Which Company?

CONTENTS
Preface...........................................................................................4 Introduction: The Importance of Information.............................11 Fundamental Analysis: The Search for Intrinsic Value................19

PART III : COMPANY ANALYSIS: 48
THE MANAGEMENT ……………………………………………..50 THE COMPANY …………………………………………..............59 THE ANNUAL REPORT ………………………………………….63 A.The Director's Report …………………………………...64 B.The Auditor's Report ……………………………………66 C. Financial Statements …………………………………….70 D. Schedules and Notes to the Accounts ………………....82 RATIOS…………………………………………………………........86 A. Market Value ………………………………………........89 B. Earnings …………………………………………............94 C. Profitability …………………………………..................98 D. Liquidity …………………………………………..........104 E. Leverage ……………………………………..................112 F. Debt Service Capacity ……………..............................117 G. Asset-Management/Efficiency ……………………......121 H. Margins …………………………................................127 CASH FLOW ………………………………….............................135 Conclusion …………………………………..................................140 Fundamental Analysis: Quick Check List ……………………….142

PART I : ECONOMIC ANALYSIS: 13
Politico-Economic Analysis................................................25 The Economic Cycle.............................................................34

PART II : INDUSTRY ANALYSIS: 37
Industry Analysis..................................................................38

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Which Company?

Which Company?

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Which Company?

Preface
The ride has been tumultuous. The interest and growth of the market began with the FERA dilution i.e. when foreign companies diluted their interest. The interest grew with speculators and others entering the arena. Though one may question the means, individuals such as the late Harshad Mehta must be recognized as individuals who did much to cre4
Preface

Fundamental analysis is for the rational man.

Raghu Palat

ual who is investing in the third quarter 2003 boom in the markets is the young investor - investors who had not lost monies in the Harshad Mehta or Ketan Parekh scams. And yet, the investor dreams even after he has been mauled. This is because man is essentially both an optimist and a risktaker. The market excites him because of its ability

he Indian capital market is vibrant and alive. Its growth in the last two decades has been phenomenal. In 1983, the market capitalization of the shares quoted in the Bombay Stock exchange amounted to a mere $7 billion. It grew to $65 billion in 1992, to $220 billion by April 2000 and it is, at the end of 2003, estimated at $432 billion. India ranks 7th in price index and 4th in total return index.

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ate an awareness of the market and make the average Indian Ram and Sita invest in shares. The reforms following the liberalization and the entering into this market of Foreign Institutional Investors and Mutual Funds coupled with scams and downturns forced the individual investor out of the market. The bursting of the dotcom bubble and the Ketan Parekh scam punctuated the average investors' fears. It is interesting to note that the individ-

to make him more wealthy then he ever dreamed possible. The possibility of this spurs him on. With the growth of IT Shares, Azim Premji of Wipro was for a brief period the second richest man in the world (after Buffetting Warren Buffett for that position) and Infosys Chairman Narayanamurthy of Infosys was, at one time, worth in excess of Rs. 14000 crores. Prices of IT stock plummeted. Others not heard of have also moved to huge highs. During the last two decades the manner of trading has changed - from traditional shop floor (trading ring) to screen-based trading with brokers linked to the major stock exchanges. Most shares are now dematerialized - making sales/ purchases and transfers easy. Payment for shares sold, is made within a few days. Information has exploded. At one time there was dearth. Now it is like a tornado. There are very good reports on companies. There are probing analysis done on performance. There are studied forecasts made. There are intelligent conclusions made. The information is there. It can be accessed. The

investor must access it and having accessed it, he must, manage the information. In terms of investors the largest investor segment is Financial Institutions and Mutual Funds. Foreign Institutional Investors (FIIs) and Non Resident Indians have a significant presence. They account today for a significant amount of the investments made in the market. In the end of July 2005 foreign institution investors by investing a little over half a billion dollars raised the stock index by nearly 300 points. The Indian market is, inspite of all this still rumour and insider driven. Even after the many scams shares, continue to bought on the basis of tips, and for the short term. The average investor does little or no research (even though more information than he can handle is available) and makes his purchase or sale decision on the strength of an article that he may have read or a conversation with a friend. This is usually because the average investor is unclear on how to analyze companies and not equipped to arrive at an investment decision. Consequently, he buys and

Preface

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who. the mar. At don. in the first four months of 1992 and "the market will rise to 10000 by later in 2000 when even prices of the March 2006. a professional. The share must have value. the investor must be warned that the world is constantly changing as a consequence of which the new situations arise which the investor must monitor. when the huge profits for the so-called experts are promoters. Thousands of new ers will fall. There are other factors. Harold Q Masur there are so many gullible investors eloquently described in his book. Morgan when asked once by but the next millennium. "To those who look upon the world rationally. Hegel once said. I'd like you to dwell a moment an illusion of endless prosperity. Yet the basic issue remains. fueled by greed. for those who arrive at a 6 Preface “ Buy when there is blood on the streets “ decision after careful thought an deliberation. By doing so I seek to discourage you from acting on rumours or on tips and encourage you to go by hard facts. It was a period not 'taken out of a hat'. untested issues. Human nature has economy of the late sixties there was not changed. Its fundamentals must be good. It is for those who are ket after many years of lying down prepared to study and analyze a is sitting up. "Bargains are companies were going available during times public at arbitrary of extreme pessimism. This book is for the investor . It must however be remembered that: “The obvious prospects for physical growth in a business do not translate into obvious profits for investors. The point I am trying to stress that in the end.the failure of the market to be logical. Mutual wringing their hands. These are numbers "dogs" doubled. buy and then “The Broker" In the super heated live to regret it.speculators. The rumour mill is company. Rothschild echoed this Glamour Stocks when he said.” Preface 7 . Its management must be competent. They have no dissimilar to Wall Street in the mid logic.fluctuate. They have no credibility. prices that generated Trouble is. which is aimed at you the investor. The art of successful investment lies in the choice of those industries that are most likely to grow in the future and then in identifying the most promising companies in these industries.P. "Buy soared to premiums that discounted not only the future when there is blood on the streets. Analysis and information give one the basis for a logical decision. However. it seemed was spermatic. will introduce you to the world of fundamental analysis and guide you through the factors that you should look at before you buy any shares. that are sometimes not logical and cannot be predicted. To select the most promising shares the investor faces obstacles. The first is in the assessment . sixties which Mr.the human fallibility factor. The aim of the investor comers opened accounts.Which Company? sells with inadequate information churning out figures with gay abanand often suffers needless losses. Fundamental analysis is for the rational man. I would be out there in the market accumulating that wealth.and to sell when it is high. My aim is to introduce you to the world of information and analysis and to show you how one can arrive at a buy or sell decision." As I write this preface. a housewife. funds were plunging nobody has the recklessly into new Rothschild courage to buy". On on a thought by Wall Street the bulls Harold Masur. He were rampant. especially the human factor.Properly an investor on his view of the marinvested in the womb of Wall Street.be he or she an executive. Private says. the world in its turn presents a rational aspect". The investor may be wrong in his estimate of the future or even if he is right the current price may already reflect what he is anticipating. a student or a self employed person. Consequently there is no fixed formula that will give one "wealth beyond belief". ket is said to have stated: "It will it would produce wildly proliferat. If such a formula existed I wouldn't be writing this book. The second is from the nature of the competition. "the market will grow to 8500 no time was this more evident than by September 2005". Yet. This book. Money. Fundamental analysis is not for mism." J. Another says. Brokerage must be to buy when the price is low firms expanded with quixotic opti. There are however pitfalls in the approach and one must be careful." Some will rise while othing offspring. The third is from sheer perversity . the manner the prices of shares moved depend on a host of factors.

accounting and stock market lore." Benjamin Graham added to this by saying." This is why finance theory does not support the belief that the fundamental approach. "Even if. you knew the future growth rate of the little darling you just discovered." This is why he also said. demand and a host of other reasons. they will have to behave more responsibly. Further. you do not really know how the market will capitalize that growth." This book attempts to arm you. 2000 after offering certain tax sops at the budget session. by some magic. or for that matter any other approach be it technical analysis." In summary the purpose of this book is to help you the individual investor to invest in stocks that have value. that have good fundamentals." Benjamin Graham adds. Santayana once said. as Adam Smith said. "You can have no preconceived ideas. Sometimes the market will pay twenty times earnings for company growing at an annual compounded rate of 30 percent. "To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of stocks have behaved under varying conditions . At other times the alternatives are enticing enough to draw away some of the money that goes into pursuing growth. Sometime the market goes on a growth binge. random walk. I'd like to leave you with an observation made by the then Finance Minister.Which Company? “The experts do not have dependable ways of concentrating on the most promising companies in the most promising industries.some of which one is likely to meet again in one's experience. especially when bonds and the more traditional securities do not seem to offer intriguing alternatives. "Those who do not remember the past are condemned to return to it. Yashwant Sinha on May 4. He said. Mr. fundamental analysis gives you a fighting chance and it is because of this that I urge you to be familiar with it and practice it when you go out to do battle. All the charts and breadth indicators and technical palavers are the statisticians attempts to describe an emotional state. but the unexplored area is the emotional area. but a market which responds to rumours is irresponsible and silly. etc. More money has been made and kept by ordinary people who were temperamently well suited for the investment process than by those who lacked this quality even though they had extensive knowledge of finance. "The investors' chief problem is likely to be himself. sometimes it will pay sixty times earnings for the same company. The BSE (Bombay Stock Exchange) is being driven by rumours. speculations. There are fundamentals in the market place. However.” There could also be imbalances on account of political happenings. 8 Preface Preface 9 . It all depends in the psychological climate of the time. "I can appreciate a market responding to fundamentals. can consistently outperform the market.

This booklet is meant for private circulation only and is not meant for sale.Which Company? This booklet is distributed as part of the Sharekhan First step to Investing Program. information Introduction to Fundamental Analysis The importance of information importance of The 10 11 . 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.

The market is fascinating and addictive and once you have entered it" it is foolish to think that you can withdraw from the exchange after you have tasted the sweetness of the honey". He believes in value investing . Many shrewd promoters changed the names of their companies to "infotech" or added the word "infotech" to its name and made a killing in the market. the investors who do not have their eye crowd acts with a single-minded on the market at all times nor do purpose and not very rationally. of emulating persons like Buffett and his gurus T Benjamin Graham and Bernard Baruch that spurs investors on. and act in a Gustave Le Bon asked him for some manner different from Vice-chairman. their character ing there is no end to of their intelligence. His net worth was estimated by Forbes in September 2003 at 436 billion. He had fascination and the rational investor received a tip that the price would becoming mindless in the sense that double and was passing it on. I have been absorbed and immersed since 1924 and I know this is no science. I rememthe fact that they have ber a person advising been transformed into me to buy the shares a crowd puts them in of a certain company. sensing patterns of behavior. then and on hearsay fueled by greed. This occurred again in early 2000 when information technology share prices rose to phenomenal heights. did the company do? Who were its think. Johnson in Adam smith's The Money Game.a company whose share was lanlate 1999 and early 2000 every. It was then heard that like a balloon it burst." Le Bon speaks of the the last three years? He did not crowd being in a state of hypnotized know nor did he care.what that in which each individual of them would feel. The crowd in . The wealth is entirely from the market .investors were buying on the flimsiest of reasons believtions.by managing an investing company called Hathaway. always changing always mystifying. overwhelming greed for riches. however like or unlike be in the last twelve years.Which Company? 12 The importance of information “ he market. and act were he in a state of directors? How had it performed in isolation. at the end of the millennium (in the first 4 months of 2000) and from the end of the second quarter of 2003 when prices soared. Fidelity information .happening to the market. says Mr. The law of gravity has to prevail and their prices fell in March and April 2000 dramatically supporting the truth that prices of companies will fall or rise to their true level in time. It had to.endlessly fascinating endlessly complex. De La Vega commented in the seventeenth century. I think. undiscerned. known company. The prices of shares rose at this time as the crowd had taken over and there was no place then for logic or good sense. the rumor about Harshad Mehta's Unfortunately at times such as these interest in the share was false.in fundamental analysis. Sparked by where and in India in 1992 acted on a rumor that Harshad Mehta was impulse. he surrenders his rational thinking Another share that must be menmind to the domination of the tioned was Karnataka Ball Bearings mood of the moment. Let us examine what happened ever be the individuals that compose it. It is personal intuition. In 1992 the rush to buy shares in India was so great that ancestral land and family jewels were sold or pawned in the overpowering. The “ The crowd acts with a singleminded purpose The importance of information 13 . possession of a sort of This was at the time collective mind which not a very well makes them feel. It is an art. The manner in which these speculative drives occur are similar and happens with amazing frequency and regularity. their occupa. As Gustave Le Bon observed the ones that lose are the small in his "Psychologic des toules".guishing in the low 20s. This lure was demonstrated in India in 1992. The magic of the market is the promise of great wealth. The tulip mania in Holland in the seventeenth century sent their prices soaring. Now we have computers and all sorts of statistics but the market is still the same and understanding the market is still no easier. In 1992 their mode of life. For a time prices rose and then the bubble burst. on expectations and hope buying the share price rose 60. The 68 and went upto 180 all in matter index bloated like a balloon and of 10 days. This is not restricted to shares either. they have the contacts/they where According to him the most striking withal to know what is likely to be peculiarity of a crowd is that "who. the boom. There is always something unknown. is like a beautiful woman. Warren Buffett became several years ago the Second richest man in the world. It is the promise of great wealth.

The price rose again to 120. It is impossible to get more esoteric. "No one should buy without knowing as much as possible about the company that issues it". hopes. Jim Slater was one of the most successful stock pickers of all time. and on the strength of his experience and investment maturity. taxation. And this is the foremost tenet of fundamental analysis. This had a snowballing effect and soon prices had fallen by a half or over that. Investment in shares is serious business and all aspects and factors. its sales and its products including its performance in relation to other similar companies." Fundamental analysis demands.predictions. He evolved a theory called the Zulu theory which submits that one must know all about the company and the industry and any other factor that may affect the company's performance. Infosys (lovingly called Infy) and Satyam (Sify) began to be quoted in America in the NASDAQ. His argument was that one could never lose if one has this information. b) Information about government policy. Not so. d) Information about the company its management. The question that begas an answer is “Will they never learn?” The answer probably is that man's greed is bottomless. Internet The internet is a tremendous source of information. on information about a company. however minor. fashions and spending. c) Information about the industry in which the company operates. these shares began rising and a wave feeling took over that software is the new mantra and that the shares of all IT companies can only go one way up. If the company is likely to do badly. once said. nay insists. This began an upward movement that gained momentum every day till prices became unreal. must be analyzed and considered. The wise began to exit and as this took root prices began to fall. In 2003. prices have again begun moving upwards. profiles and a host of other information. He told me that the Company was sick and that there was no activity. One would have thought one learns. and vice versa. e) Information about consumer outlook. It can tell you about the economy. levies. Fundamental analysis submits that no one should purchase a share on a whim. until his death the richest man in the world. duties and others. The price had risen on the flimsiest of excuses and the crowd comprising of otherwise intelligent. History repeats itself. expectations. Now you can even buy and sell shares instantly on the "net". Many buy on the "strength" of these predictions which are all they are . papers and directories that are available 15 14 The importance of information The importance of information . having bought it with no other information that the rumor that Harshad Mehta was buying the share. A lot of persons did make money on the stock . Media There are several investment and business focused magazines. All information is important and can be grouped under the following classifications: a) Information about the economy. This is the philosophy of professional and successful investors . The rumor was again condemned as false and the price fell. It was on the verge of being closed down. The sensex broke through the 5000 barrier and there are some who claim that it will reach 6000 in six months/ one year/ very soon. The billionaire Jean Paul Getty. his analysis. shares were priced on "stickiness of eyeballs".Which Company? share price plunged to 50 in 4 days. one can sell and then buy shares to cover this when the price falls. At that time I spoke with a person intimately connected with the Company. Then later when the dotcom boom occurred. As Adam Smith says. And the fundamentalist makes his buy or sell decision on the basis of his interpretation of the information that he receives. The market is not a roulette wheel. Nothing backed by logic or sense.informed investing. Good research and good ideas are the one absolute necessity in the market place. It requires subjecting a company's performance and its financial statements to the most piercing scrutiny as well as the analysis of the economy and the industry in which the company operates. researchers and professional investment consultants are addressing that need. In India we are fortunate that there is greater awareness of the need for information today than ever before and this need is being addressed by the media. With the rise in NASDAQ. Later in 2000 people began buying shares that Ketan Parekh was purportedly buying. The original rumor raised its head. logical and rational human beings acted irrationally and illogically. company results. "There is no substitute for information.but most lost. At the end of the last century Indian shares especially those related to Information Technology (IT) such as Wipro. its performance.

When they arrived. finance and allied subjects. aware of the importance of information.the day the Duke of Wellington pitted his 75. Investors in London were concerned and worried. One can even share thoughts with those they meet. political readjustments or what may be called normal accidents." Seminars and Lectures by investment experts Insiders Insiders are persons who work for a company or who have intimate dealings with a company and have access to. Edwin Leferre. They also contain knowledgeable articles on tax. a fabulous amount at that time and it is this that led him to state. Within hours the news of Wellington's victory sent the market booming.Which Company? today that discuss the economy. This was well known. it is fraught with other risks. That is what Rothschild did. These are the major sources of information. I would insist that the serious investor should read at least one good financial paper every day and two magazines a month. This ought to keep him well informed. These may be on how an industry is doing. Stockbrokers Stockbrokers are always in touch with companies and are normally aware of their performance and other factors affecting the price of a share. Rothschild earned one million pounds. the investor must act fast if he wishes to make a killing. The market collapsed. 18 June 1815. The Securities Exchange Excellent seminars and lecture are being held in the country. As soon as the war was over. or are aware of information that is not generally known. a leading merchant banker. This is the essential governing principle of fundamental analysis . was a date that will be remembered as the day when one of the most decisive battles in Europe was fought . There was fear that its allies might desert England. This can result in forming opinions. investment strategies. pestilence.000 English troops against the 100. Rothschild's agents dispatched to him carrier pigeons with the result of the war in code. had invested a considerable sum to develop a private intelligence system. The future of the English Empire was at stake. One should analyze and interpret the information to determine the profitable course of action to be taken. As the German army under Marshal Von Blucher had not joined his English allies at the time the battle began. Investors awaited news. investors panicked and began to sell. Nathan Rothschild of the House of Rothschild. This could be information on the performance of the company or rights or bonus issues or some other relevant news.000 soldiers of Napoleon. well before the official dispatches.action only after receiving and analyzing information. Reminiscences of a Stockbroker also warned against it saying. These are conducted by eminent individuals and one can pick up a lot of information attending these lectures. Acting on these opinions could be profitable. there was concern that he would be too late as a consequence of which England would lose the battle. industries and individual companies. One must train oneself to listen and absorb information that is received. apart from the fact that it is against SEBI rules and the law. Board of India (SEBI) has published regulations prohibiting insider trading. These contain articles of a high standard that analyze industries and companies in depth. By this manouvre. The battle was momentous as the future of Europe and the European Colonies around the world rested on its outcome. 16 The importance of information The importance of information 17 . I would also caution against insider trading. As the information is not known to all. The British East India Company's trade with India and China was threatened. "Wall Street professionals know that acting on inside tips will break a man more quickly than famine. crop failure. In the belief that the English had lost. It was also well known that Rothschild had invested heavily on an English victory. Rothschild stepped in and with his agents bought and bought. in his book. Rothschild began to sell every thing he owned. This is extremely useful as they are often very up to date and contain information not generally available to the investor. “the best time to buy is when blood is running in the streets”. their view of an industry and the like. Investment Newsletters There are several professional investment managers and experts who publish investment information. In the depressed market. It is also extremely important that one acts swiftly on the information received as the person who receives it first will often be the person to profit most from it.

50 in the second. This intrinsic value changes from time to time as a consequence of both internal and external factors. dividends discounted on y i e l d the basis of its perceived safety or risk is its intrinexpected. in the long term the Calculation of Intrinsic value market price will be equal to the intrinsic value.200 at the end of 3 years. How does one calculate the intrinsic value of a share? Let us assume that one expects a return of 20% on an investment every year for 3 years. future date As the return to shareholders is in the form of divwith the idends.88 1. and not on the price at that earnings per share of the company. Fundamentalists thus seek to purchase underpriced shares and sell overpriced ones.2)2 (1. 25% and 30% on its Rs. When the market value of share is below its intrinsic value it is under valued.5 + 3 + 200 = Rs. The theory of fundamental analysis submits that one should purchase a share when it is available below its intrinsic value and sell it when it rises above its intrinsic value.2 (1.120. sic value. The dividend received on a share would therefore be Rs.2)3 ANALYSIS The Search for Intrinsic Value 18 Fundamental analysis fundamental The logic is to discount the dividend received and anticipated to be received in WHAT IS INTRINSIC VALUE AND HOW IS IT DETERMINED future years and the What is the intrinsic value of a share? How is it determined? Fundamental analysis propounds expected that the intrinsic value is. the return or present value of future. future date ? Fundamental analysis 19 .2. Let us also assume that the company would pay dividends of 20%.10 share. They believe that although the market price may deviate from the intrinsic value in the short term. and Rs.2. The intrinsic value of the share will be: 2 + 2. and has to be. under strict fundamental analysis.00 in the third.00 in the first year. This distinction is very important. The intrinsic value is based on the dividend because that is what a shareholder or Since the investor receives from a company.Which Company? F undamental analysis is based on the premise that every share has a certain intrinsic value at a period of time. whereas if the market value of a share is above its intrinsic value it is over valued. Rs. Let us also assume that the share can be sold at Rs.3. based on price at a the benefits that accrue to investors in the share.

