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Which Company?


THE MANAGEMENT ……………………………………………..50
THE COMPANY …………………………………………..............59
THE ANNUAL REPORT ………………………………………….63
A.The Director's Report …………………………………...64
Introduction: The Importance of Information.............................11
B.The Auditor's Report ……………………………………66
Fundamental Analysis: The Search for Intrinsic Value................19 C. Financial Statements …………………………………….70
D. Schedules and Notes to the Accounts ………………....82
A. Market Value ………………………………………........89
B. Earnings …………………………………………............94
Politico-Economic Analysis................................................25
C. Profitability …………………………………..................98
The Economic Cycle.............................................................34
D. Liquidity …………………………………………..........104
E. Leverage ……………………………………..................112

PART II : INDUSTRY ANALYSIS: 37 F. Debt Service Capacity ……………..............................117

G. Asset-Management/Efficiency ……………………......121
Industry Analysis..................................................................38
H. Margins …………………………................................127
CASH FLOW ………………………………….............................135
Conclusion …………………………………..................................140

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

2 Which Company? Which Company? 3

Which Company?

he Indian capital market is ate an awareness of the market and to make him more wealthy then he investor must access it and having
vibrant and alive. Its make the average Indian Ram and ever dreamed possible. The possibil- accessed it, he must, manage the
growth in the last two Sita invest in shares. The reforms ity of this spurs him on. With the information.
decades has been phenom- following the liberalization and the growth of IT Shares, Azim Premji of In terms of investors the largest
enal. In 1983, the market capitaliza- entering into this market of Foreign Wipro was for a brief period the sec- investor segment is Financial
tion of the shares quoted in the Institutional Investors and Mutual ond richest man in the world (after Institutions and Mutual Funds.
Bombay Stock exchange amounted Funds coupled with scams and Buffetting Warren Buffett for that Foreign Institutional Investors (FIIs)
to a mere $7 billion. It grew to $65 downturns forced the individual position) and Infosys Chairman and Non Resident Indians have a
billion in 1992, to $220 billion by investor out of the market. The Narayanamurthy of Infosys was, at significant presence. They account
April 2000 and it is, at the end of bursting of the dotcom bubble and one time, worth in excess of Rs. today for a significant amount of the
2003, estimated at $432 billion. the Ketan Parekh scam punctuated 14000 crores. Prices of IT stock investments made in the market. In
India ranks 7th in price index and the average investors' fears. It is plummeted. Others not heard of the end of July 2005 foreign institu-

4th in total return index. interesting to note that the individ- have also moved to tion investors by
huge highs.
During the last
Fundamental “ investing a little
over half a billion

two decades the dollars raised the
manner of trading analysis is for stock index by
has changed - from
traditional shop
the rational nearly 300 points.
The Indian market
floor (trading ring) man. is, inspite of all this
to screen-based trad- still rumour and
ing with brokers insider driven. Even
linked to the major stock exchanges. after the many scams shares, con-
Raghu Palat Most shares are now dematerialized tinue to bought on the basis of tips,
- making sales/ purchases and trans- and for the short term. The average
fers easy. Payment for shares sold, is investor does little or no research
The ride has been tumultuous. ual who is investing in the third made within a few days. (even though more information than
The interest and growth of the mar- quarter 2003 boom in the markets is Information has exploded. At he can handle is available) and
ket began with the FERA dilution the young investor - investors who one time there was dearth. Now it is makes his purchase or sale decision
i.e. when foreign companies diluted had not lost monies in the Harshad like a tornado. There are very good on the strength of an article that he
their interest. The interest grew with Mehta or Ketan Parekh scams. reports on companies. There are may have read or a conversation
speculators and others entering the And yet, the investor dreams probing analysis done on perform- with a friend. This is usually because
arena. Though one may question the even after he has been mauled. This ance. There are studied forecasts the average investor is unclear on
means, individuals such as the late is because man is essentially both an made. There are intelligent conclu- how to analyze companies and not
Harshad Mehta must be recognized optimist and a risktaker. The mar- sions made. The information is equipped to arrive at an investment
as individuals who did much to cre- ket excites him because of its ability there. It can be accessed. The decision. Consequently, he buys and

4 Preface Preface 5
Which Company?

sells with inadequate information churning out figures with gay aban- decision after careful thought an shares the investor faces obstacles.
and often suffers needless losses. At don. "the market will grow to 8500 deliberation. Hegel once said, "To The first is in the assessment - the
no time was this more evident than by September 2005". Another says, those who look upon the world human fallibility factor. The second
in the first four months of 1992 and "the market will rise to 10000 by rationally, the world in its turn pres- is from the nature of the competi-
later in 2000 when even prices of the March 2006. These are numbers ents a rational aspect". tion. The third is from sheer perver-
"dogs" doubled. It was a period not 'taken out of a hat'. They have no Fundamental analysis is for the sity - the failure of the market to be
dissimilar to Wall Street in the mid logic. They have no credibility. Yet, rational man. logical. The investor may be wrong
sixties which Mr. Harold Q Masur there are so many gullible investors This book is for the investor - be in his estimate of the future or even
eloquently described in his book, who, fueled by greed, buy and then he or she an executive, a housewife, if he is right the current price may
“The Broker" In the super heated live to regret it. Human nature has a professional, a student or a self already reflect what he is anticipat-
economy of the late sixties there was not changed. employed person. My aim is to ing. The point I am trying to stress
an illusion of endless prosperity. On I'd like you to dwell a moment introduce you to the world of infor- that in the end, the manner the
Wall Street the bulls on a thought by mation and analysis and to show prices of shares moved depend on a

were rampant. Private Harold Masur. He you how one can arrive at a buy or host of factors. Yet the basic issue
companies were going
public at arbitrary Buy “ says, "Bargains are
available during times
sell decision. By doing so I seek to
discourage you from acting on
remains. The share must have value.
Its fundamentals must be good. Its
prices that generated
huge profits for the
when there of extreme pessimism.
Trouble is, when the
rumours or on tips and encourage
you to go by hard facts.
management must be competent.
This book, which is aimed at you
promoters. Mutual is blood on so-called experts are However, the investor must be the investor, will introduce you to
funds were plunging
recklessly into new the streets wringing their hands,
nobody has the
warned that the world is constantly
changing as a consequence of which
the world of fundamental analysis
and guide you through the factors
untested issues. courage to buy". the new situations arise which the that you should look at before you
Glamour Stocks Rothschild echoed this investor must monitor. buy any shares.
soared to premiums when he said, "Buy Consequently there is no fixed for- The art of successful investment
that discounted not only the future when there is blood on the streets." mula that will give one "wealth lies in the choice of those industries
but the next millennium. Money, it J.P. Morgan when asked once by beyond belief". If such a formula that are most likely to grow in the
seemed was spermatic.Properly an investor on his view of the mar- existed I wouldn't be writing this future and then in identifying the
invested in the womb of Wall Street, ket is said to have stated: "It will book. I would be out there in the most promising companies in these
it would produce wildly proliferat- fluctuate." Some will rise while oth- market accumulating that wealth. industries. There are however pit-
ing offspring. Thousands of new ers will fall. The aim of the investor Analysis and information give one falls in the approach and one must
comers opened accounts. Brokerage must be to buy when the price is low the basis for a logical decision. be careful. It must however be
firms expanded with quixotic opti- and to sell when it is high. There are other factors, especially remembered that:
mism." Fundamental analysis is not for the human factor, that are some- “The obvious prospects for
As I write this preface, the mar- speculators. It is for those who are times not logical and cannot be pre- physical growth in a business do not
ket after many years of lying down prepared to study and analyze a dicted. translate into obvious profits for
is sitting up. The rumour mill is company; for those who arrive at a To select the most promising investors.”

6 Preface Preface 7
Which Company?

“The experts do not have state." investor to invest in stocks that have
dependable ways of concentrating This is why finance theory does value; that have good fundamentals.
on the most promising companies in not support the belief that the fun- Santayana once said, "Those who
the most promising industries.” damental approach, or for that mat- do not remember the past are con-
There could also be imbalances ter any other approach be it demned to return to it." Benjamin
on account of political happenings, technical analysis, random walk, Graham added to this by saying,
speculations, demand and a host of etc. can consistently outperform the "To invest intelligently in securities
other reasons. Further, as Adam market. However, fundamental one should be forearmed with an
Smith said, "Even if, by some magic, analysis gives you a fighting chance adequate knowledge of how the var-
you knew the future growth rate of and it is because of this that I urge ious types of stocks have behaved
the little darling you just discovered, you to be familiar with it and prac- under varying conditions - some of
you do not really know how the tice it when you go out to do battle. which one is likely to meet again in
market will capitalize that growth. I'd like to leave you with an one's experience." This book
Sometimes the market will pay observation made by the then attempts to arm you.
twenty times earnings for company Finance Minister, Mr. Yashwant
growing at an annual compounded Sinha on May 4, 2000 after offering
rate of 30 percent; sometimes it will certain tax sops at the budget ses-
pay sixty times earnings for the sion. He said, "I can appreciate a
same company. Sometime the mar- market responding to fundamentals,
ket goes on a growth binge, espe- but a market which responds to
cially when bonds and the more rumours is irresponsible and silly.
traditional securities do not seem to The BSE (Bombay Stock Exchange)
offer intriguing alternatives. At is being driven by rumours, they will
other times the alternatives are have to behave more responsibly."
enticing enough to draw away some Benjamin Graham adds, "The
of the money that goes into pursu- investors' chief problem is likely to
ing growth. It all depends in the psy- be himself. More money has been
chological climate of the time." made and kept by ordinary people
This is why he also said, "You who were temperamently well
can have no preconceived ideas. suited for the investment process
There are fundamentals in the mar- than by those who lacked this qual-
ket place, but the unexplored area is ity even though they had extensive
the emotional area. All the charts knowledge of finance, accounting
and breadth indicators and technical and stock market lore."
palavers are the statisticians In summary the purpose of this
attempts to describe an emotional book is to help you the individual

8 Preface Preface 9
Which Company?

importance of
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 alone
not be taken as the basis for an investment decision.
Introduction to Fundamental Analysis

10 The importance of information 11

Which Company?

he market, says Mr. Benjamin Graham and Bernard sense. As Gustave Le Bon observed the ones that lose are the small
Johnson in Adam Baruch that spurs investors on. This in his "Psychologic des toules", the investors who do not have their eye
smith's The Money lure was demonstrated in India in crowd acts with a single-minded on the market at all times nor do
Game, is like a beautiful 1992, at the end of the millennium purpose and not very rationally. they have the contacts/they where
woman- endlessly fascinating end- (in the first 4 months of 2000) and According to him the most striking withal to know what is likely to be
lessly complex, always changing from the end of the second quarter peculiarity of a crowd is that "who- happening to the market.
always mystifying. I have been of 2003 when prices soared. The ever be the individuals that com- Let us examine what happened
absorbed and immersed since 1924 manner in which these speculative pose it, however like or unlike be in the last twelve years. In 1992
and I know this is no science. It is drives occur are similar and hap- their mode of life, their occupa- investors were buying on the flimsi-

an art. Now we have computers and pens with amazing frequency and tions, their character est of reasons believ-
all sorts of statistics but the market regularity. This is not restricted to of their intelligence, ing there is no end to
is still the same and understanding shares either. The tulip mania in the fact that they have The crowd “ the boom. I remem-
the market is still no easier. It is per-
sonal intuition, sensing patterns of
Holland in the seventeenth century
sent their prices soaring. In 1992
been transformed into
a crowd puts them in
acts with a ber a person advising
me to buy the shares
behavior. There is always some- the rush to buy shares in India was possession of a sort of single- of a certain company.
thing unknown, undiscerned. The so great that ancestral land and collective mind which minded This was at the time
market is fascinating and addictive
and once you have entered it" it is
family jewels were sold or pawned
in the overpowering, overwhelming
makes them feel,
think, and act in a
purpose not a very well
known company. I
Gustave Le Bon
foolish to think that you can with- greed for riches. For a time prices manner different from Vice-chairman, Fidelity asked him for some
draw from the exchange after you rose and then the bubble burst. This that in which each information - what
have tasted the sweetness of the occurred again in early 2000 when individual of them would feel, did the company do? Who were its
honey", De La Vega commented in information technology share prices think, and act were he in a state of directors? How had it performed in
the seventeenth century. rose to phenomenal heights. Many isolation." Le Bon speaks of the the last three years? He did not
The magic of the market is the shrewd promoters changed the crowd being in a state of hypnotized know nor did he care. He had
promise of great wealth. Warren names of their companies to fascination and the rational investor received a tip that the price would
Buffett became several years ago the "infotech" or added the word becoming mindless in the sense that double and was passing it on.
Second richest man in the world. "infotech" to its name and made a he surrenders his rational thinking Another share that must be men-
His net worth was estimated by killing in the market. The law of mind to the domination of the tioned was Karnataka Ball Bearings
Forbes in September 2003 at 436 gravity has to prevail and their mood of the moment. The crowd in - a company whose share was lan-
billion. The wealth is entirely from prices fell in March and April 2000 late 1999 and early 2000 every- guishing in the low 20s. Sparked by
the market - by managing an invest- dramatically supporting the truth where and in India in 1992 acted on a rumor that Harshad Mehta was
ing company called Hathaway. He that prices of companies will fall or impulse, on expectations and hope buying the share price rose 60. then
believes in value investing - in fun- rise to their true level in time. The and on hearsay fueled by greed. The 68 and went upto 180 all in matter
damental analysis. It is the promise prices of shares rose at this time as index bloated like a balloon and of 10 days. It was then heard that
of great wealth, of emulating per- the crowd had taken over and there like a balloon it burst. It had to. the rumor about Harshad Mehta's
sons like Buffett and his gurus was no place then for logic or good Unfortunately at times such as these interest in the share was false. The

12 The importance of information The importance of information 13

Which Company?

share price plunged to 50 in 4 days. wise began to exit and as this took successful stock pickers of all time. All information is important and
The original rumor raised its head. root prices began to fall. This had a He evolved a theory called the Zulu can be grouped under the following
The price rose again to 120. The snowballing effect and soon prices theory which submits that one must classifications:
rumor was again condemned as had fallen by a half or over that. know all about the company and a) Information about the economy.
false and the price fell. At that time Then later when the dotcom boom the industry and any other factor b) Information about government
I spoke with a person intimately occurred, shares were priced on that may affect the company's per- policy; taxation, levies, duties and
connected with the Company. He "stickiness of eyeballs". It is impos- formance. His argument was that others.
told me that the Company was sick sible to get more esoteric. Later in one could never lose if one has this c) Information about the industry in
and that there was no activity. It 2000 people began buying shares information. If the company is like- which the company operates.
was on the verge of being closed that Ketan Parekh was purportedly ly to do badly, one can sell and then d) Information about the company -
down. The price had risen on the buying. The question that begas an buy shares to cover this when the its management, its performance, its
flimsiest of excuses and the crowd answer is “Will they never learn?” price falls, and vice versa. This is the sales and its products including its
comprising of otherwise intelligent, The answer probably is that man's philosophy of professional and suc- performance in relation to other
logical and rational human beings greed is bottomless. cessful investors - informed invest- similar companies.
acted irrationally and illogically. A In 2003, prices have again begun ing. And this is the foremost tenet of e) Information about consumer out-
lot of persons did make money on moving upwards. The sensex broke fundamental analysis. As Adam look, fashions and spending.
the stock - but most lost, having through the 5000 barrier and there Smith says, "There is no substitute In India we are fortunate that
bought it with no other information are some who claim that it will for information. The market is not a there is greater awareness of the
that the rumor that Harshad Mehta reach 6000 in six months/ one year/ roulette wheel. Good research and need for information today than
was buying the share. One would very soon. Many buy on the good ideas are the one absolute ever before and this need is being
have thought one learns. Not so. "strength" of these predictions necessity in the market place." addressed by the media, researchers
History repeats itself. At the end of which are all they are - predictions, Fundamental analysis demands, and professional investment con-
the last century Indian shares espe- hopes, expectations. Nothing nay insists, on information about a sultants are addressing that need.
cially those related to Information backed by logic or sense. company. It requires subjecting a
Technology (IT) such as Wipro, Fundamental analysis submits company's performance and its Internet
Infosys (lovingly called Infy) and that no one should purchase a share financial statements to the most The internet is a tremendous source
Satyam (Sify) began to be quoted in on a whim. Investment in shares is piercing scrutiny as well as the of information. It can tell you about
America in the NASDAQ. With the serious business and all aspects and analysis of the economy and the the economy, company results, pro-
rise in NASDAQ, these shares factors, however minor, must be industry in which the company files and a host of other informa-
began rising and a wave feeling analyzed and considered. The bil- operates. And the fundamentalist tion. Now you can even buy and sell
took over that software is the new lionaire Jean Paul Getty, until his makes his buy or sell decision on the shares instantly on the "net".
mantra and that the shares of all IT death the richest man in the world, basis of his interpretation of the
companies can only go one way - once said, "No one should buy information that he receives, his Media
up. This began an upward move- without knowing as much as possi- analysis, and on the strength of his There are several investment and
ment that gained momentum every ble about the company that issues experience and investment maturi- business focused magazines, papers
day till prices became unreal. The it". Jim Slater was one of the most ty. and directories that are available

14 The importance of information The importance of information 15

Which Company?

today that discuss the economy, Board of India (SEBI) has published share. East India Company's trade with
industries and individual compa- regulations prohibiting insider trad- These are the major sources of India and China was threatened.
nies. These contain articles of a high ing. I would also caution against information. One must train oneself There was fear that its allies might
standard that analyze industries and insider trading; apart from the fact to listen and absorb information desert England. The future of the
companies in depth. They also con- that it is against SEBI rules and the that is received. One should analyze English Empire was at stake.
tain knowledgeable articles on tax, law, it is fraught with other risks. and interpret the information to Investors awaited news, Nathan
investment strategies, finance and Edwin Leferre, in his book, determine the profitable course of Rothschild of the House of
allied subjects. Reminiscences of a Stockbroker action to be taken. This is the essen- Rothschild, a leading merchant
I would insist that the serious also warned against it saying, "Wall tial governing principle of funda- banker, aware of the importance of
investor should read at least one Street professionals know that act- mental analysis - action only after information, had invested a consid-
good financial paper every day and ing on inside tips will break a man receiving and analyzing informa- erable sum to develop a private
two magazines a month. This ought more quickly than famine, pesti- tion. intelligence system. This was well
to keep him well informed. lence, crop failure, political read- It is also extremely important known. It was also well known that
justments or what may be called that one acts swiftly on the informa- Rothschild had invested heavily on
Investment Newsletters normal accidents." tion received as the person who an English victory. As soon as the
There are several professional receives it first will often be the per- war was over, Rothschild's agents
investment managers and experts Seminars and Lectures by son to profit most from it. That is dispatched to him carrier pigeons
who publish investment informa- investment experts what Rothschild did. with the result of the war in code.
tion. This is extremely useful as they Excellent seminars and lecture are 18 June 1815, was a date that When they arrived, well before the
are often very up to date and con- being held in the country. These are will be remembered as the day when official dispatches, Rothschild
tain information not generally avail- conducted by eminent individuals one of the most decisive battles in began to sell every thing he owned.
able to the investor. and one can pick up a lot of infor- Europe was fought - the day the In the belief that the English had
mation attending these lectures. Duke of Wellington pitted his lost, investors panicked and began
Insiders These may be on how an industry is 75,000 English troops against the to sell. The market collapsed. In the
Insiders are persons who work for a doing, their view of an industry and 100,000 soldiers of Napoleon. The depressed market, Rothschild
company or who have intimate the like. One can even share battle was momentous as the future stepped in and with his agents
dealings with a company and have thoughts with those they meet. This of Europe and the European bought and bought. Within hours
access to, or are aware of informa- can result in forming opinions. Colonies around the world rested the news of Wellington's victory
tion that is not generally known. Acting on these opinions could be on its outcome. sent the market booming. By this
This could be information on the profitable. Investors in London were con- manouvre, Rothschild earned one
performance of the company or cerned and worried. As the German million pounds, a fabulous amount
rights or bonus issues or some other Stockbrokers army under Marshal Von Blucher at that time and it is this that led
relevant news. As the information is Stockbrokers are always in touch had not joined his English allies at him to state, “the best time to buy is
not known to all, the investor must with companies and are normally the time the battle began, there was when blood is running in the
act fast if he wishes to make a aware of their performance and concern that he would be too late as streets”.
killing. The Securities Exchange other factors affecting the price of a a consequence of which England
would lose the battle. The British

16 The importance of information The importance of information 17

Which Company?

undamental analysis is market price will be equal to the
based on the premise that intrinsic value.
every share has a certain Calculation of Intrinsic value
intrinsic value at a period How does one calculate the intrinsic
of time. This intrinsic value changes value of a share? Let us assume that
from time to time as a consequence one expects a return of 20% on an
of both internal and external fac- investment every year for 3 years.
tors. The theory of fundamental Let us also assume that the compa-
analysis submits that one should ny would pay dividends of 20%,
purchase a share when it is available 25% and 30% on its Rs.10 share.
below its intrinsic value and sell it The dividend received on a share
when it rises above its intrinsic would therefore be Rs.2.00 in the
value. When the market value of first year, Rs.2.50 in the second,
share is below its intrinsic value it is and Rs.3.00 in the third. Let us also
under valued, whereas if the market assume that the share can be sold at
value of a share is above its intrinsic Rs.200 at the end of 3 years. The
value it is over valued. intrinsic value of the share will be:
Fundamentalists thus seek to pur-
chase underpriced shares and sell 2 + 2.5 + 3 + 200 = Rs.120.88
overpriced ones. They believe that 1.2 (1.2)2 (1.2)3
although the market price may devi-
ate from the intrinsic value in the The logic is to discount the dividend
short term, in the long term the received and anticipated to be
received in

What is the intrinsic value of a share? How is it and the
determined? Fundamental analysis propounds expected
that the intrinsic value is, and has to be, based on price at a

the benefits that accrue to investors in the share. future date
As the return to shareholders is in the form of div-
idends, under strict fundamental analysis, the
with the
present value of future, dividends discounted on return or
the basis of its perceived safety or risk is its intrin- y i e l d
sic value. The intrinsic value is based on the divi- expected.
dend because that is what a shareholder or Since the
investor receives from a company, and not on the price at that
The Search for Intrinsic Value earnings per share of the company. This distinction is very important. future date

18 Fundamental analysis Fundamental analysis 19

Which Company?

