) Bonus sharesBonus shares are shares issued freeto shareholders by capitalizing

reserves. No monies are actuallyraised from shareholders. It can beargued, however, that if these sharesare issued by capitalizing distrib-utable reserves, i.e. profits not dis-tributed as dividends, then, in effect,shareholders are contributing capi-tal.

RESERVESReserves are profits or gains whichare retained and not distributed.Companies have two kinds ofreserves - capital reserves and rev-enue reserves :

(i) CapitalReserves

C a p i t a lreserves aregains thathave resulted

from an increase in the value ofassets and they are not freely distrib-utable to the shareholders.

The most common capitalreserves one comes across are theshare premium account arising fromthe issue of shares at a premium,and the capital revaluation reserve,i.e. unrealized gain on the value ofassets.

(ii) Revenue ReservesThese represent profits from opera-tions ploughed back into the com-

The Directors report, if read properly, cangive the investor a good grasp of the

workings of the company.


end of the accounting period detail-ing the financing condition of thecompany at that date, and the Profitand Loss Account or IncomeStatement summarizing the activi-ties of the company for the account-ing period.

BALANCE SHEET The Balance Sheet details the finan-cial position of a company on a par-ticular date; of the company's assets(that which the company owns), andliabilities (that which the companyowes), grouped logically under spe-cific heads. It must however, benoted that the Balance Sheet detailsthe financial position on a particu-lar day and that the position can bematerially different on the next dayor the day after.

Sources of funds A company has to source funds topurchase fixed assets, to procureworking capital, and to fund itsbusiness. For the company to makea profit the funds have to cost lessthan the return the company earnson their deployment.

Where does a company raise funds?

What are the sources?

Companies raise funds from itsshareholders and by borrowing.

Shareholders Funds A company sources funds fromshareholders either by the issue ofshares or by ploughing back profits.Shareholder's funds represent thestake they have in the company backprofits. Shareholders' funds repre-sent the stake they have in the com-pany, the investment they havemade.

Share Capital Share capital represents the sharesissued to the public. This is issued infollowing ways: (i) Private PlacementThis is done by offering shares toselected individuals or institutions.

(ii) Public IssueShares are offered to public. Thedetails of the offer, including thereasons for raising the money aredetailed in a prospectus and it isimportant that investors read this.Till the scam of 1992 public issueswere extremely popular as the

The Directors Report explains the per-formance of the company, its plans for

diversification, modernization andexpansion. It discusses the profits

earned and states the dividends proposed.



Which Company?

that an asset has a useful life andthat after years of toil it wearsdown. Consequently, it attempts tomeasure that wear and tear and toreduce the value of the asset accord-ingly so that at the end of its usefullife, the asset will have no value.

As depreciation is a charge onprofits, at the end of its useful life,the company would have set asidefrom profits an amount equal to theoriginal cost of the asset and thiscould be utilized to purchaseanother asset. However, in theseinflationary times, this is inadequateand some companies create an addi-tional reserve to ensure that thereare sufficient funds to replace theworn out asset. The common meth-ods of depreciation are:

(a) Straight line methodThe cost of the asset is written offequally over its life. Consequently,at the end of its useful life, the costwill equal the accumulated depreci-ation.

(b) Reducing balanceUnder this method depreciation iscalculated on the written downvalue, i.e. cost less depreciation.Consequently, depreciation ishigher in the beginning and lower asthe years progress. An asset is neverfully written off as the depreciationis always calculated on a reducingbalance.

(c) Others: There are a few others such as theinterest method and the rate of 72but these are not commonly used.

Land is the only fixed asset thatis never depreciated as it normallyappreciates in value. Capital workin progress - factories being con-structed, etc. - is not depreciateduntil it is a fully functional asset.

INVESTMENTSMany companies purchase invest-ments in the form of shares ordebentures to earn income or to uti-lize cash surpluses profitably. Thenormal investments a company hasare:

(i) TradeTrade investments are shares ordebentures of competitors that acompany holds to have access toinformation on their growth, prof-

The auditor represents shareholders andreports to them on the stewardship of

the directors and whether the accountspresented to them give a true and fair

view of the state of the company.


pany and not distributed as divi-dends to shareholders. It is impor-tant that all the profits are notdistributed as funds are required bycompanies to purchase new assets toreplace existing ones for expansionand for working capital.

LOAN FUNDS The other source of funds a com-pany has access to are borrowings.Borrowing is often preferred bycompanies as it is quicker, relativelyeasier and the rules that need to becomplied with are much less. The loans taken by companies areeither : (a) Secured loans: These loans are taken by a companyby pledging some of its assets, or bya floating charge on some or all ofits assets. The usual secured loans acompany has are debentures andterm loans.

(b) Unsecured loansCompanies do not pledge any assetswhen they take unsecured loans.The comfort a lender has is usuallyonly the good name and credit wor-thiness of the company. The morecommon unsecured loans of a com-pany are fixed deposits and shortterm loans. In case a company is dis-solved, unsecured lenders are usu-ally paid after the secured lenders

have been satisfied. Borrowings or credits for work-

ing capital which fluctuate such asbank overdrafts and trade creditorsare not normally classified as loanfunds but as current liabilities.

Fixed Assets Fixed assets are assets that a com-pany owns for use in its businessand to produce goods, typically,machinery. They are not for resaleand comprises of land, buildings, i.e.offices, warehouses and factories,vehicles, machinery, furniture,equipment and the like.

Every company has some fixedassets though the nature or kind offixed assets vary from company tocompany. A manufacturing com-pany's major fixed assets would beits factory and machinery, whereasthat of a shipping company wouldbe its ships.

Fixed assets are shown in theBalance Sheet at cost less the accu-mulated depreciation. Depreciationis based on the very sound concept

Investors must read the auditor's reportin details and in depth as the results can

materially change if adjustments aremade based on the notes or comments

in the auditors report.



Which Company?

bought by a liquor store from aliquor manufacturers.

(c) Cash equivalents:They can be used to repay dues orpurchase other assets. The mostcommon cash equivalent assets arecash in hand and at the bank, andloans given. The current assets a company hasare:

A) STOCK OR INVENTORIES These are arguably the most impor-tant current assets that a companyhas as it is by thesale of its stocksthat a companymakes its profits.Stocks, in turn,consist of:

(i) Raw materials The primary purchase which is uti-lized to manufacture the products acompany makes.

(ii) Work in progress Goods that are in the process ofmanufacture but are yet to be com-pleted.

(iii) Finished goodsThe finished products manufacturedby the company that are ready forsale.

Valuation of stocksStocks are valued at the lower ofcost or net realizable value. This isto ensure that there will be no lossat the time of sale as that wouldhave been accounted for. The common methods of valuingstocks are:

(i) FIFO or first in first outIt is assumed under this method thatstocks that come in first would besold first and those that come in lastwould be sold last.

(ii) LIFO or lastin last outThe premise onwhich thismethod is basedis the oppositeof FIFO. It is

assumed that the goods that arrivelast will be sold first. The reason-ing is that customers prefer newermaterials or products. It is important to ascertain themethod of valuation and theaccounting principles involved asstock values can easily be manipu-lated by changing the method of val-uation.

B) TRADE DEBTORS Most companies do not sell their

The auditor represents shareholders andreports to them on the stewardship of

the directors and whether the accountspresented do present a true and fair view

of the company.


itability and other details which maynot, otherwise, be easily available.

(ii) Subsidiary and associate companiesThese are shares held in subsidiaryor associate companies. The largebusiness houses hold controllinginterest in several companiesthrough cross holdings in subsidiaryand associate companies.

(iii) OthersCompanies also often hold shares

or debentures ofother companiesfor investment orto park surplusfunds. The wind-fall profits madeby many compa-nies in the year to31 March 1992was on accountof the large prof-its made by trading in shares.

Investments are also classified asquoted and unquoted investments.Quoted investments are shares anddebentures that are quoted in a rec-ognized stock exchange and can befreely traded. Unquoted investmentsare not listed or quoted in a stockexchange. Consequently, they arenot liquid and are difficult to dis-pose of.

Investments are valued andstated in the balance sheet at eitherthe acquisition cost or market value,whichever is lower. This is in orderto be conservative and to ensure thatlosses are adequately accounted for.

Current assetsCurrent assets are assets owned

by a company which are used in thenormal course of business or aregenerated by the company in thecourse of business such as debtors orfinished stock or cash.

The rule ofthumb is that anyasset that isturned into cashwithin twelvemonths is a cur-rent asset.

Current assetscan be dividedessentially intothree categories :

(a) Converting assetsAssets that are produced or gener-ated in the normal course of busi-ness, such as finished goods anddebtors.

(b) Constant assetsConstant assets are those that arepurchased and sold without any addons or conversions, such as liquor

The Auditors in the Auditors report willcomment on any changes made in

accounting principles and the effect ofthese changes made in accounting prin-

ciples and the effect of these changes onthe results. They will also comment on

any action or method of accounting theydo not agree with.



Which Company?

F) OTHER CURRENT ASSETS Other current assets are all amountsdue that are recoverable within thenext twelve months. These includeclaims receivable, interest due oninvestments and the like.

CURRENT LIABILITIESCurrent liabilities are amounts duethat are payable within the nexttwelve months. These also includeprovisions which are amounts setaside for an expense incurred forwhich the bill has not been receivedas yet or whosecost has not beenfully estimated.

( A ) T R A D ECREDITORSTrade creditorsare those to whomthe company owemonies for rawmaterials andother articles usedin the manufacture of its products.Companies usually purchase theseon credit - the credit period depend-ing on the demand for the item, thestanding of the company and mar-ket practice.

(B) ACCRUED EXPENSESCertain expenses such as interest onbank overdrafts, telephone costs,

electricity and overtime are paidafter they have been incurred. Thisis because they fluctuate and it is notpossible to either prepay or accu-rately anticipate these expenses.

However, the expense has beenincurred. To recognize this theexpense incurred is estimated basedon past trends and known expensesincurred and accrued on the date ofthe Balance Sheet.

(C) PROVISIONS Provisions are amounts set aside

from profits foran estimatedexpense or loss.Certain provi-sions such asdepreciation andprovisions forbad debts arededucted fromthe concernedasset itself.

There areothers, such as claims that may bepayable, for which provisions aremade. Other provisions normallysees on balance sheets are those fordividends and taxation.

(D) SUNDRY CREDITORS Any other amounts due are usuallyclubbed under the all embracing titleof sundry creditors. These include

The balance sheet details all the assetsand liabilities a company has on a partic-ular date. Assets are those that the com-pany owns such as fixed assets (build-

ings, cars etc.), investments and currentassets (stocks, debtors and cash).

Liabilities are those that the companyowes (trade creditors, loans, etc.) and

the shareholders investment in the com-pany (share capital and reserves).


products for cash but on credit andpurchasers are expected to pay forthe goods they have bought withinan agreed period of time - 30 daysor 60 days. The period of creditwould vary from customer to cus-tomer and from the company tocompany and depends on the creditworthiness of the customer, marketconditions and competition.

Often customers may not paywithin the agreed credit period. Thismay be due to laxity in creditadministration or the inability of thecustomers to pay. Consequently,debts are classified as:

Those over six months, and Others

These are further subdivided into; Debts considered good, and Debts considered bad and

doubtful

If debts are likely to be bad, theymust be provided for or written off.If this is not done assets will be over-stated to the extent of the bad debt.

A write off is made only whenthere is no hope of recovery.Otherwise, a provision is made.Provisions may be specific or theymay be general.

When amounts are provided oncertain identified debts, the provi-sion is termed specific whereas if aprovision amounting to a certain

percentage of all debts are made, theprovision is termed general.

C) PREPAID EXPENSES All payments are not made whendue. Many payments, such as insur-ance premiums, rent and servicecosts, are made in advance for aperiod of time which may be 3months, 6 months, or even a year.The portion of such expenses thatrelates to the next accounting periodare shown as prepaid expenses inthe Balance Sheet.

D) CASH AND BANK BALANCES Cash in hand in petty cash boxes,safes and balances in bank accountsare shown under this heading in theBalance Sheet.

E) LOANS AND ADVANCES These are loans that have been givento other corporations, individualsand employees and are repayablewithin a certain period of time. Thisalso includes amounts paid inadvance for the supply of goods,materials and services.

Financial statements of a company in anannual report consist of the balance

sheet and the profit and loss account.These detail the financial health and per-

formance of the company.



Which Company?

from sources other than from thesale of their products or the provi-sion of services. These are usuallyclubbed together under the heading,other income. The more commonitems that appear under this titleare: (i) Profit from the sale of assetsProfit from the sale of investmentsor assets.

(ii) DividendsDividends earned from investmentsmade by the company in the sharesof other companies.

(iii) RentRent received from commercialbuildings and apartments leasedfrom the company.

(iv) InterestInterest received on deposits madeand loans given to corporate andother bodies.

MATERIALSMaterials are the raw materials andother items used in the manufactureof a company's products. It is alsosometimes called the cost of goodssold.