266.17 (1.20).120.88. EPS at the end of: Year 1 will be Rs.7.16)3 Mature Share 2+ 2. The most reasonable method (even though this is arguable).22.17)3 Growing Company 2+ 2. This rate should be bolstered by a risk factor as the return is greater from riskier investments.14 1. The price earnings multiple or P/E of a share is its market price divided by its earnings per share. On 31 May 2000 the price of the shares of a company was Rs.20 x 1. the intrinsic value of a share will vary from individual to individual and will be dependant both on that individual's ability to bear risks and the return that individual expects. Rs. it is a sell signal and the share should be sold.16 (1.9. in regard to the above mentioned investment another individual (Kumar) expects a return of 16% whereas a third individual (Nair) expects a return of 25% the intrinsic value (assuming the dividends and the sale value at the end of 3 years will remain the same will be): Intrinsic value for Kumar 2.5 + 3 + 200 = Rs. In short.5 + 3 + 200 = Rs. A growing company will have risk rate of 2.Which Company? is also considered.8.13.5 in the second year and Rs.18)2 (1.19 (1.18 (1. and an earnings per share of Rs.5+ 459.5+ 6. If. and that a P/E of 20 is reasonable.2 in the first year.20 x 1. If we assume that this dividend will remain constant.459.3 in the third year and the anticipated sale price is expected to be Rs. the higher its intrinsic value.20)3 21 20 Fundamental analysis Fundamental analysis .7 per share in the current year representing a growth of 20% and if it is conservatively believed that the earnings per share (EPS) will grow 15% every year. the price at the end of 3 years would be Rs.2.20)2 (1.123.5 + 3 + 200 = Rs.25)3 Thus if the market price is Rs.3 x 1.19)2 (1.18)3 New Company 2+ 2.133.32 If it is believed that a reasonable P/E for a company of such a size in that industry should be 15.16)2 (1.130.5 + 3 + 200 = Rs. reasonably safe investment in that market.17)2 (1. the first individual (let us call him Siddarth) will hold onto the share whereas Nair would sell the share and Kumar would purchase it. on the other hand.120. the market price at the end of 3 years would be 9. Considerations It must be noted that the intrinsic value of a share can and will be different for different individuals. It is prudent and logical to remove this anomaly.66 1.63 2+ 1.16 (1.5 + 3 + 200 = Rs. If the company's earnings grow at 20% per year the EPS at the end of 3 years would be Rs.16)2 (1. the possibility of capital appreciation is considered and this is why this method of arriving at the intrinsic value is considered the most balanced and fair. If it is assumed that the return one can expect from a unreasonably safe investment (an investment say with the Unit Trust of India) is 16% and the dividend expected is Rs. A very safe investment (blue chip) will have a risk rate of 0.107. A mature near blue chip share will have a risk rate of 1.70 Year 2 will be Rs.28 1.200.88 then the share is below its intrinsic value and therefore well worth purchasing. A risky new company will have a risk rate of 3. If. The return expected should be the return one can expect from an alternate.127. Blue Chip 2+ 2.32 x 15 = Rs. Let us now look at a real example. the intrinsic value of the company's share should be Rs.3.47 Year 3 will be Rs. the market price is higher. There is however one factor that is assumed or estimated and that is the price at the end of three years.60 (EPS x P/E of 20).04 1.25)2 (1.465.139.91 1.80. Based on an expected return of 20% the intrinsic value today will therefore be: 6.133.5 + 6. If the market price of the share is below Rs. On that assumption.98 (13.25 (1. the intrinsic value of the share of the company will be as fol- lows depending on its financial strength and stage of growth.63 1.19)3 It would be noted that the safer the share.60= Rs.5 + 3 + 200 = Rs.16)3 Intrinsic value for Nair 2+ 2.279. If a company has earned Rs.20(1. The company declared a dividend of 65% for the year ended March 31 2000. in my opinion is basing the price on a price earnings multiple.

is extremely logical. determine the T h e share's pres2. Its earnings per share at Rs. shares. at every .THE COMPANY and anadevote time lyzed and and effort to ascertain the effect of various hap. its market price at the end of 2 years would be Rs.55 = Rs.145. the intrinsic value would be: 2. the EPS at the end of 2 years would be Rs.0 + 221.10.say. Its profit in the year to 31 March 2000 had grown by 60% to Rs.THE ECONOMY order to pany.158. If however.The industry within which the company likely future price at a 3 Distinct parts of fundamental analysis o p e r a t e s .77.5 1.2 + 3. to work out the 2.2)2 Efficient Market Theory Fundamental analysts often use the efficient market theory in determining the intrinsic price of a share.158.14. This theory submits that in an efficient market all investors receive information instantly and that it is understood and analyzed by all the market players and is immediately reflected in the market prices. however. At a P/E of 15. This intrinsic value profitability of the company and its must.71 1.The com1. one expects a return of 25% as that export oriented unit is a relatively new company.71 for an individual expecting a return of 25%. and only then can an investing bonus shares or offering rights ment decision be taken.THE INDUSTRY WITHIN WHICH THE COMPANY OPERATES. then. and future date in 3.2)2 At an expected return of 25% the market value of Rs.221. Its intrinsic value of Rs. It assumes distinct parts: that all foreseeable events have already been built into the current 1.5 + 3. its intrinsic value on an expected return of 20% would be : 2. The subjective assumptions made in arriving at the intrinsic value results in the intrinsic value of a share being different for different individuals.02 was very close to the market value of Rs. be compared against the likely results.Which Company? The company's share price at Rs.158.information about the economy.465 was nearly 67% above its intrinsic value and on the basis of this submission should be sold.145. In the example detailed above.160. In 2000. the expected price at the end of a period.160 was higher than the intrinsic value of Rs. The price of a 100% export oriented unit on 31 May 2000 was 160. The other assumptions too are subjective. The efficient . On the assumption that the dividend of 25% will be maintained in 2001.145. fundainterpreted mentalists 3. i. If we assume that in the next 2 years its EPs will grow by 20%.The economy. It considers he dividends that will be paid and the likely capital appreciation that will take place. and the anticipated dividends during the period.88 crore.02 for an investor who expects a return of 20% whereas it would be Rs. therefore. This method.growth and profitability of the comsible to make profits looking at old pany and it is because of this fundadata or by studying the patterns of mental analysis is broken into three previous price changes. and that it will rise to 30% in 2002.55 = Rs.0 + 221. the company paid a dividend of 25%. market price. The most important factor in fundamental analysis is information 22 Fundamental analysis Fundamental analysis 23 . This must also include market value the fundamentalists the possibility of the company issu. AND information ent intrinsic has to be value.e. Thus.the intrinsic value of the share penings (present and future) on the determined. point in time represents the latest the industry and the company itself position at all times. The market price.26 was an improvement of 23%.any information that can affect the market theory submits it is not pos.25 (1. the intrinsic value of that company share would be Rs.71 and the share should be sold.55.02 (1.17.

CHAPTER ONE 24 Politico-economic analysis 25 .Which Company? PoliticoEconomic Economic ANALYSIS ANALYSIS PART I PART I.

especially if there is the possibility of a government being ousted and replaced by another that holds diametrically different political and economic beliefs. These had an adverse impact on the development of the economy. in Africa. The Government. The other gnawing political issue that has been a thorn in India's back is the Pakistan issue. No industry or company can grow and prosper in the midst of political turmoil. If a country is ruled by a stable government which takes decisions for the long-term development of the country. East Europe and other troubled countries. Successive elections held did not give any single political party a clear majority and mandate. Earlier we have fought several wars on Kashmir and other issues.the world economy. These countries were once thriving. is in the hands of Tamil guerillas and there is no industry and little economic activity. The USSR was one of India's biggest purchasers. even though a coalition has been stable. Other examples include Sri Lanka. No person can work and live in isolation. On the other hand. Foreign Direct Investment fell. Wars push up inflation and demand declines. Let us take the example of Sri Lanka. The northern part of the country. There are predictions that by 2050. It is important. Wars have a similar effect. the economy of Kenya tailspinned to negative growth. 27 26 Politico-economic analysis Politico-economic analysis . It is estimated that the Gulf War cost India $1. There has also been much grand standing such as the Mandal recommendations in order to capture votes.5 billion on account of higher prices of petroleum products. The war in Croatia. There had been terrible political instability after the ouster of Mr. As a result there were coalitions of unlikes. Similarly. In conclusion. It is a beautiful island and was considered a paradise for tourists . The country is in the grips of a civil war. The tragedy of 9/11 (September 9 when two planes crashed into the World Trade Center at New York). Idi Amin in the seventies by expelling Asians from Uganda did that country's economy irreparable harm. In recent times this scenario has changed. to have an appreciation of the politicoeconomic factors that affect an industry and a company. the Gulf war and other wars have had an effect on exports of goods. some of which are beyond its control .Which Company? wise man once said. All these shook the confidence of the developed world in the security and stability of India. price inflation. When that enormous country broke up into the Confederation of Independent States.a pearl in the ocean. No longer. the Mombasa bombings again set it back. One wonders whether this thorn will cease to be a thorn in time. Tourism fell. This has led to renewed interest in India and investors are back. Similarly the SARS epidemic that affected South East Asia affected trade and tourism. which was once thriving. its sales and its costs are affected by factors. Earlier we have fought several wars on Kashmir and other issues. These led to considerable jockeying for power and led to the breakup of the governments and fresh elections. Many industries are yet to fully recover. There were other religious and ethnic issues that also led to violence such as the Babri Masjid/Ram Janmabhoomi issue. The defence budget is enormous. India would be one of the three most powerful nations in the world. External forces are constantly influencing an individual's actions and affecting him. Narasimha Rao from the Prime Ministership. In 1997-98. in Kosovo. no industry or company can exist in isolation. The deterioration in our relationship culminated in 1999 in the war in Kargil. This money could have been spent elsewhere for the development of the country. "No man is an island". therefore. the political stability of a country is of paramount importance. In 2005 there has been an improvement in the relationship. instability causes insecurity. due to the elections and then the bombing of the American embassy. Its policies have beren positive and the economy has been doing well. taxes and a host of others. It may have splendid managers and a tremendous product. Then a few years later as the economy was recovering. International events too impact industries and companies. balanced growth. A The political equation A stable political environment is necessary for steady. opportunity costs and fall in exports. India has gone through a fairly difficult period. industry and companies will prosper. affected the entire world. However. Investments were held back. These led to riots. The deterioration in our relationship culminated in 1999 in the war in Kargil. Indian exports declined and this affected the profitability of companies who had to search for other markets.

a country would not be able to import materials or goods for its development and there is also a loss of international confidence in such a country. During the last two years Indian customs duties have been reduced drastically. Foreign Debt and the Balance of Trade Restrictive Practices Foreign Exchange Risk This is a real risk and one must be cognizant of the effect of a revaluation or devaluation of the currency either in the home country or in the country the company deals in.Which Company? Foreign Exchange Reserves A country needs foreign exchange reserves to meet its commitments. the reserves are in excess of $100 billion. In India our currency has been appreciating against the dollar. In 2003. It is to reverse this that the government did borrow from the World Bank and devalue the currency. In May 2000. Thus. If the domestic industry is to be supported. India had by 31 December 1999 foreign investments in excess of $28 billion. especially if it is very large. This has been the price the country has had to pay due to our imports being far in excess of exports and an adverse balance of payments. In order to discourage short term flows. Licenses are given and amounts that may be imported from companies and countries are clearly detailed. In 1991. The payment could not be sent to India as the central bank refused the foreign exchange to make the payment. Companies exporting to such countries have to be careful as the importing companies may not be able to pay for their purchases because the country does not have adequate foreign exchange. at the time of devaluation. pay for its imports and service foreign debts.a far cry from the $500 million of reserves in 1991. the Reserve Bank has lowered interest rates and even mandated that the interest paid should not exceed 25 basis points over LIBOR on foreign currency funds and Non. imports more expensive and if a company is dependent on imports. the threat investors or recipients of dollars face is that the rupees that they finally receive is less than that they expected. Without foreign exchange. i. This is no small sum. and the devaluation of the rupee. Several North American banks had to write off large loans advanced to South American countries when these countries were unable to make repayments. This is an about turn from the situation earlier. To an extent this determines the prices at which goods can be sold. As a consequence many have begun quoting in rupees. Foreign debt. the foreign exchange reserves had swelled to over $38. a devaluation in the country to which one exports would make the company's products more expensive and this can adversely impact sales. Certain African countries too have very low foreign exchange reserves. India was forced to devalue the rupee as our foreign exchange reserves were. it had no alternative.resident deposits. margins can get reduced. the duties levied may be increased resulting in imports becoming unattractive. A devaluation in the home country would make the company's products more attractive in other countries. The United States of America has restrictions regarding the imports of a variety of articles such as textiles. I know of an Indian company which had exported machines to an African company a few years ago. A method by which foreign exchange risks can be hedged is by entering into forward contracts. India has a number of restrictions on what may be imported and at what rate of duty. it is important to see how sensitive it is to governmental policies and restrictive practices. When viewing a company. Following the liberalization moves initiated by the Narasimha Rao Government and endorsed/supported by successive governments. On the other hand. at $532 million very low. It lies there still. advance purchase or sale of foreign exchange thereby crystallizing the exposure. At the time the country did borrow. Similarly. The problem the Reserve Bank of India now faces is managing the huge reserves. barely enough for few weeks imports. India had only enough foreign exchange to finance the imports of few weeks. India pays around $ 5 billion a year in principal repayments and interest payments. Imports are consequently much cheaper and this has affected several industries. In 1991.4 billion .e. It would also make Restrictive practices or cartels imposed by countries can affect companies and industries. can be a tremendous burden on an economy. the pledging of gold. 29 28 Politico-economic analysis Politico-economic analysis . The crisis was averted at that time by an IMF loan. The importing company paid the money to its bank.

And an incentive to invest. Bad infrastructure leads to inefficiencies. In South America. Low inflation within a country indicates stability and domestic companies and industries prosper at such times. The level of taxation in a country has a direct effect on the economy. at one time. If one is dependent on a company for certain supplies. Government policy has a direct impact on the economy. While the tax rates may go up. the products become more attractive resulting in increased sales. Within the country it erodes purchasing power. This is possibly the reason why the 1993 budget lay 31 30 Politico-economic analysis Politico-economic analysis . nationalized companies are historically less efficient than their private sector counterparts. Taxation Inflation The Threat of Nationalization Inflation has an enormous effect in the economy. people have more disposable income.7% and 4%. If the rate of inflation in the country from which a company imports is high then the cost of production in that country will automatically go up. The USA and Europe have fairly low inflation rates (below 2%). India has one of the largest rate of savings (22%). Ironically. The initiative of the former BJP government in improving the infrastructure grabbed the attention of foreign investors. It is currently estimated between 3. As a consequence. poor productivity. Domestic Savings and its Utilization Government Policy Interest Rates A low interest rate stimulates investment and industry.) would not be liable for wealth tax. Consequently. The present government continues to focus on infrastructure as it is realized progress at a decent rate would not be possible without infrastructure.Which Company? A permanent solution will result only when the inflow of foreign currency exceeds the outflow and it is on account of this that tourism. A government that is perceived to be proindustry will attract investment. exports and exchange earning/saving industries are encouraged. high interest rates result in higher cost of production and lower consumption. This is why there it has been argued that the rates in India must be lowered. It is to be remembered that all investments are born out of savings. Investments from savings leads to greater consumption in the future. if the rate of inflation in the country to which one exports is high. If utilized productively. In addition. wastage and delays. inflation has been falling steadily in recent times. debentures. these savings have not been invested either wisely or well. al markets. Japan's growth was on account of its domestic savings invested profitably and efficiently. Money there had no real value. Conversely. In addition they have an incentive to work harder and earn more. With very few exceptions. This might reduce the cost competitiveness of the product finally manufactured. a company's competitiveness decreases. it was over 1000%. etc. domestic savings can accelerate economic growth.the fear that a company may become nationalized. In India. South American exports become attractive on account of galloping inflation and the consequent devaluation of their currency which makes their products cheaper in the internation- The threat of nationalization is a real threat in many countries . the fear of nationalization chokes private investment and there could be a flight of capital to other countries. Although India's savings are high. collection will decline. the government. If tax rates are low. In India. This has been recognized by the Government and it was in order to divert savings to industry the 1992 Finance Act stipulated that productive assets of individuals (shares. there has been little growth. This is good for the economy. Borrowed funds invested have to be returned. demand falls. it is only 2% whereas in Japan it is as high as 23%. The liberalization policies of the Narsimha Rao government excited the developed world and foreign companies grew keen to invest in India and increase their existing stakes in their Indian ventures. nationalization could result in supplies becoming erratic. Increasing competition among banks has also helped. has been successful in lowering interest rates. It is interesting to note that in every economy there is a level between 35% to 55% where tax collection will be the highest. through the Reserve Bank. Conversely. In USA. The Infrastructure The development of an economy is dependent on its infrastructure. Industry needs electricity to manufacture and roads to transport goods. When the cost of money is high.

if not checked. This would also result in a fall in money supply and a consequent fall in demand which will check inflation. In recent years there has been greater emphasis. This is not good for the economy. Both these. Expenditure stimulates the economy by creating jobs and stimulating demand. Economic activity often comes to a stand still in late March and early April as people wait to see whether the monsoon is likely to be good or not. power stations and the like.Which Company? so much emphasis. and offered so many benefits. can result in spiraling prices.build roads. national highways are being widened and made better and the improvements made in communications is awesome. Monsoons Budgetary Deficit A budgetary deficit occurs when governmental expenditure exceeds its income. such as power and transportation. CYCLE PART I. India is no exception. The Indian economy is an agrarian one and it is therefore extremely dependent on the monsoon. Flyovers have been built. The government has. Budget deficits have been high. All developing economies suffer from budget deficits as governments spend to improve the infrastructure . to infrastructural industries.CHAPTER TWO The economic cycle Economic 33 The 32 Politico-economic analysis . this can also lead to deficit financing and inflation. Employment High employment is required to achieve a good growth in national income. to reduce inflation consciously cut expenditure down and it has reduced from a high of around 15% few years ago to a little over 7% today. As the population growth is faster than the economic growth unemployment is increasing. However. To control and cut deficits governments normally cut governmental expenditure.

Conspicuous spending begins once again. The Investment Decision Boom Recovery The four stages of an economic cycle are: Depression Recovery Boom Recession During this phase. Companies begin to post profits. like the beat of the heart. Investors should attempt to determine the stage of the economic cycle the country is in. The United States went through a depression in the late seventies. Interest rates and inflation Demand starts falling. Recession The four stages of an economic cycle are: Depression At the time of depression. in fully. Companies start finding it difficult to sell their goods. “Cycles are not. of higher demand. Prices that had been rising begin to stabilize and even fall. others such as the food or health industry are not affected to the same extent. at the worst. Companies. or. Interest rates are low. This is because in regard to certain products consumers can postpone their purchase decisions. The recovery of the US economy and that of the rest of Western Europe began again in 1993. Interest rates and inflation are high. All the attributes of a recovery are evident in the economy.Which Company? C ountries go through the business or economic cycle and the stage of the cycle at which a country is in has a direct impact both on industry and individual companies. whereas in certain others they cannot. Once the recovery stage sets In the boom phase. Inflation is high and so are interest rates. The economy recovered and the eighties was a period of boom.” 34 The economic cycle The economic cycle 35 . In India 2003 could be seen as a year of recovery. Another downturn occurred in the late eighties and early nineties. India too went through a difficult period and it began its recovery in 2002. Gradually as time goes on. just after the boom. More and more new companies are floated to meet the increasing demand in the economy. the economy begins to recover. or that a boom would be for a definite period of time. Investment and disinvestments made at these times will earn the investor greater benefits. Hence the length of previous cycles should not be used as a measure to forecast the length of an existing cycle. Investment is also high. Investors should disinvest either just before or during the boom. and let workers go. demand is low and falling. Later the US again went through a period of depression at the turn of the millennium. of the essence of organism that displays them. supply begins to exceed the demand. The economy slowly begins to downturn. like tonsils. There is an increase in demand. demand reaches an all time high. especially after the Gulf War. are forced to curtail production. It affects investment decisions. employment. demand and the profitability of companies. Companies start finding it difficult to sell their goods. While some industries such as shipping or consumer durable goods are greatly affected by the business cycle. Investment begins anew and the demand grows. separable things that might be treated by themselves but are. crippled by high borrowing and falling sales. India went through a terrible recession for 4 years from 1996. Demand starts falling. It must however be noted that there is no rule or law that states that a recession would last a certain number of years. profits begin to grow at a higher proportionate rate. Demand starts falling. close down plants built at times The economy slowly begins to downturn. Then as the boom period matures prices begin to rise again. Interest rates and inflation begin to increase. Joseph Schumpeter once said. They should invest at the end of a depression when the economy begins to recover. An investor should also be aware that government policy or other events can reverse a stage and it is therefore imperative that investors analyze the impact of government and political decisions on the economy before making the final investment decision.