is also considered, the possibility of Thus if the market price is lows depending on its financial every year.
capital appreciation is considered Rs.120.88, the first individual (let strength and stage of growth.
and this is why this method of arriv- us call him Siddarth) will hold onto Blue Chip EPS at the end of:
ing at the intrinsic value is consid- the share whereas Nair would sell 2+ 2.5 + 3 + 200 = Rs.133.63 Year 1 will be Rs.7.70
ered the most balanced and fair. the share and Kumar would pur- 1.16 (1.16)2 (1.16)3
If the market price of the share is chase it. Year 2 will be Rs.8.47
below Rs.120.88 then the share is In short, the intrinsic value of a Mature Share
below its intrinsic value and there- share will vary from individual to 2+ 2.5 + 3 + 200 = Rs.130.28 Year 3 will be Rs.9.32
fore well worth purchasing. If, on individual and will be dependant 1.17 (1.17)2 (1.17)3
the other hand, the market price is both on that individual's ability to If it is believed that a reasonable P/E
higher, it is a sell signal and the bear risks and the return that indi- Growing Company for a company of such a size in that
share should be sold. vidual expects. 2+ 2.5 + 3 + 200 = Rs.127.04 industry should be 15, the market
It is prudent and logical to 1.18 (1.18)2 (1.18)3 price at the end of 3 years would be
Considerations remove this anomaly. The return 9.32 x 15 = Rs.139.80.
It must be noted that the intrinsic expected should be the return one Let us now look at a real exam-
value of a share can and will be dif- can expect from an alternate, rea- New Company ple. On 31 May 2000 the price of
ferent for different individuals. If, in sonably safe investment in that mar- 2+ 2.5 + 3 + 200 = Rs.123.91 the shares of a company was
regard to the above mentioned ket. This rate should be bolstered by 1.19 (1.19)2 (1.19)3 Rs.465. The company declared a
investment another individual a risk factor as the return is greater dividend of 65% for the year ended
(Kumar) expects a return of 16% from riskier investments. A very It would be noted that the safer the March 31 2000, and an earnings
whereas a third individual (Nair) safe investment (blue chip) will have share, the higher its intrinsic value. per share of Rs.13.3. If we assume
expects a return of 25% the intrin- a risk rate of 0. A mature near blue There is however one factor that that this dividend will remain con-
sic value (assuming the dividends chip share will have a risk rate of 1. is assumed or estimated and that is stant, and that a P/E of 20 is reason-
and the sale value at the end of 3 A growing company will have the price at the end of three years. able, the intrinsic value of the com-
years will remain the same will be): risk rate of 2. A risky new company The most reasonable method (even pany's share should be Rs.266.
will have a risk rate of 3. If it is though this is arguable), in my opin- If the company's earnings grow
Intrinsic value for Kumar assumed that the return one can ion is basing the price on a price at 20% per year the EPS at the end
expect from a unreasonably safe earnings multiple. of 3 years would be Rs.22.98 (13.3
2+ 2.5 + 3 + 200 = Rs.133.63 investment (an investment say with The price earnings multiple or x 1.20 x 1.20 x 1.20). On that
1.16 (1.16)2 (1.16)3 the Unit Trust of India) is 16% and P/E of a share is its market price assumption, the price at the end of
the dividend expected is Rs.2 in the divided by its earnings per share. If 3 years would be Rs.459.60 (EPS x
Intrinsic value for Nair first year, Rs.2.5 in the second year a company has earned Rs.7 per P/E of 20). Based on an expected
and Rs.3 in the third year and the share in the current year represent- return of 20% the intrinsic value
2+ 2.5 + 3 + 200 = Rs.107.14 anticipated sale price is expected to ing a growth of 20% and if it is con- today will therefore be:
1.25 (1.25)2 (1.25)3 be Rs.200, the intrinsic value of the servatively believed that the earn- 6.5+ 6.5 + 6.5+ 459.60= Rs.279.66
share of the company will be as fol- ings per share (EPS) will grow 15% 1.20(1.20)2 (1.20)3

20 Fundamental analysis Fundamental analysis 21

Which Company?

market price, therefore, at every - information about the economy,

The company's share price at At an expected return of 25% the point in time represents the latest the industry and the company itself
Rs.465 was nearly 67% above its market value of Rs.160 was higher position at all times. The efficient - any information that can affect the
intrinsic value and on the basis of than the intrinsic value of Rs.145.71 market theory submits it is not pos- growth and profitability of the com-
this submission should be sold. and the share should be sold. sible to make profits looking at old pany and it is because of this funda-
The price of a 100% export ori- The subjective assumptions data or by studying the patterns of mental analysis is broken into three
ented unit on 31 May 2000 was made in arriving at the intrinsic previous price changes. It assumes distinct parts:
160. Its profit in the year to 31 value results in the intrinsic value of that all foreseeable events have
March 2000 had grown by 60% to a share being different for different already been built into the current 1.The economy,
Rs.17.88 crore. Its earnings per individuals. In the example detailed market price. Thus, to work out the 2.The industry within which the
share at Rs.10.26 was an improve- above, the intrinsic value of that likely future company
ment of 23%. If we assume that in company share would be Rs.158.02 price at a 3 Distinct parts of fundamental analysis o p e r a t e s ,
the next 2 years its EPs will grow by for an investor who expects a return future date in and
20%, the EPS at the end of 2 years of 20% whereas it would be order to 1.THE ECONOMY 3.The com-
would be Rs.14.77. At a P/E of 15, Rs.145.71 for an individual expect- determine the pany.
its market price at the end of 2 years ing a return of 25%. The other share's pres- 2.THE INDUSTRY WITHIN WHICH THE T h e
would be Rs.221.55. In 2000, the assumptions too are subjective, i.e. ent intrinsic COMPANY OPERATES, AND information
company paid a dividend of 25%. the expected price at the end of a value, funda- has to be
On the assumption that the dividend period, and the anticipated divi- mentalists 3.THE COMPANY interpreted
of 25% will be maintained in 2001, dends during the period. devote time and ana-
and that it will rise to 30% in 2002, This method, however, is and effort to lyzed and
its intrinsic value on an expected extremely logical. It considers he ascertain the effect of various hap- the intrinsic value of the share
return of 20% would be : dividends that will be paid and the penings (present and future) on the determined. This intrinsic value
likely capital appreciation that will profitability of the company and its must, then, be compared against the
2.5 + 3.0 + 221.55 = Rs.158.02 take place. likely results. This must also include market value the fundamentalists
1.2 (1.2)2 the possibility of the company issu- say, and only then can an invest-
Efficient Market Theory ing bonus shares or offering rights ment decision be taken.
Its intrinsic value of Rs.158.02 was Fundamental analysts often use the shares.
very close to the market value of efficient market theory in determin- The most important factor in
Rs.160. If however, one expects a ing the intrinsic price of a share. fundamental analysis is information
return of 25% as that export orient- This theory submits that in an effi-
ed unit is a relatively new company, cient market all investors receive
the intrinsic value would be: information instantly and that it is
understood and analyzed by all the
2.5 + 3.0 + 221.55 = Rs.145.71 market players and is immediately
1.25 (1.2)2 reflected in the market prices. The

22 Fundamental analysis Fundamental analysis 23

Which Company?

Economic Economic

24 Politico-economic analysis 25
Which Company?

wise man once said, "No ouster of Mr. Narasimha Rao from USSR was one of India's biggest declines. It is estimated that the
man is an island". No the Prime Ministership. Successive purchasers. When that enormous Gulf War cost India $1.5 billion on
person can work and live elections held did not give any sin- country broke up into the account of higher prices of petrole-
in isolation. External gle political party a clear majority Confederation of Independent um products, opportunity costs and
forces are constantly influencing an and mandate. As a result there were States, Indian exports declined and fall in exports. The defence budget
individual's actions and affecting coalitions of unlikes. These led to this affected the profitability of is enormous. This money could
him. Similarly, no industry or com- considerable jockeying for power companies who had to search for have been spent elsewhere for the
pany can exist in isolation. It may and led to the breakup of the gov- other markets. Wars have a similar development of the country. Other
have splendid managers and a ernments and fresh elections. effect. The war in Croatia, in examples include Sri Lanka, East
tremendous product. However, its There has also been much grand Kosovo, in Africa, the Gulf war and Europe and other troubled coun-
sales and its costs are affected by standing such as the Mandal recom- other wars have had an effect on tries. These countries were once
factors, some of which are beyond mendations in order to capture exports of goods. The tragedy of thriving. No longer. Let us take the
its control - the world economy, votes. These led to riots. There were 9/11 (September 9 when two planes example of Sri Lanka. It is a beauti-
price inflation, taxes and a host of other religious and ethnic issues crashed into the World Trade ful island and was considered a par-
others. It is important, therefore, to that also led to violence such as the Center at New York), affected the adise for tourists - a pearl in the
have an appreciation of the politico- Babri Masjid/Ram Janmabhoomi entire world. Many industries are ocean. The country is in the grips of
economic factors that affect an issue. All these shook the confi- yet to fully recover. Similarly the a civil war. The northern part of the
industry and a company. dence of the developed world in the SARS epidemic that affected South country, which was once thriving, is
security and stability of India. East Asia affected trade and in the hands of Tamil guerillas and
The political equation Tourism fell. tourism. there is no industry and little eco-
A stable political environment is Foreign Direct Investment fell. The other gnawing political nomic activity. Idi Amin in the sev-
necessary for steady, balanced Investments were held back. These issue that has been a thorn in India's enties by expelling Asians from
growth. If a country is ruled by a had an adverse impact on the devel- back is the Pakistan issue. The dete- Uganda did that country's economy
stable government which takes deci- opment of the economy. In recent rioration in our relationship culmi- irreparable harm. In 1997-98, due
sions for the long-term development times this scenario has changed. nated in 1999 in the war in Kargil. to the elections and then the bomb-
of the country, industry and compa- The Government, even though a Earlier we have fought several wars ing of the American embassy, the
nies will prosper. On the other coalition has been stable. Its policies on Kashmir and other issues. In economy of Kenya tailspinned to
hand, instability causes insecurity, have beren positive and the econo- 2005 there has been an improve- negative growth. Then a few years
especially if there is the possibility my has been doing well. There are ment in the relationship. One won- later as the economy was recover-
of a government being ousted and predictions that by 2050, India ders whether this thorn will cease to ing, the Mombasa bombings again
replaced by another that holds dia- would be one of the three most be a thorn in time. The deteriora- set it back.
metrically different political and powerful nations in the world. This tion in our relationship culminated In conclusion, the political sta-
economic beliefs. has led to renewed interest in India in 1999 in the war in Kargil. Earlier bility of a country is of paramount
India has gone through a fairly and investors are back. we have fought several wars on importance. No industry or compa-
difficult period. There had been ter- International events too impact Kashmir and other issues. Wars ny can grow and prosper in the
rible political instability after the industries and companies. The push up inflation and demand midst of political turmoil.

26 Politico-economic analysis Politico-economic analysis 27

Which Company?

payment could not be sent to India imports more expensive and if a To an extent this determines the
Foreign Exchange Reserves as the central bank refused the for- company is dependent on imports, prices at which goods can be sold. If
A country needs foreign exchange eign exchange to make the pay- margins can get reduced. On the the domestic industry is to be sup-
reserves to meet its commitments, ment. Following the liberalization other hand, a devaluation in the ported, the duties levied may be
pay for its imports and service for- moves initiated by the Narasimha country to which one exports increased resulting in imports
eign debts. Without foreign Rao Government and endorsed/sup- would make the company's prod- becoming unattractive.
exchange, a country would not be ported by successive governments, ucts more expensive and this can During the last two years Indian
able to import materials or goods India had by 31 December 1999 adversely impact sales. A method by customs duties have been reduced
for its development and there is also foreign investments in excess of $28 which foreign exchange risks can be drastically. Imports are consequent-
a loss of international confidence in billion. In May 2000, the foreign hedged is by entering into forward ly much cheaper and this has affect-
such a country. In 1991, India was exchange reserves had swelled to contracts, i.e. advance purchase or ed several industries.
forced to devalue the rupee as our over $38.4 billion - a far cry from sale of foreign exchange thereby When viewing a company, it is
foreign exchange reserves were, at the $500 million of reserves in crystallizing the exposure. important to see how sensitive it is
$532 million very low, barely 1991. In 2003, the reserves are in In India our currency has been to governmental policies and
enough for few weeks imports. The excess of $100 billion. appreciating against the dollar. restrictive practices.
crisis was averted at that time by an The problem the Reserve Bank Thus, the threat investors or recipi-
IMF loan, the pledging of gold, and of India now faces is managing the ents of dollars face is that the rupees Foreign Debt and the Balance
the devaluation of the rupee. huge reserves. In order to discour- that they finally receive is less than of Trade
Several North American banks age short term flows, the Reserve that they expected. This is an about Foreign debt, especially if it is very
had to write off large loans Bank has lowered interest rates and turn from the situation earlier. As a large, can be a tremendous burden
advanced to South American coun- even mandated that the interest consequence many have begun on an economy. India pays around
tries when these countries were paid should not exceed 25 basis quoting in rupees. $ 5 billion a year in principal repay-
unable to make repayments. Certain points over LIBOR on foreign cur- ments and interest payments. This is
African countries too have very low rency funds and Non- resident Restrictive Practices no small sum. This has been the
foreign exchange reserves. deposits. Restrictive practices or cartels price the country has had to pay due
Companies exporting to such imposed by countries can affect to our imports being far in excess of
countries have to be careful as the Foreign Exchange Risk companies and industries. The exports and an adverse balance of
importing companies may not be This is a real risk and one must be United States of America has payments. At the time the country
able to pay for their purchases cognizant of the effect of a revalua- restrictions regarding the imports of did borrow, it had no alternative.
because the country does not have tion or devaluation of the currency a variety of articles such as textiles. In 1991, at the time of devalua-
adequate foreign exchange. I know either in the home country or in the Licenses are given and amounts tion, India had only enough foreign
of an Indian company which had country the company deals in. that may be imported from compa- exchange to finance the imports of
exported machines to an African A devaluation in the home coun- nies and countries are clearly few weeks. It is to reverse this that
company a few years ago. The try would make the company's detailed. Similarly, India has a num- the government did borrow from
importing company paid the money products more attractive in other ber of restrictions on what may be the World Bank and devalue the
to its bank. It lies there still. The countries. It would also make imported and at what rate of duty. currency.

28 Politico-economic analysis Politico-economic analysis 29

Which Company?

A permanent solution will result al markets. Taxation Domestic Savings and its
only when the inflow of foreign cur- Low inflation within a country The level of taxation in a country Utilization
rency exceeds the outflow and it is indicates stability and domestic has a direct effect on the economy. If utilized productively, domestic
on account of this that tourism, companies and industries prosper at If tax rates are low, people have savings can accelerate economic
exports and exchange earning/sav- such times. more disposable income. In addi- growth. India has one of the largest
ing industries are encouraged. tion they have an incentive to work rate of savings (22%). In USA, it is
The Threat of Nationalization harder and earn more. And an only 2% whereas in Japan it is as
Inflation The threat of nationalization is a incentive to invest. This is good for high as 23%. Japan's growth was
Inflation has an enormous effect real threat in many countries - the the economy. It is interesting to on account of its domestic savings
in the economy. Within the country fear that a company may become note that in every economy there is invested profitably and efficiently.
it erodes purchasing power. As a nationalized. a level between 35% to 55% where Although India's savings are high,
consequence, demand falls. If the With very few exceptions, tax collection will be the highest. these savings have not been invested
rate of inflation in the country from nationalized companies are histori- While the tax rates may go up, col- either wisely or well. Consequently,
which a company imports is high cally less efficient than their private lection will decline. This is why there has been little growth. It is to
then the cost of production in that sector counterparts. If one is there it has been argued that the be remembered that all investments
country will automatically go up. dependent on a company for certain rates in India must be lowered. are born out of savings. Borrowed
This might reduce the cost com- supplies, nationalization could funds invested have to be returned.
petitiveness of the product finally result in supplies becoming erratic. Government Policy Investments from savings leads to
manufactured. Conversely, if the In addition, the fear of nationaliza- Government policy has a direct greater consumption in the future.
rate of inflation in the country to tion chokes private investment and impact on the economy. A govern- This has been recognized by the
which one exports is high, the prod- there could be a flight of capital to ment that is perceived to be pro- Government and it was in order to
ucts become more attractive result- other countries. industry will attract investment. divert savings to industry the 1992
ing in increased sales. The liberalization policies of the Finance Act stipulated that produc-
The USA and Europe have fairly Interest Rates Narsimha Rao government excited tive assets of individuals (shares,
low inflation rates (below 2%). In A low interest rate stimulates the developed world and foreign debentures, etc.) would not be liable
India, inflation has been falling investment and industry. companies grew keen to invest in for wealth tax.
steadily in recent times. It is current- Conversely, high interest rates result India and increase their existing
ly estimated between 3.7% and 4%. in higher cost of production and stakes in their Indian ventures. The The Infrastructure
In South America, at one time, it lower consumption. When the cost initiative of the former BJP govern- The development of an economy is
was over 1000%. Money there had of money is high, a company's com- ment in improving the infrastruc- dependent on its infrastructure.
no real value. Ironically, South petitiveness decreases. ture grabbed the attention of for- Industry needs electricity to manu-
American exports become attractive In India, the government, through eign investors. The present govern- facture and roads to transport
on account of galloping inflation the Reserve Bank, has been success- ment continues to focus on infra- goods. Bad infrastructure leads to
and the consequent devaluation of ful in lowering interest rates. structure as it is realized progress at inefficiencies, poor productivity,
their currency which makes their Increasing competition among a decent rate would not be possible wastage and delays. This is possibly
products cheaper in the internation- banks has also helped. without infrastructure. the reason why the 1993 budget lay

30 Politico-economic analysis Politico-economic analysis 31

Which Company?

so much emphasis, and offered so Budget deficits have been high. The
many benefits, to infrastructural government has, to reduce inflation
industries, such as power and trans- consciously cut expenditure down
portation. In recent years there has and it has reduced from a high of
been greater emphasis. Flyovers around 15% few years ago to a lit-
have been built, national highways tle over 7% today.
are being widened and made better Monsoons
and the improvements made in The Indian economy is an agrarian
communications is awesome. one and it is therefore extremely
dependent on the monsoon.
Budgetary Deficit Economic activity often comes to a
A budgetary deficit occurs when stand still in late March and early
governmental expenditure exceeds April as people wait to see whether
its income. Expenditure stimulates the monsoon is likely to be good or
the economy by creating jobs and not.
stimulating demand. However, this
can also lead to deficit financing Employment
and inflation. Both these, if not High employment is required to
checked, can result in spiraling achieve a good growth in national

prices. To control and cut deficits income. As the population growth

governments normally cut govern- is faster than the economic growth
mental expenditure. This would unemployment is increasing. This is
also result in a fall in money supply not good for the economy.
and a consequent fall in demand
which will check inflation.

All developing economies suffer
from budget deficits as governments
spend to improve the infrastructure
- build roads, power stations and
the like. India is no exception.


32 Politico-economic analysis The economic cycle 33

Which Company?

ountries go through the of higher demand, and let workers in fully, profits begin to grow at a The Investment Decision
business or economic go. higher proportionate rate. More Investors should attempt to deter-
cycle and the stage of the The United States went through and more new companies are mine the stage of the economic cycle
cycle at which a country a depression in the late seventies. floated to meet the increasing the country is in. They should invest
is in has a direct impact both on The economy recovered and the demand in the economy. In India at the end of a depression when the
industry and individual companies. eighties was a period of boom. 2003 could be seen as a year of economy begins to recover.
It affects investment decisions, Another downturn occurred in the recovery. All the attributes of a Investors should disinvest either just
employment, demand and the prof- late eighties and early nineties, espe- recovery are evident in the economy. before or during the boom, or, at the
itability of companies. While some cially after the Gulf War. The recov- worst, just after the boom.
industries such as shipping or con- ery of the US economy and that of Boom Investment and disinvestments
sumer durable goods are greatly the rest of Western Europe began In the boom phase, demand reaches made at these times will earn the
affected by the business cycle, others again in 1993. Later the US again an all time high. Investment is also investor greater benefits.
such as the food or health industry went through a period of depression high. Interest rates are low. It must however be noted that
are not affected to the same extent. at the turn of the millennium. India Gradually as time goes on, supply there is no rule or law that states
This is because in regard to certain too went through a difficult period begins to exceed the demand. Prices that a recession would last a certain
products consumers can postpone and it began its recovery in 2002. that had been rising begin to stabi- number of years, or that a boom
their purchase decisions, whereas in lize and even fall. There is an would be for a definite period of
certain others they cannot. Recovery increase in demand. Then as the time. Hence the length of previous
During this phase, the economy boom period matures prices begin to cycles should not be used as a meas-
The four stages of an economic begins to recover. Investment begins rise again. ure to forecast the length of an exist-
cycle are: anew and the demand grows. ing cycle. An investor should also be
Companies begin to post profits. Recession aware that government policy or
Depression Conspicuous spending begins once The economy slowly begins to other events can reverse a stage and
Recovery again. Once the recovery stage sets downturn. Demand starts falling. it is therefore imperative that
Boom Interest rates and inflation Demand investors analyze the impact of gov-
Recession The four stages of an economic cycle are: starts falling. Interest rates and ernment and political decisions on
inflation are high. Companies start the economy before making the final
Depression finding it difficult to sell their goods. investment decision. Joseph
At the time of depression, The economy slowly begins to Schumpeter once said, “Cycles are
demand is low and falling. downturn. Demand starts falling. not, like tonsils, separable things
Inflation is high and so are Interest rates and inflation begin to that might be treated by themselves
interest rates. Companies, increase. Companies start finding it but are, like the beat of the heart, of
crippled by high borrowing difficult to sell their goods. India the essence of organism that dis-
and falling sales, are forced went through a terrible recession for plays them.”
to curtail production, close 4 years from 1996.
down plants built at times

34 The economic cycle The economic cycle 35

Which Company?

he importance of having a capacity of 20 megabytes.
industry analysis is now The memory was then increased to
dawning on the Indian 40 megabytes. In eighteen months,
investor as never before. the laptop became obsolete with the
Previously, investors purchased creation of the notebook. These
shares of companies without con- notebooks, some having a capacity
cerning themselves about the indus- of as much as 120 megabytes, are
try it operated in. And they could still not the last word in compressed
get away with it three decades ago. computing. The palm tops have
This was because India was a sell- now arrived. Mobile phones today
ers' market at that time and prod- have computing capabilities. One
ucts produced were certain to be really and honestly does not know
sold, often at a premium. Those what will be next.
happy days are over. I have used these examples to
Now, there is intense competi- illustrate how technological
tion. Consumers have now become advances make a highly regarded
quality, cost and fashion conscious. product obsolete. In the same way,
Foreign goods are easily available technological advances in one
and Indian goods have to compete industry can affect another indus-
with these. There are great techno- try. The jute industry went into
logical advances and "state of the decline when alternate and cheaper
art" equipment becomes obsolete in packing materials began to be used.

a few years. If not months. In the The popularity of cotton clothes in
late 1970s and early 1980s, movie the West affected the manmade
cameras and projectors were prized (synthetic) textile industry. An
possessions. With the advent of the investor must therefore examine the
video camera in the mid 80s they industry in which a company oper-

became obsolete. In 1988, laptop ates because this can have a tremen-
computers were the "in" thing. dous effect on its results, and even
Everyone raved about the invention its existence. A company's manage-
and how technology could com- ment may be superior, its balance
press a huge computer into such a sheet strong and its reputation envi-
small box. These early models did able. However, the company may
not have a hard disk but two fixed not have diversified and the indus-
disk drives. A few months later hard try within which it operates may be
PART II disks were incorporated, initially in a depression. This can result in a