EMPLOYMENT COSTS The costs of employment areaccounted for under this head and

would include wages, salaries,bonus, gratuity, contributions madeto provident and other funds, wel-fare expenses, and other employeerelated expenditure.

OPERATING AND OTHEREXPENSES All other costs incurred in running acompany are called operating andother expenses, and include:

(i)Selling expensesThe cost of advertising, sales com-missions, sales promotion expensesand other sales related expenses.

(ii) Administration expensesRent of offices and factories, munic-ipal taxes, stationery, telephone andtelex costs, electricity charges, insur-ance, repairs, motor maintenance,and all other expenses incurred torun a company.

(iii) Others: This includes costs that are notstrictly administration or selling

Contingent liabilities are also detailed.These are liabilities that may arise onthe happening of an event that may

never arise (guarantees, bills discount-ed). The liability crystallizes on the hap-

pening of the event.

Fundamental Analysis Primerunclaimed dividends and duespayable to third parties.

PROFIT AND LOSS ACCOUNTThe Profit and Loss account sum-marizes the activities of a companyduring an accounting period whichmay be a month, a quarter, sixmonths, a year or longer, and theresult achieved by the company. Itdetails the income earned by thecompany, its cost and the resultingprofit or loss. It is, in effect, the per-formance appraisal not only of thecompany but also of its manage-ment - its competence, foresight andability to lead.

SALES Sales is the amount received orreceivable from customers arisingfrom the sales of goods and the pro-vision of services by a company.

A sale occurs when the owner-ship of goods and the consequentrisk relating to these goods arepassed to the customer in return forconsideration, usually cash. In nor-mal circumstances the physical pos-session of the goods is alsotransferred at the same time.

A sale does not occur when acompany places goods at the shop ofa dealer with the clear understand-ing that payment need be made only

after the goods are sold failingwhich they may be returned. In sucha case, the ownership and risks arenot transferred to the dealer norany consideration paid.

Companies do give trade dis-counts and other incentive discountsto customers to entice them to buytheir products. Sales should beaccounted for after deducting thesediscounts. However, cash discountsgiven for early payment are afinance expense and should beshown as an expense and notdeducted from sales.

There are many companieswhich deduct excise duty and otherlevies from sales. There are otherswho show this as an expense. It ispreferable to deduct these from salessince the sales figures would thenreflect the actual markup made bythe company on its cost of produc-tion.

OTHER INCOME Companies may also receive income

The profit and loss account detailsnumerically the activities the companyhad undertaken during the accounting

period and the result of these activities(profit or loss).



Which Company?

TRANSFER TO RESERVES The transfer to reserves is the profitploughed back into the company.This may be done to finance work-ing capital, expansion, fixed assetsor for some other purpose. Theseare revenue reserves and can be dis-tributed to shareholders as divi-dends.

CONTINGENT LIABILITIES Contingent liabilities are liabilitiesthat may arise up on the happeningof an event. It is uncertain, however,whether the event itself may happen.This is why these are not providedfor and shown as an actual liabilityin the balance sheet. Contingent lia-bilities are detailed in the FinancialStatements as a note to inform thereaders of possible future liabilitieswhile arriving at an opinion aboutthe company. The contingent liabil-ities one normally encounters are:

a) Bills discounted with banksThese may crystallize into active lia-bilities if the bills are dishonoured.

b) Gratuity to employees not pro-vided for

c) Legal suits against the companyprovided for

d) Claims against a company not

acknowledged or accepted

e) Excise claims against the com-pany

SCHEDULES AND NOTES TOTHE ACCOUNTSThe schedules and notes to theaccounts are an integral part of thefinancial statements of a companyand it is important that they be readalong with the financial statements.Most people avoid reading these.They do so at their own risk as theseprovide vital clues and information.

SCHEDULESThe schedules detail pertinent infor-mation about the items of BalanceSheet and Profit & Loss Account. Italso details information about sales,manufacturing costs, administrationcosts, interest, and other income andexpenses. This information is vitalfor the analysis of financial state-ments. The schedules enable aninvestor to determine whichexpenses increased and seek the rea-sons for this. Similarly, investorswould be able to find out the rea-sons for the increase or decrease insales and the products that are salesleaders. The schedules even givedetails of stocks and sales, particu-lars of capacity and productions,and much other useful information.

expenses, such as donations made,losses on the sale of fixed assets orinvestments, miscellaneous expendi-ture and the like.

INTEREST AND FINANCECHARGES A company has to pay interest onmonies it borrows. This is normallyshown separately as it is a cost dis-tinct from the normal costs incurredin running a business and wouldvary from company to company.The normal borrowings that a com-pany pays interest on are: (i) Bank overdrafts (ii) Term loans taken for the pur-chase of machinery or constructionof a factory(iii) Fixed deposits from the public(iv) Debentures (v) Intercorporate loans

DEPRECIATION Depreciation represents the wearand tear incurred by the fixed assetsof a company, i.e. the reduction inthe value of fixed assets on accountof usage. This is also shown sepa-rately as the depreciation charge ofsimilar companies in the sameindustry will differ, depending onthe age of the fixed assets and thecost at which they have beenbought.

TAXATION Most companies are taxed on theprofits that they make. It must beremembered however, that taxes arepayable on the taxable income orprofit and this can differ dramati-cally from the accounting income orprofit. This is because manyamounts legitimately expensed maynot be tax deductible. Conversely,income such as agricultural incomeare not taxable.

DIVIDENDS Dividends are profits distributed toshareholders. The total profits aftertax are not always distributed - aportion is often ploughed back intothe company for its future growthand expansion. Dividends paid dur-ing the year in anticipation of prof-its are known as interim dividends.The final dividend is usuallydeclared after the results for theperiod have been determined. Thefinal dividend is proposed at theannual general meeting of the com-pany and paid after the approval ofthe shareholders.

The profit and loss account alsodetails the dividend given (interim)

and proposed.



Which Company?

(c) How the gratuity liability isexpensed.(d) How fixed assets are valued.(e) How depreciation is calculated. (f) How stock, including finishedgoods, work in progress, raw mate-rials and consumable goods are val-ued. (g) How investments are stated inthe balance sheet. (h) How has the foreign exchangetranslated?

(b) Contingent liabilities As noted earlier, contingent liabili-ties that might crystallize upon thehappening of an uncertain event. Allcontingent liabilities are detailed inthe notes to the accounts and itwould be wise to read these as theygive valuable insights. The morecommon contingent liabilities thatone comes across in the financialstatements of companies are: (a) Outstanding guarantees.(b) Outstanding letters of credit.(c) Outstanding bills discounted. (d) Claims against the company notacknowledged as debts. (e) Claim for taxes.(f) Cheques discounted. (g) Uncalled liability on partly paidshares and debentures.

(c ) Others It must be appreciated that the pur-

pose of notes to the accounts is toinform the reader more fully.Consequently, they detail all perti-nent factors which affect, or willaffect, the company and its results.Often as a consequence, adjust-ments may need to be made to theaccounts to unearth the true results.

Note 6 of Fundamental & Co.Ltd.'s Annual Report for 2003-2004 stated: "The Company hasduring the year credited an amountof Rs.132.14 lakh to surplus on saleof assets (Schedule No.13) whichincluded an amount of Rs.112.88lakh being the excess of sale priceover the original cost of the fixedassets. Till the accounting year2002-2003 such excesses over theoriginal cost was credited to capitalreserve. Had the Company followedthe earlier method of accounting theprofit for the year would have beenlower by Rs.112.88 lakh." This sug-gests that the company had changedits accounting policy in order toincrease its profits. The profit beforetax that year (year ended 31 March2004) was Rs.108.12 lakh (previousyear Rs.309.80 lakh). Had thisadjustment not been made, the com-pany would have suffered a loss ofRs.4.76 lakh. The company had alsowithdrawn Rs.35.34 from the reval-uation reserve. It was also stated inthat company's annual report that

NOTES The notes to the accounts are evenmore important than the schedulesbecause it is here that very impor-tant information relating to thecompany is stated. Notes can effec-tively be divided into:

(a) Accounting Policies(b) Contingent Liabilities and (c) Others

(a) Accounting policiesAll companies follow certainaccounting principles and these maydiffer from those of other entities.As a consequence, the profit earnedmight differ. Companies have alsobeen known to change (normallyincrease) their profit by changingthe accounting policies. Forinstance, Tata Iron and SteelCompany's Annual Report for1991-92 stated among other things,"There has been a change in themethod of accounting relating tointerest on borrowings used for cap-ital expenditure. While such interestwas fully written off in the previousyears, interest charges incurred dur-ing the year have been capitalizedfor the period upto the date fromwhich the assets have been put touse.

Accordingly, expenditure trans-ferred to capital account includes an

amount of Rs.46.63 crore towardsinterest capitalized. The profitbefore taxes for the year after theconsequential adjustments of depre-ciation of Rs.0.12 crore is thereforehigher by Rs.46.51 crore than whatit would have been had the previousbasis been followed". This meansthat by changing an accounting pol-icy TISCO was able to increase itsincome by Rs.46 crore. There couldbe similar notes on other items inthe financial statements.

The accounting policies normallydetailed in the notes relate to: (a) How sales are accounted.(b) What the research and develop-ment costs are.

Schedules and notes to the accounts arefound after the financial statements in

an annual report. The schedules detail pertinent informa-

tion about the items of the balancesheet and profit and loss account.

The notes are even more important asthey give very important information

such as the accounting policies that thecompany has followed, the contingent

liabilities of the companies and the like. It is imperative that the schedules and

notes to the accounts be read for a clear-er understanding of the company's

financial condition.


85Ratios84 The annual report

Which Company?

RATIOSCHAPTER SEVEN

"no provision had been made forRs.16.39 lakh being the fall in thebreakup value of unquoted shares inwholly owned subsidiary compa-nies" and "the income tax liabilityamounting to Rs.36.41 lakh relatingto prior years has been adjustedagainst the profits transferred to theGeneral Reserve in the respectiveyears". The latter points out that thetax change had been adjusteddirectly with reserves as opposed torouting it through the Profit andLoss account. Had that been donethe profit after tax would have fur-ther reduced. Similar comments aremade in the notes to the accounts ofother companies also.

The more common notes one comesacross are:

(a) Whether provisions for knownor likely losses have been made. (b) Estimated value of contracts out-standing.(c) Interest not provided for. (d) Arrangements agreed by thecompany with third parties. (e) Agreement with labour.

The importance of these notes cannot be overstressed. It is impera-tive that investors read these carefully.

87Ratios86 Ratios

Which Company?

is only when the various differentratios are calculated and arrangedthat the complete state of a compa-ny emerges and it is important thatan investor has as much informa-tion as possible before he actuallyinvests.

Ratios can be broken down intofour broad categories:

(A) Profit and Loss Ratios These show the relationshipbetween two items or groups ofitems in a profit and loss account orincome statement. The more com-mon of these ratiosare: 1. Sales to cost ofgoods sold.2. Selling expensesto sales.3. Net profit tosales and 4. Gross profit tosales.

(B) Balance Sheet Ratios These deal with the relationship inthe balance sheet such as : 1. Shareholders equity to borrowedfunds. 2. Current assets to current liabili-ties.3. Liabilities to net worth.4. Debt to assets and

5. Liabilities to assets. (C) Balance Sheet and Profit andLoss Account Ratios. These relate an item on the balancesheet to another in the profit andloss account such as: 1. Earnings to shareholder's funds.2. Net income to assets employed.3. Sales to stock.4. Sales to debtors and 5. Cost of goods sold to creditors.

(D) Financial Statements andMarket RatiosThese are normally known as mar-

ket ratios andare arrived atby relationfinancial fig-ures to marketprices: 1. Market valueto earnings and 2. Book value

to market value.

In this book, ratios have beengrouped into eight categories thatwill enable an investor to easilydetermine the strengths or weak-nesses of a company.

(a) Market value (b) Earnings (c) Profitability

Ratios express mathematically the rela-tionship between performance figuresand/or assets/liabilities in a form that

can be easily understood and interpreted.


o person should investin a company until hehas analyzed its finan-cial statements and

compared its performance to whatit achieved in the previous years,and with that of other companies.This can be difficult at timesbecause:

(a) The size of the companies maybe different.(b) The composition of a company'sbalance sheet may have changedsignificantly. Itmay have issuedshares, orincreased orreduced borrow-ings.

It is in theanalysis of finan-cial statements that ratios are mostuseful because they help an investorto compare the strengths, weakness-es and performance of companiesand to also determine whether it isimproving or deteriorating in prof-itability or financial strength.

Ratios express mathematicallythe relationship between perform-ance figures and/or assets/liabilitiesin a form that can be easily under-stood and interpreted. Otherwise,one may be confronted by a battery

of figures that are difficult to drawmeaningful conclusions from. Itshould be noted that figures bythemselves do not enable one toarrive at a conclusion about a com-pany's strength or performance.

Sales of Rs.500 crores a year ora profit of Rs.200 crores in a yearmay appear impressive but one can-not be impressed until this is com-pared with other figures, such as thecompany's assets or net worth orcapital employed. It is also impor-tant to focus on ratios that are

meaningful andl o g i c a l .Otherwise, nouseful conclusioncan be arrived at.A ratio express-ing sales as a per-centage of trade

creditors or investments is meaning-less as there is no commonalitybetween the figures. On the otherhand, a ratio that expresses thegross profit as a percentage of salesindicates the mark up on cost or themargin earned.