This was because India was a sellers' market at that time and products produced were certain to be sold. The palm tops have now arrived. technological advances in one industry can affect another industry. And they could get away with it three decades ago. initially having a capacity of 20 megabytes.Which Company? T ANALYSIS PART II 36 Industry analysis Industry he importance of industry analysis is now dawning on the Indian investor as never before. I have used these examples to illustrate how technological advances make a highly regarded product obsolete. These early models did not have a hard disk but two fixed disk drives. Everyone raved about the invention and how technology could compress a huge computer into such a small box. A few months later hard disks were incorporated. Mobile phones today have computing capabilities. In 1988. laptop computers were the "in" thing. often at a premium. In eighteen months. One really and honestly does not know what will be next. There are great technological advances and "state of the art" equipment becomes obsolete in a few years. cost and fashion conscious. are still not the last word in compressed computing. investors purchased shares of companies without concerning themselves about the industry it operated in. Those happy days are over. These notebooks. If not months. movie cameras and projectors were prized possessions. its balance sheet strong and its reputation enviable. In the same way. However. The memory was then increased to 40 megabytes. In the late 1970s and early 1980s. there is intense competition. the laptop became obsolete with the creation of the notebook. An investor must therefore examine the industry in which a company operates because this can have a tremendous effect on its results. Now. The popularity of cotton clothes in the West affected the manmade (synthetic) textile industry. Consumers have now become quality. This can result in a 37 Industry analysis . A company's management may be superior. the company may not have diversified and the industry within which it operates may be in a depression. The jute industry went into decline when alternate and cheaper packing materials began to be used. Foreign goods are easily available and Indian goods have to compete with these. With the advent of the video camera in the mid 80s they became obsolete. some having a capacity of as much as 120 megabytes. and even its existence. Previously.

tremendous decline in revenues and even threaten the viability of the company. Had it. The Decline or Sunset Stage Finally.Entrepreneurial. All indus. even negative. and tions of capital. This may be on account of several factors such as a change in social habits The film and video industries . or the stage of losses. In the The first step in industry is to deter. the industry declines. cent stage It takes time to establish companies 2. At this stage. The mobile phone industry is also in the growth stage . for example have suffered on account of cable and satellite television.Decline or sunset stage If a company or an industry is not nurtured LIFE CYCLE OF AN INDUSTRY or husbanded at this stage. In fact. 4. Growth is moderate. It must be noted that the stages: first 5 to 10 years are the most critical period. it can collapse. The Entrepreneurial or Nascent Stage tionally readable magazine. His intention was to start a magazine edited by journalists without inter(1) Entrepreneurial of nascent stage (2) Expansion or growth stage ference from industrial (3) Stabilization or maturity stage (4) Decline magnates or The life cycle of an industry can be illustrated in an inverted "S" curve as illus. such companies are often able to even lower their prices.Which Company? At the first stage.losses and the need for large injecrity stage. Investors can invest in these industries for comfort and average returns. changes in laws. growth and returns can be negative.Stabilization. The risk at this time is high but the returns are low. it did not have the finance needed in those critical initial years to keep it afloat and had to fold up. At this time there may also maturity of the industry. at that time. had the finance it needed it may have survived and thrived. It is for the time seeing safe.with newer models and newer entrants. A good journalist I know began a business magazine. many new companies enter the industry. The growth stage also witnesses product improvements by companies that have survived the first stage. Investors are more keen to invest at this time as companies would have demonstrated their ability to survive. The Stabilization or Maturity Stage The Expansion or Growth Stage Once the industry has established itself it enters a growth stage.not be many companies in the tries evolve through the following industry. they do so at a slower rate than before. The refrigerator industry in India is a mature industry. It was exceptrated above. In short. Growth is slow. an industry matures and stabilizes. investors can get high reward at low risk since demand outstrips supply. After the halcyon days of growth. a good example was the Indian software industry. Rewards are low and so too is the risk.have the greatest chance of failing. There may be 3. Though sales may increase.Expansion or growth stage and new products. it may actually make mine the cycle it is in. This occurs when its products are no longer popular. They must be aware though that should there be a downturn in the economy and a fall in consumer demand.early days. However. In 2003. In 2000.politicians. The various stages can be likened to the four stages in the life 39 38 Industry analysis Industry analysis . the industry is new and it can take some time for it Cycle to properly establish itself. sunrise or nas. the BPO industry is arguably in the growth stage. companies 1. Products are more standardized and less innovative and there are several competitors. at this stage investors take a high risk in the hope of great reward should the product succeed. and increase in prices. As the industry grows. At this time. stagnation or matu.

During hard times individuals postpone the purchase of consumer goods until better days. These competitive forces are: barriers to entry.Mercedes Benz cars. The question that arises is how easy is it to enter an industry ? There are some barriers to entry: a) Economies of scale: In some industries it may not be economical to set up small capacities. These are industries that produce goods individuals need. smaller profits and. As competition increases even more. bargaining of the buyers. product improvements and innovation. the reverse will occur. 4. There are competitive forces and it is these competitive forces that determine the extent of the inflow of funds. On the other hand. and the among competitors. The products produced by such established giants will be markedly cheaper. People are prepared to pay more for the product and consequently the products are at a premium . Industries that are generally unaffected during economic changes are the evergeen industries. To properly understand this phenomenon. cut throat price wars set in resulting in lower margins. If interest rates are likely to fall. 1. industries such as real estate and banking fare poorly. consumer goods such as textiles and shipping. the return on investment and the ability of companies to sustain these returns. certain industries are unaffected in a depression or a boom. it is to be appreciated that if the return is high. The more inefficient companies even close down. on the other hand. In short high returns attract competition and vice versa. Existing companies may also increase their capacity. Some industries do not perform well during a recession. 41 40 Industry analysis Industry analysis . What should Investors do? Investors should determine how an industry is affected by changes in the economy and movements in interest rates. It is safe usually to invest in such companies as there will always be a demand. others exhibit less buoyancy during a boom. Investors should begin to purchase shares when an industry is at the end of the entrepreneurial or nascent stage and during its growth stage. the threat power power rivalry of substitution. if the returns are low. investors should disinvest their holdings in cyclical industries and switch to growth or evergreen industries. However. like the food or agrobased industries (dairy products. The prime examples are durable goods. The Industry vis-à-vis the Economy Investors must ascertain how an industry reacts to changes in the economy. finally some companies begin to make losses. b) Product differentiation: A company whose products have product differentiation has greater staying power.). Growth industries are those whose growth is higher than other industries and growth occurs even though the economy may be suffering a setback. If the economy is moving towards a recession. competition in the form of new companies do not bacterially multiply just because the returns are high. investment in consumer and durable goods industries are likely to be profitable. newcomers will invest in the industry and there will be an inflow of funds. and should begin to disinvest when at its mature stage. When interest rates are high. bargaining of the suppliers. The product differentiation may be because of its name or because of the quality of its products .BARRIER TO ENTRY New entrants increase the capacity in an industry and the inflow of funds. Then there are the volatile cyclical industries which do extremely well when the economy is doing well and do badly when depression sets in. 2. National VCRs or Reebok shoes. 3. etc. or lower than that which can be obtained elsewhere. If. the economy is on the upturn.childhood. adulthood. Interest sensitive industries are those that are affected by interest rates. What are the major classifications? 1. Competition Another factor that one must con- sider is the level of competition among various companies in an industry. middle age and old age. Funds will not be invested and there will be an outflow. investors should consider investment in real estate or construction companies. This is especially true if comparatively large units are already in existence producing a vast quantity. Competition within an industry initially leads to efficiency. However.Which Company? cycle of a human being .

Even though others sought licenses there were not given. Similar cold drinks are available but it is not easy for a competition to compete with it. This may include employee restraining costs. 43 42 Industry analysis Industry analysis . One should also be aware that: If sellers face large switching costs. If buyers are well informed about trends and details they are in a better position vis-à-vis sellers as they can ensure they do not pay more than they need to. If the switching costs are high. This is especially true if the switching costs for buyers are low. Large investments and a big capital base will be barriers to entry.BARGAINING POWER OF THE BUYERS In an industry where buyers have control. 2. The industries that have to worry most are those where the substitutes are either cheaper or better. If such buyers withdraw their patronage. buyers are constantly forcing prices down. usually by not issuing licenses. there will be fewer competitors entering the industry. the Indian motor car industry was the monopoly of two companies. low margins and high costs. A prime example is Coca Cola. If buyers have achieved partial backward integration. or are produced by industries earning high profits. in a buyer's market. i. On the other hand. there are a multitude of competitors. h)Expected retaliation: The expected retaliation by existing competitors can also be a barrier to potential entrants. If a product represents a significant portion of the buyers' cost. j) International cartels: There may be international cartels that make it unprofitable for new entrants. intense competition. i) Cost of capacity additions: If the cost of capacity additions are high. and the like. the unit and even the software would have to be changed. sellers face a threat as they may become fully integrated. the buyer's power is enhanced. especially if existing competitors aggressively try to keep the new entrants out. capital intensive industries with a large capital base and high fixed cost structure have few competitors as entry is difficult. These include: Proprietary product technology Favorable access to raw materials Government subsidies Long learning curve. If it wishes to change to an IBM computer. The factors one should check are whether: a)A particular buyer buys most of the products (large purchase volumes). The automobile industry is a prime example of such an industry. An industry where this occurs constantly is the packaging industry bottles replaced by cans. A company may be using a Honeywell computer. As a consequence. The company has proprietary product technology. Till about the mid-1980s. new entrants have to offer a tremendous improvement for the buyer to switch. e)Access to distribution channels: Difficulty in securing access to distribution channels can be a barrier to entry. Its high fixed costs have to be serviced and a fall in sales can result in a more than proportionate fall in profits. cans replaced by plastic bottles.THE THREAT OF SUBSTITUTION New inventions are always taking place and new and better products replace existing ones. f) Cost disadvantages independent of scale: This barrier occurs when established firms have advantages new entrants cannot replicate. d)Switching costs: Another barrier to entry could be the cost of switching from one supplier's product to another. To ward off the threat of substitution. 3.Which Company? c) Capital requirement: Easy entry industries require little capital and technological expertise. A prime example is computers. demanding better services or higher quality and this often erodes profitability. companies often have to spend large sums of money in advertising and promotion.e. all the terminals. They can also force prices down. g)Government policy: Government policy can limit fresh entrants to an industry. cost of equipment and the likes. An industry that can be replaced by substitutes or is threatened by substitutes is normally an industry one must be careful of investing in. they can destroy an industry. It should be noted that substitutes limit the potential returns of a company. especially if existing firms already have strong and established channels. b)Buyers can play one company against another to bring prices down.

Which Company?

buyers would strongly attempt to reduce prices. If a product is standard and undifferentiated, the buyer's bargaining power is enhanced. If the buyer's profits are low, the buyer will try to reduce prices as much as possible. In short, an industry that is dictated by buyers is usually weak and its profitability is under constant threat. 4.BARGAINING POWER FOR THE SUPPLIERS An industry unduly controlled by its suppliers is also under threat. This occurs when: a) The suppliers have a monopoly, or if there are few suppliers. b) Suppliers control an essential item. c) Demand for the product exceeds supply. d) The supplier supplies to various companies. e) The switching costs are high. f) The supplier's product does not have a substitute. g) The supplier's product is an important input for the buyer's business. h) The buyer is not important to the supplier. i) The supplier's product is unique.

5.RIVALRY AMONG COMPETITORS Rivalry among competitors can cause an industry great harm. This occurs mainly by price cuts, heavy advertising, additional high cost services or offers, and the like. This rivalry occurs mainly when: a) There are many competitors and supply exceeds demand. Companies resort to price cuts and advertise heavily in order to attract customers for their goods. b) The industry growth is slow and companies are competing with each other for a greater market share. c) The economy is in a recession and companies cut the price of their products and offer better service to stimulate demand. d) There is lack of differentiation between the product of one company and that of another. In such cases, the buyer makes his choice on the basis of price or service. e) In some industries economies of scale will necessitate large additions to existing capacities in a company. The increase in production could result in over capacity & price cutting. f) Competitors may have very different strategies in selling their goods and in competing they may be continuously trying to stay ahead

of the other by price cuts or improved service. g)Rivalry increases if the stakes (profits) are high. h)Firms will compete with one another intensely if the costs of exit are great, i.e. the payment of gratuity, unfunded provident fund, pension liabilities, and such like. In such a situation, companies would prefer remaining in business even if margins are low and little or no profits are being made. Companies also tend to remain in business at low margins if there are strategic interrelationships between the company and others in the group; due to government restrictions (the government may not allow a company to close down); or in case the management does not wish to close down the company out of pride or employee commitment. If exit barriers are high, excess capacity can not be shut down and companies lose their competitive edges; profitability is eroded.If exit

barriers are high the return is low but risky. If exit barriers are low the return is low but stable. On the other hand, if entry barriers are low the returns are high but stable. High entry barriers have high, risky returns.

Selecting an Industry

When choosing an industry, it would be prudent for the investor to bear in mind or determine the following details: 1.Invest in an industry at the growth stage. 2. The faster the growth of a company or industry, the better. Indian software industry, for example, was growing at a rate of more than 50 per cent per annum at the dawn of the new millennium. 3. It is safer to invest in industries that are not subject to governmental controls and are globally competitive. 4. Cyclical industries should be avoided if possible unless one is Low Return high but stable Return low and stable

High Entry Barriers Exit Barriers Return high but risky Return low but risky

44

Industry analysis

Industry analysis

45

Which Company?

investing in them at the time the industry is prospering. 5. Export oriented industries are presently in a favorable position due to various incentives and government encouragement. On the other hand, import substitution companies are presently not doing very well due to relaxations and lower duties on imports. 6. It is important to check whether an industry is right for investment

at a particular time. There are sunrise and sunset industries. There are capital intensive and labour intensive industries. Each industry goes through a life cycle. Investments should be at the growth stage of an industry and disinvestments at the maturity or stagnation stage before decline sets in.

ANALYSIS
PART III
46
Industry analysis Company analysis

Company

47

Which Company?

At the final stage of fundamental analysis, the investor analyzes the company. This analysis has two thrusts: How has the company performed vis-à-vis other similar companies and How has the company performed in comparison to earlier years It is imperative that one completes the politico economic analysis and the industry analysis before a company is analyzed because the company's performance at a period of time is to an extent a reflection of the economy, the political situation and the industry.

What does one look at when analyzing a company? There is, in my view, no point or issue too small to be ignored. Everything matters. As I had mentioned earlier, the billionaire Jean Paul Getty, one of the most successful stock market operators of all time, said, "Do not buy stock until you know all about it". The different issues regarding a company that should be examined are: The Management The Company The Annual Report Ratios Cash flow

Management
CHAPTER FOUR
48
Company analysis The management

The

49

tent manageits factories. After a series of occurrences giant in the early eighties. inefficient management can many such examples. his sucGerstner had earlier been successful cessor diversified into agro based in reducing quite drastically and industries.R. The controlling family merged the two companies and the price of Kirloskar Pneumatic fell to around Rs. The New Delhi manager. The chief executives of his many companies had come to see him off. In the first quarter of 1993. decisions are often made with family interests in view and employees are often treated as paid servants of the family even though they may be senior managers. Narayanamurthy and Infosys and HDFC and Deepak Parekh. It be attributed to Venugopal Dhoot. Nabisco.R. standing of what was involved in A good.dismissed its. The Chairman or the Chief Executive Officer is usually a member of the "ruling" family and the Board of Directors are peopled either by members of the family or their friends and "rubber stamps". and the Reliance Empire due entirely to one man. In short. the turned the Fundamental Analysis Primer company company round with Management is the single most important factor to was forced tough compe. the bluest of blue examples. was invited to become the Chief Haksar diversified ITC into hotels Executive Officer of IBM. At that time Kirloskar Tractors was not doing well. in the United States. These leaders bent double and touched their leader's feet when he left. the big blue Killick Nixon was one of the IBM . Chief Executive most respected names in Western Officer Akers who was blamed for India. competent management running a large railway network.J. competence headed by Stuart Saunders who was and vision of the management that a lawyer and possessed little underthe future of company rests.Which Company? T he single most important tal in his getting the top job at IBM Similarly. Mr. can make a company grow while a Indian corporate history also has weak. and can only leave his master's presence after he retires for the night. For instance. This is necessarily bad. was that it was It is upon the quality. the company's dismal performance. Dhirubhai Ambani. Possibly. in one company I know the Human Resources Manager is also involved in hiring maids and houseboys for his Chairman's house and he buys the vegetables too. the largest railway never considered is its management. Upon its quality rests the to close all future of the company. I remember a few years ago Kirloskar Pneumatics was quoting at Rs. was this success that was instrumen.success of Videocon could probably aged buy out of R. there are Lou Gerstiner who was at one time numerous success stories. It is just that all policy is determined by the controlling family and some of the policies may not necessarily always be in the shareholders' best interest. the main reason attribfactor one should consider when investing in a uted for the collapse in the seventies company and one often of Penn Central. On the other hand. captains of industry in their own right and respected for their achievements and accomplishments. and three of them were actually older than their master. (the WelcomGroup chain).Bajaj Auto's growth and profitabil- ity is due to Rahul Bajaj.36 per share. In India management can be broadly divided in two types: Family Management Professional Management Family management Family managed companies are those that have at the helm a member of the controlling family. whenever his "Seth" visits that city is expected to be at the company house every morning at 7 a. Iacocca including a diversification that went wrong. ment.m.10.consider in a company. I was witness to an incident at Bombay airport many years ago. The head of a large business house was going on a trip. this may have been done as a sign of respect like a student touching his teacher's 51 50 The management The management . These gentlemen were well known individuals. of prosPresident of American Express and perity that resulted due to the forelater took charge of R. Metal Box was a name known destroy a thriving company. when the Chairman wakes up. No longer. It was probably good for the family and for the shareholders of Kirloskar Tractors but the merger was disastrous for the shareholders of Kirloskar Pneumatics. There are several others such as Azim Premji and Wipro.J. Nabisco sight and vision of management. Chrysler was an ailing chips. Corporate history is riddled with and respected. very impressively the liabilities that These have been successes The had arisen on account of the lever.

i. Additionally as these devolve on the employee only after a time.the meeting of the annual budget. rigid and looked after well and all his medical averse to change. The next circle That privilege will always be with a is the extended family of cousins member of the family. to retire. he is autocratic.. To an extent this comture most eloquently in his memoir. multinationals would do this. t h e When he Fundamental Analysis Primer founding retires he is given a good In India there are two main types of management . but I do wonder what may have from the same religious or caste occurred if these individuals had not group. a former his subordinates are graduates of Chairman of Hindustan Lever Ltd. He is not necessarily influenced by loyalty to the company. Nor will his sons succeed him although some may try to see that his happens. and such individuals are consequently not usually know for their loyalty. business schools. Companies are now to promote or create commitment offering employees stock options. traditional.exposed to modern methods. employees are unthinkably risky". growth oriented and good performers. In many professionally managed companies there is also a lot of infighting and corporate politics. Consequently. The fourth circle comprises humiliated themselves with this ges. there is often a lack of long term commitment and sometimes a lack of loyalty. Infosys. One must also not forget that the professional manager is a mercenary. although the man at the helm is a scion of the family.managers. It is a win-win situation for both.or abroad and they have been pany flat. The employee thus becomes a part owner and becomes thus involved in the profitability of the enterprise. the children were edu. He is at the helm of affairs because of his ability and experience. In the beginthan talent. However. often annually. This is because managers are constantly trying to climb up the corporate ladder and the end is often what 53 52 The management The management . have been pension. And often this loyalty is ning. It is possible Darbari Seth's son will become Chairman of Tata Chemicals.e. I educated remember an occasion when a senior employee at the best business schools in India died. As a professional he is usually aware of the latest trends in management philosophy and tries to introduce these. bines the best of two worlds and To Challenge and to Change. these were often orthodox. This is because the professional manager has to step down in time. If a retainer is ill. Mr. The employee builds his net worth. cated and she was even given a job. professional describes the family business struc. HDFC and Hindustan Lever. The companies that come readily to mind are ITC. As these options are given.of people from the same region.f a t h e r s Family and Professional. This is no longer true. T. He tries to run his company like a lean. These devolve on employees after a specified period of service and are given to them on performance. He sell his services to the highest bidder. his brothers or sons. The sons and the grandsons of expenses are borne by the family. the chief executive officer often does not even have a financial stake in the company. The frustration for the promanager in such having a series of concentric circles fessional emanating from a core . he is always result-oriented and his aim is often short term . in many family manFew professionally managed or aged companies. What I am trying Thomas says that to go beyond this to point out is that in many family was "like going out of orbit run companies. Consequently. ture of obeisance. He many such businesses are very sucspeaks of an Indian family business cessful. professionally managed companies are usually well organized. There has been some change in expected to be subservient to the family and loyalty to the family is the way family controlled businesses considered even more important have been managed. The company gets the services of a loyal competent employee. and relatives followed by people Professional Management Professionally managed companies are those that are managed by employees. His widow was given the com. the employee remains with the company for a significant period of time. The professional manager is a career employee and he remains at the seat of power so long as he meets his targets. effective machine striving for increased efficiency and productivity. and he cannot therefore enjoy the fruit of his labour for ever. Mr. he tends to stay till it does. As a consequence. In such companies. Thomas. rewarded.Which Company? feet.the core companies is that he know that he being made up of the founder and will never ever run the company.