36 Industry analysis Industry analysis 37

Which Company?

tremendous decline in revenues and The Entrepreneurial or Nascent tionally readable magazine. The Stabilization or Maturity
even threaten the viability of the Stage However, it did not have the Stage
company. At the first stage, the industry is finance needed in those critical ini- After the halcyon days of growth,
new and it can take some time for it tial years to keep it afloat and had an industry matures and stabilizes.
Cycle to properly establish itself. In the to fold up. Had it, at that time, had Rewards are low and so too is the
The first step in industry is to deter- early days, it may actually make the finance it needed it may have risk. Growth is moderate. Though
mine the cycle it is in, or the stage of losses. At this time there may also survived and thrived. sales may increase, they do so at a
maturity of the industry. All indus- not be many companies in the In short, at this stage investors slower rate than before. Products
tries evolve through the following industry. It must be noted that the take a high risk in the hope of great are more standardized and less
stages: first 5 to 10 years are the most crit- reward should the product succeed. innovative and there are several
ical period. At this time, companies competitors.
1.Entrepreneurial, sunrise or nas- have the greatest chance of failing. The Expansion or Growth The refrigerator industry in
cent stage It takes time to establish companies Stage India is a mature industry. Growth
2.Expansion or growth stage and new products. There may be Once the industry has established is slow. It is for the time seeing safe.
3.Stabilization, stagnation or matu- losses and the need for large injec- itself it enters a growth stage. As the Investors can invest in these indus-
rity stage, and tions of capital. industry grows, many new compa- tries for comfort and average
4.Decline or sunset stage If a company or an industry is nies enter the industry. returns. They must be aware though
not nurtured At this stage, investors can get that should there be a downturn in
LIFE CYCLE OF AN INDUSTRY or husbanded high reward at low risk since the economy and a fall in consumer
at this stage, it demand outstrips supply. In 2000, a demand, growth and returns can be
can collapse. good example was the Indian soft- negative.
A good ware industry.
journalist I In 2003, the BPO industry is The Decline or Sunset Stage
know began a arguably in the growth stage. The Finally, the industry declines. This
business mag- mobile phone industry is also in the occurs when its products are no
azine. His growth stage - with newer models longer popular. This may be on
intention was and newer entrants. account of several factors such as a
to start a mag- The growth stage also witnesses change in social habits The film and
azine edited product improvements by compa- video industries , for example have
by journalists nies that have survived the first suffered on account of cable and
without inter- stage. In fact, such companies are satellite television, changes in laws,
(1) Entrepreneurial of nascent stage (2) Expansion or growth stage ference from often able to even lower their prices. and increase in prices. The risk at
(3) Stabilization or maturity stage (4) Decline industrial Investors are more keen to invest at this time is high but the returns are
magnates or this time as companies would have low, even negative.
The life cycle of an industry can be illustrated in an inverted "S" curve as illus- politicians. It demonstrated their ability to sur- The various stages can be
trated above. was excep- vive. likened to the four stages in the life

38 Industry analysis Industry analysis 39

Which Company?

cycle of a human being - childhood, During hard times individuals post- sider is the level of competition threat of substitution, bargaining
adulthood, middle age and old age. pone the purchase of consumer among various companies in an power of the buyers, bargaining
Investors should begin to purchase goods until better days. industry. Competition within an power of the suppliers, and the
shares when an industry is at the industry initially leads to efficiency, rivalry among competitors.
end of the entrepreneurial or nas- 3. Interest sensitive industries are product improvements and innova-
cent stage and during its growth those that are affected by interest tion. As competition increases even 1.BARRIER TO ENTRY
stage, and should begin to disinvest rates. When interest rates are high, more, cut throat price wars set in New entrants increase the capacity
when at its mature stage. industries such as real estate and resulting in lower margins, smaller in an industry and the inflow of
banking fare poorly. profits and, finally some companies funds. The question that arises is
The Industry vis-à-vis the begin to make losses. The more how easy is it to enter an industry ?
Economy 4. Growth industries are those inefficient companies even close There are some barriers to entry:
Investors must ascertain how an whose growth is higher than other down.
industry reacts to changes in the industries and growth occurs even To properly understand this a) Economies of scale: In some
economy. Some industries do not though the economy may be suffer- phenomenon, it is to be appreciated industries it may not be economical
perform well during a recession, ing a setback. that if the return is high, newcomers to set up small capacities. This is
others exhibit less buoyancy during will invest in the industry and there especially true if comparatively
a boom. On the other hand, certain What should Investors do? will be an inflow of funds. Existing large units are already in existence
industries are unaffected in a Investors should determine how an companies may also increase their producing a vast quantity. The
depression or a boom. What are the industry is affected by changes in capacity. However, if the returns products produced by such estab-
major classifications? the economy and movements in are low, or lower than that which lished giants will be markedly
interest rates. If the economy is can be obtained elsewhere, the cheaper.
1. Industries that are generally unaf- moving towards a recession, reverse will occur. Funds will not be
fected during economic changes are investors should disinvest their invested and there will be an out- b) Product differentiation: A com-
the evergeen industries. These are holdings in cyclical industries and flow. In short high returns attract pany whose products have product
industries that produce goods indi- switch to growth or evergreen competition and vice versa. differentiation has greater staying
viduals need, like the food or industries. If interest rates are likely However, competition in the form power. The product differentiation
agrobased industries (dairy prod- to fall, investors should consider of new companies do not bacterial- may be because of its name or
ucts, etc.). investment in real estate or con- ly multiply just because the returns because of the quality of its prod-
struction companies. If, on the are high. ucts - Mercedes Benz cars; National
2. Then there are the volatile cycli- other hand, the economy is on the There are competitive forces and VCRs or Reebok shoes.
cal industries which do extremely upturn, investment in consumer and it is these competitive forces that People are prepared to pay more
well when the economy is doing durable goods industries are likely determine the extent of the inflow for the product and consequently
well and do badly when depression to be profitable. of funds, the return on investment the products are at a premium . It is
sets in. The prime examples are and the ability of companies to sus- safe usually to invest in such com-
durable goods, consumer goods Competition tain these returns. These competi- panies as there will always be a
such as textiles and shipping. Another factor that one must con- tive forces are: barriers to entry, the demand.

40 Industry analysis Industry analysis 41

Which Company?

c) Capital requirement: Easy entry Difficulty in securing access to dis- i) Cost of capacity additions: If the 3.BARGAINING POWER OF
industries require little capital and tribution channels can be a barrier cost of capacity additions are high, THE BUYERS
technological expertise. As a conse- to entry, especially if existing firms there will be fewer competitors In an industry where buyers have
quence, there are a multitude of already have strong and established entering the industry. control, i.e. in a buyer's market,
competitors, intense competition, channels. buyers are constantly forcing prices
low margins and high costs. j) International cartels: There may down, demanding better services or
On the other hand, capital inten- f) Cost disadvantages independent be international cartels that make it higher quality and this often erodes
sive industries with a large capital of scale: This barrier occurs when unprofitable for new entrants. profitability. The factors one should
base and high fixed cost structure established firms have advantages check are whether:
have few competitors as entry is dif- new entrants cannot replicate. 2.THE THREAT OF a)A particular buyer buys most of
ficult. The automobile industry is a These include: SUBSTITUTION the products (large purchase vol-
prime example of such an industry. Proprietary product technology New inventions are always taking umes). If such buyers withdraw
Its high fixed costs have to be serv- Favorable access to raw materials place and new and better products their patronage, they can destroy an
iced and a fall in sales can result in Government subsidies replace existing ones. industry. They can also force prices
a more than proportionate fall in Long learning curve. An industry that can be replaced down.
profits. Large investments and a big A prime example is Coca Cola. by substitutes or is threatened by b)Buyers can play one company
capital base will be barriers to The company has proprietary prod- substitutes is normally an industry against another to bring prices
entry. uct technology. Similar cold drinks one must be careful of investing in. down.
are available but it is not easy for a An industry where this occurs con-
d)Switching costs: Another barrier competition to compete with it. stantly is the packaging industry - One should also be aware that:
to entry could be the cost of switch- bottles replaced by cans, cans If sellers face large switching
ing from one supplier's product to g)Government policy: Government replaced by plastic bottles, and the costs, the buyer's power is
another. This may include employee policy can limit fresh entrants to an like. enhanced. This is especially true if
restraining costs, cost of equipment industry, usually by not issuing To ward off the threat of substi- the switching costs for buyers are
and the likes. If the switching costs licenses. Till about the mid-1980s, tution, companies often have to low.
are high, new entrants have to offer the Indian motor car industry was spend large sums of money in If buyers have achieved partial
a tremendous improvement for the the monopoly of two companies. advertising and promotion. The backward integration, sellers face a
buyer to switch. Even though others sought licenses industries that have to worry most threat as they may become fully
A prime example is computers. there were not given. are those where the substitutes are integrated.
A company may be using a either cheaper or better, or are pro- If buyers are well informed about
Honeywell computer. If it wishes to h)Expected retaliation: The expect- duced by industries earning high trends and details they are in a bet-
change to an IBM computer, all the ed retaliation by existing competi- profits. It should be noted that sub- ter position vis-à-vis sellers as they
terminals, the unit and even the tors can also be a barrier to poten- stitutes limit the potential returns of can ensure they do not pay more
software would have to be changed. tial entrants, especially if existing a company. than they need to.
competitors aggressively try to keep If a product represents a signifi-
e)Access to distribution channels: the new entrants out. cant portion of the buyers' cost,

42 Industry analysis Industry analysis 43

Which Company?

buyers would strongly attempt to 5.RIVALRY AMONG COMPETI- of the other by price cuts or barriers are high the return is low
reduce prices. TORS improved service. but risky. If exit barriers are low the
If a product is standard and undif- Rivalry among competitors can g)Rivalry increases if the stakes return is low but stable. On the
ferentiated, the buyer's bargaining cause an industry great harm. This (profits) are high. other hand, if entry barriers are low
power is enhanced. occurs mainly by price cuts, heavy h)Firms will compete with one the returns are high but stable. High
If the buyer's profits are low, the advertising, additional high cost another intensely if the costs of exit entry barriers have high, risky
buyer will try to reduce prices as services or offers, and the like. This are great, i.e. the payment of gratu- returns.
much as possible. rivalry occurs mainly when: ity, unfunded provident fund, pen-
In short, an industry that is dic- a) There are many competitors and sion liabilities, and such like. In Selecting an Industry
tated by buyers is usually weak and supply exceeds demand. Companies such a situation, companies would When choosing an industry, it
its profitability is under constant resort to price cuts and advertise prefer remaining in business even if would be prudent for the investor to
threat. heavily in order to attract customers margins are low and little or no bear in mind or determine the fol-
for their goods. profits are being made. Companies lowing details:
4.BARGAINING POWER FOR b) The industry growth is slow and also tend to remain in business at 1.Invest in an industry at the
THE SUPPLIERS companies are competing with each low margins if there are strategic growth stage.
An industry unduly controlled by its other for a greater market share. interrelationships between the com- 2. The faster the growth of a com-
suppliers is also under threat. This c) The economy is in a recession and pany and others in the group; due to pany or industry, the better. Indian
occurs when: companies cut the price of their government restrictions (the gov- software industry, for example, was
products and offer better service to ernment may not allow a company growing at a rate of more than 50
a) The suppliers have a monopoly, stimulate demand. to close down); or in case the man- per cent per annum at the dawn of
or if there are few suppliers. d) There is lack of differentiation agement does not wish to close the new millennium.
b) Suppliers control an essential between the product of one compa- down the company out of pride or 3. It is safer to invest in industries
item. ny and that of another. employee commitment. that are not subject to governmental
c) Demand for the product exceeds In such cases, the buyer makes his If exit barriers are high, excess controls and are globally competi-
supply. choice on the basis of price or serv- capacity can not be shut down and tive.
d) The supplier supplies to various ice. companies lose their competitive 4. Cyclical industries should be
companies. e) In some industries economies of edges; profitability is eroded.If exit avoided if possible unless one is
e) The switching costs are high. scale will necessitate large additions
f) The supplier's product does not to existing capacities in a company.
have a substitute. The increase in production could High Low
g) The supplier's product is an result in over capacity & price cut-
important input for the buyer's ting.
business. f) Competitors may have very dif- Entry Barriers Return high but risky Return high but stable
h) The buyer is not important to the ferent strategies in selling their
supplier. goods and in competing they may Exit Barriers Return low but risky Return low and stable
i) The supplier's product is unique. be continuously trying to stay ahead

44 Industry analysis Industry analysis 45

Which Company?

investing in them at the time the at a particular time. There are sun-
industry is prospering. rise and sunset industries. There are
5. Export oriented industries are capital intensive and labour inten-
presently in a favorable position sive industries. Each industry goes
due to various incentives and gov- through a life cycle. Investments
ernment encouragement. On the should be at the growth stage of an
other hand, import substitution industry and disinvestments at the
companies are presently not doing maturity or stagnation stage before
very well due to relaxations and decline sets in.
lower duties on imports.
6. It is important to check whether
an industry is right for investment


46 Industry analysis Company analysis 47

Which Company?

At the final stage of fundamental What does one look at when analyz-
analysis, the investor analyzes the ing a company? There is, in my
company. This analysis has two view, no point or issue too small to
thrusts: be ignored. Everything matters. As I
had mentioned earlier, the billion-
How has the company performed aire Jean Paul Getty, one of the most
vis-à-vis other similar companies successful stock market operators of
and all time, said, "Do not buy stock
How has the company performed until you know all about it".
in comparison to earlier years
The different issues regarding a
It is imperative that one completes company that should be examined
the politico economic analysis and are:
the industry analysis before a com- The Management
pany is analyzed because the com- The Company
pany's performance at a period of The Annual Report
time is to an extent a reflection of Ratios
the economy, the political situation Cash flow
and the industry.


48 Company analysis The management 49

Which Company?

he single most important tal in his getting the top job at IBM ity is due to Rahul Bajaj, and the family and for the shareholders of
factor one should con- Similarly, the main reason attrib- Reliance Empire due entirely to one Kirloskar Tractors but the merger
sider when investing in a uted for the collapse in the seventies man. Dhirubhai Ambani. There are was disastrous for the shareholders
company and one often of Penn Central, the largest railway several others such as Azim Premji of Kirloskar Pneumatics. In short,
never considered is its management. in the United States, was that it was and Wipro, Narayanamurthy and decisions are often made with fam-
It is upon the quality, competence headed by Stuart Saunders who was Infosys and HDFC and Deepak ily interests in view and employees
and vision of the management that a lawyer and possessed little under- Parekh. are often treated as paid servants of
the future of company rests. standing of what was involved in In India management can be broadly the family even though they may be
A good, competent management running a large railway network. divided in two types: senior managers. For instance, in
can make a company grow while a Indian corporate history also has one company I know the Human
weak, inefficient management can many such examples. Family Management Resources Manager is also involved
destroy a thriving company. Metal Box was a name known Professional Management in hiring maids and houseboys for
Corporate history is riddled with and respected, the bluest of blue his Chairman's house and he buys
examples. Chrysler was an ailing chips. After a series of occurrences Family management the vegetables too. The New Delhi
giant in the early eighties, Iacocca including a diversification that went Family managed companies are manager, whenever his "Seth" visits
turned the wrong, the those that have at the helm a mem- that city is expected to be at the
Fundamental Analysis Primer
company company ber of the controlling family. The company house every morning at 7
round with Management is the single most important factor to was forced Chairman or the Chief Executive a.m. when the Chairman wakes up,
tough compe- consider in a company. Upon its quality rests the to close all Officer is usually a member of the and can only leave his master's pres-
tent manage- future of the company. its facto- "ruling" family and the Board of ence after he retires for the night. I
ment. In the ries. Directors are peopled either by was witness to an incident at
first quarter of 1993, the big blue - Killick Nixon was one of the members of the family or their Bombay airport many years ago.
IBM - dismissed its, Chief Executive most respected names in Western friends and "rubber stamps". This is The head of a large business house
Officer Akers who was blamed for India. No longer. necessarily bad. It is just that all pol- was going on a trip. The chief exec-
the company's dismal performance. On the other hand, there are icy is determined by the controlling utives of his many companies had
Lou Gerstiner who was at one time numerous success stories, of pros- family and some of the policies may come to see him off. These gentle-
President of American Express and perity that resulted due to the fore- not necessarily always be in the men were well known individuals,
later took charge of R.J.R. Nabisco sight and vision of management. shareholders' best interest. captains of industry in their own
was invited to become the Chief Haksar diversified ITC into hotels I remember a few years ago right and respected for their achieve-
Executive Officer of IBM. Mr. (the WelcomGroup chain); his suc- Kirloskar Pneumatics was quoting ments and accomplishments. These
Gerstner had earlier been successful cessor diversified into agro based at Rs.36 per share. At that time leaders bent double and touched
in reducing quite drastically and industries. Kirloskar Tractors was not doing their leader's feet when he left, and
very impressively the liabilities that These have been successes The well. The controlling family merged three of them were actually older
had arisen on account of the lever- success of Videocon could probably the two companies and the price of than their master. Possibly, this may
aged buy out of R.J.R. Nabisco. It be attributed to Venugopal Dhoot, Kirloskar Pneumatic fell to around have been done as a sign of respect
was this success that was instrumen- Bajaj Auto's growth and profitabil- Rs.10. It was probably good for the like a student touching his teacher's

50 The management The management 51

Which Company?

feet, but I do wonder what may have from the same religious or caste Professional Management fruit of his labour for ever. Nor will
occurred if these individuals had not group. The fourth circle comprises Professionally managed companies his sons succeed him although some
humiliated themselves with this ges- of people from the same region. Mr. are those that are managed by may try to see that his happens. It is
ture of obeisance. What I am trying Thomas says that to go beyond this employees. In such companies, the possible Darbari Seth's son will
to point out is that in many family was "like going out of orbit - chief executive officer often does not become Chairman of Tata
run companies, employees are unthinkably risky". even have a financial stake in the Chemicals. One must also not forget
expected to be subservient to the There has been some change in company. He is at the helm of that the professional manager is a
family and loyalty to the family is the way family controlled businesses affairs because of his ability and mercenary. He sell his services to the
considered even more important have been managed. In the begin- experience. highest bidder, and such individuals
than talent. And often this loyalty is ning, these were often orthodox, The professional manager is a are consequently not usually know
rewarded. If a retainer is ill, he is autocratic, traditional, rigid and career employee and he remains at for their loyalty.
looked after well and all his medical averse to change. This is no longer the seat of power so long as he meets Companies are now to promote
expenses are borne by the family. true. The sons and the grandsons of his targets. Consequently, he is or create commitment offering
When he Fundamental Analysis Primer t h e always result-oriented and his aim is employees stock options. These
retires he is founding often short term - the meeting of the devolve on employees after a speci-
given a good In India there are two main types of management - f a t h e r s annual budget. He is not necessarily fied period of service and are given
pension. I Family and Professional. have been influenced by loyalty to the com- to them on performance. The
remember an educated pany. As a professional he is usually employee thus becomes a part
occasion when a senior employee at the best business schools in India aware of the latest trends in man- owner and becomes thus involved in
died. His widow was given the com- or abroad and they have been agement philosophy and tries to the profitability of the enterprise.
pany flat, the children were edu- exposed to modern methods. introduce these. He tries to run his Additionally as these devolve on the
cated and she was even given a job. Consequently, in many family man- company like a lean, effective employee only after a time, he tends
Few professionally managed or aged companies, although the man machine striving for increased effi- to stay till it does. As these options
multinationals would do this. at the helm is a scion of the family, ciency and productivity. As a conse- are given, often annually, the
Mr. T. Thomas, a former his subordinates are graduates of quence, professionally managed employee remains with the company
Chairman of Hindustan Lever Ltd., business schools, i.e. professional companies are usually well organ- for a significant period of time. It is
describes the family business struc- managers. To an extent this com- ized, growth oriented and good per- a win-win situation for both. The
ture most eloquently in his memoir, bines the best of two worlds and formers. The companies that come company gets the services of a loyal
To Challenge and to Change. He many such businesses are very suc- readily to mind are ITC, Infosys, competent employee. The employee
speaks of an Indian family business cessful. The frustration for the pro- HDFC and Hindustan Lever. builds his net worth.
having a series of concentric circles fessional manager in such However, there is often a lack of In many professionally managed
emanating from a core - the core companies is that he know that he long term commitment and some- companies there is also a lot of
being made up of the founder and will never ever run the company. times a lack of loyalty. This is infighting and corporate politics.
his brothers or sons. The next circle That privilege will always be with a because the professional manager This is because managers are con-
is the extended family of cousins member of the family. has to step down in time, to retire, stantly trying to climb up the corpo-
and relatives followed by people and he cannot therefore enjoy the rate ladder and the end is often what

52 The management The management 53

Which Company?

matters, not the means. Often too, the integrity of its management. I Rs.230. The worthy replied, "We a company is usually impartial, fair
as a consequence, the best person had the privilege once to listen to will not allow it to". Shares of such and correct.
does not get the top job; rather, it is Mr. C.S. Patel who was at one time companies are speculative shares
the person who plays the game best. the Chief Executive of Unit Trust of and artificially kept at a high price. 4. How the management fares in
This does not always happen in fam- India. He recounted an advice he They must be avoided. adversity?
ily managed companies as one is was given by his mentor, Mr. A.D. In good times everyone does well.
aware that the mantle of leadership Shroff, the erstwhile Chairman of 2. Past record of management The steel of a management is tested
will always be worn by the son or the New India Assurance; "If you Another point to consider is proven at times of adversity? And during a
daughter of the house. have the slightest doubt of manage- competence, i.e. the past record of time of recession or depression, it is
ment, do not touch the company the management. How has the man- important to consider how well the
What to look for with a pair of tongs". Seldom have agement managed the affairs of the management did? Did it streamline
It would be unfair to state that one I heard truer words. When, in a con- company during the last few years? its operations? Did it close down its
should invest only in professionally versation about a company, its man- Has the company grown? Has it factories? Did it (if it could) get rid
managed companies or family man- agement is described colloquially as become more profitable? Has it of employees? Was it able to sell its
aged companies. There are well "chor (thief) management", it is a grown more impressively than oth- products? Did the company perform
managed, profitable companies in hint to keep well away from that ers in the same industry? better than its competitors? How
both categories. There are also company. It is always wise to be a little did sales fare? A management that
badly managed companies in both In this context, one should check wary of new management and new can steer its company in difficult
categories. What then are the factors who the major shareholders of the companies as they have very high days will normally always do well.
one should look for? company are. There are some man- level of mortality. Wait until the
agements who have a record of company shows signs of success and 5. The depth of knowledge of the
1. Integrity of Management manipulating share prices. I was the management proves its compe- management
In my opinion, the most important recounted a tale wherein a non- tence. Its knowledge of its products, its
aspect is the integrity of the manage- Indian journalist asked the scion of markets and the industry is of para-
ment. This must be beyond ques- a family managed company how he 3. How highly is the manage- mount importance because upon
tion. It is often stated that a could claim that the share price of ment rated by its peers in the this can depend the success of a
determined employee can perpetrate his company would not fall below same industry? company. Often the management of
a fraud, despite good systems and This is a very telling factor. a company that has enjoyed a pre-
controls. Similarly if it so desires, Fundamental Analysis Primer Competitors are aware of nearly all eminent position sits back thinking
the management can juggle figures Investors must check on integrity of the strengths and weaknesses of a that it will always be the dominant
and cause great harm and financial managers, proven competence, how high management and if they hold the company. In doing so, it loses its
loss to a company (for their own is it rated by its peers, how did it perform management in high esteem it is touch with its customers, its markets
personal gain). at times of adversity, the management's truly worthy of respect. It should be and its competitors.
My recommendation would depth of knowledge, its innovativeness remembered that the regard the The reality sinks in only when it
therefore be to leave a company well and professionalism. industry has of the management of is too late. The management must be
alone if you are not too certain of