No single ratio tells the completestoryThere is no point in computing justone ratio at it will not give thewhole picture but just one aspect. It

N

No investment should be made withoutanalyzing the financial statements of acompany and comparing the company's

results with that of earlier years.


89Ratios88 Ratios

Which Company?

check the time it would take torecover one's investment. In addi-tion, it reflects the opinion of theinvesting public about the company,i.e. whether the company is growing

or declining, and whether the priceis likely to rise, fall or remain stag-nant.

The P/E ratio is calculated bydividing the market price of a com-pany's share by its earning's pershare, i.e. profit after tax and pref-erence dividend divided, by thenumber of shares issued by the com-pany.

Samudra Lamps Ltd. is a compa-ny involved in the manufacture ofelectric bulbs and tubelights. At 31December, 2003, its shareholders'funds were as follows : The profit that the company made

that year after tax and preferencedividend was Rs.400 lakh. Themarket price of the share on 31December 2003 was Rs.112.

The earnings per share would be400\50 = Rs.8

The price earnings ratio would be112\8 = Rs.14

This means that the investorwould take 14 years to recover hisinvestment through earnings.

This also translates to a yield of7.14% (100/14 years).

The P/E ratios of well estab-lished and financially sound compa-nies are high and as the returns arehigh for weaker companies the P/Eratio is low since they are riskierinvestments.

The P/E ratio would be high solong as the investing public has faithin a company's ability to grow andto earn a return or an appreciationin its share price. It will fall as soonas this confidence in the earningcapacity of the company falls. Thisis why prices rise dramatically inboom periods. In periods of depres-sion, they fall.

The price an investor pays for ashare is based on the futureprospects of a company and its

(Rs. lakh)

500,000 shares of Rs.10 each

50

100,000 10% preference shares of Rs.10 each

10

Reserves 70

130

(d) Liquidity(e) Leverage(f) Debt Service Capacity(g) Asset Management/Efficiency(h) Margins.

Of course, it must be ensuredthat the ratios being measured areconsistent and valid. The length ofthe periods being compared shouldbe similar. Large non-recurringincome or expenditure should beomitted when calculating ratios cal-culated for earnings or profitability,otherwise the conclusions will beincorrect.

Ratios do not provide answers.They suggest possibilities. Investorsmust examine these possibilitiesalong with general factors thatwould affect the company such asits management, management poli-cy, government policy, the state ofthe economy and the industry toarrive at a logical conclusion and hemust act on such conclusions.

Ratios are a terrific tool forinterpreting financial statements buttheir usefulness depends entirely ontheir logical and intelligent interpre-tation.

A. MARKET VALUE Ultimately the market value of ashare is what matters to an investor.An investor would purchase a shareif, in his perception, its price is low

or reasonable and has growthpotential.

On the other hand, if a share ispriced high an investor would wantto sell it. After all, the cardinal ruleof investment in shares is to buycheap, sell dear or, as BaronRothschild is credited to have said,"Buy sheep and sell deer".Additionally, the market value of ashare reflects the regard investorsand the general public have of thecompany.

Market value ratios also help aninvestor determine the length oftime it would take to recover his orher investment.

Price-Earnings Ratio The Price-Earnings or P/E ratio isarguably the most commonly quot-ed ratio. Investors, analysts andadvisers alike quote this ratio to jus-tify or support their contention. Thereason for its popularity is that itreduces to an arithmetical figure therelationship between market priceand the earnings per share andthereby allows one the opportunityto determine whether a share isoverpriced or underpriced and

Market Price per shareEarnings per share

Price Earnings Ratio

91Ratios90 Ratios

Which Company?

That may be. In my opinion,though, I feel that in India it wouldbe safer for investors to buy sharesof companies that have a relativelylower P/E (between 11 and 13). Oneshould think twice before purchas-ing a share that has a higher P/E.

Having said that, the P/E thatdifferent investors would be pre-pared to accept as reasonable woulddepend on:

(a) The company and their percep-tion of its management, growth,prospects, and the industry it oper-ates in.(b) The demand for the shares of thecompany. Certain companies suchas ITC, Reliance, Infosys etc. haverewarded their investors well overthe years and these shares commandhigher P/Es. (c) The profitability and earnings ofa company. (d) The target returns of the differ-ent investors.

In short, the P/E that is consid-ered reasonable by differentinvestors will be the one that fulfillstheir particular investment returnrequirement.

The pricing of shares as far asP/E is concerned lost all meanings in1999 with Information TechnologyShares. Companies such as

Amazon.com and many others thatwere loss making were quoting atP/E ratios that made no sense. Thebasis was on perceived earningsprojected earnings and potentialearnings not actual earnings. Insuch a situation one's guess or pricewas good as the others. Prices in themarket (it must always be remem-bered) is based on perception.

Market to Book RatioThe market to book ratio comparesthe book value of the assets of acompany to its market value. If ashare's market price is treble orquadruple its book value, it signifiesthat investors have tremendous con-fidence in the growth prospects ofthe company. It can also suggestthat the assets may be understated.If, on the other hand, the bookvalue is more than the market value,the company may not be makingprofits and may not be enjoyinginvestor confidence. The market tobook ratio is calculated by dividingthe market price per share by thebook value per share.

For example, if the market price

Market price per shareBook value per share

Market to book Ratio

anticipated earnings. As such, thereis a flaw in P/E ratios when currentmarket price is divided by past earn-ings per share. Ideally, the currentmarket price should be divided bythe current likely earnings pershare. But then that figure is diffi-cult to get.

The P/E ratio reflects the reputa-tion of the company and its man-agement and the confidenceinvestors have in the earningspotential of thecompany.

An investormay well askwhat should bethe P/E ratio of acompany; atwhat priceshould one pur-chase the share of a company. Atthe height of the 1992 scam inIndia, the P/E of several companiessuch as Hindustan Lever Ltd, ITCLtd., etc. were in excess of 100. Theaverage P/E of companies quoted onthe Bombay Stock Exchange aver-aged 80. Even a year after the scamthe average P/E was around 37.This was one of the widely-citedreasons for foreign investors notdescending in droves on the Indianstock markets. It was argued thatthe average P/E of shares in devel-

oped economies like the UnitedStates was then around 20. Thisoffered a yield of 5% which wasabout 2% above the rate of infla-tion. On that basis, if one assumesthat the rate of inflation in India isaround 10%, then the P/E of sharesone wishes to purchase should be 8.This would result in a yield of12.5% which would be 2.5% abovethe rate of inflation. As inflationfalls, the P/E will rise and the yield

will fall. In acountry likeIndia, inter-est rateshave begunto fall dra-m a t i c a l l y .W h a tshould the

P/E be now. I'd like to introduce, atthis juncture, a school of thoughtpromoted by those I term the thedeveloping economy proponents.They argue that the average P/E ofshares in developing economies, i..ein countries in South East Asia,average 45. They claim that P/Eshave to be higher in developingeconomies as companies are grow-ing and the high P/Es reflect thisgrowth. As companies mature,earnings will stabilize and the P/Esfall.

Ratios can be broken into 4 broad categories: (a) Profit and Loss Ratios (b) Balance Sheet Ratios

(c) Balance Sheet and Profit and Loss Ratios, &(d)Financial Statements to Market Ratios.


93Ratios92 Ratios

Which Company?

of the shares of MithawalaChemicals Ltd. is Rs.105 and thebook value of its shares is Rs.48, itsmarket to book ratio is 105/48 =2.1875.

The market value of the sharesof Mithawala Chemicals is morethan twice its book value. This sug-gests that either the assets of thecompany are understated or itsp r o s p e c t sare goodand thati n v e s t o r sbelieve thatit will growin income, value and profitability.

As a rule of thumb, one shouldnot purchase a share which is pricedmore than thrice its book valuebecause the gap is enormous andthe difference would not be backedby tangible assets. As a conse-quence, there could be abig fall in the price.

Let me illustrate thedifferences between mar-ket and book value in afew companies. Thereare large differencesbetween the marketvalue and the bookvalue.

Summary The market value ratios

are extremely important becausethese determine an investment deci-sion. If one remembers, as technicalanalysts would vouch, that the mar-ket price of a share takes intoaccount the profitability, earnings,prospects and all other aspects of acompany, market ratios go on toanother dimension - as the onlyratios that evaluate the price of a

share for aninvestor tod e t e r m i n ewhether it isunderpr icedor overpriced.

B) EARNINGS Earnings is the yardstick by whichcompanies are finally judged, whatinvestors earn on their investments.The earnings ratios are often usedto determine the fair market price of

In 2003, the earnings after tax of Range View Tea Estates wasRs.5,00,000. Between 1 January 2003 and 30 June 2003 thecompany had 200,000 shares of Rs.10 each outstanding. On1 July 2003, the company issued an additional 100,000shares.

The earnings per share of Range View would be :

500,000 = Rs.2(200,000 x 0.5 + (300,000 x 0.5)

Earnings per Share illustration

Income attributable to common shareholders Weighted average number of common shares

Earnings Per Share

Market to book value of certain selected companies

Name of the Company Book Value as on 31/03/2003

Market Value as on 27thNovember, 2003

ACC 59.60 219.95

Aurobindo Pharma 115.15 300.00

Bajaj Auto 320.30 949.25

Bharat Forge 55.20 623.10

Bharti Televentures 24.10 81.50

Cipla 177.80 1197.45

GAIL 75.00 170.80

GE Shipping 61.00 141.50

Hindalco 669.50 1205.00

HPCL 196.80 368.45

HLL 16.60 179.25

IOC 241.80 370.45

ITC 216.80 855.25

Infosys Technologies 431.90 4928.35

I-Flex Solutions 219.00 743.15

M&M 131.90 348.75

Mphasis BFL 560.20 573.60

MTNL 150.70 113.20

Nirma Ltd. 179.80 345.65

ONGC 249.70 603.60

Reliance Industries Ltd. 217.20 476.20

SAIL 4.80 42.20

Tata Motors 78.30 406.55

TISCO 86.50 353.50

95Ratios94 Ratios

Which Company?

the earnings of the company. If theearning per share is Rs.5 and a yieldof 10% is considered reasonable,the share is priced at Rs.50.

Cash earnings per share It is often argued that the earningsper share is not a proper measure ofthe earning of a company sincedepreciation, tax and the cost offinance varies from one company toanother. The true earnings, theargument goes on, should be calcu-lated on the earning before depreci-ation, interest and tax. The cashearning per share is arrived at bydividing earning before deprecia-tion, interest and tax (EDBIT) bythe weighted average number ofshares issued.

The cash earnings per share willalways be more than theearnings per share.

Dividend per share Investors often use thedividend per share as ameasure to determinethe real value of a share.Proponents of thisschool of thought arguethat the earning pershare is of no real valueto anyone but those whocan determine the poli-cies of a company. The

income of an investor is the divi-dend that he receives. It is thereforesubmitted that the value of a shareshould be a multiple of the dividendpaid on that share.

How does one value a share? Ifone assumes that the gains made byan investor would include anincrease in the price of the share,i.e., capital appreciation, and divi-dend income per share, the pricewould depend on the capital appre-ciation one expects. If the share hasregularly appreciated by 30% everyyear, a low dividend yield would beacceptable.

Conversely, if a share does notappreciate by more than 5% and a30% return is required, a high divi-dend yield would be expected.

If the shares of PDP have been

The shares of Divya Jeans Ltd. which has a market value ofRs.40 has appreciated during the last three years by anaverage percentage of 25. If an investor is aiming at a yieldof 30 per cent, a dividend of 5 per cent would be adequate.In such a scenario if Divya Jeans has paid a dividend of 15%,its market value on the basis of dividend per share would be(assuming 15% dividend on the face value = 5% on the mar-ket value) as follows:

Rs.1.50 (dividend) x 100 = Rs.305 (return required)

On this basis the shares of Divya Jeans is overpriced.

Dividend per Share illustration

a share and to value investments. As a consequence, these are the

most important ratios for investorsand it is important that they beappreciated and understood.

Earnings per share The earnings per share (EPS) ratioindicates the earning of a commonshare in a year. This ratio enablesinvestors to actually quantify theincome earned by a share, and todetermine whether it is reasonablypriced. Ther a t i o i sarrived atby dividingthe income

attributable to common sharehold-ers by the weighted average of com-mon shares.

In countries including Indiawhere employees are given stockoptions, investors check a compa-ny's fully diluted earnings per share.This is the earnings per share of acompany after all share options,warrants and convertible securitiesoutstanding at the end of theaccounting period are exchangedfor shares.

M a n yi n v e s t o r salso value ashare as amultiple of

The summarized Profit and Loss Account (Income Statement) of Nikhila Chips Ltd. for the yearended 31 December 2003 was as follows:

*Administration expenses includes interest costs of Rs.40 and depreciation of Rs.20.