It should be remembered that the regard the industry has of the management of Its knowledge of its products. the most important aspect is the integrity of the management. They must be avoided. In this context. There are also badly managed companies in both categories. its markets and the industry is of paramount importance because upon this can depend the success of a company. "We will not allow it to". do not touch the company with a pair of tongs". the erstwhile Chairman of the New India Assurance. The worthy replied. When. Often too. profitable companies in both categories. Rs. This does not always happen in family managed companies as one is aware that the mantle of leadership will always be worn by the son or daughter of the house. It is often stated that a determined employee can perpetrate a fraud. despite good systems and controls. Shares of such companies are speculative shares and artificially kept at a high price. There are well managed. proven competence. Competitors are aware of nearly all the strengths and weaknesses of a management and if they hold the management in high esteem it is truly worthy of respect. Integrity of Management In my opinion. How has the management managed the affairs of the company during the last few years? Has the company grown? Has it become more profitable? Has it grown more impressively than others in the same industry? It is always wise to be a little wary of new management and new companies as they have very high level of mortality. A. C. Shroff. Similarly if it so desires. the past record of the management. rather. What to look for It would be unfair to state that one should invest only in professionally managed companies or family managed companies. the management can juggle figures and cause great harm and financial loss to a company (for their own personal gain). In doing so. fair and correct. "If you have the slightest doubt of management. The steel of a management is tested at times of adversity? And during a time of recession or depression. Patel who was at one time the Chief Executive of Unit Trust of India. I had the privilege once to listen to Mr. how did it perform at times of adversity. The reality sinks in only when it is too late. My recommendation would therefore be to leave a company well alone if you are not too certain of the integrity of its management. how high is it rated by its peers. not the means. There are some managements who have a record of manipulating share prices. its markets and its competitors. 4. He recounted an advice he was given by his mentor. How highly is the management rated by its peers in the same industry? This is a very telling factor. 5. it is a hint to keep well away from that company. Wait until the company shows signs of success and the management proves its competence.D. This must be beyond question. Seldom have I heard truer words. as a consequence. the management's depth of knowledge.Which Company? matters. Past record of management Another point to consider is proven competence. its management is described colloquially as "chor (thief) management". 2. I was recounted a tale wherein a nonIndian journalist asked the scion of a family managed company how he could claim that the share price of his company would not fall below Fundamental Analysis Primer Investors must check on integrity of managers. i. Mr. the best person does not get the top job. its innovativeness and professionalism. it is the person who plays the game best. one should check who the major shareholders of the company are.S.230. it loses its touch with its customers.e. How the management fares in adversity? In good times everyone does well. Often the management of a company that has enjoyed a preeminent position sits back thinking that it will always be the dominant company. The management must be 54 The management The management 55 . What then are the factors one should look for? 1. in a conversation about a company. it is important to consider how well the management did? Did it streamline its operations? Did it close down its factories? Did it (if it could) get rid of employees? Was it able to sell its products? Did the company perform better than its competitors? How did sales fare? A management that can steer its company in difficult days will normally always do well. a company is usually impartial. The depth of knowledge of the management 3.

nieces. It must essentially know where it is going and have a plan of how to get there. ble. to generalize which is better. decide whether he is comfortable with the management of a company. There are "many chiefs and few braves". the chief executive and not with the good of the company in mind.Which Company? in touch with the industry and customers at all times and be aware of the latest techniques and innovations. to avoid investing in family controlled companies where there is infighting because the companies suffer and the one who arguably stands to lose the most is the shareholder or the investor. Avoid investing in family controlled companies 56 The management The management 57 . innovative and must also have a strategy: It must be prepared to change when required. too. before he risks his money. There may be nepotism with the nephews. The period before the split and the period soon after are the most unsettled times. There are also several professionally managed companies. the Goenkas. In such companies the most competent are not given the position of power. cousins and relatives of the chief executive holding positions not due to proven competence but because of blood ties. on how to hold onto their jobs. Their strategy is usually a personal one. this is what will determine the safety and the fate of the money that you invest.Non-professionalised Management I would not recommend investing in a company that is yet to professionalize because in such companies decisions are made on the whims of It would be wise. In India. It must be receptive to ideas and be dynamic. and whether the share is growing or at least being maintained. That is the time to keep away from such companies. In recent years. most of the larger companies are family controlled though they are managed on a day-to-day basis by professional managers. many such family controlled companies have split. A quick way of checking this is to determine what the market share of the company's products is. one can determine whether one should invest or not. Ultimately. They do not want change and often stand in the way of change. A company that has many layers of management and is top heavy tends to be very bureaucratic and ponderous. to name but a few. An investor must. When the new management settles down.The management must be open. nor would it be fair. 7. 6. Only then can it progress and keep ahead. the Birlas. It is not possi- 8. the Mafatlals.

There were many teltion of an actor/ actress by his/her evision manufacturers. Oscar is Let us take a Hollywood's greatest award.a company follows and its plans for products as petitors. They made peers. Its products may survived. vision.Which Company? n aspect not necessarily examined during an analysis of fundamentals is the company. the risk is less. It may be better one has to purchase an article and organized. Why? there was a virtual explosion of conIt is because it represents recogni. When you invest in market leaders. Its management may be has a choice one would normally 59 2. the real life example. If be far superior. Company CHAPTER FIVE 58 The company The Another aspect that should be ascertained is whether the company is the market leader in its products or in its segment. high regard? The ers. A company may have made losses consecutively for two years or more and one may not wish to touch its shares . competence and aggressiveness. A company held in scorn by a similar televisions as almost all parts competitor is not worth looking at. The investor must ascertain the reason and then determine whether the reason will continue into the foreseeable future. were imported. The shares of market leaders do not fall 1. This is because the company is one's perception of the state of a company it cannot necessarily be supported by hard facts and figures. It is held in opposed to othgrowth. There is a magic to their name by its competitors? One of the key facthat would make Fundamental Analysis Primer individuals pretors to ascertain is how a company is The investor must determine the policy fer to buy their perceived by its com. The others had died off. one held in awe must be considered not once those that were the market leaders but several times. A known for its maturity. However within a decade only On the other hand. There are several factors one should look at.yet it may be a good company and worth purchasing into. How a company is perceived as quickly as those of other companies. one most prized by the stars. In the eighties. Whether the company is the market leader in its products or in its segment The company .sumer goods.

The government has recognized this and there are plans afoot to have superhighways around the country within the next ten years. to ascertain where the company's plants and factories are and their record of industrial relations. It had a software division which was spun off as a separate company. It is at the point of leveling out that it must be given new life. was closed due to strikes for nearly four months and as a consequence its results in the year to 31 March 1993 were extremely bad. Transportation is another issue. A classic example that comes to mind is ITC Ltd. It then saw opportunity and moved into petroleum. Labour relations are extremely important. Reliance Industries was initially in Textiles. There are many companies in Madhya Pradesh in dire straits because of electricity cuts. a company that has bad industrial relations will lose several hundred mandays as a consequence of strikes and go slows. Blue Star is a airconditionFundamental Analysis Primer It is important to check how company is perceived by its competition and whether it is the market leader in its products or in its segment. It is widely believed that the textile industry died in Mumbai because of the militancy of the unions under the late Datta Samant. What is its plans for growth? What is its vision? Every company has a life. If the infrastructure is bad. the prices of market leaders fall slower than those of others in the same industry. Where the company is located and where its factories are? One must also consider where the 61 60 The company The company . Consequently. On the other hand. It is critical. A company that has motivated. Company Policies The policy a company follows is also of imperative importance. industrious work force has high productivity and practically no disruption of work. the giant shoe company. into petro chemicals and refining products. 4. if there is inadequate electricity or water the company could have tremendous problems. company is located and where its factories are. Labour Relations 3. Many cannot afford captive power. therefore. This is normal human behavior and this happens in the market place too. This tobacco giant branched into hotels under Haksar and then into agribusiness under Sapru. ing company.Which Company? buy the better one. This can give it renewed vigour and a new lease of life. If it is allowed to live a normal life it will grow upto a point and then begin to level out and eventually die. It has in 2003 got into mobile phones. In 1992 Bata. Since then both these companies have grown. 5. These are the main factors one should keep at the back of one's mind while viewing a company. It was on account of the militancy of the labour force that many companies grew reluctant to invest in states such as Kerala and West Bengal.

he must read between and beyond the lines. B. There are pictures of the factories. The tale should be heard. Consequently. if the company has made a profit and if a reasonable dividend has been paid.The Auditor's Report.The Director’s Report The Director’s Report is a report submitted by the directors of a company to its shareholders. the financial statements and the schedules.The Financial Statements. This must not be the criterion by which to judge a company. all these reports are very well written. the report they submit to justify their continued existence and it is because of this that these reports should be read with a pinch of salt. A tremendous amount of data is given about the performance of a company over a period of time. Fundamental Analysis Primer The annual report is broken into the director’s report. of newly acquired machines.Which Company? T Annual The CHAPTER SIX 62 The annual report REPORT he primary and most important source of information about a company is its Annual Report. the auditor's report. After all. The annual report 63 . advising them of the performance of the company under their stewardship. Each of these parts has a purpose and a tale to tell. The intelligent investor must read the annual report in depth. The Annual Report is broken down into the following specific parts: A. It is human nature. By law. The average shareholder looks no further. Multi-colored bar and pie charts are presented to illustrate and explain the growth of the company and the manner in which the revenues earned have been utilized. A. It is natural. It is. of the Chairman cutting a ribbon and of the Board of Directors looking responsible. in effect. and D. he must peep behind the figures and find the truth and only then should he decide whether the company is doing well or not. this is prepared every year and distributed to the shareholders. Annual Reports are usually very well presented. if a group of individuals have to present an evaluation of their own performance they are bound to highlight their achievements and gloss over their failures. C. Every sentence.The Director's Report. he is typically content in the belief that the company is in good hands.The Schedules and Notes to the Accounts. If an Annual Report is impressive.

such as a change in accounting principles or the non provision of charges that result in an increase or decrease in profits. the Director’s Report provides an investor valuable information: 1. Investors must remember that "The financial year under review 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 diversification may not suit a company. If Fundamental Analysis Primer The annul report is the primary and most important source of information on a company. 2000 the accuand its future prospects. all other issues raised in the Director’s Report should be analyzed. profits have improved it would invariably be because of superior marketing and hard work in the face of severe competition. 31st March the direction it intends taking. therepublic on the stewardship of the fore. expansion and diversification. 3. The point I am trying to make is that although companies must diversify in order to spread the risks of industrial slumps. In our opinion. mulated losses exceed the net worth of the Company and the Company has suffered cash losses in the finanB. more often than not it is not read. Auditors trial company within the meaning of are required to report whether the clause (O) of Section 3(1) of the Sick financial statements presented do.cial year ended 31st March 2000 as holders and it is his duty to report to well as in the immediately preceding the shareholders and the general financial year. for grasp of the workThe investor must read between and the year 1999ings of a company. Every happening of importance is catalogued and highlighted to convince a casual reader that the company is in good hands. They are also required to report any change. present a true and fair view of Provisions) Act 1985".Which Company? nay every word. There can be interesting contraIn short. Discusses plans for new acquisition and investments. Explains the performance and the financial results of the company in the period under review. This paragraph should normally be read with sane skepticism. Similarly. The results and operations of the various separate divisions are usually detailed and investors can determine the reasons for their good or bad performance. 65 64 The annual report The annual report . An investor must intelligently evaluate the issues raised in a Director’s Report. adverse economic conditions are usually at fault. Elaborates on the directors' views of the company's prospects in the future. The Director’s Report details the company's plans for modernization. as the directors will always argue that the performance was satisfactory. "As determine the state of the company at the year end problems it faces. a company will remain static and eventually decline. in Industrial Companies (Special fact. This is an extremely important part. the beyond the lines of an annual report to 2000 that. a Director’s Report is valuable and if read intelligently can give dictions. the Company is a sick induscompany by its directors. 2. 5. being considered. is subjected to the most piercing scrutiny.Nike Sportswear. The Auditor's Report The auditor represents the share. 6. It was stated in the Auditor's Report the investor a good Fundamental Analysis Primer of ABC Ltd. It is really the only impartial report that a shareholder or investor receives and this alone should spur one to scrutinize the auditor's report minutely. Did the company perform as well as others in the same industry? Is the finance being raised the most logical and beneficial for the company? It is imperative that the investor read between the lines of Director’s Report and find the answers to these questions. Unfortunately. If low. A diversification that was a disaster was Burroughs Wellcome's diversification into sport goods . every point out if the financial statements are not true and fair. So was Metal Box's move into ball bearings and Spartek's acquisition of Neycer Ceramics. Diversification is good but does it make sense? Industry conditions and the management's knowledge of the business must be considered. The Director’s report however stated. And there is a tendency to justify unhappy happenings. It enunciates the opinion of the directors on the state of the economy and the political situation visà-vis the company. the state of the company. 4. Discusses the profit earned in the period under review and the dividend recommended by the directors. Nevertheless. Without these.

4 regarding balance confirmations.023 had been capitalized under this head relating to the development of CT142.14 on gratuity. High input costs as well as resource constraints hampered operations.500 600 18. past gratuity liabilities as of 31 March 2000 had neither been ascertained nor provided for except to the extent of premiums paid against an LIC group gratuity policy taken by the trust.Note 3 states that no provision had been made for doubtful debts. 2000-01. The Auditor's Report of Royston Electronics Limited for 1999-2000 stated : "In our opinion and to the best of our information and explanation given to us. the effect of their qualification may not be apparent. the said accounts subject to Note No. and enunciates the opinion of the directors on the economy.. the industry and political situation.14.100 350 100 15. state otherwise.51. No.1 crore. (Note 14. When reading an Auditor's Report. No.250 700 400 400 800 450 66 The annual report The annual report 67 .16. It was noted in Note 4 that balance confirmation of sundry debtors.2.8 16(C) and 16(F) regarding stocks. The company's share towards Fundamental Analysis Primer The Director’s Report gives investors insights into the company. and give a true and fair view.3 regarding doubtful debts.580 1. Let us now look at the specific notes in this case: 1.150 300 80 12. If the product development expenses.500 7. being directors.049 were being written off over ten years from 1999-2000. the profit would have turned into a loss.200 3.3.17.) 6. Rs. No. 4. The point to remember is that at times accounting principles are changed. 2004 2003 INCOME Sales Other Income EXPENDITURE Materials Employment Operating & other expenses Interest & Finance charges Depreciation Profit for the year before tax Taxation APPROPRIATIONS Dividend General reserves BALANCE CARRIED FORWARD 14.020 600 220 200 420 600 2004 17. During the year manufacturing operations were curtailed to achieve cost effectiveness.600 3.3. or creative and innovative Fundamental limited Profit & Loss Account for the year ended 31 March.920 900 1.2000 had not been provided. The auditors were of the opinion that the company was sick whereas the directors spoke optimistically of their hope that the future would be better! I suppose they could not. Note 11 drew attention to the fact that product development expenses worth Rs. Digital TV.650 2.000 500 14.30.44. 3. CFBT which shall be written off in 10 years commencing. It was stated in Note 5 that customs liability and interest thereon worth Rs.073 against the imported raw materials lying in the ICF/Bonded godown as on 31. No.5 on custom liability and interests thereon.450 1. Note 16C stated that the raw material consumed had been estimated by the management and this had not been checked by the auditors.450 1200 1. The company made a profit of just over Rs.Which Company? in general continued to be in the grip of recession. 5. 2.11 on product development expenses.900 2. customer duty and interest and provision for bad debts had been made as is required under generally accepted accounting principles. Your directors are confident that the efforts for increased business volumes and cost control will yield better results in the current year". give the information in the manner as required by the Companies Act 1956. The performance of your Company must be assessed in the light of these factors. sundry creditors and loans and advances had not been obtained.100 9. No.

68 The annual report The annual report 69 . On 31 March 2004. 2003) 2003 SOURCES OF FUNDS Shareholder's funds (a) Capital B) Reserves LOAN FUNDS (a) Secured Loans (b) Unsecured Loans TOTAL APPLICATION OF FUNDS Fixed Assets Investments Current Assets : Trade debtors Prepaid Expenses Cash & Bank balances Other Current Assets 600 80 50 100 830 Less : Current Liabilities and provisions Trade Creditors Accrued Expenses Sundry Creditors 480 70 80 630 Net current assets TOTAL 200 3800 710 90 70 870 160 4200 700 80 100 150 1030 2004 1000 800 1800 1350 650 2000 3800 3200 400 1000 1650 2650 1050 500 1550 4200 3640 400 accounting practices resorted to by some companies in order to show a better result. Balance Sheet as at 1 April 2004 Shareholders' funds Loan funds Current liabilities 100 — 20 120 (In Rupees Lakh) 70 30 20 120 An investor reviewing the Balance Sheets would be forgiven for drawing two very different conclusions.Which Company? Fundamental limited (Balance sheet as on 31 MArch. Vasanth Ltd. it would be concluded that the company was very conservative and undercapitalized.Financial Statements The published financial statements of a company in an Annual Report consist of its Balance Sheet as at the Balance Sheet Illustration Vasanth Limited had taken a loan of Rs. on the other hand. C. Balance Sheet as at 31 March 2004 Shareholders' funds Loan funds Current liabilities 100 200 20 320 (In Rupees Lakh) 70 30 220 320 Current assets include cash of Rs. its Balance Sheet was as follows : Vasanth Ltd. as promised on 1 April 2004.200 lakh on 1 December 2003 which was repayable on 1 April 2004. The effect of these changes is at times not detailed in the notes to the accounts. Its Balance Sheet after the repayment read: Vasanth Ltd. It is for this reason that a careful reading of the Auditor's Report is not only necessary but mandatory for an investor. one financed by borrowings. At 31 March 2004. On 1 April 2004.100 lakh to repay the loan . The Auditor's Report will always draw the attention of the reader to these changes and the effect that these have on the financial statements. Vasanth Limited would be considered a highly leveraged company. as a consequence of which its growth would be limited. did repay the loans.