54 The management The management 55

Which Company?

in touch with the industry and cus- the chief executive and not with the ble, nor would it be fair, to general- Ultimately, this is what will deter-
tomers at all times and be aware of good of the company in mind. In ize which is better. An investor mine the safety and the fate of the
the latest techniques and innova- such companies the most competent must, before he risks his money, money that you invest.
tions. Only then can it progress and are not given the position of power. decide whether he is comfortable
keep ahead. A quick way of check- There may be nepotism with the with the management of a company.
ing this is to determine what the nephews, nieces, cousins and rela-
market share of the company's tives of the chief executive holding
products is, and whether the share is positions not due to proven compe-
growing or at least being main- tence but because of blood ties.
8. Avoid investing in family con-
6.The management must be trolled companies
open, innovative and must also It would be wise, too, to avoid
have a strategy: investing in family controlled com-
It must be prepared to change panies where there is infighting
when required. It must essentially because the companies suffer and
know where it is going and have a the one who arguably stands to lose
plan of how to get there. It must be the most is the shareholder or the
receptive to ideas and be dynamic. investor. In recent years, many such
A company that has many layers family controlled companies have
of management and is top heavy split, the Birlas, the Goenkas, the
tends to be very bureaucratic and Mafatlals, to name but a few. The
ponderous. There are "many chiefs period before the split and the
and few braves". They do not want period soon after are the most unset-
change and often stand in the way of tled times. That is the time to keep
change. Their strategy is usually a away from such companies. When
personal one, on how to hold onto the new management settles down,
their jobs. one can determine whether one
should invest or not.
7.Non-professionalised In India, most of the larger com-
Management panies are family controlled though
I would not recommend investing in they are managed on a day-to-day
a company that is yet to profession- basis by professional managers.
alize because in such companies There are also several professionally
decisions are made on the whims of managed companies. It is not possi-

56 The management The management 57

Which Company?

n aspect not necessarily known for its maturity, vision, com-
examined during an petence and aggressiveness.
analysis of fundamentals The investor must ascertain the
is the company. This is reason and then determine whether
because the company is one's per- the reason will continue into the
ception of the state of a company - foreseeable future.
it cannot necessarily be supported
by hard facts and figures. 2. Whether the company is the
A company may have made market leader in its products or
losses consecutively for two years or in its segment
more and one may not wish to touch Another aspect that should be ascer-
its shares - yet it may be a good com- tained is whether the company is the
pany and worth purchasing into. market leader in its products or in
There are several factors one should its segment. When you invest in
look at. market leaders, the risk is less. The
shares of market leaders do not fall
1. How a company is perceived as quickly as those of other compa-
by its competitors? nies. There is a magic to their name
One of the key fac- that would make
Fundamental Analysis Primer
tors to ascertain is individuals pre-
how a company is The investor must determine the policy fer to buy their
perceived by its com- a company follows and its plans for products as
petitors. It is held in growth. opposed to oth-
high regard? The ers.
Oscar is Let us take a
Hollywood's greatest award, the real life example. In the eighties,

The one most prized by the stars. Why? there was a virtual explosion of con-
It is because it represents recogni- sumer goods. There were many tel-
tion of an actor/ actress by his/her evision manufacturers. They made
peers. A company held in scorn by a similar televisions as almost all parts
competitor is not worth looking at. were imported.
On the other hand, one held in However within a decade only
awe must be considered not once those that were the market leaders
but several times. Its products may survived. The others had died off. If
CHAPTER FIVE be far superior. It may be better one has to purchase an article and
organized. Its management may be has a choice one would normally

58 The company The company 59

Which Company?

buy the better one. This is normal ing company. It had a software divi- company is located and where its government has recognized this and
human behavior and this happens in sion which was spun off as a sepa- factories are. If the infrastructure is there are plans afoot to have super-
the market place too. Consequently, rate company. Since then both these bad, if there is inadequate electricity highways around the country within
the prices of market leaders fall companies have grown. or water the company could have the next ten years.
slower than those of others in the tremendous problems. These are the main factors one
same industry. 4. Labour Relations There are many companies in should keep at the back of one's
Labour relations are extremely Madhya Pradesh in dire straits mind while viewing a company.
3. Company Policies important. A company that has because of electricity cuts. Many
The policy a company follows is motivated, industrious work force cannot afford captive power.
also of imperative importance. has high productivity and practi- Transportation is another issue. The
What is its plans for growth? cally no disruption of work.
What is its vision? Every company On the other hand, a company
has a life. If it is allowed to live a that has bad industrial relations will
normal life it will grow upto a point lose several hundred mandays as a
and then begin to level out and even- consequence of strikes and go slows.
tually die. It is at the point of level- In 1992 Bata, the giant shoe
ing out that it must be given new company, was closed due to strikes
life. This can give it renewed vigour for nearly four months and as a con-
and a new lease of life. A classic sequence its results in the year to 31
example that comes to mind is ITC March 1993 were extremely bad. It
Ltd. This tobacco giant branched is widely believed that the textile
into hotels under Haksar and then industry died in Mumbai because of
into agribusiness under Sapru. the militancy of the unions under
Reliance Industries was initially in the late Datta Samant. It was on
Textiles. It then saw opportunity account of the militancy of the
and moved into petroleum, into labour force that many companies
petro chemicals and refining prod- grew reluctant to invest in states
ucts. It has in 2003 got into mobile such as Kerala and West Bengal. It
phones. Blue Star is a aircondition- is critical, therefore, to ascertain
where the company's plants and fac-
Fundamental Analysis Primer tories are and their record of indus-
It is important to check how company is trial relations.
perceived by its competition and
whether it is the market leader in its 5. Where the company is located
products or in its segment. and where its factories are?
One must also consider where the

60 The company The company 61

Which Company?

he primary and most The Annual Report is broken down
important source of infor- into the following specific parts:
mation about a company A.The Director's Report,
is its Annual Report. By B.The Auditor's Report,
law, this is prepared every year and C.The Financial Statements, and
distributed to the shareholders. D.The Schedules and Notes to the
Annual Reports are usually very Accounts.
well presented. A tremendous
amount of data is given about the Each of these parts has a purpose
performance of a company over a and a tale to tell. The tale should be
period of time. Multi-colored bar heard.
and pie charts are presented to illus-
trate and explain the growth of the A.The Director’s Report
company and the manner in which The Director’s Report is a report
the revenues earned have been uti- submitted by the directors of a com-
lized. There are pictures of the fac- pany to its shareholders, advising
tories; of newly acquired machines; them of the performance of the com-
of the Chairman cutting a ribbon pany under their stewardship. It is,

and of the Board of Directors look- in effect, the report they submit to

ing responsible. justify their continued existence and
The average shareholder looks it is because of this that these reports
no further. If an Annual Report is should be read with a pinch of salt.
impressive, if the company has made After all, if a group of individuals
a profit and if a reasonable dividend have to present an evaluation of
has been paid, he is typically content their own performance they are
in the belief that the company is in bound to highlight their achieve-

good hands. ments and gloss over their failures.
This must not be the criterion by It is natural. It is human nature.
which to judge a company. The Consequently, all these reports are
intelligent investor must read the very well written. Every sentence,
annual report in depth; he must read
Fundamental Analysis Primer
between and beyond the lines; he
must peep behind the figures and The annual report is broken into the
find the truth and only then should director’s report, the auditor's report, the
CHAPTER SIX he decide whether the company is financial statements and the schedules.
doing well or not.

62 The annual report The annual report 63

Which Company?

Fundamental Analysis Primer

nay every word, is subjected to the diversification may not suit a com- point out if the financial statements
most piercing scrutiny. Every hap- The annul report is the primary and most pany. Similarly, all other issues are not true and fair. They are also
pening of importance is catalogued important source of information on a raised in the Director’s Report required to report any change, such
and highlighted to convince a casual company. should be analyzed. Did the com- as a change in accounting principles
reader that the company is in good pany perform as well as others in the or the non provision of charges that
hands. And there is a tendency to same industry? Is the finance being result in an increase or decrease in
justify unhappy happenings. profits have improved it would raised the most logical and benefi- profits. It is really the only impartial
Nevertheless, the Director’s Report invariably be because of superior cial for the company? It is impera- report that a shareholder or investor
provides an investor valuable infor- marketing and hard work in the face tive that the investor read between receives and this alone should spur
mation: of severe competition. If low, the lines of Director’s Report and one to scrutinize the auditor's report
1. It enunciates the opinion of the adverse economic conditions are find the answers to these questions. minutely. Unfortunately, more often
directors on the state of the econ- usually at fault. than not it is not read.
omy and the political situation vis- 5. Elaborates on the directors' views In short, a Director’s Report is valu- There can be interesting contra-
à-vis the company. of the company's prospects in the able and if read intelligently can give dictions. It was stated in the
2. Explains the performance and the future. the investor a good Auditor's Report
Fundamental Analysis Primer
financial results of the company in 6. Discusses plans for new acquisi- grasp of the work- of ABC Ltd. for
the period under review. This is an tion and investments. ings of a com- The investor must read between and the year 1999-
extremely important part. The pany, the beyond the lines of an annual report to 2000 that, "As
results and operations of the various An investor must intelligently problems it faces, determine the state of the company at the year end
separate divisions are usually evaluate the issues raised in a the direction it being considered. 31st March
detailed and investors can determine Director’s Report. Diversification is intends taking, 2000 the accu-
the reasons for their good or bad good but does it make sense? and its future prospects. mulated losses exceed the net worth
performance. Industry conditions and the man- of the Company and the Company
3. The Director’s Report details the agement's knowledge of the busi- B. The Auditor's Report has suffered cash losses in the finan-
company's plans for modernization, ness must be considered. A The auditor represents the share- cial year ended 31st March 2000 as
expansion and diversification. diversification that was a disaster holders and it is his duty to report to well as in the immediately preceding
Without these, a company will was Burroughs Wellcome's diversi- the shareholders and the general financial year. In our opinion, there-
remain static and eventually decline. fication into sport goods - Nike public on the stewardship of the fore, the Company is a sick indus-
4. Discusses the profit earned in the Sportswear. So was Metal Box's company by its directors. Auditors trial company within the meaning of
period under review and the divi- move into ball bearings and are required to report whether the clause (O) of Section 3(1) of the Sick
dend recommended by the directors. Spartek's acquisition of Neycer financial statements presented do, in Industrial Companies (Special
This paragraph should normally be Ceramics. The point I am trying to fact, present a true and fair view of Provisions) Act 1985". The
read with sane skepticism, as the make is that although companies the state of the company. Director’s report however stated,
directors will always argue that the must diversify in order to spread the Investors must remember that "The financial year under review
performance was satisfactory. If risks of industrial slumps, every the auditors are their representatives has not been a favorable year for the
and that they are required by law to Company as the Computer Industry

64 The annual report The annual report 65

Which Company?

in general continued to be in the grip 1956, and give a true and fair view. past gratuity liabilities as of 31 The company made a profit of
of recession. High input costs as Let us now look at the specific notes March 2000 had neither been ascer- just over Rs.1 crore. If the product
well as resource constraints ham- in this case: tained nor provided for except to development expenses, customer
pered operations. The performance the extent of premiums paid against duty and interest and provision for
of your Company must be assessed 1.Note 3 states that no provision an LIC group gratuity policy taken bad debts had been made as is
in the light of these factors. During had been made for doubtful debts. by the trust. (Note 14.) required under generally accepted
the year manufacturing operations 2. It was noted in Note 4 that bal- 6. Note 16C stated that the raw accounting principles, the profit
were curtailed to achieve cost effec- ance confirmation of sundry material consumed had been esti- would have turned into a loss.
tiveness. Your directors are confi- debtors, sundry creditors and loans mated by the management and this The point to remember is that at
dent that the efforts for increased and advances had not been had not been checked by the audi- times accounting principles are
business volumes and cost control obtained. tors. changed, or creative and innovative
will yield better results in the current 3. It was stated in Note 5 that cus-
year". The auditors were of the toms liability and interest thereon Fundamental limited Profit & Loss Account for the year ended
opinion that the company was sick worth Rs.3,14,30,073 against the 31 March, 2004
whereas the directors spoke opti- imported raw materials lying in the 2003 2004
mistically of their hope that the ICF/Bonded godown as on INCOME
future would be better! I suppose 31.3.2000 had not been provided. Sales 14,000 17,500
they could not, being directors, state 4. Note 11 drew attention to the fact Other Income 500 600
otherwise. that product development expenses 14,500 18,100
When reading an Auditor's worth Rs.17,44,.049 were being EXPENDITURE
Report, the effect of their qualifica- written off over ten years from Materials 7,600 9,200
tion may not be apparent. The 1999-2000. Rs.2,16,51,023 had Employment 3,450 3,900
Auditor's Report of Royston been capitalized under this head Operating & other expenses 1,150 2,100
Electronics Limited for 1999-2000 relating to the development of Interest & Finance charges 300 350
stated : "In our opinion and to the CT142, Digital TV, CFBT which Depreciation 80 100
best of our information and expla- shall be written off in 10 years com- 12,580 15,650
nation given to us, the said accounts mencing, 2000-01. Profit for the year before tax 1,920 2,450
subject to Note No.3 regarding 5. The company's share towards Taxation 900 1200
doubtful debts, No.4 regarding bal- 1,020 1,250
Fundamental Analysis Primer
ance confirmations, No.5 on custom
liability and interests thereon, The Director’s Report gives investors
Dividend 220 400
No.11 on product development insights into the company.
expenses, No.14 on gratuity, No.8 and enunciates the opinion of the direc- General reserves 200 400
16(C) and 16(F) regarding stocks, tors on the economy, the industry and 420 800
give the information in the manner political situation. BALANCE CARRIED FORWARD 600 450
as required by the Companies Act

66 The annual report The annual report 67

Which Company?

Fundamental limited (Balance sheet as on 31 MArch, 2003) accounting practices resorted to by is for this reason that a careful read-
2003 2004 some companies in order to show a ing of the Auditor's Report is not
SOURCES OF FUNDS better result. The effect of these only necessary but mandatory for an
Shareholder's funds changes is at times not detailed in investor.
(a) Capital 1000 1000 the notes to the accounts. The
B) Reserves 800 1650 Auditor's Report will always draw C.Financial Statements
1800 2650 the attention of the reader to these The published financial statements
LOAN FUNDS changes and the effect that these of a company in an Annual Report
(a) Secured Loans 1350 1050 have on the financial statements. It consist of its Balance Sheet as at the
(b) Unsecured Loans 650 500
2000 1550 Balance Sheet Illustration
TOTAL 3800 4200 Vasanth Limited had taken a loan of Rs.200 lakh on 1 December 2003 which was repayable on
APPLICATION OF FUNDS 1 April 2004. On 31 March 2004, its Balance Sheet was as follows :
Fixed Assets 3200 3640 Vasanth Ltd. Balance Sheet as at 31 March 2004
Investments 400 400 (In Rupees Lakh)
Current Assets : Shareholders' funds 100 70
Trade debtors 600 700 Loan funds 200 30
Prepaid Expenses 80 80 Current liabilities 20 220
Cash & Bank balances 50 100 320 320
Other Current Assets 100 150
Current assets include cash of Rs.100 lakh to repay the loan . Vasanth Ltd. did repay the loans,
830 1030 as promised on 1 April 2004. Its Balance Sheet after the repayment read:

Less : Vasanth Ltd. Balance Sheet as at 1 April 2004

(In Rupees Lakh)
Current Liabilities and provisions Shareholders' funds 100 70
Trade Creditors 480 710 Loan funds — 30
Current liabilities 20 20
Accrued Expenses 70 90
120 120
Sundry Creditors 80 70
An investor reviewing the Balance Sheets would be forgiven for drawing two very different con-
630 870 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 the
Net current assets 200 160 company was very conservative and undercapitalized, as a consequence of which its growth
would be limited.
TOTAL 3800 4200

68 The annual report The annual report 69

Which Company?

end of the accounting period detail- Shareholders Funds shares were often issued to investors reserves. No monies are actually
ing the financing condition of the A company sources funds from at a price much lower than its real raised from shareholders. It can be
company at that date, and the Profit shareholders either by the issue of value. As a consequence, they were argued, however, that if these shares
and Loss Account or Income shares or by ploughing back profits. oversubscribed many times. This is are issued by capitalizing distrib-
Statement summarizing the activi- Shareholder's funds represent the no longer true. As companies are utable reserves, i.e. profits not dis-
ties of the company for the account- stake they have in the company back now free to price their issues as they tributed as dividends, then, in effect,
ing period. profits. Shareholders' funds repre- like and the office of the controller shareholders are contributing capi-
sent the stake they have in the com- of capital issues has been abolished, tal.
BALANCE SHEET pany, the investment they have companies typically price their
The Balance Sheet details the finan- made. shares at what the market can bear. RESERVES
cial position of a company on a par- As a consequence the investing pub- Reserves are profits or gains which
ticular date; of the company's assets Share Capital lic are no longer applying blindly for are retained and not distributed.
(that which the company owns), and Share capital represents the shares new shares but do so only after a Companies have two kinds of
liabilities (that which the company issued to the public. This is issued in careful analysis. reserves - capital reserves and rev-
owes), grouped logically under spe- following ways: enue reserves :
cific heads. It must however, be (i) Private Placement (iii) Rights issues Fundamental Analysis Primer
noted that the Balance Sheet details This is done by offering shares to Companies may also (i) Capital
the financial position on a particu- selected individuals or institutions. issue shares to its The Directors report, if read properly, can Reserves
lar day and that the position can be shareholders as a give the investor a good grasp of the Capital
materially different on the next day (ii) Public Issue matter of right in workings of the company. reserves are
or the day after. Shares are offered to public. The proportion to their gains that
details of the offer, including the holding. This was have resulted
Sources of funds reasons for raising the money are often done at a price lower than its from an increase in the value of
A company has to source funds to detailed in a prospectus and it is market value and shareholders assets and they are not freely distrib-
purchase fixed assets, to procure important that investors read this. stood to gain enormously. With the utable to the shareholders.
working capital, and to fund its Till the scam of 1992 public issues new-found freedom in respect of The most common capital
business. For the company to make were extremely popular as the pricing of shares, companies have reserves one comes across are the
a profit the funds have to cost less begun pricing them nearer their share premium account arising from
than the return the company earns Fundamental Analysis Primer intrinsic value. Consequently, these the issue of shares at a premium,
on their deployment. The Directors Report explains the per- issues have not been particularly and the capital revaluation reserve,
Where does a company raise formance of the company, its plans for attractive to investors and several i.e. unrealized gain on the value of
funds? diversification, modernization and have failed to be fully subscribed. assets.
What are the sources? expansion. It discusses the profits
earned and states the dividends (iv) Bonus shares (ii) Revenue Reserves
Companies raise funds from its proposed. Bonus shares are shares issued free These represent profits from opera-
shareholders and by borrowing. to shareholders by capitalizing tions ploughed back into the com-

70 The annual report The annual report 71

Which Company?

pany and not distributed as divi- have been satisfied. that an asset has a useful life and (b) Reducing balance
dends to shareholders. It is impor- Borrowings or credits for work- that after years of toil it wears Under this method depreciation is
tant that all the profits are not ing capital which fluctuate such as down. Consequently, it attempts to calculated on the written down
distributed as funds are required by bank overdrafts and trade creditors measure that wear and tear and to value, i.e. cost less depreciation.
companies to purchase new assets to are not normally classified as loan reduce the value of the asset accord- Consequently, depreciation is
replace existing ones for expansion funds but as current liabilities. ingly so that at the end of its useful higher in the beginning and lower as
and for working capital. life, the asset will have no value. the years progress. An asset is never
Fixed Assets As depreciation is a charge on fully written off as the depreciation
LOAN FUNDS Fixed assets are assets that a com- profits, at the end of its useful life, is always calculated on a reducing
The other source of funds a com- pany owns for use in its business the company would have set aside balance.
pany has access to are borrowings. and to produce goods, typically, from profits an amount equal to the
Borrowing is often preferred by machinery. They are not for resale original cost of the asset and this (c) Others:
companies as it is quicker, relatively and comprises of land, buildings, i.e. could be utilized to purchase There are a few others such as the
easier and the rules that need to be offices, warehouses and factories, another asset. However, in these interest method and the rate of 72
complied with are much less. vehicles, machinery, furniture, inflationary times, this is inadequate but these are not commonly used.
The loans taken by companies are equipment and the like. and some companies create an addi- Land is the only fixed asset that
either : Every company has some fixed tional reserve to ensure that there is never depreciated as it normally
(a) Secured loans: assets though the nature or kind of are sufficient funds to replace the appreciates in value. Capital work
These loans are taken by a company fixed assets vary from company to worn out asset. The common meth- in progress - factories being con-
by pledging some of its assets, or by company. A manufacturing com- ods of depreciation are: structed, etc. - is not depreciated
a floating charge on some or all of pany's major fixed assets would be until it is a fully functional asset.
its assets. The usual secured loans a its factory and machinery, whereas (a) Straight line method
company has are debentures and that of a shipping company would The cost of the asset is written off INVESTMENTS
term loans. be its ships. equally over its life. Consequently, Many companies purchase invest-
Fixed assets are shown in the at the end of its useful life, the cost ments in the form of shares or
(b) Unsecured loans Balance Sheet at cost less the accu- will equal the accumulated depreci- debentures to earn income or to uti-
Companies do not pledge any assets mulated depreciation. Depreciation ation. lize cash surpluses profitably. The
when they take unsecured loans. is based on the very sound concept normal investments a company has
The comfort a lender has is usually are:
only the good name and credit wor- Fundamental Analysis Primer Fundamental Analysis Primer
thiness of the company. The more Investors must read the auditor's report The auditor represents shareholders and (i) Trade
common unsecured loans of a com- in details and in depth as the results can reports to them on the stewardship of Trade investments are shares or
pany are fixed deposits and short materially change if adjustments are the directors and whether the accounts debentures of competitors that a
term loans. In case a company is dis- made based on the notes or comments presented to them give a true and fair company holds to have access to
solved, unsecured lenders are usu- in the auditors report. view of the state of the company. information on their growth, prof-
ally paid after the secured lenders

72 The annual report The annual report 73

Which Company?

itability and other details which may Investments are valued and bought by a liquor store from a
not, otherwise, be easily available. stated in the balance sheet at either liquor manufacturers. Valuation of stocks
the acquisition cost or market value, Stocks are valued at the lower of
(ii) Subsidiary and associate whichever is lower. This is in order (c) Cash equivalents: cost or net realizable value. This is
companies to be conservative and to ensure that They can be used to repay dues or to ensure that there will be no loss
These are shares held in subsidiary losses are adequately accounted for. purchase other assets. The most at the time of sale as that would
or associate companies. The large common cash equivalent assets are have been accounted for.
business houses hold controlling Current assets cash in hand and at the bank, and The common methods of valuing
interest in several companies Current assets are assets owned loans given. stocks are:
through cross holdings in subsidiary by a company which are used in the The current assets a company has
and associate companies. normal course of business or are are: (i) FIFO or first in first out
generated by the company in the It is assumed under this method that
(iii) Others course of business such as debtors or A) STOCK OR INVENTORIES stocks that come in first would be
Companies also often hold shares finished stock or cash. These are arguably the most impor- sold first and those that come in last
or debentures of Fundamental Analysis Primer The rule of tant current assets that a company would be sold last.
other companies thumb is that any has as it is by the
for investment or The Auditors in the Auditors report will asset that is sale of its stocks Fundamental Analysis Primer (ii) LIFO or last
to park surplus comment on any changes made in turned into cash that a company The auditor represents shareholders and in last out
funds. The wind- accounting principles and the effect of within twelve makes its profits. reports to them on the stewardship of The premise on
fall profits made these changes made in accounting prin- months is a cur- Stocks, in turn, the directors and whether the accounts which this
by many compa- ciples and the effect of these changes on rent asset. consist of: presented do present a true and fair view method is based
nies in the year to the results. They will also comment on Current assets of the company. is the opposite
31 March 1992 any action or method of accounting they can be divided (i) Raw materials of FIFO. It is
was on account do not agree with. essentially into The primary purchase which is uti- assumed that the goods that arrive
of the large prof- three categories : lized to manufacture the products a last will be sold first. The reason-
its made by trading in shares. company makes. ing is that customers prefer newer
Investments are also classified as (a) Converting assets materials or products.
quoted and unquoted investments. Assets that are produced or gener- (ii) Work in progress It is important to ascertain the
Quoted investments are shares and ated in the normal course of busi- Goods that are in the process of method of valuation and the
debentures that are quoted in a rec- ness, such as finished goods and manufacture but are yet to be com- accounting principles involved as
ognized stock exchange and can be debtors. pleted. stock values can easily be manipu-
freely traded. Unquoted investments lated by changing the method of val-
are not listed or quoted in a stock (b) Constant assets (iii) Finished goods uation.
exchange. Consequently, they are Constant assets are those that are The finished products manufactured
not liquid and are difficult to dis- purchased and sold without any add by the company that are ready for B) TRADE DEBTORS
pose of. ons or conversions, such as liquor sale. Most companies do not sell their

74 The annual report The annual report 75

Which Company?