The company had issued 500,000 shares of Rs.10 each. The cash earning of a share in Nikhila Chips Ltd. would therefore be :

1500 + 40 + 20 = Rs.3.12500

Cash Earnings per Share illustration

Rs. (lakh) Rs. (lakh) Sales 5000

Cost of Goods Sold 3000Gross Income 2000Selling Costs 300

*Administration Cost 200 500Net Income 1500

EDBITWeighted average number of shares issued

Cash Earnings Per Share

97Ratios96 Ratios

Which Company?

Summary It is important to remember thatearnings ratios are not indicators ofprofitability. They advise aninvestor on the earnings made pershare, the dividend policy of a com-pany, and the extent of incomeploughed back into the companyfor its expansion, growth andreplacement of assets.

It is critical that investors examinethese ratios, especially the earningsper share and the dividend payout.The earnings per share would helpone determine whether the marketprice of a share is reasonable. If thedividend payout ratios are very highinvestors must be concerned as itcan indicate that the managementof the company is not particularlycommitted to its long-term growthand prospects.

C. PROFITABILITY The profitability of a company is ofprime importance for an investor.Unless a company is profitable, itcannot grow; it cannot pay divi-dends, its value will not increaseand it cannot survive in the longrun.

Profitability ratios assist aninvestor in determining how well aparticular company is doing vis-à-vis other companies within the same

industry, and with reference to itsown performance in earlier years.With the help of these ratios, aninvestor can evaluate the manage-ment's effectiveness on the basis ofthe returns generated on sales andinvestments.

While calculating and evaluatinga company's profitability, aninvestor must bear the following inmind:

As far as possible ratios must becalculated on average assets and lia-bilities and not on the assets or lia-bilities on a particular date. Therecan be large variations in these fig-ures during the year which can dis-tort results quite materially.Companies have also been knownto windowdress their balance sheetsby either reducing or increasingassets or liabilities. Moreover, sinceprofits are earned not on a particu-lar date but over a year, ratios cal-culated on average assets and liabil-ities would portray a truer indica-tion of the results achieved by acompany.

The investor should bear inmind the rate of inflation and thecost of capital and borrowings.

Net Income After TaxNAverage Total Asset

Return on Total Assets

appreciating at 7% per annum andthe company declares a dividend of30% or Rs.3 per share the realvalue of the share would be (30%dividend will be construed as a yieldof 23%).

3 (dividend per share) x100 =Rs.1323 (return required)

It must be noted that this method ofvaluation is so ridden with assump-t i o n s(apprecia-tion everyyear ande x p e c t e dreturn) thatit is rarely used.

Dividend payout ratioThe dividend payout ratio measuresthe quantum or amount of dividendpaid out of earnings. This ratioenables an investor to determinehow much of the annual earnings ispaid out as dividend to shareholdersand how much is ploughed backinto the company for its long-termgrowth. This is an important ratio

when assessing a company'sprospects because if all its income isdistributed there would be no inter-nal generation of capital availableto finance expansion and to nullifythe ravages of inflation and toachieve these the company wouldhave to borrow.

This ratio is calculated by divid-ing the dividend by net income aftertax.

Normally, young, aggressivegrowth com-panies havelow dividendpayout ratiosas theyplough back

their profits for growth. Maturecompanies, on the other hand, havehigh payouts. This is of concern asthey may not be retaining capital torenew assets or grow. Investorsmust also ensure that the dividend isbeing paid out of current incomeand not out of retained earningsbecause that tantamounts to eatinginto the funding set aside forgrowth, expansion and replacementof assets.

Excel Railings Ltd.'s earnings after tax in the year ended 31 March 2004 was Rs.68 lakh. Ofthis, it paid a dividend of Rs.28 lakh. Its dividend payout ratio would be 28/68 = 0.412.The company distributed 41.2% of its net income as dividends, retaining 58.8% in the businessfor its growth.

Dividend payout Ratio illustration

DividendNet Income After Tax

Dividend Payout Ratio

99Ratios98 Ratios

Which Company?

good as often alternativesavailable. This return iscalculated by expressingincome, i.e. the net profitafter tax, as a percentageof share holder's equity.It is to be noted that theincome figure should notinclude extraordinary,unusual or non recurringitems as that would dis-tort the results arrived at.In addition, the netincome on which thisratio is calculated shouldexclude dividends onp r e f e r e n c e s h a r e s .Shareholders' equity isthe stake ordinary share-holders have in a compa-ny and includes, reservesand retained earnings. It must be rememberedthat if there are otherinvestments that earn ahigher return with lowerrisks then the profitabili-ty is low. The ROE should be com-pared with other alternatives takinginto account the risks of the invest-ment. The normal rule is: the higher

the return, the higher the risk.

Pre-interest return on assets It is often said that the pre-interestreturn on assets is a purer measureof profitability since it is difficult tocompare the post-tax performanceof companies on account of interestand taxation. This is because the

In 2003, the published results of Homedale Limitedincluded the following

The return on total assets are as follows:

1000 - (300 - 200)2002 -------------------------------------- = 8.57%

0.5 x (10000 + 11000)

12002003 -------------------------------------- = 10.34%

0.5 x (10000 + 12200)

The ROE has improved in 2003. The investor would howeverneed to determine whether this is the best return that hecould have got i.e. could have earned more if he hadinvested his money elsewhere.

Return on Equity illustration

2001 2002 2003Rs.(lakh) Rs.(lakh) Rs.(lakh)

Income before tax 400 1700

Extra ordinary Items300

---------1400

--------------------1700

Taxation 400 500

Income after taxation 1000 1200

Shareholder's Equity10000

11,000 12,200

Earning Before Interest and TaxAverage Total Asset

Pre-IInterest Return on Assets

When evaluating a prof-itability ratio, aninvestor should considerwhether a better returnwould have beenreceived elsewhere. Andwhether the return haskept pace with the rateof inflation.

Finally, ratios shouldbe considered as an indi-cation or as a suggestionof future development.

Return on total assets The first ratio oneshould check is thereturn on total assets.This is an extremely important indi-cator as it would help the investordetermine:

Whether the company has earneda reasonable return on its sales

Whether the company's assetshave been effectively and efficientlyused, and

Whether the cost of the compa-ny's borrowings are too high

This ratio should be used tocompare the performance of a com-

pany with other companies withinthe same industry, and with previ-ous years. It could also be used toproject the performance of futureyears.

Return on equity Another important measure of prof-itability is the return on equity, orROE as it is often termed. The pur-pose of this ratio is to determinewhether the return earned is as

Nair Limited is a company engaged in the manufacture ofrefrigerators and washing machines.

The return on total assets are as follows:

4002002 -------------------------------- = 6.67

0.5 x (5000 + 7000)

2003 600-------------------------------- = 6.67%0.5 x (7000 + 11000)

Although net income has improved by 50%, the company'sprofitability has not improved since its average assets have

also increased by 50%.

Return on Total Assets illustration

2001 2002 2003Rs.(lakh) Rs.(lakh) Rs.(lakh)

Net income after tax 300 400 600Total Assets 5000 7000 11000

Net Income After Tax-DDividend on preference shares Average Shareholders Equity

Return on Equity

101Ratios100 Ratios

Which Company?

whether the capital available to acompany has been efficiently used isthe return on total invested capital.

By using this ratio, an investorcan check whether he could have

earned more elsewhere. It thereforegives him an opportunity to com-pare returns from alternative com-panies. Invested capital in this ratioincludes all liabilities that have a

An extract of the financials of Bhagwan Ltd. is as follows:

Pre-interest after tax return on tax is as follows:

600 + 200 x 50 \ 1002002 ------------------------------- = 8.75%

0.5 (7000 + 9000)

800 + 400 x 50 \ 1002003 ------------------------------- = 10.00%

0.5 (9000 + 11000)

In 2002, Bhagwan Ltd. earned a return on assets prior to the cost of financing of 8.75%. Thisimproved to 10.00% in 2003, suggesting that the assets had been used more effectively in

2003. However while comparing other companies one should compare the return and deter-mine whether the return is adequate (considering the size and the nature of the company)

Pre-interest after Tax return on asset Ratio illustration

2001 2002 2003Rs.(crore) Rs.(crore) Rs.(crore)

Earnings before interest & tax 800 1200Interest expense 200 400

Pretax income 600 800Tax at 50% 300 400

Net income after tax 300 400Total assets 7000 9000 11000

Earnings Before Interest and TaxAverage Total Invested Capital

Return on Total Invested Capital

interest paid will vary from compa-ny to company and will depend onits borrowings. Similarly, the taxliability of companies differs anddepends on the manner in which ithas planned its tax. This ratio there-fore suggests that the return shouldbe based on operating income and isarrived at by dividing earningsbefore interest and tax by the aver-age total assets. An investor must compare thereturn earned by a company withthat of other companies, preferablyin the same industry, to determinewhether the return earned is high orlow

Pre-interest after tax return ofassets

The purpose of calculating thisratio is to determine the manage-ment's performance in deployingassets effectively without financing.Tax is included in the calculation asit is deducted before arriving at theprofits. Interest, however, is notconsidered as it will vary from com-pany to company and is a paymentfor capital or funds. The ratio isarrived at by expressing net returnafter tax but exclusive of interest asa percentage of average total assets.

Return on total invested capital The ratio used for determining

Nair Limited is a company engaged in the manufacture of refrigerators and washing machines.

Pre-interest return on assets would be:

300------------------------------x 100 = 12.1/2% 0.5 x (1000 + 1400)

Pre-interest return on asset s illustration

2002 2003Rs.(lakh) Rs.(lakh)

Earnings before interest & tax 250 300Total Assets 1000 1400

Net Income After Tax + Interest Expense Net of Income Tax SavingAverage Total Assets

Pre-IInterest After Tax Return on Assets

103Ratios102 Ratios

Which Company?

of any investment. It is importantthat investments be liquid so thatthey can be converted to cash easilyto meet obligations. Similarly, it isimportant for a company to be liq-uid in order for it to meet its matur-ing financial obligations and tohave enough funds to meet its oper-ational requirements.

If a company is unable to do so,it may be forced to sell its moreimportant assets at a loss and, inextreme cases, be forced into liqui-dation. After the securities scam in1992, many mutual funds wereforced to sell their blue chip sharesto generate liquidity as they werenot able to sell their large holdingsof securities of public sector under-takings (PSUs). In the first quarterof 2000 when the values ofInformation Technology sharesplummeted there was fear thatprices would fall further as mutualfunds sold shares to meet redemp-

tions of their units. When the UTIwent through its troubles, Mr.Damodaran after taking chargeorchestrated a sale of the more mar-ketable securities to book profitsand to be liquid to meet redemptiondemands.

Current Ratio The current ratio is the most com-monly used ratio to measure liquid-ity. Its purpose is to check whethera company's current assets areenough to meet its immediate liabil-ities, i.e. those that mature withinone year. The ratio is arrived at bydividing current assets by currentliabilities

Normally, the current ratio isaround 1 or even a little below 1.This in itself is not bad. Today, allcompanies are aware of the cost ofcapital, the opportunity cost oftying up capital, the opportunitycost of tying up capital unproduc-tively, and just in time (JIT) inven-tory control. Consequently, there isan effort to keep current assets low,be it stock levels, debtors or cash.Thus, often the current ratio is well

Current AssetsCurrent Liabilities

Current Ratio

At 31 March 2003, Spear Canisters Ltd's current assets were Rs.400 crore whereas its cur-rent liabilities were Rs.125 crore. Its current ratio is 16:5 or 3.2. In short, Spear Canisters Ltd.

can easily meet its current liabilities. It can do so by selling a mere 31.25% of its currentassets

Current Ratio illustration

cost associated with them, such asdebentures, share capital and loans.

The ratio is arrived at by divid-ing a company's earnings beforeinterest and tax by average totalinvested capital.

An investor must check whetherthe return on capital is higher thanthe prevailing rate of interest andthe weighted average cost of bor-rowings. If the rate of interest ishigher then the return on the capitalshould be considered inadequate.

Summary The profitability ratios are arguably

the most important of all ratios foran investor as they indicate whetheran enterprise is viable, and better orworse than other similar ones.These ratios should not be seen inisolation. One should rememberthat a lower ratio is not necessarilybad. In order to increase sales andprofits companies may sell goods atlower prices in volume driven busi-nesses. Like all ratios, these ratiosare indicators and they should beconsidered as such.

D) LIQUIDITYLiquidity is one of the cornerstones

Bombay Pistons Ltd's earnings before interest and tax in 2003 was Rs.18.50 crores. Its totalinvested capital in 2002 and 2003 were as follows:

The return on total invested capital is:

18.50 ------------------------------ x 100 = 2.58

0.5 x (730 + 705)

Return on Total Invested Capital illustration

2002 2003

Rs.(crore) Rs.(crore)

Term loan 150 120

Debentures 500 500

Shareholders' funds 80 85

Total invested capital 730 705

Net income after tax 300 400

Total assets 9000 11000

105Ratios104 Ratios

Which Company?