unrealized gain on the value of have failed to be fully subscribed. companies have reserves one comes across are the begun pricing them nearer their share premium account arising from intrinsic value.e. attractive to investors and several i. its plans for diversification. Share Capital Share capital represents the shares issued to the public. in effect. then. can Reserves give the investor a good grasp of the shareholders as a Capital workings of the company. This was have resulted often done at a price lower than its from an increase in the value of market value and shareholders assets and they are not freely distribstood to gain enormously. The details of the offer. they were oversubscribed many times. (iv) Bonus shares Bonus shares are shares issued free to shareholders by capitalizing (ii) Revenue Reserves These represent profits from operations ploughed back into the com71 RESERVES 70 The annual report The annual report . new-found freedom in respect of The most common capital pricing of shares. Reserves are profits or gains which are retained and not distributed. Shareholders' funds represent the stake they have in the company. of the company's assets (that which the company owns). and the Profit and Loss Account or Income Statement summarizing the activities of the company for the accounting period. i. As a consequence the investing public are no longer applying blindly for new shares but do so only after a careful analysis. A company sources funds from shareholders either by the issue of shares or by ploughing back profits. Consequently. reserves. For the company to make a profit the funds have to cost less than the return the company earns on their deployment. and liabilities (that which the company owes). matter of right in reserves are proportion to their gains that holding. companies typically price their shares at what the market can bear. It discusses the profits earned and states the dividends proposed.e. This is no longer true. Till the scam of 1992 public issues were extremely popular as the Fundamental Analysis Primer The Directors Report explains the performance of the company. As companies are now free to price their issues as they like and the office of the controller of capital issues has been abolished. Companies have two kinds of reserves . that if these shares are issued by capitalizing distributable reserves. It can be argued. these the issue of shares at a premium. assets.Which Company? end of the accounting period detailing the financing condition of the company at that date. Shareholder's funds represent the stake they have in the company back profits. modernization and expansion. It must however. including the reasons for raising the money are detailed in a prospectus and it is important that investors read this. to procure working capital. (ii) Public Issue Shares are offered to public. if read properly. however. Where does a company raise funds? What are the sources? Companies raise funds from its shareholders and by borrowing. and to fund its business.capital reserves and revenue reserves : (iii) Rights issues Fundamental Analysis Primer Companies may also (i) Capital issue shares to its The Directors report. be noted that the Balance Sheet details the financial position on a particular day and that the position can be materially different on the next day or the day after. Shareholders Funds BALANCE SHEET The Balance Sheet details the financial position of a company on a particular date. shareholders are contributing capital. As a consequence. the investment they have made. Sources of funds A company has to source funds to purchase fixed assets. profits not distributed as dividends. grouped logically under specific heads. issues have not been particularly and the capital revaluation reserve. This is issued in following ways: (i) Private Placement This is done by offering shares to selected individuals or institutions. With the utable to the shareholders. No monies are actually raised from shareholders. shares were often issued to investors at a price much lower than its real value.

this is inadequate and some companies create an additional reserve to ensure that there are sufficient funds to replace the worn out asset. at the end of its useful life. Land is the only fixed asset that is never depreciated as it normally appreciates in value. relatively easier and the rules that need to be complied with are much less. It is important that all the profits are not distributed as funds are required by companies to purchase new assets to replace existing ones for expansion and for working capital.e. vehicles. A manufacturing company's major fixed assets would be its factory and machinery. However. Consequently. The normal investments a company has are: (i) Trade Trade investments are shares or debentures of competitors that a company holds to have access to information on their growth. cost less depreciation. the company would have set aside from profits an amount equal to the original cost of the asset and this could be utilized to purchase another asset. that an asset has a useful life and that after years of toil it wears down.Which Company? pany and not distributed as dividends to shareholders. machinery. equipment and the like. in these inflationary times. INVESTMENTS Many companies purchase investments in the form of shares or debentures to earn income or to utilize cash surpluses profitably. etc. They are not for resale and comprises of land. it attempts to measure that wear and tear and to reduce the value of the asset accordingly so that at the end of its useful life. Consequently. whereas that of a shipping company would be its ships. In case a company is dissolved. i. the asset will have no value. Fundamental Analysis Primer The auditor represents shareholders and reports to them on the stewardship of the directors and whether the accounts presented to them give a true and fair view of the state of the company. As depreciation is a charge on profits. machinery. or by a floating charge on some or all of its assets.is not depreciated until it is a fully functional asset. The more common unsecured loans of a company are fixed deposits and short term loans. Borrowings or credits for working capital which fluctuate such as bank overdrafts and trade creditors are not normally classified as loan funds but as current liabilities. i. The common methods of depreciation are: (a) Straight line method The cost of the asset is written off equally over its life. The usual secured loans a company has are debentures and term loans. Fixed Assets Fixed assets are assets that a company owns for use in its business and to produce goods. at the end of its useful life. LOAN FUNDS The other source of funds a company has access to are borrowings. (b) Reducing balance Under this method depreciation is calculated on the written down value. buildings. furniture. warehouses and factories. Borrowing is often preferred by companies as it is quicker. An asset is never fully written off as the depreciation is always calculated on a reducing balance. unsecured lenders are usually paid after the secured lenders have been satisfied. The loans taken by companies are either : (a) Secured loans: These loans are taken by a company by pledging some of its assets. the cost will equal the accumulated depreciation. Consequently. Depreciation is based on the very sound concept Fundamental Analysis Primer Investors must read the auditor's report in details and in depth as the results can materially change if adjustments are made based on the notes or comments in the auditors report. . depreciation is higher in the beginning and lower as the years progress. prof- 72 The annual report The annual report 73 .e. (b) Unsecured loans Companies do not pledge any assets when they take unsecured loans. Every company has some fixed assets though the nature or kind of fixed assets vary from company to company. Fixed assets are shown in the Balance Sheet at cost less the accumulated depreciation. offices. The comfort a lender has is usually only the good name and credit worthiness of the company.factories being constructed. Capital work in progress . typically. (c) Others: There are a few others such as the interest method and the rate of 72 but these are not commonly used.

A) STOCK OR INVENTORIES These are arguably the most important current assets that a company has as it is by the Fundamental Analysis Primer sale of its stocks (ii) LIFO or last that a company The auditor represents shareholders and in last out makes its profits. Unquoted investments are not listed or quoted in a stock (b) Constant assets exchange. otherwise. was on account essentially into of the large profthree categories : its made by trading in shares. freely traded. such as liquor Current assets Stocks are valued at the lower of cost or net realizable value. It is The primary purchase which is uti. (c) Cash equivalents: They can be used to repay dues or purchase other assets.Which Company? itability and other details which may not. The common methods of valuing stocks are: (i) FIFO or first in first out It is assumed under this method that stocks that come in first would be sold first and those that come in last would be sold last. Most companies do not sell their 74 The annual report The annual report 75 . They will also comment on Current assets 31 March 1992 any action or method of accounting they can be divided do not agree with. (ii) Work in progress It is important to ascertain the Goods that are in the process of method of valuation and the manufacture but are yet to be com. The wind. Investments are valued and stated in the balance sheet at either the acquisition cost or market value. The reasoncompany makes.months is a curby many compa. Consequently. nies in the year to the results. bought by a liquor store from a liquor manufacturers. whichever is lower. Investments are also classified as (a) Converting assets quoted and unquoted investments. or debentures of The rule of Fundamental Analysis Primer other companies thumb is that any for investment or The Auditors in the Auditors report will asset that is comment on any changes made in to park surplus turned into cash funds.ciples and the effect of these changes on rent asset.purchased and sold without any add pose of. reports to them on the stewardship of The premise on Stocks. is the opposite (i) Raw materials of FIFO. be easily available. lated by changing the method of valuation. The most common cash equivalent assets are cash in hand and at the bank. The large business houses hold controlling interest in several companies through cross holdings in subsidiary and associate companies. such as finished goods and ognized stock exchange and can be debtors. and loans given. (iii) Finished goods The finished products manufactured by the company that are ready for B) TRADE DEBTORS sale. The current assets a company has are: Valuation of stocks Current assets are assets owned by a company which are used in the normal course of business or are generated by the company in the (iii) Others course of business such as debtors or Companies also often hold shares finished stock or cash. This is to ensure that there will be no loss at the time of sale as that would have been accounted for. ons or conversions. in turn.accounting principles and the effect of within twelve fall profits made these changes made in accounting prin.assumed that the goods that arrive lized to manufacture the products a last will be sold first. the directors and whether the accounts which this presented do present a true and fair view method is based consist of: of the company.ness. Assets that are produced or generQuoted investments are shares and ated in the normal course of busidebentures that are quoted in a rec. they are Constant assets are those that are not liquid and are difficult to dis. This is in order to be conservative and to ensure that losses are adequately accounted for. (ii) Subsidiary and associate companies These are shares held in subsidiary or associate companies. ing is that customers prefer newer materials or products.accounting principles involved as stock values can easily be manipupleted.

the provision is termed specific whereas if a provision amounting to a certain Fundamental Analysis Primer Financial statements of a company in an annual report consist of the balance sheet and the profit and loss account. The period of credit would vary from customer to customer and from the company to company and depends on the credit worthiness of the customer. Debts considered good. safes and balances in bank accounts are shown under this heading in the Balance Sheet. they must be provided for or written off. D) CASH AND BANK BALANCES Cash in hand in petty cash boxes. Other provisions normally ing on the demand for the item.dividends and taxation. CURRENT LIABILITIES Current liabilities are amounts due that are payable within the next twelve months. debtors and cash). If this is not done assets will be overstated to the extent of the bad debt. This is because they fluctuate and it is not possible to either prepay or accurately anticipate these expenses. the provision is termed general. Provisions may be specific or they may be general. loans. C) PREPAID EXPENSES All payments are not made when due. investments and current depreciation and provisions for Trade creditors assets (stocks. The portion of such expenses that relates to the next accounting period are shown as prepaid expenses in the Balance Sheet. However. such as claims that may be Companies usually purchase these payable. interest due on investments and the like. These also include provisions which are amounts set aside for an expense incurred for (C) PROVISIONS which the bill has not been received Provisions are amounts set aside from profits for as yet or whose Fundamental Analysis Primer estimated cost has not been The balance sheet details all the assets an expense or loss. Consequently. Assets are those that the com. These include claims receivable. These detail the financial health and performance of the company. rent and service costs. materials and services. Often customers may not pay within the agreed credit period. (D) SUNDRY CREDITORS Any other amounts due are usually (B) ACCRUED EXPENSES Certain expenses such as interest on clubbed under the all embracing title bank overdrafts. of sundry creditors. for which provisions are on credit . 6 months.the credit period depend. cars etc. This may be due to laxity in credit administration or the inability of the customers to pay. A write off is made only when there is no hope of recovery. others. are made in advance for a period of time which may be 3 months. etc.). This also includes amounts paid in advance for the supply of goods.the concerned asset itself. telephone costs.sions such as CREDITORS ings. 76 The annual report The annual report 77 . These include electricity and overtime are paid after they have been incurred. market conditions and competition. such as insurance premiums. When amounts are provided on certain identified debts. There are other articles used in the manufacture of its products.30 days or 60 days. individuals and employees and are repayable within a certain period of time. are those to whom Liabilities are those that the company bad debts are the company owe owes (trade creditors. F) OTHER CURRENT ASSETS Other current assets are all amounts due that are recoverable within the next twelve months. ket practice. the expense has been incurred. and Debts considered bad and doubtful If debts are likely to be bad. Otherwise. fully estimated. materials and pany (share capital and reserves).Certain provi( A ) T R A D E pany owns such as fixed assets (build. To recognize this the expense incurred is estimated based on past trends and known expenses incurred and accrued on the date of the Balance Sheet.Which Company? products for cash but on credit and purchasers are expected to pay for the goods they have bought within an agreed period of time . and liabilities a company has on a particular date. a provision is made. or even a year. percentage of all debts are made. and Others These are further subdivided into.) and deducted from monies for raw the shareholders investment in the com.made. Many payments. the sees on balance sheets are those for standing of the company and mar. E) LOANS AND ADVANCES These are loans that have been given to other corporations. debts are classified as: Those over six months.

(iii) Others: This includes costs that are not strictly administration or selling 79 78 The annual report The annual report . (iv) Interest Interest received on deposits made and loans given to corporate and other bodies. other income. six months. sales commissions. OPERATING AND OTHER EXPENSES All other costs incurred in running a company are called operating and other expenses. sales promotion expenses and other sales related expenses. However. (ii) Dividends Dividends earned from investments made by the company in the shares of other companies. A sale occurs when the ownership of goods and the consequent risk relating to these goods are passed to the customer in return for consideration. a year or longer. and include: (i)Selling expenses The cost of advertising. In such a case. bills discounted). In normal circumstances the physical possession of the goods is also transferred at the same time. and the result achieved by the company. It is preferable to deduct these from sales since the sales figures would then reflect the actual markup made by the company on its cost of production. municipal taxes. the performance appraisal not only of the company but also of its management . welfare expenses. from sources other than from the sale of their products or the provision of services. repairs. There are many companies which deduct excise duty and other levies from sales.Which Company? unclaimed dividends and dues payable to third parties. insurance. Companies do give trade discounts and other incentive discounts to customers to entice them to buy their products. (iii) Rent Rent received from commercial buildings and apartments leased from the company. These are usually clubbed together under the heading. SALES Sales is the amount received or receivable from customers arising from the sales of goods and the provision of services by a company. telephone and telex costs. would include wages. gratuity. The liability crystallizes on the happening of the event. usually cash. and other employee related expenditure. There are others who show this as an expense. OTHER INCOME Companies may also receive income Fundamental Analysis Primer The profit and loss account details numerically the activities the company had undertaken during the accounting period and the result of these activities (profit or loss). stationery. and all other expenses incurred to run a company. It is. It is also sometimes called the cost of goods sold. bonus. foresight and ability to lead. salaries. in effect. the ownership and risks are not transferred to the dealer nor any consideration paid. PROFIT AND LOSS ACCOUNT The Profit and Loss account summarizes the activities of a company during an accounting period which may be a month. It details the income earned by the company. EMPLOYMENT COSTS The costs of employment are accounted for under this head and Fundamental Analysis Primer Contingent liabilities are also detailed. A sale does not occur when a company places goods at the shop of a dealer with the clear understanding that payment need be made only after the goods are sold failing which they may be returned. motor maintenance. its cost and the resulting profit or loss. a quarter. cash discounts given for early payment are a finance expense and should be shown as an expense and not deducted from sales. MATERIALS Materials are the raw materials and other items used in the manufacture of a company's products. The more common items that appear under this title are: (i) Profit from the sale of assets Profit from the sale of investments or assets. (ii) Administration expenses Rent of offices and factories. electricity charges. Sales should be accounted for after deducting these discounts.its competence. These are liabilities that may arise on the happening of an event that may never arise (guarantees. contributions made to provident and other funds.

i. investors would be able to find out the reasons for the increase or decrease in sales and the products that are sales leaders. and much other useful information.e. It is uncertain.Which Company? expenses. however. manufacturing costs. TRANSFER TO RESERVES The transfer to reserves is the profit ploughed back into the company.a portion is often ploughed back into the company for its future growth and expansion. and other income and expenses. SCHEDULES The schedules detail pertinent information about the items of Balance Sheet and Profit & Loss Account. The final dividend is proposed at the annual general meeting of the company and paid after the approval of the shareholders. administration costs. This is why these are not provided for and shown as an actual liability in the balance sheet. It must be remembered however. Dividends paid during the year in anticipation of profits are known as interim dividends. whether the event itself may happen. TAXATION Most companies are taxed on the profits that they make. The final dividend is usually declared after the results for the period have been determined. expansion. It also details information about sales. CONTINGENT LIABILITIES Contingent liabilities are liabilities that may arise up on the happening of an event. Conversely. depending on the age of the fixed assets and the cost at which they have been bought. fixed assets or for some other purpose. This may be done to finance working capital. the reduction in the value of fixed assets on account of usage. The normal borrowings that a company pays interest on are: (i) Bank overdrafts (ii) Term loans taken for the purchase of machinery or construction of a factory (iii) Fixed deposits from the public (iv) Debentures (v) Intercorporate loans DEPRECIATION Depreciation represents the wear and tear incurred by the fixed assets of a company. The total profits after tax are not always distributed . The schedules enable an investor to determine which expenses increased and seek the reasons for this. Fundamental Analysis Primer The profit and loss account also details the dividend given (interim) and proposed. This information is vital for the analysis of financial statements. INTEREST AND FINANCE CHARGES A company has to pay interest on monies it borrows. losses on the sale of fixed assets or investments. income such as agricultural income are not taxable. The schedules even give details of stocks and sales. Similarly. particulars of capacity and productions. DIVIDENDS Dividends are profits distributed to shareholders. miscellaneous expenditure and the like. that taxes are payable on the taxable income or profit and this can differ dramatically from the accounting income or profit. Contingent liabilities are detailed in the Financial Statements as a note to inform the readers of possible future liabilities while arriving at an opinion about the company. This is because many amounts legitimately expensed may not be tax deductible. This is normally shown separately as it is a cost distinct from the normal costs incurred in running a business and would vary from company to company. Most people avoid reading these. The contingent liabilities one normally encounters are: a) Bills discounted with banks These may crystallize into active liabilities if the bills are dishonoured. interest. b) Gratuity to employees not provided for c) Legal suits against the company provided for d) Claims against a company not acknowledged or accepted e) Excise claims against the company SCHEDULES AND NOTES TO THE ACCOUNTS The schedules and notes to the accounts are an integral part of the financial statements of a company and it is important that they be read along with the financial statements. such as donations made. 81 80 The annual report The annual report . These are revenue reserves and can be distributed to shareholders as dividends. They do so at their own risk as these provide vital clues and information. This is also shown separately as the depreciation charge of similar companies in the same industry will differ.

The profit before tax that year (year ended 31 March 2004) was Rs. While such interest they give very important information was fully written off in the previous such as the accounting policies that the years. (d) Claims against the company not acknowledged as debts. Had the Company followed the earlier method of accounting the profit for the year would have been lower by Rs. (e) Claim for taxes. Consequently.35. adjustments may need to be made to the accounts to unearth the true results. Note 6 of Fundamental & Co.108.112. interest charges incurred dur. (f) How stock.76 lakh.132. The company had also withdrawn Rs. for the period upto the date from It is imperative that the schedules and which the assets have been put to notes to the accounts be read for a clearuse.46. It was also stated in that company's annual report that 83 82 The annual report The annual report . The more common contingent liabilities that one comes across in the financial statements of companies are: (a) Outstanding guarantees. The schedules detail pertinent informa"There has been a change in the tion about the items of the balance method of accounting relating to sheet and profit and loss account.12 crore is therefore higher by Rs. (c) How the gratuity liability is expensed.12 lakh (previous year Rs. Companies have also (b) What the research and developbeen known to change (normally ment costs are.46.63 crore towards interest capitalized. (b) Outstanding letters of credit.Which Company? NOTES The notes to the accounts are even more important than the schedules because it is here that very important information relating to the company is stated. might differ.0.88 lakh.34 from the revaluation reserve. (f) Cheques discounted. This means that by changing an accounting policy TISCO was able to increase its income by Rs." This suggests that the company had changed its accounting policy in order to increase its profits. (h) How has the foreign exchange translated? (b) Contingent liabilities As noted earlier. (e) How depreciation is calculated. raw materials and consumable goods are valued. Had this adjustment not been made.company has followed. the contingent ing the year have been capitalized liabilities of the companies and the like. (c) Outstanding bills discounted. Often as a consequence. increase) their profit by changing Fundamental Analysis Primer the accounting policies.4. er understanding of the company's Accordingly. the company and its results.51 crore than what it would have been had the previous basis been followed". interest on borrowings used for capThe notes are even more important as ital expenditure. Tata Iron and Steel found after the financial statements in Company's Annual Report for an annual report. ferred to capital account includes an amount of Rs. detailed in the notes relate to: As a consequence. contingent liabilities that might crystallize upon the happening of an uncertain event. (g) How investments are stated in the balance sheet. There could be similar notes on other items in the financial statements.80 lakh). the company would have suffered a loss of Rs. or will affect. Till the accounting year 2002-2003 such excesses over the original cost was credited to capital reserve. they detail all pertinent factors which affect.88 lakh being the excess of sale price over the original cost of the fixed assets. All contingent liabilities are detailed in the notes to the accounts and it would be wise to read these as they give valuable insights.112. Ltd. (g) Uncalled liability on partly paid shares and debentures. the profit earned (a) How sales are accounted.14 lakh to surplus on sale of assets (Schedule No. including finished goods. expenditure transfinancial condition.'s Annual Report for 20032004 stated: "The Company has during the year credited an amount of Rs. The profit before taxes for the year after the consequential adjustments of depreciation of Rs. Notes can effectively be divided into: (a) Accounting Policies (b) Contingent Liabilities and (c) Others (a) Accounting policies All companies follow certain accounting principles and these may The accounting policies normally differ from those of other entities.309.13) which included an amount of Rs. (d) How fixed assets are valued. work in progress. 1991-92 stated among other things. For Schedules and notes to the accounts are instance. (c ) Others It must be appreciated that the pur- pose of notes to the accounts is to inform the reader more fully.46 crore.

(e) Agreement with labour.41 lakh relating to prior years has been adjusted against the profits transferred to the General Reserve in the respective years".Which Company? "no provision had been made for Rs. RATIOS CHAPTER SEVEN 84 The annual report Ratios 85 .39 lakh being the fall in the breakup value of unquoted shares in wholly owned subsidiary companies" and "the income tax liability amounting to Rs. Similar comments are made in the notes to the accounts of other companies also. It is imperative that investors read these carefully. The more common notes one comes across are: (a) Whether provisions for known or likely losses have been made.36. The importance of these notes cannot be overstressed. (d) Arrangements agreed by the company with third parties. The latter points out that the tax change had been adjusted directly with reserves as opposed to routing it through the Profit and Loss account.16. Had that been done the profit after tax would have further reduced. (c) Interest not provided for. (b) Estimated value of contracts outstanding.