Fundamental Analysis Primer

products for cash but on credit and F) OTHER CURRENT ASSETS electricity and overtime are paid
purchasers are expected to pay for Financial statements of a company in an Other current assets are all amounts after they have been incurred. This
the goods they have bought within annual report consist of the balance due that are recoverable within the is because they fluctuate and it is not
an agreed period of time - 30 days sheet and the profit and loss account. next twelve months. These include possible to either prepay or accu-
or 60 days. The period of credit These detail the financial health and per- claims receivable, interest due on rately anticipate these expenses.
would vary from customer to cus- formance of the company. investments and the like. However, the expense has been
tomer and from the company to incurred. To recognize this the
company and depends on the credit percentage of all debts are made, the CURRENT LIABILITIES expense incurred is estimated based
worthiness of the customer, market provision is termed general. Current liabilities are amounts due on past trends and known expenses
conditions and competition. that are payable within the next incurred and accrued on the date of
Often customers may not pay C) PREPAID EXPENSES twelve months. These also include the Balance Sheet.
within the agreed credit period. This All payments are not made when provisions which are amounts set
may be due to laxity in credit due. Many payments, such as insur- aside for an expense incurred for (C) PROVISIONS
administration or the inability of the ance premiums, rent and service which the bill has not been received Provisions are amounts set aside
customers to pay. Consequently, costs, are made in advance for a as yet or whose Fundamental Analysis Primer from profits for
debts are classified as: period of time which may be 3 cost has not been The balance sheet details all the assets an estimated
Those over six months, and months, 6 months, or even a year. fully estimated. and liabilities a company has on a partic- expense or loss.
Others The portion of such expenses that ular date. Assets are those that the com- Certain provi-
These are further subdivided into; relates to the next accounting period ( A ) T R A D E pany owns such as fixed assets (build- sions such as
Debts considered good, and are shown as prepaid expenses in CREDITORS ings, cars etc.), investments and current depreciation and
Debts considered bad and the Balance Sheet. Trade creditors assets (stocks, debtors and cash). provisions for
doubtful are those to whom Liabilities are those that the company bad debts are
D) CASH AND BANK BALANCES the company owe owes (trade creditors, loans, etc.) and deducted from
If debts are likely to be bad, they Cash in hand in petty cash boxes, monies for raw the shareholders investment in the com- the concerned
must be provided for or written off. safes and balances in bank accounts materials and pany (share capital and reserves). asset itself.
If this is not done assets will be over- are shown under this heading in the other articles used There are
stated to the extent of the bad debt. Balance Sheet. in the manufacture of its products. others, such as claims that may be
A write off is made only when Companies usually purchase these payable, for which provisions are
there is no hope of recovery. E) LOANS AND ADVANCES on credit - the credit period depend- made. Other provisions normally
Otherwise, a provision is made. These are loans that have been given ing on the demand for the item, the sees on balance sheets are those for
Provisions may be specific or they to other corporations, individuals standing of the company and mar- dividends and taxation.
may be general. and employees and are repayable ket practice.
When amounts are provided on within a certain period of time. This (D) SUNDRY CREDITORS
certain identified debts, the provi- also includes amounts paid in (B) ACCRUED EXPENSES Any other amounts due are usually
sion is termed specific whereas if a advance for the supply of goods, Certain expenses such as interest on clubbed under the all embracing title
provision amounting to a certain materials and services. bank overdrafts, telephone costs, of sundry creditors. These include

76 The annual report The annual report 77

Which Company?

Fundamental Analysis Primer

unclaimed dividends and dues after the goods are sold failing from sources other than from the
payable to third parties. which they may be returned. In such sale of their products or the provi- Contingent liabilities are also detailed.
a case, the ownership and risks are sion of services. These are usually These are liabilities that may arise on
PROFIT AND LOSS ACCOUNT not transferred to the dealer nor clubbed together under the heading, the happening of an event that may
The Profit and Loss account sum- any consideration paid. other income. The more common never arise (guarantees, bills discount-
marizes the activities of a company Companies do give trade dis- items that appear under this title ed). The liability crystallizes on the hap-
during an accounting period which counts and other incentive discounts are: pening of the event.
may be a month, a quarter, six to customers to entice them to buy (i) Profit from the sale of assets
months, a year or longer, and the their products. Sales should be Profit from the sale of investments would include wages, salaries,
result achieved by the company. It accounted for after deducting these or assets. bonus, gratuity, contributions made
details the income earned by the discounts. However, cash discounts to provident and other funds, wel-
company, its cost and the resulting given for early payment are a (ii) Dividends fare expenses, and other employee
profit or loss. It is, in effect, the per- finance expense and should be Dividends earned from investments related expenditure.
formance appraisal not only of the shown as an expense and not made by the company in the shares
company but also of its manage- deducted from sales. of other companies. OPERATING AND OTHER
ment - its competence, foresight and There are many companies EXPENSES
ability to lead. which deduct excise duty and other (iii) Rent All other costs incurred in running a
levies from sales. There are others Rent received from commercial company are called operating and
SALES who show this as an expense. It is buildings and apartments leased other expenses, and include:
Sales is the amount received or preferable to deduct these from sales from the company.
receivable from customers arising since the sales figures would then (i)Selling expenses
from the sales of goods and the pro- reflect the actual markup made by (iv) Interest The cost of advertising, sales com-
vision of services by a company. the company on its cost of produc- Interest received on deposits made missions, sales promotion expenses
A sale occurs when the owner- tion. and loans given to corporate and and other sales related expenses.
ship of goods and the consequent other bodies.
risk relating to these goods are OTHER INCOME (ii) Administration expenses
passed to the customer in return for Companies may also receive income MATERIALS Rent of offices and factories, munic-
consideration, usually cash. In nor- Fundamental Analysis Primer Materials are the raw materials and ipal taxes, stationery, telephone and
mal circumstances the physical pos- other items used in the manufacture telex costs, electricity charges, insur-
session of the goods is also The profit and loss account details of a company's products. It is also ance, repairs, motor maintenance,
transferred at the same time. numerically the activities the company sometimes called the cost of goods and all other expenses incurred to
A sale does not occur when a had undertaken during the accounting sold. run a company.
company places goods at the shop of period and the result of these activities
a dealer with the clear understand- (profit or loss). EMPLOYMENT COSTS (iii) Others:
ing that payment need be made only The costs of employment are This includes costs that are not
accounted for under this head and strictly administration or selling

78 The annual report The annual report 79

Which Company?

expenses, such as donations made, TAXATION TRANSFER TO RESERVES acknowledged or accepted

losses on the sale of fixed assets or Most companies are taxed on the The transfer to reserves is the profit
investments, miscellaneous expendi- profits that they make. It must be ploughed back into the company. e) Excise claims against the com-
ture and the like. remembered however, that taxes are This may be done to finance work- pany
payable on the taxable income or ing capital, expansion, fixed assets
INTEREST AND FINANCE profit and this can differ dramati- or for some other purpose. These SCHEDULES AND NOTES TO
CHARGES cally from the accounting income or are revenue reserves and can be dis- THE ACCOUNTS
A company has to pay interest on profit. This is because many tributed to shareholders as divi- The schedules and notes to the
monies it borrows. This is normally amounts legitimately expensed may dends. accounts are an integral part of the
shown separately as it is a cost dis- not be tax deductible. Conversely, financial statements of a company
tinct from the normal costs incurred income such as agricultural income CONTINGENT LIABILITIES and it is important that they be read
in running a business and would are not taxable. Contingent liabilities are liabilities along with the financial statements.
vary from company to company. that may arise up on the happening Most people avoid reading these.
The normal borrowings that a com- DIVIDENDS of an event. It is uncertain, however, They do so at their own risk as these
pany pays interest on are: Dividends are profits distributed to whether the event itself may happen. provide vital clues and information.
(i) Bank overdrafts shareholders. The total profits after This is why these are not provided
(ii) Term loans taken for the pur- tax are not always distributed - a for and shown as an actual liability SCHEDULES
chase of machinery or construction portion is often ploughed back into in the balance sheet. Contingent lia- The schedules detail pertinent infor-
of a factory the company for its future growth bilities are detailed in the Financial mation about the items of Balance
(iii) Fixed deposits from the public and expansion. Dividends paid dur- Statements as a note to inform the Sheet and Profit & Loss Account. It
(iv) Debentures ing the year in anticipation of prof- readers of possible future liabilities also details information about sales,
(v) Intercorporate loans its are known as interim dividends. while arriving at an opinion about manufacturing costs, administration
The final dividend is usually the company. The contingent liabil- costs, interest, and other income and
DEPRECIATION declared after the results for the ities one normally encounters are: expenses. This information is vital
Depreciation represents the wear period have been determined. The for the analysis of financial state-
and tear incurred by the fixed assets final dividend is proposed at the a) Bills discounted with banks ments. The schedules enable an
of a company, i.e. the reduction in annual general meeting of the com- These may crystallize into active lia- investor to determine which
the value of fixed assets on account pany and paid after the approval of bilities if the bills are dishonoured. expenses increased and seek the rea-
of usage. This is also shown sepa- the shareholders. sons for this. Similarly, investors
rately as the depreciation charge of b) Gratuity to employees not pro- would be able to find out the rea-
similar companies in the same Fundamental Analysis Primer vided for sons for the increase or decrease in
industry will differ, depending on sales and the products that are sales
the age of the fixed assets and the The profit and loss account also c) Legal suits against the company leaders. The schedules even give
cost at which they have been details the dividend given (interim) provided for details of stocks and sales, particu-
bought. and proposed. lars of capacity and productions,
d) Claims against a company not and much other useful information.

80 The annual report The annual report 81

Which Company?

NOTES amount of Rs.46.63 crore towards (c) How the gratuity liability is pose of notes to the accounts is to
The notes to the accounts are even interest capitalized. The profit expensed. inform the reader more fully.
more important than the schedules before taxes for the year after the (d) How fixed assets are valued. Consequently, they detail all perti-
because it is here that very impor- consequential adjustments of depre- (e) How depreciation is calculated. nent factors which affect, or will
tant information relating to the ciation of Rs.0.12 crore is therefore (f) How stock, including finished affect, the company and its results.
company is stated. Notes can effec- higher by Rs.46.51 crore than what goods, work in progress, raw mate- Often as a consequence, adjust-
tively be divided into: it would have been had the previous rials and consumable goods are val- ments may need to be made to the
basis been followed". This means ued. accounts to unearth the true results.
(a) Accounting Policies that by changing an accounting pol- (g) How investments are stated in Note 6 of Fundamental & Co.
(b) Contingent Liabilities and icy TISCO was able to increase its the balance sheet. Ltd.'s Annual Report for 2003-
(c) Others income by Rs.46 crore. There could (h) How has the foreign exchange 2004 stated: "The Company has
be similar notes on other items in translated? during the year credited an amount
(a) Accounting policies the financial statements. of Rs.132.14 lakh to surplus on sale
All companies follow certain (b) Contingent liabilities of assets (Schedule No.13) which
accounting principles and these may The accounting policies normally As noted earlier, contingent liabili- included an amount of Rs.112.88
differ from those of other entities. detailed in the notes relate to: ties that might crystallize upon the lakh being the excess of sale price
As a consequence, the profit earned (a) How sales are accounted. happening of an uncertain event. All over the original cost of the fixed
might differ. Companies have also (b) What the research and develop- contingent liabilities are detailed in assets. Till the accounting year
been known to change (normally ment costs are. the notes to the accounts and it 2002-2003 such excesses over the
increase) their profit by changing Fundamental Analysis Primer would be wise to read these as they original cost was credited to capital
the accounting policies. For Schedules and notes to the accounts are give valuable insights. The more reserve. Had the Company followed
instance, Tata Iron and Steel found after the financial statements in common contingent liabilities that the earlier method of accounting the
Company's Annual Report for an annual report. one comes across in the financial profit for the year would have been
1991-92 stated among other things, The schedules detail pertinent informa- statements of companies are: lower by Rs.112.88 lakh." This sug-
"There has been a change in the tion about the items of the balance (a) Outstanding guarantees. gests that the company had changed
method of accounting relating to sheet and profit and loss account. (b) Outstanding letters of credit. its accounting policy in order to
interest on borrowings used for cap- The notes are even more important as (c) Outstanding bills discounted. increase its profits. The profit before
ital expenditure. While such interest they give very important information (d) Claims against the company not tax that year (year ended 31 March
was fully written off in the previous such as the accounting policies that the acknowledged as debts. 2004) was Rs.108.12 lakh (previous
years, interest charges incurred dur- company has followed, the contingent (e) Claim for taxes. year Rs.309.80 lakh). Had this
ing the year have been capitalized liabilities of the companies and the like. (f) Cheques discounted. adjustment not been made, the com-
for the period upto the date from It is imperative that the schedules and (g) Uncalled liability on partly paid pany would have suffered a loss of
which the assets have been put to notes to the accounts be read for a clear- shares and debentures. Rs.4.76 lakh. The company had also
use. er understanding of the company's withdrawn Rs.35.34 from the reval-
Accordingly, expenditure trans- financial condition. (c ) Others uation reserve. It was also stated in
ferred to capital account includes an It must be appreciated that the pur- that company's annual report that

82 The annual report The annual report 83

Which Company?

"no provision had been made for The more common notes one comes
Rs.16.39 lakh being the fall in the across are:
breakup value of unquoted shares in
wholly owned subsidiary compa- (a) Whether provisions for known
nies" and "the income tax liability or likely losses have been made.
amounting to Rs.36.41 lakh relating (b) Estimated value of contracts out-
to prior years has been adjusted standing.
against the profits transferred to the (c) Interest not provided for.
General Reserve in the respective (d) Arrangements agreed by the
years". The latter points out that the company with third parties.
tax change had been adjusted (e) Agreement with labour.
directly with reserves as opposed to
routing it through the Profit and The importance of these notes
Loss account. Had that been done cannot be overstressed. It is impera-
the profit after tax would have fur- tive that investors read these
ther reduced. Similar comments are carefully.
made in the notes to the accounts of
other companies also.


84 The annual report Ratios 85

Which Company?

o person should invest of figures that are difficult to draw is only when the various different 5. Liabilities to assets.
in a company until he meaningful conclusions from. It ratios are calculated and arranged (C) Balance Sheet and Profit and
has analyzed its finan- should be noted that figures by that the complete state of a compa- Loss Account Ratios.
cial statements and themselves do not enable one to ny emerges and it is important that These relate an item on the balance
compared its performance to what arrive at a conclusion about a com- an investor has as much informa- sheet to another in the profit and
it achieved in the previous years, pany's strength or performance. tion as possible before he actually loss account such as:
and with that of other companies. Sales of Rs.500 crores a year or invests. 1. Earnings to shareholder's funds.
This can be difficult at times a profit of Rs.200 crores in a year Ratios can be broken down into 2. Net income to assets employed.
because: may appear impressive but one can- four broad categories: 3. Sales to stock.
not be impressed until this is com- 4. Sales to debtors and
(a) The size of the companies may pared with other figures, such as the (A) Profit and Loss Ratios 5. Cost of goods sold to creditors.
be different. company's assets or net worth or These show the relationship
(b) The composition of a company's capital employed. It is also impor- between two items or groups of (D) Financial Statements and
balance sheet may have changed tant to focus on ratios that are items in a profit and loss account or Market Ratios
significantly. It meaningful and income statement. The more com- These are normally known as mar-
may have issued Fundamental Analysis Primer l o g i c a l . mon of these ratios ket ratios and
shares, or No investment should be made without Otherwise, no are: Fundamental Analysis Primer are arrived at
increased or analyzing the financial statements of a useful conclusion 1. Sales to cost of Ratios express mathematically the rela- by relation
reduced borrow- company and comparing the company's can be arrived at. goods sold. tionship between performance figures financial fig-
ings. results with that of earlier years. A ratio express- 2. Selling expenses and/or assets/liabilities in a form that ures to market
It is in the ing sales as a per- to sales. can be easily understood and prices:
analysis of finan- centage of trade 3. Net profit to interpreted. 1. Market value
cial statements that ratios are most creditors or investments is meaning- sales and to earnings and
useful because they help an investor less as there is no commonality 4. Gross profit to 2. Book value
to compare the strengths, weakness- between the figures. On the other sales. to market value.
es and performance of companies hand, a ratio that expresses the
and to also determine whether it is gross profit as a percentage of sales (B) Balance Sheet Ratios In this book, ratios have been
improving or deteriorating in prof- indicates the mark up on cost or the These deal with the relationship in grouped into eight categories that
itability or financial strength. margin earned. the balance sheet such as : will enable an investor to easily
Ratios express mathematically 1. Shareholders equity to borrowed determine the strengths or weak-
the relationship between perform- No single ratio tells the complete funds. nesses of a company.
ance figures and/or assets/liabilities story 2. Current assets to current liabili-
in a form that can be easily under- There is no point in computing just ties. (a) Market value
stood and interpreted. Otherwise, one ratio at it will not give the 3. Liabilities to net worth. (b) Earnings
one may be confronted by a battery whole picture but just one aspect. It 4. Debt to assets and (c) Profitability

86 Ratios Ratios 87
Which Company?

(d) Liquidity or reasonable and has growth check the time it would take to that year after tax and preference
(e) Leverage potential. recover one's investment. In addi- dividend was Rs.400 lakh. The
(f) Debt Service Capacity On the other hand, if a share is tion, it reflects the opinion of the market price of the share on 31
(g) Asset Management/Efficiency priced high an investor would want investing public about the company, December 2003 was Rs.112.
(h) Margins. to sell it. After all, the cardinal rule i.e. whether the company is growing
Of course, it must be ensured of investment in shares is to buy The earnings per share would be
that the ratios being measured are cheap, sell dear or, as Baron (Rs. lakh) 400\50 = Rs.8
consistent and valid. The length of Rothschild is credited to have said,
the periods being compared should "Buy sheep and sell deer". 500,000 shares of 50 The price earnings ratio would be
be similar. Large non-recurring Additionally, the market value of a Rs.10 each 112\8 = Rs.14
income or expenditure should be share reflects the regard investors
omitted when calculating ratios cal- and the general public have of the 100,000 10% This means that the investor
culated for earnings or profitability, company. preference shares would take 14 years to recover his
otherwise the conclusions will be Market value ratios also help an of Rs.10 each investment through earnings.
incorrect. investor determine the length of This also translates to a yield of
Ratios do not provide answers. time it would take to recover his or Reserves 70 7.14% (100/14 years).
They suggest possibilities. Investors her investment. The P/E ratios of well estab-
must examine these possibilities 130 lished and financially sound compa-
along with general factors that Price-Earnings Ratio nies are high and as the returns are
would affect the company such as The Price-Earnings or P/E ratio is or declining, and whether the price high for weaker companies the P/E
its management, management poli- arguably the most commonly quot- is likely to rise, fall or remain stag- ratio is low since they are riskier
cy, government policy, the state of ed ratio. Investors, analysts and nant. investments.
the economy and the industry to advisers alike quote this ratio to jus- The P/E ratio is calculated by The P/E ratio would be high so
arrive at a logical conclusion and he tify or support their contention. The dividing the market price of a com- long as the investing public has faith
must act on such conclusions. reason for its popularity is that it pany's share by its earning's per in a company's ability to grow and
Ratios are a terrific tool for reduces to an arithmetical figure the share, i.e. profit after tax and pref- to earn a return or an appreciation
interpreting financial statements but relationship between market price erence dividend divided, by the in its share price. It will fall as soon
their usefulness depends entirely on and the earnings per share and number of shares issued by the com- as this confidence in the earning
their logical and intelligent interpre- thereby allows one the opportunity pany. capacity of the company falls. This
tation. to determine whether a share is Samudra Lamps Ltd. is a compa- is why prices rise dramatically in
overpriced or underpriced and ny involved in the manufacture of boom periods. In periods of depres-
A. MARKET VALUE Price Earnings Ratio electric bulbs and tubelights. At 31 sion, they fall.
Ultimately the market value of a December, 2003, its shareholders' The price an investor pays for a
share is what matters to an investor. Market Price per share funds were as follows : share is based on the future
An investor would purchase a share Earnings per share The profit that the company made prospects of a company and its
if, in his perception, its price is low