In 2003, Samudra Fisheries had a sales turnover of Rs.2,000 lakh. Its net current assets were:

Samudra Fisheries thus had net current assets of Rs.450 lakh. This means it had Rs.450 lakhleft after meeting its current obligations.

Net Current Assets Illustration

2002 2003(Rs.lakh) (Rs.lakh)

CURRENT ASSETSDebtors 280 310

320 390Total current assets 600 700CURRENT LIABILITIES

Creditors 190 220Accrued expenses 3 5

Tax payable 7 25Tax current liabilities 200 250

Net current assets 400 450

Net Current Assets Net current assets or net workinginvestments is arrived at by deduct-ing current liabilities from currentworking assets (trade assets). Thisis clearly not a ratio. Its usefulnesslies in quickly ascertaining whethera company has adequate currentassets to meet its current liabilities.Net current assets is really theworking capital of a company.

Consequently, several deriva-tives can be calculated from this fig-ure, such as its relationship to sales,income and even to capital.

Net current assets can also beused as a base to determine the

quantum of working capitalrequired to support a certain levelof sales. A ratio of 20% could sug-gest that if sales were to increase by20%, net current assets would alsoneed to increase proportionately. Inthis context, it is better to have alow ratio as the increase in workingcapital needed will be less. Thecompany can therefore grow quiterapidly.

In the example of Sumudra

Average Debtors X 365Sales

Debtors Turnover

below 1. This does not necessarilymean that the company is not liq-uid, it could merely be using itsassets effectively.

Quick or Acid Test The acid test is afavorite ofinvestors and credi-tors. This ratio isused to checkwhether a compa-ny has enough cash or cash equiva-lents to meet its current obligationsor liabilities.

The underlying logic being thatthere usually is no conversion cost when cash or cash equivalents are

used to pay debts. Other assets such as inventories

(stocks) may realise less than bookvalue if sold at a distress. In otherwords, company could lose whenconverting these to cash in an emer-

gency. This ratio is

arrived at bydividing cash,m a r k e t a b l einvestments and

debtors by current liabilities. It is tobe noted that investments, thoughstrictly not a current asset, is used incalculating this ratio. This isbecause they are easily realisable

Cash & Cash EquivalentsCurrent Liabilities

Quick Ratio

An extract of Nivya Ltd's financial statement at 31 March 2003 was as follows:

The quick ratio will be :

150 + 1850 + 500 ------------------------------ = 0.625

4000The company cannot pay off its entire current liabilities with cash or cash equivalents. It

should be remembered that stocks have not been considered in calculating this ratio as it isnot a cash equivalent and, as explained above, if one wishes to sell these in a hurry there is

likely to be a loss arising out of dumping of goods.

Quick Ratio illustration

Rs. (lakh) Cash at Bank 150

Debtors 1850Stocks 3100

Investments 500Current Assets 5600

Current liabilities 4000

107Ratios106 Ratios

Which Company?

Net Trade CycleIt is important to determine the timea company takes to realize its salesproceeds after paying for the pur-chase of its raw materials. This is avery useful tool for determining acompany's liquidity and is comput-ed by adding the debtors turnoverin days to the stock turnover indays, and deducting from it thecreditors turnover in days.

If this ratio improves, it indi-

cates an improvement in the man-agement of net current workingassets. Of course, it can also indi-cate that the company is experienc-ing difficulty in paying its credi-tors. Thus one must go beyond thefigures to determine the reasons fora change in the net trade cycle. Itmust be remembered that thelonger the cycle, the greater theneed for financing.

The net trade cycle shouldtherefore be brought down as

much as possible. This can beachieved by reducing debtors andstock levels.

Investors should apart fromchecking whether there is animprovement in the cycle, checkthe individual components. Anincrease in creditors turnover couldalso suggest that the company hasdifficulty in making payments. Afall in debtors could suggest a fallin credit sales or improved debt

collection. The reason must belooked into.

Defensive Interval This ratio indicates the number ofdays a company can remain in busi-ness without any additional financ-ing or sales. It can be likened to aworker on strike. How many dayscan he survive on the assets that hehas before he becomes bankrupt?

The defensive interval ratio iscalculated by dividing a company's

Average Daily Cash operating ExpensesMost liquid Assets

Defensive Ratio

Cash Inflow From OperationsAverage Current Liabilities

Current Liability Coverage

Fisheries, net current assets wereRs.450 lakh and sales Rs.2000lakh. Its net current assets to saleswill be:

0.5 x (400 + 450) x 100 = 21.25%2000

This means that working capitalshould increase by 21.25% to sup-port every increase in sales. Thus,if sales were to increase by Rs.1crore, working capital would needto necessarily increase by Rs.21.25lakh.

Vindhya Bearings Ltd's financials included the following figures: Net Trade Cycle Illustration

2002 2003Rs.(crores) Rs.(crores)

SALES 200 280Cost of goods sold 160 224

Debtors 24 44Stocks 36 48

THE NET TRADE CYCLE IS:

Debtor turnover 0.5 x (24 + 44) =

28044 Days

Stock turnover 0.5 x (36 + 48) x 365 =

22468 Days

Less

Creditor turnover0.5 x (16 + 32) x 365 =

22439 Days

Net trade cycle (days) 73 Days

Average Stocks X 365Sales

Stock Turnover

Debtors Turnover + Stock turnover Sales — Creditors turnover

Net Trade Cycle

Average Creditors X 365Sales

Creditors Turnover

109Ratios108 Ratios

Which Company?

Current Liability CoverageThe current liability coverage ratioenables investors to examine therelationship between cash inflowsfrom operations and current liabili-ties, and to determine whether thecompany can meet its currentlymaturing obligations from internal-ly generated funds. At times of cre-ative accounting and cash crunchesthis is an extremely important ratio.

Summary Liquidity is becoming increasinglyimportant for companies and thisfactor alone has resulted in compa-nies becoming sick - an inadequacyof funds to finance operations. It iscrucial that investors examine theliquidity of a company, andwhether it is improving or deterio-rating.

As companies begin to havefinancial difficulties, they begin topostpone and delay paying theirbills. Current liabilities begin tobuild up. As current liabilities buildup, suppliers become more andmore reluctant to sell goods. Thisfirst affects production, then salesand has snowballing effect.Therefore if the liquidity ratios of acompany are deteriorating, aninvestor should be concerned.

However, negative liquidityratios need not necessarily be bad.

Many strong companies keep lowcurrent assets and are able to getlong credit from suppliers, especial-ly those that operate with extremelylow margins.

Historically, companies havevery high liquidity ratios. This isbecause fixed assets and stocks aresold and gets converted into cash.Current liabilities decrease as credi-tors are paid off. So good liquidityis also not always wonderful.

An investor should always checkthe quality of a company's currentassets. It should also be ascertainedwhether they are at current realis-able value. Moreover, current assetsshould not include deferred revenueexpenditure like advertising costs asthey do not have any encashablevalue. Finally, it must be remem-bered that balance sheets can bewindowdressed. Therefore, the fig-ures should be properly scrutinized.

The optimal liquidity requiredvaries from company to companyand from industry to industry. Itdepends both on market conditionsand the prominence of a company.While viewing liquidity ratios, theinvestor must check whether a com-pany is adequately liquid andwhether its liquidity position hasdeteriorated or improved. If it asdeteriorated and there does notseem a likelihood of it, improving in

average daily cash operatingexpenses by its most liquid assets. Itis important to note that only themost liquid of assets are used in cal-culating this ratio, such as cash and

cash equivalents. Debtors andstocks are not to be considered asthey are not cash equivalents.

The cash and cash equivalents of General Balls Ltd. a company whose annual operatingexpenses were Rs.730 crore and were as follows:

This means that General Balls Ltd. can remain in existence for 90 days without any sales orfinancing.

Defensive Ratio illustration

Rs.(crore) CASH 35

Marketable securities 145Rs. 180

ITS DAILY OPERATING EXPENSES WOULD BE :

730 365

Rs.2 crore

ITS DEFENSIVE INTERVAL WOULD BE

1802

90 days

In the year ended March 2003, Bharat Bolts Ltd. earned a net income before tax but afterdepreciation of Rs.750 lakh. Depreciation was Rs.25 lakh. Current liabilities at 31 March 2002

and 31 March 2003 were Rs.1450 lakh and Rs.2350 lakh

The current liability coverage is:

In other words, cash flow from operations was only 41% of current liabilities. If current liabili-ties were to be paid out of internally generated funds it would take 2.44 years.

Current Liability Coverage illustration

750 + 25 = 0.40.5(1450 + 2350)

111Ratios110 Ratios

Which Company?

the imminent future, one shouldconsider selling the company'sshares.

E) LEVERAGE Leverage indicates the extent towhich a company is dependent onborrowed funds to finance its busi-ness. These borrowings would be inthe form of debentures, term loans,short term loans and bank over-drafts.

In highly leveraged firms, theowner's funds are minimal and theowners are able to control the busi-ness with a fairly low stake. Themain risks are borne by the lenders.In good times these companiesmake large profits, especially if theyare in high margin businesses.However, the reverse occurs intimes of recession. Interest costs areexorbitant and the large profitsmade in boom times turn into largelosses.

The effect on profits is illustrat-ed in Table I. Company A is a high-ly leveraged, Company B's bor-rowed funds amount to 20% of itstotal funds, and Company C is acash rich company and does notborrow at all.

In a good year the returnCompany A makes is stupendous170% before tax, whereas

Company C makes a comparativelymodest 50%. It must be noted thatso long as the return or the earningsrate exceeds the cost of borrowings,a highly leveraged company willmake impressive profits. As this ratedecreases profits will fall. In a rea-sonable year, too, the profits ofhighly leveraged companies wouldbe more than companies that do notborrow. In the example in Table I, itwould be noticed that the returnbefore tax of Company A is twicethat of Company C.

The tide turns in year of depres-sion or recession as borrowingshave to be serviced. At such times,the cost of borrowings often exceedthe profits made and results in loss-es and the company that makes thehighest profits is the one that has noborrowings.

One can safely conclude, there-fore, that though companies withvery little or no borrowings aresafer and can be depended upon forsome returns both in good yearsand bad, highly leveraged compa-nies are risky and earnings can benegative in bad years. Conversely,in good years the results of highlyleveraged companies can be verygood indeed.

TABLE 1Company A Company B Company C(Rs. lakh) (Rs. lakh) (Rs. lakh)

Share Capital 40 160 200Borrowed Funds 160 40 -----------------

200 200 200GOOD YEAR

Earnings before interest and tax 100 100 100Interest @ 20% p.a. 32 8 -----------------Income before tax 68 92 100

Tax @ 50% p.a. 34 46 50

Income after tax 34 46 50

Return to ordinary shareholdersBefore tax (%) 170.00 57.50 50.00After tax (%) 85.00 28.75 25.00

REASONABLE YEAR Earnings before interest and tax 60 60 60

Interest @ 20% p.a. 32 8 -----------------Income before tax 28 52 60

Tax at 50% 14 26 30


Return to Ordinary Shareholders:

Before tax (%) 70.00 32.50 30.00

After tax (%) 30.00 16.25 15.00

BAD YEAR Earnings before interest and tax 24 24 24

Interest @ 20% p.a. 32 8 -----------------Income before tax 8 16 24

Tax @ 50% p.a. ----------------- 8 12


Return to ordinary shareholders : Before tax (%) 10 12

After tax (%) 5 6

113Ratios112 Ratios

Which Company?

legal suits, and the like. Shouldthese be significant and likely tocrystallize, the ratio would changedramatically.

An extract of the financial statements of Pushpa Refrigerators Ltd. is detailed below:

The Debt to Assets ratio would be :

Even if assets were to reduce by as much as 32%, the company would still be able to meet itscommitments.

Debt to Assets ratio illustration

Rs. LakhTerm loan 200

14% Debentures 500

Bank Overdraft 50750

TOTAL ASSETS 1200

Goodwill 100

750 = 0.681200-100

DebtNet Worth

Debt to Net Worth Ratio

Nikhila Ltd's debt on 31 March 2004 was Rs.385 lakh. The shareholders' equity was Rs.105lakh. There were no intangible assets.

The debt to net worth ratio was:

In other words, borrowed funds were 3.67 times the shareholders' equity. For every Re1invested by shareholders, borrowings were Rs.3.67. This shows the company is highly

geared.

Debt to Net worth Ratio illustration

385 = 3.67105

Liabilities to Assets Ratio This ratio, indicates the total bor-rowings used to finance the compa-ny, and the extent to which theseexternal liabilities finances theassets of a company. Liabilities inthis context include both currentand long term liabilities. Assetsinclude all assets excluding intangi-

bles, such as deferred revenueexpenditure (preliminary expenses,good will, deferred advertisingexpenditure and the like). The ratiois calculated by dividing total liabil-ities by the total assets

An investor would be wise toexamine also a company's contin-gent liabilities, such as guarantees,

The Balance Sheet of SWW Ltd. at 31 March 2003 is detailed below: The liabilities to assets ratio would be :

50 + 200 = 0.74350 -10

This means that 74% of the assets of the company were financed by liabilities. Conversely, itcan also be said that assets sold at even 74% of their book value would meet and extinguish

the company's liability commitments.