Otherwise. (a) Market value (b) Earnings (c) Profitability 86 Ratios Ratios 87 . one ratio at it will not give the one may be confronted by a battery whole picture but just one aspect. In this book. Cost of goods sold to creditors. This can be difficult at times because: N is only when the various different ratios are calculated and arranged that the complete state of a company emerges and it is important that an investor has as much information as possible before he actually invests. tionship between performance figures financial fig2. no increased or analyzing the financial statements of a useful conclusion reduced borrow. 4. Book value 4. Sales of Rs. It o person should invest in a company until he has analyzed its financial statements and compared its performance to what it achieved in the previous years. results with that of earlier years. to earnings and sales and 2. Ratios can be broken down into four broad categories: (A) Profit and Loss Ratios These show the relationship between two items or groups of (D) Financial Statements and items in a profit and loss account or Market Ratios income statement. Shareholders equity to borrowed funds. ing sales as a perIt is in the centage of trade analysis of financial statements that ratios are most creditors or investments is meaninguseful because they help an investor less as there is no commonality to compare the strengths. Net income to assets employed. Earnings to shareholder's funds.between the figures. It Fundamental Analysis Primer l o g i c a l . 2. Selling expenses and/or assets/liabilities in a form that ures to market prices: to sales. sales. 3. ratios have been grouped into eight categories that will enable an investor to easily determine the strengths or weaknesses of a company. can be easily understood and 1. The more com.No single ratio tells the complete ance figures and/or assets/liabilities story in a form that can be easily under. itability or financial strength. Liabilities to net worth. (C) Balance Sheet and Profit and Loss Account Ratios. A ratio expressings. Net profit to interpreted. weakness. such as the company's assets or net worth or be different. may have issued shares.indicates the mark up on cost or the margin earned. 3. 4. It is also imporbalance sheet may have changed tant to focus on ratios that are meaningful and significantly. (B) Balance Sheet Ratios These deal with the relationship in the balance sheet such as : 1. Gross profit to to market value. or No investment should be made without Otherwise.These are normally known as market ratios and mon of these ratios Fundamental Analysis Primer are arrived at are: relation 1. On the other es and performance of companies hand. and with that of other companies. Current assets to current liabilities. a ratio that expresses the and to also determine whether it is gross profit as a percentage of sales improving or deteriorating in prof. Sales to stock. Sales to debtors and 5. Sales to cost of Ratios express mathematically the rela. 2. Liabilities to assets. (b) The composition of a company's capital employed. Market value 3.by goods sold.200 crores in a year may appear impressive but one cannot be impressed until this is com(a) The size of the companies may pared with other figures.Which Company? of figures that are difficult to draw meaningful conclusions from. These relate an item on the balance sheet to another in the profit and loss account such as: 1.There is no point in computing just stood and interpreted.500 crores a year or a profit of Rs. It should be noted that figures by themselves do not enable one to arrive at a conclusion about a company's strength or performance. Debt to assets and 5.company and comparing the company's can be arrived at. Ratios express mathematically the relationship between perform.

as Baron Rothschild is credited to have said. "Buy sheep and sell deer".10 each Reserves 50 10 that year after tax and preference dividend was Rs. They suggest possibilities. fall or remain stagnant. On the other hand. Samudra Lamps Ltd. Investors must examine these possibilities along with general factors that would affect the company such as its management. It will fall as soon as this confidence in the earning capacity of the company falls. The price an investor pays for a share is based on the future prospects of a company and its 70 130 Price-Earnings Ratio A. whether the company is growing (Rs. in his perception.10 each 100. its shareholders' funds were as follows : The profit that the company made 88 Ratios Ratios 89 . This also translates to a yield of 7. 2003.112. The earnings per share would be 400\50 = Rs. and whether the price is likely to rise. In periods of depression. Investors. it reflects the opinion of the investing public about the company.14 This means that the investor would take 14 years to recover his investment through earnings. profit after tax and preference dividend divided. The P/E ratios of well established and financially sound companies are high and as the returns are high for weaker companies the P/E ratio is low since they are riskier investments. sell dear or.8 The price earnings ratio would be 112\8 = Rs. management policy. the cardinal rule of investment in shares is to buy cheap. otherwise the conclusions will be incorrect. The market price of the share on 31 December 2003 was Rs. i. Ratios do not provide answers. The reason for its popularity is that it reduces to an arithmetical figure the relationship between market price and the earnings per share and thereby allows one the opportunity to determine whether a share is overpriced or underpriced and Price Earnings Ratio Market Price per share Earnings per share Ultimately the market value of a share is what matters to an investor. if a share is priced high an investor would want to sell it.e. analysts and advisers alike quote this ratio to justify or support their contention. In addition. government policy.000 10% preference shares of Rs. This is why prices rise dramatically in boom periods. or reasonable and has growth potential. it must be ensured that the ratios being measured are consistent and valid.000 shares of Rs. check the time it would take to recover one's investment. At 31 December. the state of the economy and the industry to arrive at a logical conclusion and he must act on such conclusions. The length of the periods being compared should be similar.14% (100/14 years). lakh) 500.400 lakh. they fall. Market value ratios also help an investor determine the length of time it would take to recover his or her investment. Of course. the market value of a share reflects the regard investors and the general public have of the company. its price is low or declining. i. Large non-recurring income or expenditure should be omitted when calculating ratios calculated for earnings or profitability.Which Company? (d) Liquidity (e) Leverage (f) Debt Service Capacity (g) Asset Management/Efficiency (h) Margins. Ratios are a terrific tool for interpreting financial statements but their usefulness depends entirely on their logical and intelligent interpretation. Additionally. After all. by the number of shares issued by the company.e. An investor would purchase a share if. The P/E ratio would be high so long as the investing public has faith in a company's ability to grow and to earn a return or an appreciation in its share price. The P/E ratio is calculated by dividing the market price of a company's share by its earning's per share. MARKET VALUE The Price-Earnings or P/E ratio is arguably the most commonly quoted ratio. is a company involved in the manufacture of electric bulbs and tubelights.

etc. As such. Certain companies such as ITC. the P/E that different investors would be prepared to accept as reasonable would depend on: (a) The company and their perception of its management. On that basis. In a potential of the Fundamental Analysis Primer country like company. In my opinion.12. As companies mature. (d) The target returns of the different investors. Prices in the market (it must always be remembered) is based on perception. Infosys etc. the current about 2% above the rate of inflamarket price should be divided by tion. at the height of the 1992 scam in this juncture. on the other hand.5% above agement and the confidence the rate of inflation. (b) The demand for the shares of the company. interest rates may well ask (a) Profit and Loss Ratios have begun what should be (b) Balance Sheet Ratios the P/E ratio of a (c) Balance Sheet and Profit and Loss Ratios. That may be. stock markets. In short. the book value is more than the market value.offered a yield of 5% which was ings per share. (c) The profitability and earnings of a company. I'd like to introduce. aged 80. If.. then the P/E of shares one wishes to purchase should be 8. have rewarded their investors well over the years and these shares command higher P/Es. Reliance. They claim that P/Es the average P/E was around 37.. If a share's market price is treble or quadruple its book value. The basis was on perceived earnings projected earnings and potential earnings not actual earnings. The market to book ratio is calculated by dividing the market price per share by the book value per share. The They argue that the average P/E of average P/E of companies quoted on shares in developing economies. cult to get.This would result in a yield of tion of the company and its man.5% which would be 2. the company may not be making profits and may not be enjoying investor confidence. One should think twice before purchasing a share that has a higher P/E. at (d)Financial Statements to Market Ratios. growth. Having said that. the P/E that is considered reasonable by different investors will be the one that fulfills their particular investment return requirement. ITC developing economy proponents. It was argued that earnings will stabilize and the P/Es the average P/E of shares in devel.around 10%.Which Company? anticipated earnings. though. The pricing of shares as far as P/E is concerned lost all meanings in 1999 with Information Technology Shares. if the market price Market to book Ratio Market price per share Book value per share 90 Ratios Ratios 91 . there oped economies like the United is a flaw in P/E ratios when current States was then around 20. As inflation investors have in the earnings falls. At P/E be now. it signifies that investors have tremendous confidence in the growth prospects of the company. This market price is divided by past earn. the P/E will rise and the yield will fall. the P/E of several companies promoted by those I term the the such as Hindustan Lever Ltd. But then that figure is diffi. W h a t what price should the should one purchase the share of a company. were in excess of 100. i. I feel that in India it would be safer for investors to buy shares of companies that have a relatively lower P/E (between 11 and 13). Market to Book Ratio The market to book ratio compares the book value of the assets of a company to its market value. Companies such as Amazon. For example. An investor Ratios can be broken into 4 broad categories: India. prospects. Ideally.com and many others that were loss making were quoting at P/E ratios that made no sense. In such a situation one's guess or price was good as the others. company. The P/E ratio reflects the reputa.in countries in South East Asia. a school of thought India. if one assumes the current likely earnings per that the rate of inflation in India is share. Even a year after the scam average 45.fall. have to be higher in developing This was one of the widely-cited economies as companies are growreasons for foreign investors not ing and the high P/Es reflect this descending in droves on the Indian growth. Ltd. and the industry it operates in.e the Bombay Stock Exchange aver. It can also suggest that the assets may be understated. & to fall dramatically.

what because the gap is enormous and investors earn on their investments.1875. there could be a Earnings per Share illustration big fall in the price. earnings.00 131.company. SAIL Tata Motors TISCO Book Value as on 31/03/2003 59. ONGC Reliance Industries Ltd.20 406.45 855.80 431. the difference would not be backed The earnings ratios are often used by tangible assets.20 4. This sug.10 each outstanding.45 170.20 150. If one remembers. the earnings after tax of Range View Tea Estates was ket and book value in a Rs. as technical market to book ratio is 105/48 = analysts would vouch.48.000 x 0.00 949.80 216.80 75.30 55.5 + (300. that the market price of a share takes into 2. Between 1 January 2003 and 30 June 2003 the few companies.20 345.35 743. value and profitability. Let me illustrate the differences between mar. As a rule of thumb. is Rs. one should B) EARNINGS not purchase a share which is priced Earnings is the yardstick by which more than thrice its book value companies are finally judged.000 x 0.50 1205.50 of the shares of Mithawala are extremely important because Chemicals Ltd.50 1197.30 86.60 241.80 78.25 623.15 348. it will grow in income.2 The market value ratios 93 92 Ratios Ratios .00 368. There company had 200.70 217. On are large differences 1 July 2003.000 (200.60 113.20 24.80 249. 2003 219. Summary 500.as the only company are understated or its ratios that evaluate the price of a share for an prospects investor to are good Earnings Per Share determine and that Income attributable to common shareholders whether it is investors Weighted average number of common shares underpriced believe that or overpriced.000 shares.25 4928.15 320.00 61.80 141. the company issued an additional 100. its sion. of Mithawala Chemicals is more prospects and all other aspects of a than twice its book value.50 Market Value as on 27th November. between the market value and the book The earnings per share of Range View would be : value.75 573.105 and the these determine an investment decibook value of its shares is Rs.000.70 179.95 300. The market value of the shares account the profitability.Which Company? Market to book value of certain selected companies Name of the Company ACC Aurobindo Pharma Bajaj Auto Bharat Forge Bharti Televentures Cipla GAIL GE Shipping Hindalco HPCL HLL IOC ITC Infosys Technologies I-Flex Solutions M&M Mphasis BFL MTNL Nirma Ltd.5) = Rs.10 81.20 42. As a conse.55 353.5.to determine the fair market price of quence.80 16.10 177.In 2003.00.50 196.60 115.65 603.00 669.000 shares of Rs.45 179.90 560.60 476. market ratios go on to gests that either the assets of the another dimension .25 370.90 219.

capital appreciation. investors check a compaEarnings per share ny's fully diluted earnings per share. a dividend of 5 per cent would be adequate.3. share in a year.40 has appreciated during the last three years by an average percentage of 25. The cash earnings per share will always be more than the Dividend per Share illustration earnings per share. The M a n y Cash Earnings Per Share r a t i o i s investors arrived at also value a EDBIT by dividing share as a Weighted average number of shares issued the income multiple of Cash Earnings per Share illustration The summarized Profit and Loss Account (Income Statement) of Nikhila Chips Ltd. If an investor is aiming at a yield of 30 per cent.20. for the year ended 31 December 2003 was as follows: Rs.50 (dividend) x 100 = Rs. a high dividend yield would be expected.On this basis the shares of Divya Jeans is overpriced. cies of a company.000 shares of Rs.1. the argument goes on. If the shares of PDP have been Dividend per share 300 200 *Administration expenses includes interest costs of Rs. This ratio enables warrants and convertible securities investors to actually quantify the outstanding at the end of the income earned by a share. The company had issued 500. Conversely. i. If the share has regularly appreciated by 30% every year. The true earnings. priced. income of an investor is the dividend that he receives. a low dividend yield would be acceptable. The cash earning per share is arrived at by dividing earning before depreciation.e. attributable to common shareholders by the weighted average of common shares.30 5 (return required) share is of no real value to anyone but those who can determine the poli. its market value on the basis of dividend per share would be (assuming 15% dividend on the face value = 5% on the market value) as follows: 94 Ratios Ratios 95 . As a consequence. would therefore be : 1500 + 40 + 20 = Rs. interest and tax. the share is priced at Rs. (lakh) 5000 3000 2000 500 1500 the earnings of the company. Proponents of this school of thought argue that the earning per Rs. The earnings per share (EPS) ratio This is the earnings per share of a indicates the earning of a common company after all share options. and dividend income per share. and to accounting period are exchanged determine whether it is reasonably for shares. (lakh) Sales Cost of Goods Sold Gross Income Selling Costs *Administration Cost Net Income Rs. interest and tax (EDBIT) by the weighted average number of shares issued.12 500 Investors often use the dividend per share as a measure to determine the real value of a share. The The shares of Divya Jeans Ltd.10 each. the price would depend on the capital appreciation one expects. In countries including India where employees are given stock options. If the earning per share is Rs.5 and a yield of 10% is considered reasonable. It is therefore submitted that the value of a share should be a multiple of the dividend paid on that share.. which has a market value of Rs. these are the most important ratios for investors and it is important that they be appreciated and understood. In such a scenario if Divya Jeans has paid a dividend of 15%.Which Company? a share and to value investments. should be calculated on the earning before depreciation. How does one value a share? If one assumes that the gains made by an investor would include an increase in the price of the share. The cash earning of a share in Nikhila Chips Ltd. if a share does not appreciate by more than 5% and a 30% return is required. Cash earnings per share It is often argued that the earnings per share is not a proper measure of the earning of a company since depreciation. tax and the cost of finance varies from one company to another.50.40 and depreciation of Rs.

While calculating and evaluating a company's profitability. since profits are earned not on a particular date but over a year. on the other hand. The company distributed 41. an investor can evaluate the management's effectiveness on the basis of the returns generated on sales and investments.28 lakh. valuation is so ridden with assumpNormally. With the help of these ratios. Return on Total Assets Net Income After Tax NAverage Total Asset 96 Ratios Ratios 97 .412. ratios calculated on average assets and liabilities would portray a truer indication of the results achieved by a company. especially the earnings per share and the dividend payout. growth and replacement of assets.'s earnings after tax in the year ended 31 March 2004 was Rs. Mature companies. it cannot grow. It is critical that investors examine these ratios.Which Company? when assessing a company's prospects because if all its income is distributed there would be no internal generation of capital available to finance expansion and to nullify the ravages of inflation and to achieve these the company would 3 (dividend per share) x100 =Rs. their profits for growth. it paid a dividend of Rs. Profitability ratios assist an investor in determining how well a particular company is doing vis-àvis other companies within the same industry. This is an important ratio of assets.8% in the business for its growth. There can be large variations in these figures during the year which can distort results quite materially. If the dividend payout ratios are very high investors must be concerned as it can indicate that the management of the company is not particularly committed to its long-term growth and prospects. The investor should bear in mind the rate of inflation and the cost of capital and borrowings.3 per share the real value of the share would be (30% dividend will be construed as a yield of 23%). aggressive growth comt i o n s Dividend Payout Ratio (appreciapanies have low dividend tion every Dividend year and payout ratios Net Income After Tax expected as they plough back return) that it is rarely used. They advise an investor on the earnings made per share. Summary It is important to remember that earnings ratios are not indicators of profitability. and with reference to its own performance in earlier years. Its dividend payout ratio would be 28/68 = 0. C. PROFITABILITY The profitability of a company is of prime importance for an investor. 23 (return required) This ratio is calculated by dividing the dividend by net income after It must be noted that this method of tax.68 lakh. have Dividend payout ratio high payouts. it cannot pay dividends. Moreover.13 have to borrow. The earnings per share would help one determine whether the market price of a share is reasonable. the dividend policy of a company. an investor must bear the following in mind: As far as possible ratios must be calculated on average assets and liabilities and not on the assets or liabilities on a particular date. Dividend payout Ratio illustration Excel Railings Ltd. Investors paid out of earnings. young. appreciating at 7% per annum and the company declares a dividend of 30% or Rs. This ratio must also ensure that the dividend is enables an investor to determine being paid out of current income how much of the annual earnings is and not out of retained earnings paid out as dividend to shareholders because that tantamounts to eating and how much is ploughed back into the funding set aside for into the company for its long-term growth. This is of concern as The dividend payout ratio measures they may not be retaining capital to the quantum or amount of dividend renew assets or grow. Unless a company is profitable. and the extent of income ploughed back into the company for its expansion. its value will not increase and it cannot survive in the long run. retaining 58. Companies have also been known to windowdress their balance sheets by either reducing or increasing assets or liabilities. expansion and replacement growth. Of this.2% of its net income as dividends.

reserves 0.67 2002 -------------------------------0. and with previdetermine: ous years.(lakh) Rs.67% 0.000 12.200 10000 income on which this ratio is calculated should The return on total assets are as follows: exclude dividends on 1000 . ratios should be considered as an indication or as a suggestion of future development. Return on Total Assets illustration Nair Limited is a company engaged in the manufacture of refrigerators and washing machines. Finally. This is an extremely important indi.57% Shareholders' equity is 2002 0. pared with other alternatives taking into account the risks of the invest.5 x (10000 + 12200) and retained earnings. Income before tax 400 1700 It is to be noted that the 300 ----------income figure should not ----------------Extra ordinary Items include extraordinary.e. In addition. Whether the company's assets have been effectively and efficiently Return on equity used. The ROE should be com.Pre-interest return on assets ment. And whether the return has kept pace with the rate of inflation. It must be remembered The ROE has improved in 2003. The normal rule is: the higher It is often said that the pre-interest return on assets is a purer measure Pre-Interest Return on Assets I of profitability since it is difficult to compare the post-tax performance Earning Before Interest and Tax of companies on account of interest Average Total Asset and taxation.5 x (7000 + 11000) The first ratio one Although net income has improved by 50%. The investor would however that if there are other need to determine whether this is the best return that he could have got i. -------------------------------------. This return is In 2003.e. and Another important measure of profWhether the cost of the compa.5 x (10000 + 11000) the stake ordinary share1200 holders have in a compa-------------------------------------.200) preferenceshares.whether the return earned is as Return on Equity Net Income After Tax-Dividend on preference shares D Average Shareholders Equity Return on total assets good as often alternatives Return on Equity illustration available.5 x (5000 + 7000) 2003 600 -------------------------------. the higher the risk. This is because the 99 98 Ratios Ratios . i. the published results of Homedale Limited calculated by expressing included the following income.34% 2003 ny and includes. It could also be used to Whether the company has earned project the performance of future a reasonable return on its sales years. an investor should consider whether a better return would have been received elsewhere. as a percentage Rs. could have earned more if he had investments that earn a invested his money elsewhere.(300 . The purThis ratio should be used to pose of this ratio is to determine compare the performance of a com.the return.(lakh) Rs. the company's profitability has not improved since its average assets have should check is the also increased by 50%.itability is the return on equity. higher return with lower risks then the profitability is low.pany with other companies within cator as it would help the investor the same industry.(lakh) Net income after tax 300 400 600 Total Assets 5000 7000 11000 The return on total assets are as follows: 400 = 6.(lakh) Rs. or ny's borrowings are too high ROE as it is often termed. 1400 1700 unusual or non recurring Taxation 400 500 items as that would disIncome after taxation 1000 1200 tort the results arrived at.(lakh) Rs. 2001 2002 2003 Rs.Which Company? When evaluating a profitability ratio.= 10.= 6.(lakh) of share holder's equity. the net profit 2001 2002 2003 after tax. the net Shareholder's Equity 11.= 8. return on total assets.

to determine whether the return earned is high or low Pre-interest after tax return of assets Pre-interest after tax return on tax is as follows: 2002 600 + 200 x 50 \ 100 ------------------------------0.1/2% 0.75%.00% in 2003. Bhagwan Ltd.(lakh) Rs. the tax liability of companies differs and depends on the manner in which it has planned its tax. Similarly. Invested capital in this ratio includes all liabilities that have a Pre-Interest After Tax Return on Assets I Net Income After Tax + Interest Expense Net of Income Tax Saving Average Total Assets Return on Total Invested Capital Earnings Before Interest and Tax Average Total Invested Capital 100 Ratios Ratios 101 . The ratio is arrived at by expressing net return after tax but exclusive of interest as a percentage of average total assets. This ratio therefore suggests that the return should be based on operating income and is arrived at by dividing earnings before interest and tax by the average total assets.5 x (1000 + 1400) Pre-interest after Tax return on asset Ratio illustration An extract of the financials of Bhagwan Ltd. By using this ratio. earned a return on assets prior to the cost of financing of 8.00% In 2002.(crore) Earnings before interest & tax Interest expense Pretax income Tax at 50% Net income after tax Total assets 2002 Rs. however.Which Company? Pre-interest return on asset s illustration Nair Limited is a company engaged in the manufacture of refrigerators and washing machines. However while comparing other companies one should compare the return and determine whether the return is adequate (considering the size and the nature of the company) Return on total invested capital The ratio used for determining whether the capital available to a company has been efficiently used is the return on total invested capital. 2002 2003 Rs.75% The purpose of calculating this ratio is to determine the management's performance in deploying assets effectively without financing. is as follows: 2001 Rs. 2003 = 10. It therefore gives him an opportunity to compare returns from alternative companies.(crore) 800 200 600 300 300 9000 2003 Rs. an investor can check whether he could have earned more elsewhere.(lakh) Earnings before interest & tax 250 300 Total Assets 1000 1400 Pre-interest return on assets would be: 300 ------------------------------x 100 = 12. suggesting that the assets had been used more effectively in 2003. Tax is included in the calculation as it is deducted before arriving at the profits. is not considered as it will vary from company to company and is a payment for capital or funds. Interest. An investor must compare the return earned by a company with that of other companies.5 (7000 + 9000) 800 + 400 x 50 \ 100 ------------------------------0. This improved to 10.5 (9000 + 11000) = 8.(crore) 1200 400 800 400 400 11000 7000 interest paid will vary from company to company and will depend on its borrowings. preferably in the same industry.