88 Ratios Ratios 89
Which Company?

anticipated earnings. As such, there oped economies like the United That may be. In my opinion, and many others that
is a flaw in P/E ratios when current States was then around 20. This though, I feel that in India it would were loss making were quoting at
market price is divided by past earn- offered a yield of 5% which was be safer for investors to buy shares P/E ratios that made no sense. The
ings per share. Ideally, the current about 2% above the rate of infla- of companies that have a relatively basis was on perceived earnings
market price should be divided by tion. On that basis, if one assumes lower P/E (between 11 and 13). One projected earnings and potential
the current likely earnings per that the rate of inflation in India is should think twice before purchas- earnings not actual earnings. In
share. But then that figure is diffi- around 10%, then the P/E of shares ing a share that has a higher P/E. such a situation one's guess or price
cult to get. one wishes to purchase should be 8. Having said that, the P/E that was good as the others. Prices in the
The P/E ratio reflects the reputa- This would result in a yield of different investors would be pre- market (it must always be remem-
tion of the company and its man- 12.5% which would be 2.5% above pared to accept as reasonable would bered) is based on perception.
agement and the confidence the rate of inflation. As inflation depend on:
investors have in the earnings falls, the P/E will rise and the yield Market to Book Ratio
potential of the will fall. In a (a) The company and their percep- The market to book ratio compares
company. Fundamental Analysis Primer country like tion of its management, growth, the book value of the assets of a
An investor Ratios can be broken into 4 broad categories: India, inter- prospects, and the industry it oper- company to its market value. If a
may well ask (a) Profit and Loss Ratios est rates ates in. share's market price is treble or
what should be (b) Balance Sheet Ratios have begun (b) The demand for the shares of the quadruple its book value, it signifies
the P/E ratio of a (c) Balance Sheet and Profit and Loss Ratios, & to fall dra- company. Certain companies such that investors have tremendous con-
company; at (d)Financial Statements to Market Ratios. matically. as ITC, Reliance, Infosys etc. have fidence in the growth prospects of
what price W h a t rewarded their investors well over the company. It can also suggest
should one pur- should the the years and these shares command that the assets may be understated.
chase the share of a company. At P/E be now. I'd like to introduce, at higher P/Es. If, on the other hand, the book
the height of the 1992 scam in this juncture, a school of thought (c) The profitability and earnings of value is more than the market value,
India, the P/E of several companies promoted by those I term the the a company. the company may not be making
such as Hindustan Lever Ltd, ITC developing economy proponents. (d) The target returns of the differ- profits and may not be enjoying
Ltd., etc. were in excess of 100. The They argue that the average P/E of ent investors. investor confidence. The market to
average P/E of companies quoted on shares in developing economies, i..e In short, the P/E that is consid- book ratio is calculated by dividing
the Bombay Stock Exchange aver- in countries in South East Asia, ered reasonable by different the market price per share by the
aged 80. Even a year after the scam average 45. They claim that P/Es investors will be the one that fulfills book value per share.
the average P/E was around 37. have to be higher in developing their particular investment return For example, if the market price
This was one of the widely-cited economies as companies are grow- requirement.
reasons for foreign investors not ing and the high P/Es reflect this The pricing of shares as far as Market to book Ratio
descending in droves on the Indian growth. As companies mature, P/E is concerned lost all meanings in Market price per share
stock markets. It was argued that earnings will stabilize and the P/Es 1999 with Information Technology Book value per share
the average P/E of shares in devel- fall. Shares. Companies such as

90 Ratios Ratios 91
Which Company?

Market to book value of certain selected companies of the shares of Mithawala are extremely important because
Name of the Company
Book Value as on Market Value as on 27th Chemicals Ltd. is Rs.105 and the these determine an investment deci-
31/03/2003 November, 2003 book value of its shares is Rs.48, its sion. If one remembers, as technical
ACC 59.60 219.95 market to book ratio is 105/48 = analysts would vouch, that the mar-
Aurobindo Pharma 115.15 300.00
2.1875. ket price of a share takes into
The market value of the shares account the profitability, earnings,
Bajaj Auto 320.30 949.25 of Mithawala Chemicals is more prospects and all other aspects of a
Bharat Forge 55.20 623.10 than twice its book value. This sug- company, market ratios go on to
Bharti Televentures 24.10 81.50 gests that either the assets of the another dimension - as the only
company are understated or its ratios that evaluate the price of a
Cipla 177.80 1197.45 prospects share for an
GAIL 75.00 170.80 are good Earnings Per Share investor to
GE Shipping 61.00 141.50 and that determine
investors Income attributable to common shareholders whether it is
Hindalco 669.50 1205.00
believe that Weighted average number of common shares underpriced
HPCL 196.80 368.45
it will grow or overpriced.
HLL 16.60 179.25 in income, value and profitability.
IOC 241.80 370.45 As a rule of thumb, one should B) EARNINGS
not purchase a share which is priced Earnings is the yardstick by which
ITC 216.80 855.25
more than thrice its book value companies are finally judged, what
Infosys Technologies 431.90 4928.35 because the gap is enormous and investors earn on their investments.
the difference would not be backed The earnings ratios are often used
I-Flex Solutions 219.00 743.15
by tangible assets. As a conse- to determine the fair market price of
M&M 131.90 348.75 quence, there could be a
big fall in the price. Earnings per Share illustration
Mphasis BFL 560.20 573.60
Let me illustrate the
MTNL 150.70 113.20 differences between mar- In 2003, the earnings after tax of Range View Tea Estates was
Nirma Ltd. 179.80 345.65 ket and book value in a Rs.5,00,000. Between 1 January 2003 and 30 June 2003 the
few companies. There company had 200,000 shares of Rs.10 each outstanding. On
ONGC 249.70 603.60 are large differences 1 July 2003, the company issued an additional 100,000
Reliance Industries Ltd. 217.20 476.20 between the market
value and the book The earnings per share of Range View would be :
SAIL 4.80 42.20
Tata Motors 78.30 406.55 500,000 = Rs.2
TISCO 86.50 353.50
Summary (200,000 x 0.5 + (300,000 x 0.5)
The market value ratios

92 Ratios Ratios 93
Which Company?

a share and to value investments. attributable to common sharehold- the earnings of the company. If the income of an investor is the divi-
As a consequence, these are the ers by the weighted average of com- earning per share is Rs.5 and a yield dend that he receives. It is therefore
most important ratios for investors mon shares. of 10% is considered reasonable, submitted that the value of a share
and it is important that they be In countries including India the share is priced at Rs.50. should be a multiple of the dividend
appreciated and understood. where employees are given stock paid on that share.
options, investors check a compa- Cash earnings per share How does one value a share? If
Earnings per share ny's fully diluted earnings per share. It is often argued that the earnings one assumes that the gains made by
The earnings per share (EPS) ratio This is the earnings per share of a per share is not a proper measure of an investor would include an
indicates the earning of a common company after all share options, the earning of a company since increase in the price of the share,
share in a year. This ratio enables warrants and convertible securities depreciation, tax and the cost of i.e., capital appreciation, and divi-
investors to actually quantify the outstanding at the end of the finance varies from one company to dend income per share, the price
income earned by a share, and to accounting period are exchanged another. The true earnings, the would depend on the capital appre-
determine whether it is reasonably for shares. argument goes on, should be calcu- ciation one expects. If the share has
priced. The M a n y lated on the earning before depreci- regularly appreciated by 30% every
r a t i o i s Cash Earnings Per Share investors ation, interest and tax. The cash year, a low dividend yield would be
arrived at EDBIT also value a earning per share is arrived at by acceptable.
by dividing Weighted average number of shares issued share as a dividing earning before deprecia- Conversely, if a share does not
the income multiple of tion, interest and tax (EDBIT) by appreciate by more than 5% and a
the weighted average number of 30% return is required, a high divi-
Cash Earnings per Share illustration shares issued. dend yield would be expected.
The cash earnings per share will If the shares of PDP have been
The summarized Profit and Loss Account (Income Statement) of Nikhila Chips Ltd. for the year always be more than the
ended 31 December 2003 was as follows: earnings per share. Dividend per Share illustration
Rs. (lakh) Rs. (lakh) The shares of Divya Jeans Ltd. which has a market value of
Sales 5000 Dividend per share Rs.40 has appreciated during the last three years by an
Cost of Goods Sold 3000 Investors often use the average percentage of 25. If an investor is aiming at a yield
Gross Income 2000 dividend per share as a of 30 per cent, a dividend of 5 per cent would be adequate.
Selling Costs 300 measure to determine In such a scenario if Divya Jeans has paid a dividend of 15%,
*Administration Cost 200 500 its market value on the basis of dividend per share would be
the real value of a share.
Net Income 1500 (assuming 15% dividend on the face value = 5% on the mar-
Proponents of this ket value) as follows:
*Administration expenses includes interest costs of Rs.40 and depreciation of Rs.20.
school of thought argue
The company had issued 500,000 shares of Rs.10 each. that the earning per Rs.1.50 (dividend) x 100 = Rs.30
The cash earning of a share in Nikhila Chips Ltd. would therefore be : share is of no real value 5 (return required)
to anyone but those who
1500 + 40 + 20 = Rs.3.12 can determine the poli- On this basis the shares of Divya Jeans is overpriced.
500 cies of a company. The

94 Ratios Ratios 95
Which Company?

appreciating at 7% per annum and when assessing a company's Summary industry, and with reference to its
the company declares a dividend of prospects because if all its income is It is important to remember that own performance in earlier years.
30% or Rs.3 per share the real distributed there would be no inter- earnings ratios are not indicators of With the help of these ratios, an
value of the share would be (30% nal generation of capital available profitability. They advise an investor can evaluate the manage-
dividend will be construed as a yield to finance expansion and to nullify investor on the earnings made per ment's effectiveness on the basis of
of 23%). the ravages of inflation and to share, the dividend policy of a com- the returns generated on sales and
achieve these the company would pany, and the extent of income investments.
3 (dividend per share) x100 =Rs.13 have to borrow. ploughed back into the company While calculating and evaluating
23 (return required) This ratio is calculated by divid- for its expansion, growth and a company's profitability, an
ing the dividend by net income after replacement of assets. investor must bear the following in
It must be noted that this method of tax. mind:
valuation is so ridden with assump- Normally, young, aggressive It is critical that investors examine As far as possible ratios must be
t i o n s growth com- these ratios, especially the earnings calculated on average assets and lia-
Dividend Payout Ratio
(apprecia- panies have per share and the dividend payout. bilities and not on the assets or lia-
tion every Dividend low dividend The earnings per share would help bilities on a particular date. There
year and Net Income After Tax payout ratios one determine whether the market can be large variations in these fig-
expected as they price of a share is reasonable. If the ures during the year which can dis-
return) that plough back dividend payout ratios are very high tort results quite materially.
it is rarely used. their profits for growth. Mature investors must be concerned as it Companies have also been known
companies, on the other hand, have can indicate that the management to windowdress their balance sheets
Dividend payout ratio high payouts. This is of concern as of the company is not particularly by either reducing or increasing
The dividend payout ratio measures they may not be retaining capital to committed to its long-term growth assets or liabilities. Moreover, since
the quantum or amount of dividend renew assets or grow. Investors and prospects. profits are earned not on a particu-
paid out of earnings. This ratio must also ensure that the dividend is lar date but over a year, ratios cal-
enables an investor to determine being paid out of current income C. PROFITABILITY culated on average assets and liabil-
how much of the annual earnings is and not out of retained earnings The profitability of a company is of ities would portray a truer indica-
paid out as dividend to shareholders because that tantamounts to eating prime importance for an investor. tion of the results achieved by a
and how much is ploughed back into the funding set aside for Unless a company is profitable, it company.
into the company for its long-term growth, expansion and replacement cannot grow; it cannot pay divi- The investor should bear in
growth. This is an important ratio of assets. dends, its value will not increase mind the rate of inflation and the
and it cannot survive in the long cost of capital and borrowings.
Dividend payout Ratio illustration
run. Return on Total Assets
Excel Railings Ltd.'s earnings after tax in the year ended 31 March 2004 was Rs.68 lakh. Of Profitability ratios assist an
this, 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 business investor in determining how well a Net Income After Tax
for its growth. particular company is doing vis-à- NAverage Total Asset
vis other companies within the same

96 Ratios Ratios 97
Which Company?

When evaluating a prof- Return on Total Assets illustration good as often alternatives Return on Equity illustration
itability ratio, an available. This return is
Nair Limited is a company engaged in the manufacture of In 2003, the published results of Homedale Limited
investor should consider refrigerators and washing machines.
calculated by expressing included the following
whether a better return income, i.e. the net profit 2001 2002 2003
2001 2002 2003
would have been after tax, as a percentage Rs.(lakh) Rs.(lakh) Rs.(lakh)
Rs.(lakh) Rs.(lakh) Rs.(lakh)
received elsewhere. And of share holder's equity. Income before tax 400 1700
Net income after tax 300 400 600
whether the return has Total Assets 5000 7000 11000 It is to be noted that the 300 -----------
kept pace with the rate income figure should not Extra ordinary Items --------- ---------
of inflation. The return on total assets are as follows: include extraordinary, 1400 1700
Finally, ratios should 400 unusual or non recurring Taxation 400 500
be considered as an indi- 2002 -------------------------------- = 6.67 items as that would dis-
0.5 x (5000 + 7000) Income after taxation 1000 1200
cation or as a suggestion tort the results arrived at.
of future development. 2003 600 In addition, the net Shareholder's Equity
-------------------------------- = 6.67% 11,000 12,200
0.5 x (7000 + 11000) income on which this 10000
Return on total assets ratio is calculated should
The return on total assets are as follows:
The first ratio one Although net income has improved by 50%, the company's exclude dividends on
profitability has not improved since its average assets have
should check is the also increased by 50%. preferenceshares. 1000 - (300 - 200)
-------------------------------------- = 8.57%
return on total assets. Shareholders' equity is 2002 0.5 x (10000 + 11000)
This is an extremely important indi- pany with other companies within the stake ordinary share-
cator as it would help the investor the same industry, and with previ- holders have in a compa- 1200
2003 -------------------------------------- = 10.34%
determine: ous years. It could also be used to ny and includes, reserves 0.5 x (10000 + 12200)
Whether the company has earned project the performance of future and retained earnings.
a reasonable return on its sales years. It must be remembered The ROE has improved in 2003. The investor would however
Whether the company's assets that if there are other need to determine whether this is the best return that he
could have got i.e. could have earned more if he had
have been effectively and efficiently Return on equity investments that earn a invested his money elsewhere.
used, and Another important measure of prof- higher return with lower
Whether the cost of the compa- itability is the return on equity, or risks then the profitabili-
ny's borrowings are too high ROE as it is often termed. The pur- ty is low. The ROE should be com- the return, the higher the risk.
This ratio should be used to pose of this ratio is to determine pared with other alternatives taking
compare the performance of a com- whether the return earned is as into account the risks of the invest- Pre-interest return on assets
ment. The normal rule is: the higher It is often said that the pre-interest
Return on Equity return on assets is a purer measure
Pre-IInterest Return on Assets of profitability since it is difficult to
Net Income After Tax-D
Dividend on preference shares compare the post-tax performance
Average Shareholders Equity Earning Before Interest and Tax of companies on account of interest
Average Total Asset and taxation. This is because the

98 Ratios Ratios 99
Which Company?

Pre-interest after Tax return on asset Ratio illustration

Pre-interest return on asset s illustration
An extract of the financials of Bhagwan Ltd. is as follows:
Nair Limited is a company engaged in the manufacture of refrigerators and washing machines.
2002 2003 2001 2002 2003
Rs.(lakh) Rs.(lakh) Rs.(crore) Rs.(crore) Rs.(crore)
Earnings before interest & tax 250 300 Earnings before interest & tax 800 1200
Total Assets 1000 1400 Interest expense 200 400
Pretax income 600 800
Pre-interest return on assets would be: Tax at 50% 300 400
Net income after tax 300 400
------------------------------x 100 = 12.1/2% Total assets 7000 9000 11000
0.5 x (1000 + 1400)

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

interest paid will vary from compa- Pre-interest after tax return of
ny to company and will depend on assets 600 + 200 x 50 \ 100
its borrowings. Similarly, the tax The purpose of calculating this 2002 ------------------------------- = 8.75%
liability of companies differs and ratio is to determine the manage- 0.5 (7000 + 9000)
depends on the manner in which it ment's performance in deploying
has planned its tax. This ratio there- assets effectively without financing. 800 + 400 x 50 \ 100
fore suggests that the return should Tax is included in the calculation as 2003 ------------------------------- = 10.00%
be based on operating income and is it is deducted before arriving at the 0.5 (9000 + 11000)
arrived at by dividing earnings profits. Interest, however, is not
before interest and tax by the aver- considered as it will vary from com- In 2002, Bhagwan Ltd. earned a return on assets prior to the cost of financing of 8.75%. This
age total assets. pany to company and is a payment improved 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-
An investor must compare the for capital or funds. The ratio is mine whether the return is adequate (considering the size and the nature of the company)
return earned by a company with arrived at by expressing net return
that of other companies, preferably after tax but exclusive of interest as
in the same industry, to determine a percentage of average total assets. whether the capital available to a earned more elsewhere. It therefore
whether the return earned is high or company has been efficiently used is gives him an opportunity to com-
low Return on total invested capital the return on total invested capital. pare returns from alternative com-
The ratio used for determining By using this ratio, an investor panies. Invested capital in this ratio
can check whether he could have includes all liabilities that have a
Pre-IInterest After Tax Return on Assets Return on Total Invested Capital
Net Income After Tax + Interest Expense Net of Income Tax Saving Earnings Before Interest and Tax
Average Total Assets Average Total Invested Capital

100 Ratios Ratios 101

Which Company?

Return on Total Invested Capital illustration of any investment. It is important tions of their units. When the UTI
Bombay Pistons Ltd's earnings before interest and tax in 2003 was Rs.18.50 crores. Its total that investments be liquid so that went through its troubles, Mr.
invested capital in 2002 and 2003 were as follows: they can be converted to cash easily Damodaran after taking charge
2002 2003 to meet obligations. Similarly, it is orchestrated a sale of the more mar-
Rs.(crore) Rs.(crore) important for a company to be liq- ketable securities to book profits
Term loan 150 120 uid in order for it to meet its matur- and to be liquid to meet redemption
ing financial obligations and to demands.
Debentures 500 500
have enough funds to meet its oper-
Shareholders' funds 80 85
ational requirements. Current Ratio
Total invested capital 730 705 If a company is unable to do so, The current ratio is the most com-
Net income after tax 300 400 it may be forced to sell its more monly used ratio to measure liquid-
Total assets 9000 11000 important assets at a loss and, in ity. Its purpose is to check whether
extreme cases, be forced into liqui- a company's current assets are
dation. After the securities scam in enough to meet its immediate liabil-
The return on total invested capital is: 1992, many mutual funds were ities, i.e. those that mature within
forced to sell their blue chip shares one year. The ratio is arrived at by
18.50 to generate liquidity as they were dividing current assets by current
------------------------------ x 100 = 2.58
0.5 x (730 + 705) not able to sell their large holdings liabilities
of securities of public sector under- Normally, the current ratio is
takings (PSUs). In the first quarter around 1 or even a little below 1.
cost associated with them, such as the most important of all ratios for of 2000 when the values of This in itself is not bad. Today, all
debentures, share capital and loans. an investor as they indicate whether Information Technology shares companies are aware of the cost of
The ratio is arrived at by divid- an enterprise is viable, and better or plummeted there was fear that capital, the opportunity cost of
ing a company's earnings before worse than other similar ones. prices would fall further as mutual tying up capital, the opportunity
interest and tax by average total These ratios should not be seen in funds sold shares to meet redemp- cost of tying up capital unproduc-
invested capital. isolation. One should remember tively, and just in time (JIT) inven-
Current Ratio
An investor must check whether that a lower ratio is not necessarily tory control. Consequently, there is
the return on capital is higher than bad. In order to increase sales and Current Assets an effort to keep current assets low,
the prevailing rate of interest and profits companies may sell goods at Current Liabilities be it stock levels, debtors or cash.
the weighted average cost of bor- lower prices in volume driven busi- Thus, often the current ratio is well
rowings. If the rate of interest is nesses. Like all ratios, these ratios
higher then the return on the capital are indicators and they should be Current Ratio illustration
should be considered inadequate. considered as such. 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 current
Summary D) LIQUIDITY assets
The profitability ratios are arguably Liquidity is one of the cornerstones

102 Ratios Ratios 103

Which Company?

below 1. This does not necessarily used to pay debts. Net Current Assets quantum of working capital
mean that the company is not liq- Other assets such as inventories Net current assets or net working required to support a certain level
uid, it could merely be using its (stocks) may realise less than book investments is arrived at by deduct- of sales. A ratio of 20% could sug-
assets effectively. value if sold at a distress. In other ing current liabilities from current gest that if sales were to increase by
words, company could lose when working assets (trade assets). This 20%, net current assets would also
Quick or Acid Test converting these to cash in an emer- is clearly not a ratio. Its usefulness need to increase proportionately. In
The acid test is a gency. lies in quickly ascertaining whether this context, it is better to have a
favorite of Quick Ratio This ratio is a company has adequate current low ratio as the increase in working
investors and credi- arrived at by assets to meet its current liabilities. capital needed will be less. The
tors. This ratio is Cash & Cash Equivalents dividing cash, Net current assets is really the company can therefore grow quite
used to check Current Liabilities marketable working capital of a company. rapidly.
whether a compa- investments and Consequently, several deriva- In the example of Sumudra
ny has enough cash or cash equiva- debtors by current liabilities. It is to tives can be calculated from this fig-
lents to meet its current obligations be noted that investments, though ure, such as its relationship to sales, Debtors Turnover
or liabilities. strictly not a current asset, is used in income and even to capital.
Average Debtors X 365
The underlying logic being that calculating this ratio. This is Net current assets can also be
there usually is no conversion cost because they are easily realisable used as a base to determine the
when cash or cash equivalents are
Net Current Assets Illustration
Quick Ratio illustration In 2003, Samudra Fisheries had a sales turnover of Rs.2,000 lakh. Its net current assets were:
An extract of Nivya Ltd's financial statement at 31 March 2003 was as follows:
2002 2003
Rs. (lakh)
(Rs.lakh) (Rs.lakh)
Cash at Bank 150
Stocks 3100 Debtors 280 310
Investments 500 320 390
Current Assets 5600 Total current assets 600 700
Current liabilities 4000 CURRENT LIABILITIES
The quick ratio will be : Creditors 190 220
Accrued expenses 3 5
150 + 1850 + 500
Tax payable 7 25
------------------------------ = 0.625
4000 Tax current liabilities 200 250
The company cannot pay off its entire current liabilities with cash or cash equivalents. It Net current assets 400 450
should be remembered that stocks have not been considered in calculating this ratio as it is Samudra Fisheries thus had net current assets of Rs.450 lakh. This means it had Rs.450 lakh
not a cash equivalent and, as explained above, if one wishes to sell these in a hurry there is left after meeting its current obligations.
likely to be a loss arising out of dumping of goods.