Liabilities to assets Ratio illustration

Rs. LakhSOURCES OF FUNDS Shareholder's Funds 100

Debentures 50

CURRENT LIABILITIES 200350

APPLICATION OF FUNDS

Fixed Assets 80Investments 40

Preliminary expenses 10Current Assets 220

350

Total LiabilitiesTotal Assets

Liabilities to Assets Ratio

Total DebtTotal Tangible Assets

Debt to Assets Ratio

115Ratios114 Ratios

Which Company?

Liabilities to Net Worth The liabilities to net worth is a larg-er measure than the debt to networth ratio and attempts to deter-mine how dependent a company ison liabilities to fund its business. Itis calculated by dividing the totalliabilities of a company by its networth. Net worth is arrived at afterdeducting intangible assets

Incremental Gearing The incremental gearing ratioattempts to determine the addition-al borrowings required to finance

growth. To an extent this ratio issimilar to the net working invest-ments ratio. The ratio is calculatedby dividing the net increase in debtby the increase in net income aftertax but before dividend .

Other Ratios There are several other gearingratios but these are seldom used.For instance, the long-term debtratio determines how importantborrowings are to total long-termliabilities and shareholders' equity.Another ratio is the liability to equi-ty issue. Liabilities in this calcula-

Net increase in DebtIncrease in Net Income After Tax but Before Dividend

Incremental Gearing

The financials of Raman Tea Ltd. were as follows:

The incremental gearing isFor every Re 1 used to finance growth, net income would increase by Rs.75.

That is very high dependence.

Incremental Gearing illustration

2002 2003$00s $00s

NET INCOME BEFORE TAX 300 400Taxation 50 75

250 325Borrowings 400 480

0.5 x (480 - 400) = 7575

Debt to Assets ratio The debt to assets ratio is a morespecific ratio. It determines theextent debt or borrowed funds arecovered by assets and measures howmuch assets can depreciate in valueand still meet the debt commit-ments. Debts are defined as bor-rowed funds and would includebank overdrafts. Assets exclude

intangibles, such as goodwill anddeferred assets. The ratio is calcu-lated by dividing debt by total tan-gible assets.

Debt to Net Worth Ratio The debt to net worth ratio showsthe extent funds are sourced fromexternal sources and hence theextent a company is dependent onborrowings to finance its business.It is arrived at by dividing a compa-ny's debt by its net worth. Networth is defined as shareholders'equity, less intangible assets.

Total LiabilitiesNet Worth

Liabilities to Net Worth Ratio

The Balance Sheet of Ravi Hawali Ltd. is as follows :

The liability to net worth ratio would be:

The company's liabilities are thus 1.55 times its net worth. Alternatively, liabilities finance60.85% of the assets (230/230 = (158 - 10). This is an extremely useful ratio when one is

determining how well shareholders would be compensated should the company gointo liquidation.

Liabilities to Net Worth Ratio illustration

Rs. LakhShareholder's equity 158

Debentures 150

Term loans 40Current Liabilities 40

388

Tangible Assets 378Intangibles 10

388

______230 = 1.55158-10

117Ratios116 Ratios

Which Company?

through additional borrowings orrights and public issues of shares.

Debt Coverage This ratio is used to determine thetime it would take a company torepay its short and long term debtfrom its income or internally gener-ated funds. This is relevant if thedebt is not to be extinguishedthrough the sale of assets, or by theissue of fresh capital or debt.

For calculating this ratio, inter-nally generated funds means incomeafter tax plus non-cash expensessuch as deprecia-tion, and non oper-ating income andexpenses. Debtwould comprise ofbank overdrafts, term loans anddebentures. The ratio is calculatedby dividing a company's internallygenerated funds by its average debt.

Liability Coverage Liability coverage ratio is an exten-sion of the debt coverage ratio. It isused to check whether a companycan repay all liabilities throughinternal generation.

This ratio is calculated by divid-ing the internally generated funds ofa company by its average total lia-bilities

It is also possible to calculatethis ratio using the liabilities figureat the date of the balance sheet, theargument being that what has to beconsidered is the time it would take

to repay thetotal liabilitiesat a particulartime.

Interest Cover An important factor that investorsmust ascertain is whether a compa-ny's profits are adequate to meet its

In the year ended 31 March 2003, Tongues and Tongs Ltd. generated Rs.500 lakh internally.Its total liabilities at the end of 20021999 and 2003 were Rs.3,500 lakh and Rs.4,500 lakh,

respectively.

The liability coverage ratio =

This means that internally generated funds were only 25 per cent of the company's total aver-age liabilities. At this level, the entire debt can be paid off in 4 years.

Liabilities Coverage Ratio illustration

500_ = 0.250.5 x (3500 + 4500)

Internally Generated FundsAverage Total Liabilities

Liability Coverage Ratio

tion includes total liabilities as wellas shareholders' equity.

SummaryThe gearing ratios highlight thedependence a company has onexternal funds and the extent towhich liabilitiesfinance the compa-ny. These ratios areextremely impor-tant for investors toconsider whileevaluating a company.

F) DEBT SERVICE CAPACITYDebt is a source of finance whichhas become increasingly popular in

recent years. Fifteen years ago fewcompanies issued or offered con-vertible and non convertible deben-tures. Now, there are more deben-tures, of one kind or another beingoffered than equity. In this scenario,the investor must ascertain whether

a company canservice its debtthrough inter-nally generatedfunds.

Can it meetthe principal and interest paymentsout of its profits? This of course isbased on the assumption that thecompany is a profitable going con-cern and that debt will not be repaid

Internally Generated FundsAverage Debt

Debt Coverage Ratio

Debt coverage ratio would be :

This means that it would take Pear Ltd. 1.7 years to repay borrowers from its profits.

Debt Coverage Ratio illustration2002 2003

Rs.(crore) Rs.(crore)Net income before tax and depreciation 500

Depreciation 100Net profit before tax 400

Tax 160Net profit after tax 240

Bank overdraft 100 150Debentures 400 380

Term loan 100 90600 520

240 + 100 = 0.600.5 x (600 + 520)

119Ratios118 Ratios

Which Company?

idend payable on preferred sharesshould also be accounted for in cal-culating this ratio as it is a fixedcharge that has to be paid. In thatcase, the fixed charge cover is calcu-

lated in two stages. In the first stage,the fixed charge cover is calculatedas explained above, and then thepreferred dividends paid are takeninto account.The above is a better ratio than theinterest cover ratio as it considersall the fixed expenses that a compa-ny has and examines whether itsearnings are sufficient to meet these.

Cash Flow Surplus The cash flow surplus ratio is basedon the going concern concept andassumes that companies will nor-mally grow and will therefore incur

capital expenditure and that therewould be an increase in its networking capital. As such, a compa-ny's ability to pay its debt should bedetermined only after providing forincreases in its capital expenditure

Net Income + (1— Tax Rate) (Interest and Rental Expenses)(1 — Tax Rate) ( Interest and Rental Expense) + Preferred Dividends

Fixed Charge Cover

Ram Oil Soaps Ltd.'s income statement included the following figures :

Fixed charge cover =

Fixed Charge Cover illustration

(Rs. crore)Rental expense 400

Earnings before interest & tax 750Interest 200

Earnings before tax 550Tax @ 40 220

Profit after tax 330

750 + 400 = 1.91200 + 400

Cash Flow surplusTotal Average debt

Cash Flow Surplus

interest dues. If not, the interest willhave to be paid from either from thecompany's reserves, additional bor-

rowings, or from a fresh issue ofcapital and these are a sure sign offinancial weakness.

The interest cover ratio is calcu-lated by dividing a company's earn-ings before interest and tax by itsinterest expense. The ratio mustalways be in excess of 1 - and thehigher it is the better. If it is below1, even a marginal fall in profitwould force the company to payinterest out of its retained earningsor capital.

Fixed Charge CoverThe eighties witnessed the birth andthe development of several financ-ing and leasing companies in India.

These companies offered theopportunity of leasing equipment asopposed to purchasing it. One ben-efit of leasing is that the rentals paidare entirely tax deductible.Secondly, funds do not need to bedeployed for the purchase of assets.

This is known as "off balancesheet financing", i.e. neither the realcost of the asset nor its liability isreflected in the balance sheet. Thefixed charge cover considers off bal-ance sheet obligations, such asrental expenses, and checks whethera company earns enough income tomeet its interest and rental commit-ments

At times it is argued that the div-

Earnings Before Interest and TaxInterest expense

Interest Cover Ratio

Bombay Green Ltd. earned Rs.450 crore before interest and tax in 2003. Its internet expensewas Rs.200 crore.

Interest cover ratio =

The company's earnings before interest are more than double its interest expense. A comfortable situation

Interest Cover Ratio illustration

450 = 2.25200

Earnings Before Interest and Tax + rental expenseInterest and Rental expense

Fixed Charge Cover

121Ratios120 Ratios

Which Company?

trends and to determine how wellassets have been utilized.Comparisons can be made betweenone year and the next, between onecompany and another in the sameindustry, and in other industries.These ratios also help enormouslyin making forecasts and budgets.

It must be remembered, howev-er, that like other ratios asset man-agement ratios too are pointers.

A high asset turnover does notnecessarily suggest great efficiencyor a high return on investments, itmay be so because a company doesnot maintain adequate assets andthis can affect its performance in thelong run. Investors should thereforealways look beyond the indications.It is important to bear in mind thata deterioration in asset ratios is asign of decline and should be heed-ed.

Stock Utilization The stock utilization ratios measurehow efficiently a company's stocksare used. With the cost of borrow-ings being high, managers are con-stantly alert to the need to keepstocks low. In these days of the just-in-time principle, these ratios arealways carefully scrutinized andevaluated.

Stock utilization can be meas-ured by two ratios:

(a) Stock Turnover RatioThis ratio indicates the number oftimes stocks (inventory) are turnedover in a year and is calculated bydividing the cost of goods sold in ayear by the average stocks held in ayear

(b) Stock Holding Ratio The stock holding ratio measuresthe number of days of stocks (inrelation to sales) held by a compa-ny. With companies attempting tokeep as little stock as possible, thisis an important efficiency indicator.It is calculated by expressing thestock held in terms of the days ofcost of goods sold

Investors should ascertain thereason for the improvement instocks, i.e. is it because stocks havebeen dumped on dealers, due to dif-ficulties in procuring stocks, or dueto a strike in the manufacturingplants?

Cost of goods SoldAverage Stock

Stock Turnover Ratio

Average StockCost of goods sold divided by 365

Stock Holding Ratio

and net working capital. Cash flowis net expenditure and increase innet working investments. The ratiois calculated by dividing the cashflow surplus by the total debt.

This ratio is often negative. Thisis because when a company growsrapidly it purchases assets of a cap-ital nature and its net workinginvestments also increase and thisincrease is usually more than itsinternally generated funds. This isusually funded by loans or short-term bank facilities.

Summary Investors must always consider

debt service ratios as these help todetermine whether the companyunder consideration has the capaci-ty to service its debts and repay itsliabilities. This becomes all themore critical at times of high infla-tion and recession when the inabili-ty to service debt can plunge a com-pany into bankruptcy.

G) ASSET MANAGEMENT/EFFICIENCY It is by the efficient management ofassets that companies make profits.Accordingly, investors must deter-mine whether the assets a companyhas are adequate to meet its needsand whether the returns are reason-able. It must be remembered thatassets are acquired either from cap-ital or from borrowings. If there aremore assets than is necessary, thecompany is locking up funds itcould have used more profitably or,conversely, is paying interest need-lessly. If the assets are less thanrequired, the company's operationswould not be using its resources asproductively and effectively as pos-sible.

Asset management ratios allowinvestors to determine whether acompany has adequate assets and isutilizing them efficiently. It isassumed that sales volumes areaffected by the utilization of assets.

Asset ratios are used to assess

In 2003, the average debt of Culture Ltd. was Rs.400 crore. Its internally generated fundswere Rs.40 crore. Its net working investments had increased by Rs.10 crore and the company

had incurred capital expenditure of Rs.20 crore.

Cash flow surplus =

It would take the company 40 years to repay its debts by utilizing its cash flow surplus.

Cash Flow Surplus illustration

40 - 10 - 20400

123Ratios122 Ratios

Which Company?

period ratio is an early warningindicator of large bad debts andfinancial sickness and by control-ling thus one can improve efficiencyand reduce borrowings, thereby

saving on interest. A falling ratio is not however

always wonderful. Just before com-panies fold up, they begin collectingon their debts and also sell their

In 2003, the sales of PDN Ltd. grew by 15% , from Rs.348 crore to Rs.400 crore. Its averagetrade debtors during 2002 and 2003 were Rs.49 crore and Rs.59 crore, respectively.

The average collection period was therefore :

2002

2003

The period of credit increased from 2002 to 2003. If PDN Ltd's normal credit terms are only 30days and customers are taking 51 to 54 days to pay, the company is finding difficulty in get-ting its customers to pay in time, or it may be extending longer periods of credit, or the man-

agement may not be controlling credit effectively.