(crore) 120 500 85 705 400 11000 The return on total invested capital is: 18. These ratios should not be seen in isolation. In order to increase sales and profits companies may sell goods at lower prices in volume driven businesses.2. D) LIQUIDITY Liquidity is one of the cornerstones of any investment. Its purpose is to check whether a company's current assets are enough to meet its immediate liabilities.58 0. Consequently.400 crore whereas its current liabilities were Rs. the most important of all ratios for an investor as they indicate whether an enterprise is viable. The ratio is arrived at by dividing a company's earnings before interest and tax by average total invested capital. these ratios are indicators and they should be considered as such.e. After the securities scam in 1992. such as debentures. Spear Canisters Ltd's current assets were Rs. This in itself is not bad. it is important for a company to be liquid in order for it to meet its maturing financial obligations and to have enough funds to meet its operational requirements.x 100 = 2. Spear Canisters Ltd. i. Like all ratios. there is an effort to keep current assets low. it may be forced to sell its more important assets at a loss and. The ratio is arrived at by dividing current assets by current liabilities Normally. the opportunity cost of tying up capital.(crore) 150 500 80 730 300 9000 2003 Rs. In the first quarter of 2000 when the values of Information Technology shares plummeted there was fear that prices would fall further as mutual funds sold shares to meet redempCurrent Ratio Current Assets Current Liabilities tions of their units. If the rate of interest is higher then the return on the capital should be considered inadequate. all companies are aware of the cost of capital. Similarly. It is important that investments be liquid so that they can be converted to cash easily to meet obligations. It can do so by selling a mere 31. share capital and loans. often the current ratio is well Current Ratio illustration At 31 March 2003. those that mature within one year. Mr. An investor must check whether the return on capital is higher than the prevailing rate of interest and the weighted average cost of borrowings.18. in extreme cases. and better or worse than other similar ones. the opportunity cost of tying up capital unproductively. debtors or cash. be it stock levels.5 x (730 + 705) cost associated with them. Its current ratio is 16:5 or 3. many mutual funds were forced to sell their blue chip shares to generate liquidity as they were not able to sell their large holdings of securities of public sector undertakings (PSUs). One should remember that a lower ratio is not necessarily bad.50 -----------------------------.25% of its current assets Summary The profitability ratios are arguably 102 Ratios Ratios 103 . Thus. can easily meet its current liabilities.50 crores. In short. be forced into liquidation. Its total invested capital in 2002 and 2003 were as follows: 2002 Term loan Debentures Shareholders' funds Total invested capital Net income after tax Total assets Rs. and just in time (JIT) inventory control. Damodaran after taking charge orchestrated a sale of the more marketable securities to book profits and to be liquid to meet redemption demands. If a company is unable to do so. When the UTI went through its troubles. Current Ratio The current ratio is the most commonly used ratio to measure liquidity.125 crore.Which Company? Return on Total Invested Capital illustration Bombay Pistons Ltd's earnings before interest and tax in 2003 was Rs. the current ratio is around 1 or even a little below 1. Today.

104 Ratios Ratios 105 . if one wishes to sell these in a hurry there is likely to be a loss arising out of dumping of goods. Net current assets is really the working capital of a company. The company can therefore grow quite rapidly. it could merely be using its assets effectively. It is to lents to meet its current obligations be noted that investments.2. Samudra Fisheries thus had net current assets of Rs. Net current assets can also be used as a base to determine the quantum of working capital required to support a certain level of sales. In this context.Which Company? below 1. This does not necessarily mean that the company is not liquid. In the example of Sumudra Debtors Turnover Average Debtors X 365 Sales Net Current Assets Illustration In 2003. strictly not a current asset. net current assets would also need to increase proportionately. such as its relationship to sales. This is clearly not a ratio.debtors by current liabilities.450 lakh left after meeting its current obligations.450 lakh. several derivatives can be calculated from this figure. (lakh) 150 1850 3100 500 5600 4000 Net Current Assets Net current assets or net working investments is arrived at by deducting current liabilities from current working assets (trade assets). Consequently. This is there usually is no conversion cost because they are easily realisable when cash or cash equivalents are Quick Ratio illustration An extract of Nivya Ltd's financial statement at 31 March 2003 was as follows: Cash at Bank Debtors Stocks Investments Current Assets Current liabilities The quick ratio will be : Rs.000 lakh. favorite of This ratio is Quick Ratio investors and crediarrived at by Cash & Cash Equivalents tors. used to pay debts. In other words. This means it had Rs.lakh) 310 390 700 220 5 25 250 450 150 + 1850 + 500 -----------------------------. income and even to capital. Its usefulness lies in quickly ascertaining whether a company has adequate current assets to meet its current liabilities. This ratio is dividing cash. as explained above. Its net current assets were: 2002 (Rs. It should be remembered that stocks have not been considered in calculating this ratio as it is not a cash equivalent and. is used in The underlying logic being that calculating this ratio.= 0. company could lose when Quick or Acid Test converting these to cash in an emerThe acid test is a gency.625 4000 The company cannot pay off its entire current liabilities with cash or cash equivalents. Current Liabilities used to check marketable whether a compainvestments and ny has enough cash or cash equiva.lakh) CURRENT ASSETS Debtors Total current assets CURRENT LIABILITIES Creditors Accrued expenses Tax payable Tax current liabilities Net current assets 280 320 600 190 3 7 200 400 2003 (Rs. Samudra Fisheries had a sales turnover of Rs. though or liabilities. A ratio of 20% could suggest that if sales were to increase by 20%. it is better to have a low ratio as the increase in working capital needed will be less. Other assets such as inventories (stocks) may realise less than book value if sold at a distress.

if sales were to increase by Rs. An increase in creditors turnover could also suggest that the company has difficulty in making payments. A fall in debtors could suggest a fall in credit sales or improved debt Net Trade Cycle Debtors Turnover + Stock turnover Sales — Creditors turnover Net Trade Cycle Illustration Vindhya Bearings Ltd's financials included the following figures: 2002 Rs. it can also indicate that the company is experiencing difficulty in paying its creditors. Thus. It can be likened to a worker on strike. it indi- much as possible.2000 lakh. working capital would need to necessarily increase by Rs. Investors should apart from checking whether there is an improvement in the cycle. net current assets were Rs.Which Company? Fisheries. This is a very useful tool for determining a company's liquidity and is computed by adding the debtors turnover in days to the stock turnover in days. How many days can he survive on the assets that he has before he becomes bankrupt? The defensive interval ratio is calculated by dividing a company's 39 Days 73 Days Current Liability Coverage Cash Inflow From Operations Average Current Liabilities 106 Ratios Ratios 107 .450 lakh and sales Rs. Its net current assets to sales will be: 0.5 x (400 + 450) x 100 = 21.5 x (24 + 44) = 280 0.5 x (36 + 48) x 365 = 224 0. and deducting from it the creditors turnover in days.1 crore.25% 2000 Creditors Turnover Average Creditors X 365 Sales This means that working capital should increase by 21. It must be remembered that the longer the cycle.(crores) 200 160 24 36 0.5 x (16 + 32) x 365 = 224 2003 Rs.(crores) 280 224 44 48 44 Days 68 Days Defensive Ratio Average Daily Cash operating Expenses Most liquid Assets cates an improvement in the management of net current working assets. check the individual components. The reason must be looked into. the greater the need for financing. SALES Cost of goods sold Debtors Stocks THE NET TRADE CYCLE IS: Debtor turnover Stock turnover Less Creditor turnover Net trade cycle (days) Defensive Interval This ratio indicates the number of days a company can remain in business without any additional financing or sales. Of course.21. This can be achieved by reducing debtors and stock levels.25 lakh. Stock Turnover Average Stocks X 365 Sales Net Trade Cycle It is important to determine the time a company takes to realize its sales proceeds after paying for the purchase of its raw materials. Thus one must go beyond the figures to determine the reasons for a change in the net trade cycle. The net trade cycle should therefore be brought down as collection. If this ratio improves.25% to support every increase in sales.

then sales and has snowballing effect. they begin to postpone and delay paying their bills.44 years. the figures should be properly scrutinized.2350 lakh The current liability coverage is: 750 + 25 0.730 crore and were as follows: CASH Marketable securities ITS DAILY OPERATING EXPENSES WOULD BE : 730 365 ITS DEFENSIVE INTERVAL WOULD BE 180 2 90 days Rs.1450 lakh and Rs. Finally.4 In other words.Which Company? Defensive Ratio illustration The cash and cash equivalents of General Balls Ltd. a company whose annual operating expenses were Rs. cash flow from operations was only 41% of current liabilities. Summary This means that General Balls Ltd. The optimal liquidity required varies from company to company and from industry to industry. It should also be ascertained whether they are at current realisable value. Debtors and stocks are not to be considered as they are not cash equivalents. negative liquidity ratios need not necessarily be bad. Historically. Current Liability Coverage illustration In the year ended March 2003. However. companies have very high liquidity ratios. Current liabilities begin to build up. Therefore. an investor should be concerned.750 lakh. Therefore if the liquidity ratios of a company are deteriorating. Bharat Bolts Ltd. 180 Rs.2 crore Current Liability Coverage The current liability coverage ratio enables investors to examine the relationship between cash inflows from operations and current liabilities.(crore) 35 145 Rs. As companies begin to have financial difficulties. improving in 109 108 Ratios Ratios . Moreover. the investor must check whether a company is adequately liquid and whether its liquidity position has deteriorated or improved. At times of creative accounting and cash crunches this is an extremely important ratio. While viewing liquidity ratios.25 lakh. So good liquidity is also not always wonderful. It depends both on market conditions and the prominence of a company. Current liabilities at 31 March 2002 and 31 March 2003 were Rs. Depreciation was Rs. Current liabilities decrease as creditors are paid off. As current liabilities build up. Liquidity is becoming increasingly important for companies and this factor alone has resulted in companies becoming sick .5(1450 + 2350) = 0. can remain in existence for 90 days without any sales or financing. earned a net income before tax but after depreciation of Rs. it must be remembered that balance sheets can be windowdressed. An investor should always check the quality of a company's current assets. especially those that operate with extremely low margins. average daily cash operating expenses by its most liquid assets. This is because fixed assets and stocks are sold and gets converted into cash. If current liabilities were to be paid out of internally generated funds it would take 2. It is important to note that only the most liquid of assets are used in calculating this ratio. and to determine whether the company can meet its currently maturing obligations from internally generated funds. such as cash and cash equivalents. This first affects production. If it as deteriorated and there does not seem a likelihood of it.an inadequacy of funds to finance operations. Many strong companies keep low current assets and are able to get long credit from suppliers. suppliers become more and more reluctant to sell goods. current assets should not include deferred revenue expenditure like advertising costs as they do not have any encashable value. It is crucial that investors examine the liquidity of a company. and whether it is improving or deteriorating.

At such times. whereas Company C makes a comparatively modest 50%.a. that though companies with very little or no borrowings are safer and can be depended upon for some returns both in good years and bad. E) LEVERAGE Leverage indicates the extent to which a company is dependent on borrowed funds to finance its business.00 60 32 28 14 14 Company B (Rs.00 25. Income after tax Return to ordinary shareholders : Before tax (%) After tax (%) 70.75 60 8 52 26 26 Company C (Rs. Income before tax Tax @ 50% p. the cost of borrowings often exceed the profits made and results in losses and the company that makes the highest profits is the one that has no borrowings.50 16. the profits of highly leveraged companies would be more than companies that do not borrow. short term loans and bank overdrafts. Income after tax Return to ordinary shareholders Before tax (%) After tax (%) REASONABLE YEAR Earnings before interest and tax Interest @ 20% p. too. In a good year the return Company A makes is stupendous 170% before tax. The effect on profits is illustrated in Table I. especially if they are in high margin businesses. In highly leveraged firms. In the example in Table I.a. Conversely. It must be noted that so long as the return or the earnings rate exceeds the cost of borrowings. the reverse occurs in times of recession.a. 110 Ratios Ratios 111 . a highly leveraged company will make impressive profits. Interest costs are exorbitant and the large profits made in boom times turn into large losses. highly leveraged companies are risky and earnings can be negative in bad years. Company A is a highly leveraged. Company B's borrowed funds amount to 20% of its total funds. lakh) 200 ----------------200 100 ----------------100 50 50 50. one should consider selling the company's shares.25 24 8 16 8 8 10 5 30.00 24 32 8 ----------------8 32. As this rate decreases profits will fall.a. term loans. lakh) 40 160 200 100 32 68 34 34 170. The tide turns in year of depression or recession as borrowings have to be serviced. One can safely conclude. In good times these companies make large profits.00 24 ----------------24 12 12 12 6 Company A (Rs. the owner's funds are minimal and the owners are able to control the business with a fairly low stake.Which Company? TABLE 1 Share Capital Borrowed Funds GOOD YEAR Earnings before interest and tax Interest @ 20% p. in good years the results of highly leveraged companies can be very good indeed. it would be noticed that the return before tax of Company A is twice that of Company C. In a reasonable year.00 60 ----------------60 30 30 the imminent future.00 30.a. These borrowings would be in the form of debentures. and Company C is a cash rich company and does not borrow at all. Income before tax Tax @ 50% p.00 15. However.00 85. therefore. The main risks are borne by the lenders. lakh) 160 40 200 100 8 92 46 46 57. Income before tax Tax at 50% Income after tax Return to Ordinary Shareholders: Before tax (%) After tax (%) BAD YEAR Earnings before interest and tax Interest @ 20% p.50 28.

The debt to net worth ratio was: 385 105 = 3. legal suits. the company would still be able to meet its commitments. and the extent to which these external liabilities finances the assets of a company. borrowed funds were 3.67 In other words. Assets include all assets excluding intangiLiabilities to Assets Ratio Total Liabilities Total Assets bles.68 1200-100 Even if assets were to reduce by as much as 32%. borrowings were Rs. at 31 March 2003 is detailed below: The liabilities to assets ratio would be : Rs. is detailed below: Term loan 14% Debentures Bank Overdraft TOTAL ASSETS Goodwill The Debt to Assets ratio would be : 750 = 0. Should these be significant and likely to crystallize. Lakh SOURCES OF FUNDS Shareholder's Funds 100 Debentures 50 CURRENT LIABILITIES 200 350 APPLICATION OF FUNDS Fixed Assets 80 Investments 40 Preliminary expenses 10 Current Assets 220 350 50 + 200 = 0. The ratio is calculated by dividing total liabilities by the total assets Debt to Assets Ratio Total Debt Total Tangible Assets An investor would be wise to examine also a company's contingent liabilities. Lakh 200 500 50 750 1200 100 Liabilities to assets Ratio illustration The Balance Sheet of SWW Ltd. such as deferred revenue expenditure (preliminary expenses. deferred advertising expenditure and the like). For every Re1 invested by shareholders. it can also be said that assets sold at even 74% of their book value would meet and extinguish the company's liability commitments. such as guarantees. the ratio would change dramatically.3.Which Company? Liabilities to Assets Ratio This ratio. indicates the total borrowings used to finance the company. This shows the company is highly geared.105 lakh.67. Rs. There were no intangible assets. Debt to Net Worth Ratio Debt Net Worth Debt to Assets ratio illustration An extract of the financial statements of Pushpa Refrigerators Ltd. 112 Ratios Ratios 113 . The shareholders' equity was Rs.67 times the shareholders' equity.385 lakh. and the like.74 350 -10 This means that 74% of the assets of the company were financed by liabilities. good will. Liabilities in this context include both current and long term liabilities. Conversely. Debt to Net worth Ratio illustration Nikhila Ltd's debt on 31 March 2004 was Rs.

75. Net worth is arrived at after deducting intangible assets growth.400) = 75 75 That is very high dependence. such as goodwill and deferred assets. Lakh Shareholder's equity 158 Debentures 150 Term loans 40 Current Liabilities 40 388 Tangible Assets 378 Intangibles 10 388 The liability to net worth ratio would be: ______230 158-10 = 1. The incremental gearing is For every Re 1 used to finance growth. is as follows : Rs. This is an extremely useful ratio when one is determining how well shareholders would be compensated should the company go into liquidation. Incremental Gearing Net increase in Debt Increase in Net Income After Tax but Before Dividend Debt to Net Worth Ratio The debt to net worth ratio shows the extent funds are sourced from external sources and hence the extent a company is dependent on borrowings to finance its business. Other Ratios Liabilities to Net Worth Ratio illustration The Balance Sheet of Ravi Hawali Ltd. Liabilities to Net Worth The liabilities to net worth is a larger measure than the debt to net worth ratio and attempts to determine how dependent a company is on liabilities to fund its business. 0. It is calculated by dividing the total liabilities of a company by its net worth. Net worth is defined as shareholders' equity. were as follows: 2002 $00s 300 50 250 400 2003 $00s 400 75 325 480 NET INCOME BEFORE TAX Taxation Borrowings The company's liabilities are thus 1. Debts are defined as borrowed funds and would include bank overdrafts. The ratio is calculated by dividing the net increase in debt by the increase in net income after tax but before dividend . It determines the extent debt or borrowed funds are covered by assets and measures how much assets can depreciate in value and still meet the debt commitments. 114 Ratios Ratios 115 . Another ratio is the liability to equity issue. It is arrived at by dividing a company's debt by its net worth. Assets exclude Liabilities to Net Worth Ratio Total Liabilities Net Worth intangibles. The ratio is calculated by dividing debt by total tangible assets.85% of the assets (230/230 = (158 .55 times its net worth.5 x (480 . liabilities finance 60.Which Company? Debt to Assets ratio The debt to assets ratio is a more specific ratio.10). less intangible assets. Alternatively. Liabilities in this calcula- Incremental Gearing illustration The financials of Raman Tea Ltd. For instance. To an extent this ratio is similar to the net working investments ratio. the long-term debt ratio determines how important borrowings are to total long-term liabilities and shareholders' equity.55 Incremental Gearing The incremental gearing ratio attempts to determine the additional borrowings required to finance There are several other gearing ratios but these are seldom used. net income would increase by Rs.