104 Ratios Ratios 105

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Fisheries, net current assets were This means that working capital Net Trade Cycle much as possible. This can be
Rs.450 lakh and sales Rs.2000 should increase by 21.25% to sup- It is important to determine the time achieved by reducing debtors and
lakh. Its net current assets to sales port every increase in sales. Thus, a company takes to realize its sales stock levels.
will be: if sales were to increase by Rs.1 proceeds after paying for the pur- Investors should apart from
crore, working capital would need chase of its raw materials. This is a checking whether there is an
0.5 x (400 + 450) x 100 = 21.25% to necessarily increase by Rs.21.25 very useful tool for determining a improvement in the cycle, check
2000 lakh. company's liquidity and is comput- the individual components. An
ed by adding the debtors turnover increase in creditors turnover could
Creditors Turnover Stock Turnover in days to the stock turnover in also suggest that the company has
Average Creditors X 365 Average Stocks X 365 days, and deducting from it the difficulty in making payments. A
Sales Sales creditors turnover in days. fall in debtors could suggest a fall
If this ratio improves, it indi- in credit sales or improved debt
Net Trade Cycle
Defensive Ratio
Debtors Turnover + Stock turnover Sales — Creditors turnover Average Daily Cash operating Expenses
Most liquid Assets
Net Trade Cycle Illustration
Vindhya Bearings Ltd's financials included the following figures: cates an improvement in the man- collection. The reason must be
agement of net current working looked into.
2002 2003
Rs.(crores) Rs.(crores) assets. Of course, it can also indi-
SALES 200 280 cate that the company is experienc- Defensive Interval
Cost of goods sold 160 224 ing difficulty in paying its credi- This ratio indicates the number of
Debtors 24 44 tors. Thus one must go beyond the days a company can remain in busi-
Stocks 36 48 figures to determine the reasons for ness without any additional financ-
THE NET TRADE CYCLE IS: a change in the net trade cycle. It ing or sales. It can be likened to a
0.5 x (24 + 44) = must be remembered that the worker on strike. How many days
Debtor turnover 44 Days
280 longer the cycle, the greater the can he survive on the assets that he
0.5 x (36 + 48) x 365 =
need for financing. has before he becomes bankrupt?
Stock turnover 68 Days The net trade cycle should The defensive interval ratio is
therefore be brought down as calculated by dividing a company's
0.5 x (16 + 32) x 365 = Current Liability Coverage
Creditor turnover 39 Days
224 Cash Inflow From Operations
Net trade cycle (days) 73 Days Average Current Liabilities

106 Ratios Ratios 107

Which Company?

Defensive Ratio illustration Current Liability Coverage Many strong companies keep low
The cash and cash equivalents of General Balls Ltd. a company whose annual operating The current liability coverage ratio current assets and are able to get
expenses were Rs.730 crore and were as follows:
enables investors to examine the long credit from suppliers, especial-
Rs.(crore) relationship between cash inflows ly those that operate with extremely
CASH 35 from operations and current liabili- low margins.
Marketable securities 145 ties, and to determine whether the Historically, companies have
Rs. 180 company can meet its currently very high liquidity ratios. This is
ITS DAILY OPERATING EXPENSES WOULD BE : maturing obligations from internal- because fixed assets and stocks are
730 ly generated funds. At times of cre- sold and gets converted into cash.
Rs.2 crore
365 ative accounting and cash crunches Current liabilities decrease as credi-
ITS DEFENSIVE INTERVAL WOULD BE this is an extremely important ratio. tors are paid off. So good liquidity
180 is also not always wonderful.
90 days Summary An investor should always check
Liquidity is becoming increasingly the quality of a company's current
This means that General Balls Ltd. can remain in existence for 90 days without any sales or important for companies and this assets. It should also be ascertained
factor alone has resulted in compa- whether they are at current realis-
nies becoming sick - an inadequacy able value. Moreover, current assets
average daily cash operating cash equivalents. Debtors and of funds to finance operations. It is should not include deferred revenue
expenses by its most liquid assets. It stocks are not to be considered as crucial that investors examine the expenditure like advertising costs as
is important to note that only the they are not cash equivalents. liquidity of a company, and they do not have any encashable
most liquid of assets are used in cal- whether it is improving or deterio- value. Finally, it must be remem-
culating this ratio, such as cash and rating. bered that balance sheets can be
As companies begin to have windowdressed. Therefore, the fig-
Current Liability Coverage illustration financial difficulties, they begin to ures should be properly scrutinized.
In the year ended March 2003, Bharat Bolts Ltd. earned a net income before tax but after postpone and delay paying their The optimal liquidity required
depreciation of Rs.750 lakh. Depreciation was Rs.25 lakh. Current liabilities at 31 March 2002 bills. Current liabilities begin to varies from company to company
and 31 March 2003 were Rs.1450 lakh and Rs.2350 lakh build up. As current liabilities build and from industry to industry. It
up, suppliers become more and depends both on market conditions
The current liability coverage is:
more reluctant to sell goods. This and the prominence of a company.
first affects production, then sales While viewing liquidity ratios, the
750 + 25 = 0.4 and has snowballing effect. investor must check whether a com-
0.5(1450 + 2350)
Therefore if the liquidity ratios of a pany is adequately liquid and
company are deteriorating, an whether its liquidity position has
investor should be concerned. deteriorated or improved. If it as
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.
However, negative liquidity deteriorated and there does not
ratios need not necessarily be bad. seem a likelihood of it, improving in

108 Ratios Ratios 109

Which Company?

TABLE 1 the imminent future, one should Company C makes a comparatively

Company A Company B Company C consider selling the company's modest 50%. It must be noted that
(Rs. lakh) (Rs. lakh) (Rs. lakh) shares. so long as the return or the earnings
Share Capital 40 160 200 rate exceeds the cost of borrowings,
Borrowed Funds 160 40 ----------------- E) LEVERAGE a highly leveraged company will
200 200 200 Leverage indicates the extent to make impressive profits. As this rate
GOOD YEAR which a company is dependent on decreases profits will fall. In a rea-
Earnings before interest and tax 100 100 100 borrowed funds to finance its busi- sonable year, too, the profits of
Interest @ 20% p.a. 32 8 ----------------- ness. These borrowings would be in highly leveraged companies would
Income before tax 68 92 100 the form of debentures, term loans, be more than companies that do not
Tax @ 50% p.a. 34 46 50 short term loans and bank over- borrow. In the example in Table I, it
drafts. would be noticed that the return
Income after tax 34 46 50
In highly leveraged firms, the before tax of Company A is twice
Return to ordinary shareholders
owner's funds are minimal and the that of Company C.
Before tax (%) 170.00 57.50 50.00 owners are able to control the busi- The tide turns in year of depres-
After tax (%) 85.00 28.75 25.00 ness with a fairly low stake. The sion or recession as borrowings
REASONABLE YEAR main risks are borne by the lenders. have to be serviced. At such times,
Earnings before interest and tax 60 60 60 In good times these companies the cost of borrowings often exceed
Interest @ 20% p.a. 32 8 ----------------- make large profits, especially if they the profits made and results in loss-
Income before tax 28 52 60 are in high margin businesses. es and the company that makes the
Tax at 50% 14 26 30 However, the reverse occurs in highest profits is the one that has no
Income after tax 14 26 30 times of recession. Interest costs are borrowings.
Return to Ordinary Shareholders: exorbitant and the large profits One can safely conclude, there-
made in boom times turn into large fore, that though companies with
Before tax (%) 70.00 32.50 30.00
losses. very little or no borrowings are
After tax (%) 30.00 16.25 15.00 The effect on profits is illustrat- safer and can be depended upon for
BAD YEAR ed in Table I. Company A is a high- some returns both in good years
Earnings before interest and tax 24 24 24 ly leveraged, Company B's bor- and bad, highly leveraged compa-
Interest @ 20% p.a. 32 8 ----------------- rowed funds amount to 20% of its nies are risky and earnings can be
Income before tax 8 16 24 total funds, and Company C is a negative in bad years. Conversely,
Tax @ 50% p.a. ----------------- 8 12 cash rich company and does not in good years the results of highly
Income after tax 8 8 12 borrow at all. leveraged companies can be very
Return to ordinary shareholders : In a good year the return good indeed.
Before tax (%) 10 12 Company A makes is stupendous
After tax (%) 5 6 170% before tax, whereas

110 Ratios Ratios 111

Which Company?

Liabilities to Assets Ratio bles, such as deferred revenue legal suits, and the like. Should Debt to Net Worth Ratio
This ratio, indicates the total bor- expenditure (preliminary expenses, these be significant and likely to
rowings used to finance the compa- good will, deferred advertising crystallize, the ratio would change Debt
ny, and the extent to which these expenditure and the like). The ratio dramatically. Net Worth
external liabilities finances the is calculated by dividing total liabil-
assets of a company. Liabilities in ities by the total assets
this context include both current
and long term liabilities. Assets Debt to Assets Ratio
Debt to Assets ratio illustration
include all assets excluding intangi- Total Debt An extract of the financial statements of Pushpa Refrigerators Ltd. is detailed below:
Total Tangible Assets
Rs. Lakh
Liabilities to Assets Ratio Term loan 200
An investor would be wise to
Total Liabilities 14% Debentures 500
examine also a company's contin-
Total Assets Bank Overdraft 50
gent liabilities, such as guarantees,
Liabilities to assets Ratio illustration
Goodwill 100
The Balance Sheet of SWW Ltd. at 31 March 2003 is detailed below:
The liabilities to assets ratio would be : The Debt to Assets ratio would be :
Rs. Lakh
Shareholder's Funds 100
Debentures 50
Even if assets were to reduce by as much as 32%, the company would still be able to meet its
Debt to Net worth Ratio illustration
Fixed Assets 80 Nikhila Ltd's debt on 31 March 2004 was Rs.385 lakh. The shareholders' equity was Rs.105
Investments 40 lakh. There were no intangible assets.
Preliminary expenses 10
Current Assets 220 The debt to net worth ratio was:
350 385 = 3.67
50 + 200 = 0.74 105
350 -10
In other words, borrowed funds were 3.67 times the shareholders' equity. For every Re1
This means that 74% of the assets of the company were financed by liabilities. Conversely, it invested by shareholders, borrowings were Rs.3.67. This shows the company is highly
can also be said that assets sold at even 74% of their book value would meet and extinguish geared.
the company's liability commitments.

112 Ratios Ratios 113

Which Company?

Incremental Gearing
Debt to Assets ratio intangibles, such as goodwill and
The debt to assets ratio is a more deferred assets. The ratio is calcu- Net increase in Debt
specific ratio. It determines the lated by dividing debt by total tan- Increase in Net Income After Tax but Before Dividend
extent debt or borrowed funds are gible assets.
covered by assets and measures how growth. To an extent this ratio is
much assets can depreciate in value Debt to Net Worth Ratio Liabilities to Net Worth similar to the net working invest-
and still meet the debt commit- The debt to net worth ratio shows The liabilities to net worth is a larg- ments ratio. The ratio is calculated
ments. Debts are defined as bor- the extent funds are sourced from er measure than the debt to net by dividing the net increase in debt
rowed funds and would include external sources and hence the worth ratio and attempts to deter- by the increase in net income after
bank overdrafts. Assets exclude extent a company is dependent on mine how dependent a company is tax but before dividend .
borrowings to finance its business. on liabilities to fund its business. It
Liabilities to Net Worth Ratio It is arrived at by dividing a compa- is calculated by dividing the total Other Ratios
ny's debt by its net worth. Net liabilities of a company by its net There are several other gearing
Total Liabilities worth is defined as shareholders' worth. Net worth is arrived at after ratios but these are seldom used.
Net Worth equity, less intangible assets. deducting intangible assets For instance, the long-term debt
ratio determines how important
Liabilities to Net Worth Ratio illustration Incremental Gearing borrowings are to total long-term
The Balance Sheet of Ravi Hawali Ltd. is as follows : The incremental gearing ratio liabilities and shareholders' equity.
Rs. Lakh attempts to determine the addition- Another ratio is the liability to equi-
Shareholder's equity 158 al borrowings required to finance ty issue. Liabilities in this calcula-
Debentures 150
Term loans 40 Incremental Gearing illustration
Current Liabilities 40 The financials of Raman Tea Ltd. were as follows:
2002 2003
Tangible Assets 378 $00s $00s
Intangibles 10 NET INCOME BEFORE TAX 300 400
388 Taxation 50 75
The liability to net worth ratio would be: 250 325
Borrowings 400 480
______230 = 1.55 The incremental gearing is
For every Re 1 used to finance growth, net income would increase by Rs.75.
The company's liabilities are thus 1.55 times its net worth. Alternatively, liabilities finance 0.5 x (480 - 400) = 75
60.85% of the assets (230/230 = (158 - 10). This is an extremely useful ratio when one is 75
determining how well shareholders would be compensated should the company go
into liquidation. That is very high dependence.

114 Ratios Ratios 115

Which Company?

tion includes total liabilities as wellrecent years. Fifteen years ago few through additional borrowings or Liability Coverage
as shareholders' equity. companies issued or offered con- rights and public issues of shares. Liability coverage ratio is an exten-
vertible and non convertible deben- sion of the debt coverage ratio. It is
Summary tures. Now, there are more deben- Debt Coverage used to check whether a company
The gearing ratios highlight the tures, of one kind or another being This ratio is used to determine the can repay all liabilities through
dependence a company has on offered than equity. In this scenario, time it would take a company to internal generation.
external funds and the extent to the investor must ascertain whether repay its short and long term debt This ratio is calculated by divid-
which liabilities a company can from its income or internally gener- ing the internally generated funds of
finance the compa- Debt Coverage Ratio service its debt ated funds. This is relevant if the a company by its average total lia-
ny. These ratios are through inter- debt is not to be extinguished bilities
Internally Generated Funds
extremely impor- nally generated through the sale of assets, or by the It is also possible to calculate
Average Debt
tant for investors to funds. issue of fresh capital or debt. this ratio using the liabilities figure
consider while Can it meet For calculating this ratio, inter- at the date of the balance sheet, the
evaluating a company. the principal and interest payments nally generated funds means income argument being that what has to be
out of its profits? This of course is after tax plus non-cash expenses considered is the time it would take
F) DEBT SERVICE CAPACITY based on the assumption that the such as deprecia- Liability Coverage Ratio to repay the
Debt is a source of finance which company is a profitable going con- tion, and non oper- total liabilities
has become increasingly popular in cern and that debt will not be repaid ating income and Internally Generated Funds at a particular
expenses. Debt Average Total Liabilities time.
Debt Coverage Ratio illustration would comprise of
2002 2003 bank overdrafts, term loans and Interest Cover
Rs.(crore) Rs.(crore) debentures. The ratio is calculated An important factor that investors
Net income before tax and depreciation 500 by dividing a company's internally must ascertain is whether a compa-
Depreciation 100 generated funds by its average debt. ny's profits are adequate to meet its
Net profit before tax 400
Tax 160 Liabilities Coverage Ratio illustration
Net profit after tax 240
Bank overdraft 100 150 In the year ended 31 March 2003, Tongues and Tongs Ltd. generated Rs.500 lakh internally.
Debentures 400 380 Its total liabilities at the end of 20021999 and 2003 were Rs.3,500 lakh and Rs.4,500 lakh,
Term loan 100 90 respectively.
600 520
The liability coverage ratio =
Debt coverage ratio would be : 500_ = 0.25
240 + 100 0.5 x (3500 + 4500)
= 0.60
0.5 x (600 + 520)
This means that internally generated funds were only 25 per cent of the company's total aver-
This means that it would take Pear Ltd. 1.7 years to repay borrowers from its profits. age liabilities. At this level, the entire debt can be paid off in 4 years.

116 Ratios Ratios 117

Which Company?

Interest Cover Ratio Fixed Charge Cover

interest dues. If not, the interest will
have to be paid from either from the Earnings Before Interest and Tax Net Income + (1— Tax Rate) (Interest and Rental Expenses)
company's reserves, additional bor- Interest expense (1 — Tax Rate) ( Interest and Rental Expense) + Preferred Dividends

Interest Cover Ratio illustration

Bombay Green Ltd. earned Rs.450 crore before interest and tax in 2003. Its internet expense idend payable on preferred shares Cash Flow Surplus
was Rs.200 crore. should also be accounted for in cal- The cash flow surplus ratio is based
Interest cover ratio = culating this ratio as it is a fixed on the going concern concept and
450 = 2.25 charge that has to be paid. In that assumes that companies will nor-
200 case, the fixed charge cover is calcu- mally grow and will therefore incur
The company's earnings before interest are more than double its interest expense.
A comfortable situation Fixed Charge Cover illustration
Ram Oil Soaps Ltd.'s income statement included the following figures :
rowings, or from a fresh issue of These companies offered the (Rs. crore)
capital and these are a sure sign of opportunity of leasing equipment as Rental expense 400
financial weakness. opposed to purchasing it. One ben- Earnings before interest & tax 750
The interest cover ratio is calcu- efit of leasing is that the rentals paid Interest 200
lated by dividing a company's earn- are entirely tax deductible. Earnings before tax 550
ings before interest and tax by its Secondly, funds do not need to be Tax @ 40 220
interest expense. The ratio must deployed for the purchase of assets. Profit after tax 330
always be in excess of 1 - and the This is known as "off balance Fixed charge cover =
higher it is the better. If it is below sheet financing", i.e. neither the real 750 + 400 = 1.91
1, even a marginal fall in profit cost of the asset nor its liability is 200 + 400
would force the company to pay reflected in the balance sheet. The
interest out of its retained earnings fixed charge cover considers off bal- lated in two stages. In the first stage, Cash Flow Surplus
or capital. ance sheet obligations, such as the fixed charge cover is calculated Cash Flow surplus
rental expenses, and checks whether as explained above, and then the Total Average debt
Fixed Charge Cover a company earns enough income to preferred dividends paid are taken
The eighties witnessed the birth and meet its interest and rental commit- into account.
the development of several financ- ments The above is a better ratio than the capital expenditure and that there
ing and leasing companies in India. At times it is argued that the div- interest cover ratio as it considers would be an increase in its net
all the fixed expenses that a compa- working capital. As such, a compa-
Fixed Charge Cover ny has and examines whether its ny's ability to pay its debt should be
Earnings Before Interest and Tax + rental expense earnings are sufficient to meet these. determined only after providing for
Interest and Rental expense increases in its capital expenditure

118 Ratios Ratios 119

Which Company?

Cash Flow Surplus illustration

trends and to determine how well Stock Turnover Ratio
In 2003, the average debt of Culture Ltd. was Rs.400 crore. Its internally generated funds assets have been utilized.
were Rs.40 crore. Its net working investments had increased by Rs.10 crore and the company Comparisons can be made between Cost of goods Sold
had incurred capital expenditure of Rs.20 crore. one year and the next, between one Average Stock
40 - 10 - 20 company and another in the same
Cash flow surplus = 400 industry, and in other industries.
It would take the company 40 years to repay its debts by utilizing its cash flow surplus. These ratios also help enormously (a) Stock Turnover Ratio
in making forecasts and budgets. This ratio indicates the number of
It must be remembered, howev- times stocks (inventory) are turned
and net working capital. Cash flow G) ASSET MANAGEMENT/ er, that like other ratios asset man- over in a year and is calculated by
is net expenditure and increase in EFFICIENCY agement ratios too are pointers. dividing the cost of goods sold in a
net working investments. The ratio It is by the efficient management of A high asset turnover does not year by the average stocks held in a
is calculated by dividing the cash assets that companies make profits. necessarily suggest great efficiency year
flow surplus by the total debt. Accordingly, investors must deter- or a high return on investments, it
This ratio is often negative. This mine whether the assets a company may be so because a company does Stock Holding Ratio
is because when a company grows has are adequate to meet its needs not maintain adequate assets and Average Stock
rapidly it purchases assets of a cap- and whether the returns are reason- this can affect its performance in the Cost of goods sold divided by 365
ital nature and its net working able. It must be remembered that long run. Investors should therefore
investments also increase and this assets are acquired either from cap- always look beyond the indications.
increase is usually more than its ital or from borrowings. If there are It is important to bear in mind that (b) Stock Holding Ratio
internally generated funds. This is more assets than is necessary, the a deterioration in asset ratios is a The stock holding ratio measures
usually funded by loans or short- company is locking up funds it sign of decline and should be heed- the number of days of stocks (in
term bank facilities. could have used more profitably or, ed. relation to sales) held by a compa-
conversely, is paying interest need- ny. With companies attempting to
Summary lessly. If the assets are less than Stock Utilization keep as little stock as possible, this
Investors must always consider required, the company's operations The stock utilization ratios measure is an important efficiency indicator.
debt service ratios as these help to would not be using its resources as how efficiently a company's stocks It is calculated by expressing the
determine whether the company productively and effectively as pos- are used. With the cost of borrow- stock held in terms of the days of
under consideration has the capaci- sible. ings being high, managers are con- cost of goods sold
ty to service its debts and repay its Asset management ratios allow stantly alert to the need to keep Investors should ascertain the
liabilities. This becomes all the investors to determine whether a stocks low. In these days of the just- reason for the improvement in
more critical at times of high infla- company has adequate assets and is in-time principle, these ratios are stocks, i.e. is it because stocks have
tion and recession when the inabili- utilizing them efficiently. It is always carefully scrutinized and been dumped on dealers, due to dif-
ty to service debt can plunge a com- assumed that sales volumes are evaluated. ficulties in procuring stocks, or due
pany into bankruptcy. affected by the utilization of assets. Stock utilization can be meas- to a strike in the manufacturing
Asset ratios are used to assess ured by two ratios: plants?

120 Ratios Ratios 121

Which Company?

Stock Turnover Ratio illustration Average Collection Period illustration

The average inventory of Nandan Switchgears Ltd. was Rs.150 crore in 2002 and Rs.160 crore In 2003, the sales of PDN Ltd. grew by 15% , from Rs.348 crore to Rs.400 crore. Its average
in 2003. During this period the cost of goods sold was Rs.1,050 crore and Rs.1,200 crores in trade debtors during 2002 and 2003 were Rs.49 crore and Rs.59 crore, respectively.
2002 and 2003, respectively. The ratios are as follows: The average collection period was therefore :
Stock turnover ratio :
2002 49 ______ = 51 days
1050 = 7 times 348 + 365
2002 150

120 = _________59_________ = 54 days

7.5 times 2003 400 + 365
The period of credit increased from 2002 to 2003. If PDN Ltd's normal credit terms are only 30
Stock holding ratio : days 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-
2002 150 = 52.14 days agement may not be controlling credit effectively.
1050 + 365

160 = 48.67 days period ratio is an early warning saving on interest.