Average Collection Period illustration

49 ______ = 51 days 348 + 365

_________59_________ = 54 days 400 + 365

True Steel Ltd. is a large company based in Pondicherry. Its financials indicated that its aver-age trade creditors in 2002 and 2003 were Rs.29 crore and Rs.34 crore respectively. Its cost

of goods sold was Rs.410 crore in 2002 and Rs.425 crore in 2003. Its average payment period would be:

2002

2003

In this illustration, the average payment period ratio is low, though it has improved in 2003over 2002. The investor should determine whether:

1) The company is availing all the credit that it can. 2)The company is having difficulty inprocuring credit. 3) The company is having difficulty in paying its creditors.

If the company is in a strong and commanding position, it can obtain longer credit terms. Thisis good since the company can effectively use creditors to finance its working capital and to

that extent the cost of finance falls.

Average Payment Period Ratio illustration

29__________ = 26 days 410 + 365

_________34________ = 29 days 425 + 365

As companies close down stocklevels fall. Purchases are not madeand existing stocks are sold. Thereasons for the improvement in thisratio must therefore be ascertained.In addition, an investor should tryand ascertain whether the existinglevel of stocks can support the level-of sales of a company has.

Average Collection Period Most companies sell to their cus-tomers on credit. To finance thesesales, they need to either block theirown internal funds or resort tobank finance. The cost of finance istherefore usually built into the saleprice and companies offer a cashdiscount to customers who pay incash either at the time of sale orsoon thereafter.

The average collection ratio iscalculated by dividing average tradedebtors by the average daily sales

An increasing average collection

The average inventory of Nandan Switchgears Ltd. was Rs.150 crore in 2002 and Rs.160 crorein 2003. During this period the cost of goods sold was Rs.1,050 crore and Rs.1,200 crores in

2002 and 2003, respectively. The ratios are as follows: Stock turnover ratio :

2002

2003

Stock holding ratio :

2002

2003

Nandan Switchgears Ltd. has successfully reduced inventory levels by 3.47 days of produc-tion and turned over stock 0.5 times more. This is usually good.

Stock Turnover Ratio illustration

1050 = 7 times 150

120 = 7.5 times 160

150 = 52.14 days1050 + 365

160 = 48.67 days1200 + 365

Average Trade DebtorsAverage Sales Per Day

Average Collection Period

125Ratios124 Ratios

Which Company?

sales commensurate with its invest-ment in assets. It indicates how effi-ciently assets are being utilized andis an extremely useful ratio forpreparing forecasts. The ratio is cal-culated by dividing the sales by theaverage total assets.

Fixed Asset Utilization The fixed asset utliziation ratiomeasures how well a company isutilizing its fixed assets. Investorscan compare this with the utiliza-tion of other companies in the sameindustry to determine how effective-ly a company is utilizing its fixedassets. It should be rememberedthat this ratio needs to be calculated

on net fixed assets( written downvalue of fixed assets). It should beremembered that this ratio needs tocalculated on net fixed assets, i.e.cost less accumulated depreciation.It is arrived at by dividing sales bythe average net fixed assets.

An increasing net fixed asset uti-lization ratio suggests that salesmay have fallen and the efficiency inthe handling of net fixed assets mayhave deteriorated.

It must be borne in mind thatthis ratio is not truly reflective ofperformance as fixed asset costs willdiffer when comparing companies.

A new company with recentlyacquired fixed assets will show aworse ratio than one that has oldassets. In such a scenario, it wouldbe unfair to label the older compa-ny inefficient.

Divya Tyres Ltd. was successful in increasing its sales in 2003 to Rs.630 crore from Rs.495crore in 2002. Its average assets grew by 10% to Rs.90 crore. Its total asset utilization ratios

for the two years were:

2002

2003

It is clear that the total assets utilization ratio has increased. This means, too, that the assetsrequired to support an increase

Total assets Utilization Ratio

495 = 6.0382630 = 7.090

SalesNet Fixed assets

Fixed Asset Utilisation

goods for cash. The result is afalling average collection periodratio.

Average Payment PeriodThe average payment period ratioor the creditor ratio indicates thetime it takes a company to pay itstrade creditors, i.e. the number ofdays' credit it enjoys. The ratio iscalculated by dividing trade credi-tors by the average daily cost of

goods sold.

Net Working Investments Ratio Net working investments are thoseassets that directly affect sales suchas trade debtors, stocks and trade

creditors. The ratio is calculated bydividing the net working assets bysales. In short, this ratio highlights theworking capital requirements of acompany and helps an investordetermine whether the company'sworking capital is controlled effi-ciently. Total Asset Utilization The total asset utilization ratio iscalculated in order to determinewhether a company is generating

Trade CreditorsAverage Daily Cost of Goods Sold

Average Payment Period

In 2003, the average stocks, debtors and creditors of Tamana Ltd. were Rs.38 crore, Rs.45crore and Rs.30 crore, respectively. Its sales in that year were Rs.500 crore.

Net working investments ratio =

2002

The company's net working investment were 8.6% of its sales. If this is the optimum level,then for every Rs.100 lakh of sales, net working investment would need to rise by Rs.8.6 lakh.

This ratio is therefore extremely useful in assessing working capital requirements.

Net working investments ratio

38 + 45 - 30 = 0.086500

Stocks + Debtors — CreditorsSales

Net working investments Ratio

SalesAverage Total assets

Total Asset Utilisation

127Ratios126 Ratios

Which Company?

ket can bear or that which he thinkswill fuel sales.

Usually low volume businessesare high margin businesses as goodsoften have to be held for some time.Others, such as supermarkets or forthat matter brokers, work at verylow margins because volumes arevery high.

Margins help to determine thecost structure of a business, i.e. is ithigh cost or low cost, and whetherthe business is a high volume lowmargin business or otherwise. Thisis important as it will indicate howdependent the company is on mar-gins. If the company operates withlow margins a small increase incosts can result in large losses.

The performance between com-panies within an industry or agroup can also be compared withthe help of margins. Let us assumethat the gross margin earned byHindustan York is 20 percentwhereas the industry average is 18percent. It can be argued in thisinstance that Hindustan York ismore efficient and that its productscommand a greater premium.

Management trends can also beassessed by margins. Efficient andstrong managements will work toimprove margin or, at least main-tain them.

Margins help an investor deter-mine whether increases in costs,whether on account of inflation orgovernmental levies, have beenpassed onto customers in part or infull. Should there be a strongdemand for the company's product,it will pass on the entire costincrease to the customers. On theother hand, if the demand for thecompany's products is not veryhigh, the company would often beara part of the cost increase becauseof the fear that the customer wouldnot purchase the product. A goodexample of falling margins is the TVindustry. As competition is intenseand the buyer has a choice betweenseveral brands, manufacturers havebeen bearing a portion of costincreases and, in some instances,have dropped their prices in orderto be competitive.

Product mix has an effect onmargins. A company may be sellingseveral products - each of thempriced differently. Some may behigh margin products and otherslow margin ones. If more high mar-gin products are sold, the marginearned by the company would behigh. Conversely, if more low mar-gin products are sold, the averagemargin earned on sales will reduce.It must be remembered that low

SummaryAsset management ratios are calcu-lated to assess the competence andthe effective of management bydetermining how efficiently assetshave been managed. It also high-lights how effectively credit policyhas been administered and whethera company is availing of all thecredit it is entitled to and is offeredby its suppliers. It can also indicatewhether a company is encounteringdifficulties.

H) MARGINSIt is not uncommon to read in annu-

al reports that "although sales haveincreased by 24 percent in the yearprofits have fallen due to increasesin the cost of production causingmargins to erode".

Margins indicate the earnings acompany makes on its sales, i.e. itsmark up on the cost of the items itmanufacturers or trades in. Thehigher the mark up, the greater theprofit per item sold and vice versa.Margins are so important that theydetermine the success or failure of abusiness. And the mark up or mar-gin made by the seller is usuallybased on what he believes the mar-

The relevant financials of Nikhila Pistons Ltd. were as follows:

The net fixed asset utilization was

2002

2003

Although sales increased by only 6% fixed assets went up by 31%. This suggests that the com-pany might be expanding and the fruits or the result of this expansion is yet to be reflected in

the net fixed asset utilization.

Fixed assets Utilization Illustration ratio

580 = 10.55(45 + 65) + 2

2001 2002 2003Rs.(crore) Rs.(crore) Rs.(crore)

Sales 540 580 620Fixed Assets

Gross 105 130 150Accumulated Depreciation 60 65 70

45 65 80

620 = 8.55(65 + 80) + 2

129Ratios128 Ratios

Which Company?

tionary cost increases on to cus-tomers.

Operating Margin The profitability of a companybefore the incidence of tax, miscel-laneous income and interest costs isindicated by the operating margin.The operating margin can bearrived at by deducting, selling, gen-eral and administrative expensesfrom the gross profit, and express-ing it as a percentage of sales

An investor must always exam-ine the operating margin ratio as itindicates the likely reasons for animprovement, or a deterioration, in

a company's profitability and onemust ascertain the actual causes forthis.

Breakeven MarginEvery organization has certainexpenses, like selling, administra-tion and other miscellaneousexpenses that it has to bear even ifthere are no sales. The breakevenmargin indicates the number ofunits that a company must sell to

The relevant information in the results of Patel Nair Ltd. was :

There was an improvement in the operating margin by 1.17%. One of the reasons for thiscould be that operating expenses did not increase as much as the sales. Sales grew by 33% as

did the gross profit, whereas operating expenses grew by 25%. This could be one of the reasons though not the only one. In another situation, despite thesales going up the gross margin may decrease and costs increase resulting in a fall in the

operating margin. Normally the operating margin should improve with sales since costs do not usually rise at

the same rate. In a recession, or at a time of high inflation, the reverse can be true. Costs mayincrease at a faster rate than sales and gross margins may also fall.

Operating margin

2002 2003Rs.(lakh) Rs.(lakh)

Sales 3000 4000Cost of goods sold 2400 3200

Gross profit 600 800Selling, general and administration expenses 400 500

Operating profit 200 300Operating margin (%) 6.33 7.50

Expenses + Financing CostsGross income / Number of Units sold

Breakeven Margin

margin businesses are not bad.Some of the most successful busi-nesses in the world are low marginones that operate with very highturnovers and produce an impres-sive return on capital employed.

Gross Margin The gross margin is the surplusavailable to meet the company'sexpenses. It is calculated by dividingthe difference between sales and thecost of goods sold, and expressing itas a percentage of sales

An investor should not jump to

a conclusion on seeing an improve-ment or a deterioration in the gross

margin. He must go beyond the fig-ures and seek the reason for thechange. An increase in the marginmay simply be due to an increase inprice whereas a fall could be dueeither as a consequence of a con-scious decision to increase sales orcompany's inability to pass infla-

The following figures were extracted from the financial statements of Hindustan York Ltd.

Hindustan York's sales increased by 25% to Rs.500 crore and its gross profit increased byRs.25 crore, or 20%. Both of these, in these difficult times, are positive. However its gross

margin fell by 1.25%. This could be due to several reasons, such as: 1) Increased competition : the company reduced its margins to boost sales.

2) The company took a conscious decision to reduce its margins in order to improve sales. 3) A deterioration in the product mix.

4) The company was unable to pass on cost increases to its customers.

Gross margin

2002 2003Rs.(crore) Rs.(crore)

Sales 400 500Cost of sales 275 350

125 150Gross margin (%) 31.25 30.00

Sales — Cost of goods Sold X100Sales

Gross Margin

Gross Profit — selling, General & administration expensess X100Sales

Operating Margin

131Ratios130 Ratios

Which Company?

exactly how many units need to besold by a company before it canbegin to make profit. This is animportant management ratio, too,in decision making when alterna-tives are being considered.

Prefinancing Margin The prefinancing margin is the rateof profit earned prior to the costs offinancing. The reason for excludingfinancing costs is that these varyfrom organization. These also varyon account of the method of financ-ing. The prefinancing margin istherefore calculated by dividingearnings before interest and tax bysales, and expressing this as a per-centage.

Pretax Margin The pretax margin indicates the rateof profit earned on sales afteraccounting for the cost of financingbut before tax. In short, this is cal-culated on the income before taxand expressed as a percentage ofsales.

Pretax margin is not a fair meas-ure of profitability and comparisonas the manner of funding, i.e. the

In the earlier example of Kumar Wheels Ltd. the relevant figures were :

It would be more appropriate to calculate the prefinancing margin after excluding non-recur-ring income or expenses. In that case, the Rs.50 lakh profit on the sale of a factory should be

deducted and the margin would be:

This is a good measure for comparing the profitability of organizations.

PreFinancing margin

Rs.(lakh)Sales 8000

Earnings before interest and tax 850

Earnings Before interest and Tax X100Sales

PreFinancing Margin

Prefinancing margin = 850 x 100 = 10.25% 8000

850 - 50 x 100 = 108000

Earnings Before interest and Tax X100Sales

Pretax Margin

meet these expenses. If a company's breakeven is at 50%of its capacity, it means that thecompany would be in a no-profit-no-loss position if it produced andsold half its capacity. Any unit soldabove this would yield a profit, andvice versa.