1200 + 365 indicator of large bad debts and A falling ratio is not however
financial sickness and by control- always wonderful. Just before com-
Nandan Switchgears Ltd. has successfully reduced inventory levels by 3.47 days of produc- ling thus one can improve efficiency panies fold up, they begin collecting
tion and turned over stock 0.5 times more. This is usually good. and reduce borrowings, thereby on their debts and also sell their

Average Payment Period Ratio illustration

As companies close down stock Average Collection Period True Steel Ltd. is a large company based in Pondicherry. Its financials indicated that its aver-
levels fall. Purchases are not made Most companies sell to their cus- age trade creditors in 2002 and 2003 were Rs.29 crore and Rs.34 crore respectively. Its cost
and existing stocks are sold. The tomers on credit. To finance these of goods sold was Rs.410 crore in 2002 and Rs.425 crore in 2003.
reasons for the improvement in this sales, they need to either block their Its average payment period would be:
29__________ = 26 days
ratio must therefore be ascertained. own internal funds or resort to 2002
In addition, an investor should try bank finance. The cost of finance is 410 + 365
and ascertain whether the existing therefore usually built into the sale _________34________ = 29 days
level of stocks can support the level- price and companies offer a cash 2003 425 + 365
of sales of a company has. discount to customers who pay in
cash either at the time of sale or In this illustration, the average payment period ratio is low, though it has improved in 2003
soon thereafter. over 2002. The investor should determine whether:
Average Collection Period 1) The company is availing all the credit that it can. 2)The company is having difficulty in
The average collection ratio is procuring credit. 3) The company is having difficulty in paying its creditors.
Average Trade Debtors calculated by dividing average trade If the company is in a strong and commanding position, it can obtain longer credit terms. This
Average Sales Per Day debtors by the average daily sales is good since the company can effectively use creditors to finance its working capital and to
An increasing average collection that extent the cost of finance falls.

122 Ratios Ratios 123

Which Company?

Average Payment Period Total assets Utilization Ratio

goods for cash. The result is a
falling average collection period Trade Creditors Divya Tyres Ltd. was successful in increasing its sales in 2003 to Rs.630 crore from Rs.495
crore in 2002. Its average assets grew by 10% to Rs.90 crore. Its total asset utilization ratios
ratio. Average Daily Cost of Goods Sold for the two years were:

Average Payment Period creditors. The ratio is calculated by 2002 495 = 6.03
The average payment period ratio dividing the net working assets by 82
or the creditor ratio indicates the sales. 630 = 7.0
time it takes a company to pay its In short, this ratio highlights the 2003
trade creditors, i.e. the number of working capital requirements of a
days' credit it enjoys. The ratio is company and helps an investor It is clear that the total assets utilization ratio has increased. This means, too, that the assets
calculated by dividing trade credi- determine whether the company's required to support an increase
tors by the average daily cost of working capital is controlled effi-
Net working investments Ratio
Total Asset Utilization sales commensurate with its invest- on net fixed assets( written down
Stocks + Debtors — Creditors The total asset utilization ratio is ment in assets. It indicates how effi- value of fixed assets). It should be
Sales calculated in order to determine ciently assets are being utilized and remembered that this ratio needs to
whether a company is generating is an extremely useful ratio for calculated on net fixed assets, i.e.
goods sold. preparing forecasts. The ratio is cal- cost less accumulated depreciation.
Total Asset Utilisation culated by dividing the sales by the It is arrived at by dividing sales by
Net Working Investments Ratio Sales average total assets. the average net fixed assets.
Net working investments are those Average Total assets An increasing net fixed asset uti-
assets that directly affect sales such Fixed Asset Utilization lization ratio suggests that sales
as trade debtors, stocks and trade The fixed asset utliziation ratio may have fallen and the efficiency in
measures how well a company is the handling of net fixed assets may
Net working investments ratio utilizing its fixed assets. Investors have deteriorated.
In 2003, the average stocks, debtors and creditors of Tamana Ltd. were Rs.38 crore, Rs.45 can compare this with the utiliza- It must be borne in mind that
crore and Rs.30 crore, respectively. Its sales in that year were Rs.500 crore. tion of other companies in the same this ratio is not truly reflective of
industry to determine how effective- performance as fixed asset costs will
Net working investments ratio = ly a company is utilizing its fixed differ when comparing companies.
38 + 45 - 30 = 0.086 assets. It should be remembered A new company with recently
2002 500 that this ratio needs to be calculated acquired fixed assets will show a
The company's net working investment were 8.6% of its sales. If this is the optimum level, Fixed Asset Utilisation worse ratio than one that has old
then for every Rs.100 lakh of sales, net working investment would need to rise by Rs.8.6 lakh. assets. In such a scenario, it would
This ratio is therefore extremely useful in assessing working capital requirements. Sales be unfair to label the older compa-
Net Fixed assets ny inefficient.

124 Ratios Ratios 125

Which Company?

Fixed assets Utilization Illustration ratio

The relevant financials of Nikhila Pistons Ltd. were as follows: ket can bear or that which he thinks Margins help an investor deter-
2001 2002 2003 will fuel sales. mine whether increases in costs,
Rs.(crore) Rs.(crore) Rs.(crore) Usually low volume businesses whether on account of inflation or
Sales 540 580 620
are high margin businesses as goods governmental levies, have been
Fixed Assets
Gross 105 130 150 often have to be held for some time. passed onto customers in part or in
Accumulated Depreciation 60 65 70 Others, such as supermarkets or for full. Should there be a strong
45 65 80 that matter brokers, work at very demand for the company's product,
low margins because volumes are it will pass on the entire cost
The net fixed asset utilization was
very high. increase to the customers. On the
2002 580 = 10.55 Margins help to determine the other hand, if the demand for the
(45 + 65) + 2 cost structure of a business, i.e. is it company's products is not very
high cost or low cost, and whether high, the company would often bear
620 = 8.55
2003 the business is a high volume low a part of the cost increase because
(65 + 80) + 2 margin business or otherwise. This of the fear that the customer would
is important as it will indicate how not purchase the product. A good
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 dependent the company is on mar- example of falling margins is the TV
the net fixed asset utilization. gins. If the company operates with industry. As competition is intense
low margins a small increase in and the buyer has a choice between
costs can result in large losses. several brands, manufacturers have
Summary al reports that "although sales have The performance between com- been bearing a portion of cost
Asset management ratios are calcu- increased by 24 percent in the year panies within an industry or a increases and, in some instances,
lated to assess the competence and profits have fallen due to increases group can also be compared with have dropped their prices in order
the effective of management by in the cost of production causing the help of margins. Let us assume to be competitive.
determining how efficiently assets margins to erode". that the gross margin earned by Product mix has an effect on
have been managed. It also high- Margins indicate the earnings a Hindustan York is 20 percent margins. A company may be selling
lights how effectively credit policy company makes on its sales, i.e. its whereas the industry average is 18 several products - each of them
has been administered and whether mark up on the cost of the items it percent. It can be argued in this priced differently. Some may be
a company is availing of all the manufacturers or trades in. The instance that Hindustan York is high margin products and others
credit it is entitled to and is offered higher the mark up, the greater the more efficient and that its products low margin ones. If more high mar-
by its suppliers. It can also indicate profit per item sold and vice versa. command a greater premium. gin products are sold, the margin
whether a company is encountering Margins are so important that they Management trends can also be earned by the company would be
difficulties. determine the success or failure of a assessed by margins. Efficient and high. Conversely, if more low mar-
business. And the mark up or mar- strong managements will work to gin products are sold, the average
H) MARGINS gin made by the seller is usually improve margin or, at least main- margin earned on sales will reduce.
It is not uncommon to read in annu- based on what he believes the mar- tain them. It must be remembered that low

126 Ratios Ratios 127

Which Company?

margin businesses are not bad. a conclusion on seeing an improve- Operating margin
Some of the most successful busi- ment or a deterioration in the gross The relevant information in the results of Patel Nair Ltd. was :
nesses in the world are low margin 2002 2003
Rs.(lakh) Rs.(lakh)
ones that operate with very high Gross Margin
Sales 3000 4000
turnovers and produce an impres-
Sales — Cost of goods Sold X100 Cost of goods sold 2400 3200
sive return on capital employed. Gross profit 600 800
Selling, general and administration expenses 400 500
Operating profit 200 300
Gross margin
Operating margin (%) 6.33 7.50
The following figures were extracted from the financial statements of Hindustan York Ltd.
2002 2003 There was an improvement in the operating margin by 1.17%. One of the reasons for this
Rs.(crore) Rs.(crore) could be that operating expenses did not increase as much as the sales. Sales grew by 33% as
Sales 400 500 did the gross profit, whereas operating expenses grew by 25%.
Cost of sales 275 350 This could be one of the reasons though not the only one. In another situation, despite the
125 150 sales going up the gross margin may decrease and costs increase resulting in a fall in the
Gross margin (%) 31.25 30.00 operating margin.
Normally the operating margin should improve with sales since costs do not usually rise at
Hindustan York's sales increased by 25% to Rs.500 crore and its gross profit increased by the same rate. In a recession, or at a time of high inflation, the reverse can be true. Costs may
Rs.25 crore, or 20%. Both of these, in these difficult times, are positive. However its gross increase at a faster rate than sales and gross margins may also fall.
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. tionary cost increases on to cus- a company's profitability and one
3) A deterioration in the product mix. tomers. must ascertain the actual causes for
4) The company was unable to pass on cost increases to its customers. this.
Operating Margin
Gross Margin margin. He must go beyond the fig- The profitability of a company Breakeven Margin
The gross margin is the surplus ures and seek the reason for the before the incidence of tax, miscel- Every organization has certain
available to meet the company's change. An increase in the margin laneous income and interest costs is expenses, like selling, administra-
expenses. It is calculated by dividing may simply be due to an increase in indicated by the operating margin. tion and other miscellaneous
the difference between sales and the price whereas a fall could be due The operating margin can be expenses that it has to bear even if
cost of goods sold, and expressing it either as a consequence of a con- arrived at by deducting, selling, gen- there are no sales. The breakeven
as a percentage of sales scious decision to increase sales or eral and administrative expenses margin indicates the number of
An investor should not jump to company's inability to pass infla- from the gross profit, and express- units that a company must sell to
ing it as a percentage of sales
Operating Margin An investor must always exam- Breakeven Margin
Gross Profit — selling, General & administration expensess X100 ine the operating margin ratio as it Expenses + Financing Costs
Sales indicates the likely reasons for an Gross income / Number of Units sold
improvement, or a deterioration, in

128 Ratios Ratios 129

Which Company?

PreFinancing Margin
meet these expenses. The breakeven margin ratio is exactly how many units need to be
If a company's breakeven is at 50% arrived at by dividing expenses sold by a company before it can Earnings Before interest and Tax X100
of its capacity, it means that the including financing costs, by the begin to make profit. This is an Sales
company would be in a no-profit- gross income per unit. Non-recur- important management ratio, too,
no-loss position if it produced and ring or unusual profits must be in decision making when alterna- Pretax Margin
sold half its capacity. Any unit sold excluded from the calculation. tives are being considered. The pretax margin indicates the rate
above this would yield a profit, and The breakeven margin is an of profit earned on sales after
vice versa. important measure as it indicates Prefinancing Margin accounting for the cost of financing
The prefinancing margin is the rate but before tax. In short, this is cal-
of profit earned prior to the costs of culated on the income before tax
Breakeven Margin financing. The reason for excluding and expressed as a percentage of
The results of Kumar Wheels ltd. during the year ended 31 March 2003 were as follows: financing costs is that these vary sales.
The total number of units sold were 1000
from organization. These also vary Pretax margin is not a fair meas-
on account of the method of financ- ure of profitability and comparison
Sales 8000 ing. The prefinancing margin is as the manner of funding, i.e. the
Less : Cost of sales 6000 therefore calculated by dividing
Gross Income 2000 earnings before interest and tax by Pretax Margin
Less : Expenses 1200 sales, and expressing this as a per- Earnings Before interest and Tax X100
Operating income 800 centage. Sales
Add : Profit on sale of factory 50
Earning before interest and tax 850
PreFinancing margin
Less : Interest charges 150
Earnings before tax 700 In the earlier example of Kumar Wheels Ltd. the relevant figures were :
Breakeven margin = 1200 + 150 = 675 units Sales 8000
2000 / 1000
Earnings before interest and tax 850
Kumar Wheels Ltd. have to sell, at present costs, 675 units to bear its expenses. If it sells 676
units it would make a profit of Rs.2. The company would lose Rs.2 should it sell only 674 Prefinancing margin = 850 x 100 = 10.25%
units. Some investors prefer to calculate the breakeven margin by deducting selling costs 8000
from the gross profit to arrive at the gross profit per unit. This is done because selling cost are
It would be more appropriate to calculate the prefinancing margin after excluding non-recur-
connected with sales and no selling expenses would be incurred if no sales are made. If, in
ring income or expenses. In that case, the Rs.50 lakh profit on the sale of a factory should be
the example of Kumar Wheels Ltd. stated above, selling expenses were 400, the breakeven
deducted and the margin would be:
margin would be calculated as:
1200 - 400 + 150 = 593.7 units 850 - 50 x 100 = 10
2000 - 400 / 1000 8000
This is arguably a purer Measure This is a good measure for comparing the profitability of organizations.

130 Ratios Ratios 131

Which Company?

Pretax Margin Summary falling demand for its products.

Kumar Wheels Ltd. Margins, thus help both in under- Investors must always check into
Rs.(lakh) standing the cost structure of a busi- the reasons for variations and the
Sales 8000 ness and evaluation of its perform- various measures mentioned in this
Earnings before interest and tax 700
ance. It is important to remember chapter will point out to the
Pretax margin would be = 700 x 100 = 8.75%
that low margins are not always investor the possible reasons.
8000 bad nor high margins always good.
A company may opt to work on
As mentioned earlier, non-recurring income or expense should not be included in the calcula- very low margins to achieve vol-
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:
umes. On the other hand, a compa-
ny earning high margins may face
700 - 50 x 100 = 8.125%

financing costs, vary from company order to facilitate comparison and

to company. It can however be used to get a true picture, non-recurring
effectively for comparing the per- income and expense should be
formance of a company over sever- excluded in the calculation.
al years. The net profit margin also
enables a shareholder to determine
the additional earnings available to
Net profit margin him on increases in sales.
Net profit margin shows the after-
tax rate a company earns on sales. It
indicates the rate on sales
that is available for Net Profit Margin
appropriation after all Net Income Excluding Non-R Recuring items After Tax
expenses and commit- Sales
ments have been met. In
Net Profit Margin
In Kumar Wheels Ltd. the pretax income was Rs.700 lakh. If tax was Rs.350 lakh, the pretax
income would be Rs.350 lakh. Non-recurring income was Rs.50 lakh.
The net profit margin therefore was 350 - 50 x 100 = 3.75%
The return after tax to shareholders on sales was 3.75%.

132 Ratios Ratios 133

Which Company?

n this age of creative account- mary of changes in financial state-
ing, accounting principles are ments which is, in effect, a cash flow
changed, provisions created or statement.
written back, and generally A statement of sources and uses
accepted accounting principles lib- begins with the profit for the year to
erally interpreted or ignored by which are added the increases in lia-
companies in order to show profits. bility accounts (sources) and from
Shareholders do not realize this which are reduced the increases in
when they look at the published asset accounts (uses). The net result
profits in the financial statements of shows whether there has been an
companies. It comes therefore as a excess or deficit of funds and how
surprise when a regular profit mak- this was financed.
ing company suddenly downs its For example, as shown in Table
shutters and goes into liquidation. 1 Fundamental and Company
This occurs when a company is Limited (Fundamental) reported a
unable to obtain finance or pay its profit before tax of Rs.108.12 lakh.
creditors. History is strewn with This included, however, other
such examples and investors must income of Rs.247.74 lakh, profit on
always check: sale of fixed assets of Rs.112.88
lakh and an amount of Rs.38.56
How much is the company's cash lakh withdrawn from a revaluation
earnings? reserve. If these are deducted, the
How is the company being profit changes to a loss of Rs.291.06
financed? lakh.
How is the company using its The changes in Fundamental's
finance? Balance Sheet are summarized in
Table I, and its Sources and Uses of

Cash flow
The answers to the above can be Funds (S & U) for the year ended 31
determined by preparing a state- March 2004 detailed in Table III.
ment of sources and uses of funds. The S & U statement shows that the
Its importance has been recognized company had a deficit cash flow in
in the United States and in many 2004, and that it had to borrow
European countries where it is Rs.1,927.92 lakh to finance its cur-
mandatory for a company to pub- rent assets. As it had made a loss, the
lish with its Annual Report, a sum- company paid its dividend on pref-
CHAPTER EIGHT erence shares not out of current

134 Cash flow Cash flow 135

Which Company?

profits but from reserves. Further, as surplus stock cannot be ignored. TABLE II : Fundamental & Co. Ltd.
inventories and other current assets The Dynamic Iron and Steel Sources and Uses of funds for the year ended 31 March 2004
increased, the possibility that the Company Ltd. (DISCO) (See Tables (Rs. lakh)
company was unable to get rid of its III & IV) also had a cash flow deficit
TABLE 1: Dynamic Iron and Steel Company Ltd. Operating Income (loss) (139.62)
Balance Sheet as at 31 March Add depreciation 160.25
(Rs. crore) Less Profit on sale of fixed assets (112.88)
2004 2003 Movement Operating Income (loss) (92.25)
SOURCES Other Income 247.74
Share Capital 287.79 282.75 0.04 Increase in liabilities 1485.50
Reserves 3069.32 3083.37 (14.05) Misc. expenditure written off 61.30
Loan funds 5058.14 3130.22 1927.92
Profit on sale of fixed assets 132.14
8410.25 6496.34 1913.91
Net Fixed assets 3434.53 3100.06 334.47
Investments 92.37 65.85 26.52 Purchase of Fixed Assets(net) 513.98
Net Current assets 4878.90 3264.68 1614.22 Purchase of investments 26.52
Misc. expenditure 4.45 65.75 (61.30) Increase in Inventories 1141.38
8410.25 6496.34 1913.91 Increase in sundry debtors 1350.50
TABLE II : Dynamic Iron and Steel Company Ltd. Increase in other current assets 88.99
Balance Sheet as at 31 March Increase in loans to subsidiary companies 205.92
(Rs. crore) Increase in loans to others 138.86
2004 2003 Movement Decrease in provisions 14.08
SOURCE Decrease in reserves 79.75
Share Capital 230.12 229.89 0.23 3559.98
Reserves 1315.36 1194.22 121.14
Loan funds 2051.30 1183.75 867.55 Net increase (deficit) 1725.55
3596.78 2607.86 988.92 FINANCED BY
APPLICATION Shares Capital 0.06
Net Fixed assets 2878.19 1713.79 1164.40 Increase in cash and bank balances (202.43)
Investments 248.77 571.86 (323.09) Increase in loan funds 1927.92
Current assets (net) 469.82 322.21 147.61
3596.78 2607.86 988.92

136 Cash flow Cash flow 137

Which Company?

TABLE IV: Dynamic Iron and Steel Company Limited

Sources and Uses of funds for the year ended 31 March 2004
(Rs. crore)
Operating Net Income 278.16
Less payments to employees for prior periods (13.61)
Add : Depreciation 164.89
Funds from Operations 429.44
Sale of Investments 323.09
Decrease in other current assets 0.06
Increase in liabilities 78.34
Increase in provisions 73.20
Total Sources 904.13
Net purchases of fixed assets 1329.29
Increase in Inventories 221.20
Increase in sundry debtors 24.77
Increase in loans and advances 156.59
Total applications 1731.85
Excess (deficit) 827.72
Issue of shares 1.37
Increase in loans 867.55
Increases in cash and bank balances (41.20)

although the company made a cash how it was utilized. Investors must
profit of Rs.429.44 crore. If one be concerned if a company is financ-
assumes this was used to finance the ing either its inventories or paying
increase in inventories and partially dividends from borrowings without
finance assets, the dividend of real growth as that shows a deterio-

Rs.80.55 lakh was once again ration.
financed by loans. In short, the cash flow or sources
Investors must examine a com- and uses of funds statement strips
pany's cash flow as it reveals exactly the accounting creativeness from
where the money came from and financial statements.

138 Cash flow 139

Which Company?

undamental analysis holds that an investment decision is
that no investment decision arrived at after analyzing informa-
should be made without tion and making logical assump-
processing and analyzing tions and deductions. And this
all relevant information. where there can be differences in
Its strength lies in the fact that the value - the assumptions made by dif-
information analyzed is real as ferent analyst would differ. Their
opposed to hunches or assumptions. reasoning will be based on their
On the other hand, while funda- exposure to the market, their matu-
mental analysis deals with tangible rity, their knowledge and their gut
facts, it does tend to ignore the fact feel of the market.
that human beings do not always act Furthermore, fundamental
rationally. Market prices do some- analysis ensures that one does not
times deviate from fundamentals. recklessly buy or sell shares - espe-
Prices rise or fall due to insider trad- cially buy. One should buy a share
ing, speculation, rumour, and a host only if its intrinsic value is higher
of other factors. This was eloquently than its book value. This also pro-
stated by Gerald Loeb, the author of tects one against possible loss since
The Battle for Investment Survival, one would dispose of a share whose
who wrote, “There is no such thing market value is higher than its
as a final answer to security values. intrinsic value. Hence fundamental
“A dozen experts will arrive at 12 analysis supports and encourages
different conclusions. It often hap- safe investing.
pens that a few moments later each No system is fool proof. No sys-
would alter his verdict if given a tem has consistently outperformed
chance to reconsider because of a the market. There is no system that
changed condition. Market values does not call for human judgement
are fixed only in part by balance and input. All systems require
sheets and income statements; much thought and some assumptions.
more by hopes and fears of human- However, of all the systems that I
ity; by greed, ambition, acts of God, have experimented with and tried,
invention, financial stress and the one I am most comfortable with
strain, weather, discovery, fashion is fundamental analysis as it is the
and numberless other causes impos- most logical and the most meaning-
sible to be listed without omission". ful. And this is the system I would
This is true to an extent but the urge you to consider as an investor.
strength of fundamental analysis is Happy Investing!

140 Which Company? Which Company? 141

Which Company?

Fundamental Analysis
Quick check List DISCLAIMER
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1. Check the political situation. Is it pany in? What is its competition? Disclosure Document before investing. This document is prepared for assistance only and is not intended
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sequence? tors one should look at is its man-
Each recipient of this book should make such investigations as it deems necessary to arrive at an inde-
agement and its annual report. The pendent evaluation of an investment avenue referred to in this document and determine the merits and
2. What is revealed by the economic ratios should be analyzed and the risks of such an investment. The views expressed may not be suitable for all investors
indicators? Is the growth rate rea- cash flow checked.
Any review, retransmission, reprinting, reproduction or any other use is prohibited.
sonable? Have export improved?
This document is for Private circulation only
How comfortable is the balance of 5.Finally, before purchasing or sell-
payment position? ing a share, check its intrinsic value.
A decision should only be taken
3.Check the industry or industries in after this is done.
which the company operates. At
what stage of the cycle is the com-

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