The breakeven margin ratio isarrived at by dividing expensesincluding financing costs, by thegross income per unit. Non-recur-ring or unusual profits must beexcluded from the calculation.

The breakeven margin is animportant measure as it indicates

The results of Kumar Wheels ltd. during the year ended 31 March 2003 were as follows: The total number of units sold were 1000

Kumar Wheels Ltd. have to sell, at present costs, 675 units to bear its expenses. If it sells 676units it would make a profit of Rs.2. The company would lose Rs.2 should it sell only 674

units. Some investors prefer to calculate the breakeven margin by deducting selling costsfrom the gross profit to arrive at the gross profit per unit. This is done because selling cost are

connected with sales and no selling expenses would be incurred if no sales are made. If, inthe example of Kumar Wheels Ltd. stated above, selling expenses were 400, the breakeven

margin would be calculated as: 1200 - 400 + 150 = 593.7 units 2000 - 400 / 1000

This is arguably a purer Measure

Breakeven Margin

Rs.(lakh)Sales 8000

Less : Cost of sales 6000

Gross Income 2000

Less : Expenses 1200

Operating income 800

Add : Profit on sale of factory 50

Earning before interest and tax 850

Less : Interest charges 150

Earnings before tax 700

Breakeven margin = 1200 + 150 = 675 units 2000 / 1000

133Ratios132 Ratios

Which Company?

Summary Margins, thus help both in under-standing the cost structure of a busi-ness and evaluation of its perform-ance. It is important to rememberthat low margins are not alwaysbad nor high margins always good.A company may opt to work onvery low margins to achieve vol-umes. On the other hand, a compa-ny earning high margins may face

falling demand for its products.Investors must always check intothe reasons for variations and thevarious measures mentioned in thischapter will point out to theinvestor the possible reasons.

financing costs, vary from companyto company. It can however be usedeffectively for comparing the per-formance of a company over sever-al years.

Net profit margin Net profit margin shows the after-tax rate a company earns on sales. Itindicates the rate on salesthat is available forappropriation after allexpenses and commit-ments have been met. In

order to facilitate comparison andto get a true picture, non-recurringincome and expense should beexcluded in the calculation.

The net profit margin alsoenables a shareholder to determinethe additional earnings available tohim on increases in sales.

Kumar Wheels Ltd.

As mentioned earlier, non-recurring income or expense should not be included in the calcula-tion as it would distort comparisons. If the Rs.50 lakh of non-recurring income is omitted, the

margin would reduce to 8.125% as follows:

Pretax Margin

Rs.(lakh)Sales 8000

Earnings before interest and tax 700

Pretax margin would be = 700 x 100 = 8.75% 8000

700 - 50 x 100 = 8.125%8000

Net Income Excluding Non-RRecuring items After TaxSales

Net Profit Margin

In Kumar Wheels Ltd. the pretax income was Rs.700 lakh. If tax was Rs.350 lakh, the pretaxincome would be Rs.350 lakh. Non-recurring income was Rs.50 lakh.

The return after tax to shareholders on sales was 3.75%.

Net Profit Margin

The net profit margin therefore was 350 - 50 x 100 = 3.75% 8000

135Cash flow134 Cash flow

Which Company?

n this age of creative account-ing, accounting principles arechanged, provisions created orwritten back, and generally

accepted accounting principles lib-erally interpreted or ignored bycompanies in order to show profits.Shareholders do not realize thiswhen they look at the publishedprofits in the financial statements ofcompanies. It comes therefore as asurprise when a regular profit mak-ing company suddenly downs itsshutters and goes into liquidation.This occurs when a company isunable to obtain finance or pay itscreditors. History is strewn withsuch examples and investors mustalways check:

How much is the company's cashearnings?

How is the company beingfinanced?

How is the company using itsfinance?

The answers to the above can bedetermined by preparing a state-ment of sources and uses of funds.Its importance has been recognizedin the United States and in manyEuropean countries where it ismandatory for a company to pub-lish with its Annual Report, a sum-

mary of changes in financial state-ments which is, in effect, a cash flowstatement.

A statement of sources and usesbegins with the profit for the year towhich are added the increases in lia-bility accounts (sources) and fromwhich are reduced the increases inasset accounts (uses). The net resultshows whether there has been anexcess or deficit of funds and howthis was financed.

For example, as shown in Table1 Fundamental and CompanyLimited (Fundamental) reported aprofit before tax of Rs.108.12 lakh.This included, however, otherincome of Rs.247.74 lakh, profit onsale of fixed assets of Rs.112.88lakh and an amount of Rs.38.56lakh withdrawn from a revaluationreserve. If these are deducted, theprofit changes to a loss of Rs.291.06lakh.

The changes in Fundamental'sBalance Sheet are summarized inTable I, and its Sources and Uses ofFunds (S & U) for the year ended 31March 2004 detailed in Table III.The S & U statement shows that thecompany had a deficit cash flow in2004, and that it had to borrowRs.1,927.92 lakh to finance its cur-rent assets. As it had made a loss, thecompany paid its dividend on pref-erence shares not out of current

I

Cash flowCHAPTER EIGHT

137Cash flow136 Cash flow

Which Company?

TABLE II : Fundamental & Co. Ltd. Sources and Uses of funds for the year ended 31 March 2004

(Rs. lakh)

SOURCES

Operating Income (loss) (139.62)

Add depreciation 160.25

Less Profit on sale of fixed assets (112.88)

Operating Income (loss) (92.25)

Other Income 247.74

Increase in liabilities 1485.50

Misc. expenditure written off 61.30

Profit on sale of fixed assets 132.14

1834.43

APPLICATION

Purchase of Fixed Assets(net) 513.98

Purchase of investments 26.52

Increase in Inventories 1141.38

Increase in sundry debtors 1350.50

Increase in other current assets 88.99

Increase in loans to subsidiary companies 205.92Increase in loans to others 138.86

Decrease in provisions 14.08

Decrease in reserves 79.75

3559.98

Net increase (deficit) 1725.55

FINANCED BY

Shares Capital 0.06

Increase in cash and bank balances (202.43)

Increase in loan funds 1927.92

1725.55

profits but from reserves. Further, asinventories and other current assetsincreased, the possibility that thecompany was unable to get rid of its

surplus stock cannot be ignored. The Dynamic Iron and Steel

Company Ltd. (DISCO) (See TablesIII & IV) also had a cash flow deficit

TABLE 1: Dynamic Iron and Steel Company Ltd.Balance Sheet as at 31 March

(Rs. crore)

2004 2003 MovementSOURCES

Share Capital 287.79 282.75 0.04Reserves 3069.32 3083.37 (14.05)

Loan funds 5058.14 3130.22 1927.928410.25 6496.34 1913.91

APPLICATIONS Net Fixed assets 3434.53 3100.06 334.47

Investments 92.37 65.85 26.52

Net Current assets 4878.90 3264.68 1614.22

Misc. expenditure 4.45 65.75 (61.30)8410.25 6496.34 1913.91

TABLE II : Dynamic Iron and Steel Company Ltd. Balance Sheet as at 31 March

(Rs. crore)2004 2003 Movement

SOURCE Share Capital 230.12 229.89 0.23

Reserves 1315.36 1194.22 121.14Loan funds 2051.30 1183.75 867.55

3596.78 2607.86 988.92

APPLICATION Net Fixed assets 2878.19 1713.79 1164.40

Investments 248.77 571.86 (323.09)Current assets (net) 469.82 322.21 147.61

3596.78 2607.86 988.92

Conclusion139138 Cash flow

Which Company?

although the company made a cashprofit of Rs.429.44 crore. If oneassumes this was used to finance theincrease in inventories and partiallyfinance assets, the dividend ofRs.80.55 lakh was once againfinanced by loans.

Investors must examine a com-pany's cash flow as it reveals exactlywhere the money came from and

how it was utilized. Investors mustbe concerned if a company is financ-ing either its inventories or payingdividends from borrowings withoutreal growth as that shows a deterio-ration.

In short, the cash flow or sourcesand uses of funds statement stripsthe accounting creativeness fromfinancial statements.

TABLE IV: Dynamic Iron and Steel Company Limited Sources and Uses of funds for the year ended 31 March 2004

(Rs. crore)SOURCES

Operating Net Income 278.16Less payments to employees for prior periods (13.61)

264.55Add : Depreciation 164.89

Funds from Operations 429.44Sale of Investments 323.09

Decrease in other current assets 0.06Increase in liabilities 78.34

Increase in provisions 73.20Total Sources 904.13

USES Net purchases of fixed assets 1329.29

Increase in Inventories 221.20Increase in sundry debtors 24.77

Increase in loans and advances 156.59Total applications 1731.85

Excess (deficit) 827.72FINANCED BY

Issue of shares 1.37Increase in loans 867.55

Increases in cash and bank balances (41.20)827.72

141Which Company?140 Which Company?

Which Company?

undamental analysis holdsthat no investment decisionshould be made withoutprocessing and analyzingall relevant information.

Its strength lies in the fact that theinformation analyzed is real asopposed to hunches or assumptions.

On the other hand, while funda-mental analysis deals with tangiblefacts, it does tend to ignore the factthat human beings do not always actrationally. Market prices do some-times deviate from fundamentals.Prices rise or fall due to insider trad-ing, speculation, rumour, and a hostof other factors. This was eloquentlystated by Gerald Loeb, the author ofThe Battle for Investment Survival,who wrote, “There is no such thingas a final answer to security values.“A dozen experts will arrive at 12different conclusions. It often hap-pens that a few moments later eachwould alter his verdict if given achance to reconsider because of achanged condition. Market valuesare fixed only in part by balancesheets and income statements; muchmore by hopes and fears of human-ity; by greed, ambition, acts of God,invention, financial stress andstrain, weather, discovery, fashionand numberless other causes impos-sible to be listed without omission".

This is true to an extent but thestrength of fundamental analysis is

that an investment decision isarrived at after analyzing informa-tion and making logical assump-tions and deductions. And thiswhere there can be differences invalue - the assumptions made by dif-ferent analyst would differ. Theirreasoning will be based on theirexposure to the market, their matu-rity, their knowledge and their gutfeel of the market.

Furthermore, fundamentalanalysis ensures that one does notrecklessly buy or sell shares - espe-cially buy. One should buy a shareonly if its intrinsic value is higherthan its book value. This also pro-tects one against possible loss sinceone would dispose of a share whosemarket value is higher than itsintrinsic value. Hence fundamentalanalysis supports and encouragessafe investing.

No system is fool proof. No sys-tem has consistently outperformedthe market. There is no system thatdoes not call for human judgementand input. All systems requirethought and some assumptions.However, of all the systems that Ihave experimented with and tried,the one I am most comfortable withis fundamental analysis as it is themost logical and the most meaning-ful. And this is the system I wouldurge you to consider as an investor. Happy Investing!

F

142 Fundamental analysis quick check list

Which Company?

1. Check the political situation. Is itsafe? Are there problems? Could thegovernment be overthrown andcould there by difficulties as a con-sequence?

2. What is revealed by the economicindicators? Is the growth rate rea-sonable? Have export improved?How comfortable is the balance ofpayment position?

3.Check the industry or industries inwhich the company operates. Atwhat stage of the cycle is the com-

pany in? What is its competition?How easy is it to enter or exit thebusiness?4.Then check the company. The fac-tors one should look at is its man-agement and its annual report. Theratios should be analyzed and thecash flow checked.

5.Finally, before purchasing or sell-ing a share, check its intrinsic value.A decision should only be takenafter this is done.

Fundamental AnalysisQuick check List

As investment in Equity related securities involves high risk, please read the SEBI prescribed RiskDisclosure Document before investing. This document is prepared for assistance only and is not intendedto be and must not alone be taken as the basis for an investment decision. The views expressed in thisbook are that of the author. Although all efforts have been directed towards explaining the features per-taining to fundamental analysis and related aspects, SSKI Investor Services Pvt. LTd.(SHAREKHAN)does not in any way do not claim that the author has explained all aspects exhaustively.

Each recipient of this book should make such investigations as it deems necessary to arrive at an inde-pendent evaluation of an investment avenue referred to in this document and determine the merits andrisks of such an investment. The views expressed may not be suitable for all investors

Any review, retransmission, reprinting, reproduction or any other use is prohibited. This document is for Private circulation only

DISCLAIMER

S S Kantilal Ishwarlal Securities Pvt. Ltd. - NSE: INB/INF 231022931; BSE:Cash-INB010622230; F&O-INF010622230;MAPIN 100008383; SSKI Investor Services Pvt. Ltd. - BSE: Cash-INB011073351; F&O-INF011073351; DP: NSDL-IN-DP-NSDL-233-2003; CSDL-IN-DP-CSDL-271-2004; PMS INP000000662; MAPIN 100008375; Sharekhan Commodities

Pvt. Ltd. MCX-10080; NCDEX-00132; MAPIN 100013912

A-206, Phoenix House, Phoenix Mills Compound, Senapati Bapat Marg, Lower Parel, Mumbai 400 013Phone: 022-24982000 Email: [email protected]

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