The ratio is calculated An important factor that investors by dividing a company's internally must ascertain is whether a compagenerated funds by its average debt.(crore) Net income before tax and depreciation Depreciation Net profit before tax Tax Net profit after tax Bank overdraft Debentures Term loan 2003 Rs. The liability coverage ratio = 500_ = 0.7 years to repay borrowers from its profits.(crore) 500 100 400 160 240 150 380 90 520 through additional borrowings or rights and public issues of shares.5 x (600 + 520) This means that it would take Pear Ltd.60 0.25 0. recent years. 1. consider while Can it meet evaluating a company. or by the It is also possible to calculate issue of fresh capital or debt.5 x (3500 + 4500) This means that internally generated funds were only 25 per cent of the company's total average liabilities. Tongues and Tongs Ltd. the entire debt can be paid off in 4 years. generated Rs. Debt would comprise of bank overdrafts.Which Company? tion includes total liabilities as well as shareholders' equity. ny's profits are adequate to meet its Liabilities Coverage Ratio illustration In the year ended 31 March 2003. Now. Its total liabilities at the end of 20021999 and 2003 were Rs. 116 Ratios Ratios 117 . of one kind or another being dependence a company has on offered than equity. this ratio using the liabilities figure For calculating this ratio. inter. term loans and Interest Cover debentures. In this scenario. respectively.ing the internally generated funds of ated funds. external funds and the extent to the investor must ascertain whether which liabilities a company can finance the compaservice its debt Debt Coverage Ratio ny. This is relevant if the a company by its average total liadebt is not to be extinguished bilities through the sale of assets. Liability coverage ratio is an extension of the debt coverage ratio. It is Debt Coverage used to check whether a company This ratio is used to determine the can repay all liabilities through time it would take a company to internal generation. and non operInternally Generated Funds at a particular ating income and Average Total Liabilities time.3. expenses. At this level.500 lakh and Rs.500 lakh internally. Fifteen years ago few companies issued or offered convertible and non convertible debenSummary tures. the principal and interest payments out of its profits? This of course is F) DEBT SERVICE CAPACITY based on the assumption that the Debt is a source of finance which company is a profitable going conhas become increasingly popular in cern and that debt will not be repaid Debt Coverage Ratio illustration 2002 Rs. there are more debenThe gearing ratios highlight the tures. repay its short and long term debt This ratio is calculated by dividfrom its income or internally gener.at the date of the balance sheet. the nally generated funds means income argument being that what has to be after tax plus non-cash expenses considered is the time it would take such as depreciato repay the Liability Coverage Ratio total liabilities tion.500 lakh. These ratios are through interInternally Generated Funds extremely impornally generated Average Debt tant for investors to funds.4. Liability Coverage 100 400 100 600 Debt coverage ratio would be : 240 + 100 = 0.

e. In that case.and the higher it is the better. such as rental expenses. crore) 400 750 200 550 220 330 rowings. even a marginal fall in profit would force the company to pay interest out of its retained earnings or capital. Its internet expense was Rs. This is known as "off balance sheet financing". Interest cover ratio = 450 = 2. and checks whether a company earns enough income to meet its interest and rental commitments At times it is argued that the div- Fixed Charge Cover Earnings Before Interest and Tax + rental expense Interest and Rental expense lated in two stages. neither the real cost of the asset nor its liability is reflected in the balance sheet. If not. i.'s income statement included the following figures : Rental expense Earnings before interest & tax Interest Earnings before tax Tax @ 40 Profit after tax Fixed charge cover = 750 + 400 = 1. Fixed Charge Cover The eighties witnessed the birth and the development of several financing and leasing companies in India. earned Rs. or from a fresh issue of capital and these are a sure sign of financial weakness. These companies offered the opportunity of leasing equipment as opposed to purchasing it.450 crore before interest and tax in 2003. a company's ability to pay its debt should be determined only after providing for increases in its capital expenditure 118 Ratios Ratios 119 . The above is a better ratio than the interest cover ratio as it considers all the fixed expenses that a company has and examines whether its earnings are sufficient to meet these. the interest will have to be paid from either from the company's reserves.Which Company? interest dues. In the first stage.25 200 The company's earnings before interest are more than double its interest expense. As such. The interest cover ratio is calculated by dividing a company's earnings before interest and tax by its interest expense. Cash Flow Surplus Cash Flow surplus Total Average debt capital expenditure and that there would be an increase in its net working capital. the fixed charge cover is calcu- Interest Cover Ratio illustration Bombay Green Ltd. If it is below 1. additional bor- Interest Cover Ratio Earnings Before Interest and Tax Interest expense Fixed Charge Cover Net Income + (1— Tax Rate) (Interest and Rental Expenses) (1 — Tax Rate) ( Interest and Rental Expense) + Preferred Dividends idend payable on preferred shares should also be accounted for in calculating this ratio as it is a fixed charge that has to be paid. One benefit of leasing is that the rentals paid are entirely tax deductible. funds do not need to be deployed for the purchase of assets.200 crore. The ratio must always be in excess of 1 . The fixed charge cover considers off balance sheet obligations. and then the preferred dividends paid are taken into account. Secondly. A comfortable situation Cash Flow Surplus The cash flow surplus ratio is based on the going concern concept and assumes that companies will normally grow and will therefore incur Fixed Charge Cover illustration Ram Oil Soaps Ltd. the fixed charge cover is calculated as explained above.91 200 + 400 (Rs.

i. Accordingly. This is usually funded by loans or shortterm bank facilities. is paying interest needlessly. It must be remembered that assets are acquired either from capital or from borrowings. It must be remembered. Cash flow is net expenditure and increase in net working investments.20 crore. between one company and another in the same industry. Asset management ratios allow investors to determine whether a company has adequate assets and is utilizing them efficiently. Investors should therefore always look beyond the indications. or due to a strike in the manufacturing plants? 121 120 Ratios Ratios .20 400 It would take the company 40 years to repay its debts by utilizing its cash flow surplus. It is calculated by expressing the stock held in terms of the days of cost of goods sold Investors should ascertain the reason for the improvement in stocks. investors must determine whether the assets a company has are adequate to meet its needs and whether the returns are reasonable. it may be so because a company does not maintain adequate assets and this can affect its performance in the long run. due to difficulties in procuring stocks. the company is locking up funds it could have used more profitably or. Stock utilization can be measured by two ratios: The stock holding ratio measures the number of days of stocks (in relation to sales) held by a company.400 crore. A high asset turnover does not necessarily suggest great efficiency or a high return on investments. These ratios also help enormously in making forecasts and budgets. This is because when a company grows rapidly it purchases assets of a capital nature and its net working investments also increase and this increase is usually more than its internally generated funds. Its internally generated funds were Rs.40 crore. Cash flow surplus = 40 . is it because stocks have been dumped on dealers. Its net working investments had increased by Rs. conversely. that like other ratios asset management ratios too are pointers. managers are constantly alert to the need to keep stocks low. If there are more assets than is necessary.Which Company? Cash Flow Surplus illustration In 2003.e. however. Summary Investors must always consider debt service ratios as these help to determine whether the company under consideration has the capacity to service its debts and repay its liabilities. Stock Turnover Ratio Cost of goods Sold Average Stock (a) Stock Turnover Ratio This ratio indicates the number of times stocks (inventory) are turned over in a year and is calculated by dividing the cost of goods sold in a year by the average stocks held in a year Stock Holding Ratio Average Stock Cost of goods sold divided by 365 (b) Stock Holding Ratio Stock Utilization The stock utilization ratios measure how efficiently a company's stocks are used. With the cost of borrowings being high. The ratio is calculated by dividing the cash flow surplus by the total debt. It is important to bear in mind that a deterioration in asset ratios is a sign of decline and should be heeded. In these days of the justin-time principle. This ratio is often negative. these ratios are always carefully scrutinized and evaluated. the company's operations would not be using its resources as productively and effectively as possible. Comparisons can be made between one year and the next.10 . If the assets are less than required. and net working capital. was Rs. this is an important efficiency indicator. and in other industries. the average debt of Culture Ltd. G) ASSET MANAGEMENT/ EFFICIENCY It is by the efficient management of assets that companies make profits. This becomes all the more critical at times of high inflation and recession when the inability to service debt can plunge a company into bankruptcy. It is assumed that sales volumes are affected by the utilization of assets. With companies attempting to keep as little stock as possible. Asset ratios are used to assess trends and to determine how well assets have been utilized.10 crore and the company had incurred capital expenditure of Rs.

is a large company based in Pondicherry. The investor should determine whether: 1) The company is availing all the credit that it can. an investor should try and ascertain whether the existing level of stocks can support the levelof sales of a company has. they begin collecting on their debts and also sell their As companies close down stock levels fall. the sales of PDN Ltd. period ratio is an early warning indicator of large bad debts and financial sickness and by controlling thus one can improve efficiency and reduce borrowings. 2)The company is having difficulty in procuring credit. the average payment period ratio is low.5 times Average Collection Period illustration In 2003.400 crore.47 days of production and turned over stock 0. A falling ratio is not however always wonderful.160 crore in 2003.14 days 48. The reasons for the improvement in this ratio must therefore be ascertained. The average collection period was therefore : 2002 49 ______ = 348 + 365 51 days 2003 2003 _________59_________ = 54 days 400 + 365 The period of credit increased from 2002 to 2003.150 crore in 2002 and Rs. Its financials indicated that its average trade creditors in 2002 and 2003 were Rs.Which Company? Stock Turnover Ratio illustration The average inventory of Nandan Switchgears Ltd. During this period the cost of goods sold was Rs. 122 Ratios Ratios 123 . grew by 15% . Nandan Switchgears Ltd.1. Just before companies fold up. though it has improved in 2003 over 2002. Its average payment period would be: 29__________ = 26 days 2002 410 + 365 2003 _________34________ = 29 days 425 + 365 Most companies sell to their customers on credit. they need to either block their own internal funds or resort to bank finance. thereby saving on interest.410 crore in 2002 and Rs. This is good since the company can effectively use creditors to finance its working capital and to that extent the cost of finance falls.348 crore to Rs. Average Collection Period Average Trade Debtors Average Sales Per Day Average Collection Period Average Payment Period Ratio illustration True Steel Ltd. The average collection ratio is calculated by dividing average trade debtors by the average daily sales An increasing average collection In this illustration. the company is finding difficulty in getting its customers to pay in time.050 crore and Rs. or the management may not be controlling credit effectively.200 crores in 2002 and 2003. Its average trade debtors during 2002 and 2003 were Rs. from Rs.29 crore and Rs.59 crore. respectively. Purchases are not made and existing stocks are sold.34 crore respectively.67 days 7 times 7. 3) The company is having difficulty in paying its creditors. was Rs. respectively. The cost of finance is therefore usually built into the sale price and companies offer a cash discount to customers who pay in cash either at the time of sale or soon thereafter. To finance these sales. The ratios are as follows: Stock turnover ratio : 2002 1050 = 150 120 = 160 Stock holding ratio : 2002 2003 150 1050 + 365 160 1200 + 365 = = 52.49 crore and Rs. has successfully reduced inventory levels by 3. or it may be extending longer periods of credit.5 times more. Its cost of goods sold was Rs. If PDN Ltd's normal credit terms are only 30 days and customers are taking 51 to 54 days to pay.1. In addition. If the company is in a strong and commanding position. it can obtain longer credit terms.425 crore in 2003. This is usually good.

0 90 Average Payment Period The average payment period ratio or the creditor ratio indicates the time it takes a company to pay its trade creditors.6 lakh. This means. 124 Ratios Ratios 125 . Its sales in that year were Rs. respectively. It must be borne in mind that this ratio is not truly reflective of performance as fixed asset costs will differ when comparing companies.e. it would be unfair to label the older company inefficient. Its total asset utilization ratios for the two years were: 2002 2003 495 = 6. In short.30 = 0.100 lakh of sales. on net fixed assets( written down value of fixed assets). the number of days' credit it enjoys. In such a scenario. that the assets required to support an increase Total Asset Utilization The total asset utilization ratio is calculated in order to determine whether a company is generating Total Asset Utilisation Sales Average Total assets Net Working Investments Ratio Net working investments are those assets that directly affect sales such as trade debtors. was successful in increasing its sales in 2003 to Rs.03 82 630 = 7.6% of its sales.086 500 2002 The fixed asset utliziation ratio measures how well a company is utilizing its fixed assets.500 crore. A new company with recently acquired fixed assets will show a worse ratio than one that has old assets. It is arrived at by dividing sales by the average net fixed assets. i.Which Company? goods for cash. Total assets Utilization Ratio Divya Tyres Ltd. cost less accumulated depreciation. Rs. then for every Rs. this ratio highlights the working capital requirements of a company and helps an investor determine whether the company's working capital is controlled efficiently. If this is the optimum level. the average stocks.90 crore.630 crore from Rs. were Rs. It should be remembered that this ratio needs to calculated on net fixed assets. stocks and trade sales commensurate with its investment in assets. The ratio is calculated by dividing the sales by the average total assets. It should be remembered that this ratio needs to be calculated Fixed Asset Utilisation Sales Net Fixed assets The company's net working investment were 8. Investors can compare this with the utilization of other companies in the same industry to determine how effectively a company is utilizing its fixed assets. Fixed Asset Utilization Net working investments ratio In 2003. The ratio is calculated by dividing the net working assets by sales. It is clear that the total assets utilization ratio has increased. It indicates how efficiently assets are being utilized and is an extremely useful ratio for preparing forecasts. Average Payment Period Trade Creditors Average Daily Cost of Goods Sold creditors.45 crore and Rs. An increasing net fixed asset utilization ratio suggests that sales may have fallen and the efficiency in the handling of net fixed assets may have deteriorated. Net working investments ratio = 38 + 45 . The result is a falling average collection period ratio. Its average assets grew by 10% to Rs. This ratio is therefore extremely useful in assessing working capital requirements.38 crore.495 crore in 2002.8. net working investment would need to rise by Rs.e. too. The ratio is calculated by dividing trade creditors by the average daily cost of Net working investments Ratio Stocks + Debtors — Creditors Sales goods sold. i.30 crore. debtors and creditors of Tamana Ltd.

its mark up on the cost of the items it manufacturers or trades in. work at very low margins because volumes are very high. at least maintain them.e. It must be remembered that low 126 Ratios Ratios 127 . Usually low volume businesses are high margin businesses as goods often have to be held for some time. the company would often bear a part of the cost increase because of the fear that the customer would not purchase the product. if more low margin products are sold. As competition is intense and the buyer has a choice between several brands. i. It can also indicate whether a company is encountering difficulties. in some instances. Summary Asset management ratios are calculated to assess the competence and the effective of management by determining how efficiently assets have been managed. Conversely. It can be argued in this instance that Hindustan York is more efficient and that its products command a greater premium. Margins indicate the earnings a company makes on its sales. Efficient and strong managements will work to improve margin or. This suggests that the company might be expanding and the fruits or the result of this expansion is yet to be reflected in the net fixed asset utilization. A company may be selling several products .55 (65 + 80) + 2 Although sales increased by only 6% fixed assets went up by 31%. Management trends can also be assessed by margins. This is important as it will indicate how dependent the company is on margins.55 (45 + 65) + 2 620 = 8. A good example of falling margins is the TV industry. It also highlights how effectively credit policy has been administered and whether a company is availing of all the credit it is entitled to and is offered by its suppliers. the average margin earned on sales will reduce. Let us assume that the gross margin earned by Hindustan York is 20 percent whereas the industry average is 18 percent.each of them priced differently. Should there be a strong demand for the company's product. On the other hand. The performance between companies within an industry or a group can also be compared with the help of margins. Some may be high margin products and others low margin ones.(crore) Rs. Margins help an investor determine whether increases in costs. whether on account of inflation or governmental levies. Margins help to determine the cost structure of a business. Product mix has an effect on margins. it will pass on the entire cost increase to the customers. The higher the mark up. if the demand for the company's products is not very high.(crore) Rs. the margin earned by the company would be high. and whether the business is a high volume low margin business or otherwise. such as supermarkets or for that matter brokers.e. the greater the profit per item sold and vice versa. If the company operates with low margins a small increase in costs can result in large losses. i. If more high margin products are sold. Margins are so important that they determine the success or failure of a business. have dropped their prices in order to be competitive.Which Company? Fixed assets Utilization Illustration ratio The relevant financials of Nikhila Pistons Ltd.(crore) Sales 540 580 620 Fixed Assets Gross 105 130 150 65 70 Accumulated Depreciation 60 65 80 45 The net fixed asset utilization was 2002 2003 580 = 10. Others. is it high cost or low cost. have been passed onto customers in part or in full. manufacturers have been bearing a portion of cost increases and. H) MARGINS It is not uncommon to read in annu- al reports that "although sales have increased by 24 percent in the year profits have fallen due to increases in the cost of production causing margins to erode". And the mark up or margin made by the seller is usually based on what he believes the mar- ket can bear or that which he thinks will fuel sales. were as follows: 2001 2002 2003 Rs.

Normally the operating margin should improve with sales since costs do not usually rise at the same rate. 2) The company took a conscious decision to reduce its margins in order to improve sales.(lakh) Sales 3000 4000 Cost of goods sold 2400 3200 Gross profit 600 800 400 500 Selling. such as: 1) Increased competition : the company reduced its margins to boost sales.00 Gross margin (%) Hindustan York's sales increased by 25% to Rs. General & administration expensess X100 Sales The profitability of a company before the incidence of tax. In a recession. administration and other miscellaneous expenses that it has to bear even if there are no sales.Which Company? margin businesses are not bad. It is calculated by dividing the difference between sales and the cost of goods sold. 2002 2003 Rs. This could be due to several reasons.(crore) Sales 400 500 Cost of sales 275 350 125 150 31.(lakh) Rs. This could be one of the reasons though not the only one.25%. 3) A deterioration in the product mix. in these difficult times.500 crore and its gross profit increased by Rs. selling. He must go beyond the figures and seek the reason for the change. in Breakeven Margin Every organization has certain expenses. whereas operating expenses grew by 25%. Gross margin The following figures were extracted from the financial statements of Hindustan York Ltd. Gross Margin The gross margin is the surplus available to meet the company's expenses. However its gross margin fell by 1.25 30. Sales grew by 33% as did the gross profit. tionary cost increases on to customers. are positive. Costs may increase at a faster rate than sales and gross margins may also fall. In another situation. despite the sales going up the gross margin may decrease and costs increase resulting in a fall in the operating margin.25 crore. 4) The company was unable to pass on cost increases to its customers. or at a time of high inflation.33 7. or a deterioration. miscellaneous income and interest costs is indicated by the operating margin. Some of the most successful businesses in the world are low margin ones that operate with very high turnovers and produce an impressive return on capital employed.50 There was an improvement in the operating margin by 1. and expressing it as a percentage of sales An investor should not jump to margin. general and administration expenses Operating profit 200 300 Operating margin (%) 6.17%. An increase in the margin may simply be due to an increase in price whereas a fall could be due either as a consequence of a conscious decision to increase sales or company's inability to pass infla- Operating Margin a company's profitability and one must ascertain the actual causes for this. the reverse can be true. The operating margin can be arrived at by deducting. and expressing it as a percentage of sales An investor must always examine the operating margin ratio as it indicates the likely reasons for an improvement.(crore) Rs. One of the reasons for this could be that operating expenses did not increase as much as the sales. like selling. was : 2002 2003 Rs. general and administrative expenses from the gross profit. or 20%. Both of these. The breakeven margin indicates the number of units that a company must sell to Breakeven Margin Expenses + Financing Costs Gross income / Number of Units sold 128 Ratios Ratios 129 . Operating Margin Gross Profit — selling. a conclusion on seeing an improvement or a deterioration in the gross Gross Margin Sales — Cost of goods Sold X100 Sales Operating margin The relevant information in the results of Patel Nair Ltd.

the relevant figures were : Rs. The pretax margin indicates the rate of profit earned on sales after accounting for the cost of financing but before tax. If a company's breakeven is at 50% of its capacity.(lakh) Sales 8000 Earnings before interest and tax 850 Prefinancing margin = 850 x 100 = 10. it means that the company would be in a no-profitno-loss position if it produced and sold half its capacity. Some investors prefer to calculate the breakeven margin by deducting selling costs from the gross profit to arrive at the gross profit per unit. 675 units to bear its expenses. The breakeven margin ratio is arrived at by dividing expenses including financing costs. 130 Ratios Ratios 131 .400 / 1000 This is arguably a purer Measure The prefinancing margin is the rate of profit earned prior to the costs of financing. and expressing this as a percentage. in decision making when alternatives are being considered. the Rs.2 should it sell only 674 units. stated above. during the year ended 31 March 2003 were as follows: The total number of units sold were 1000 Rs. have to sell. PreFinancing Margin Earnings Before interest and Tax X100 Sales Pretax Margin Prefinancing Margin Breakeven Margin The results of Kumar Wheels ltd. If it sells 676 units it would make a profit of Rs.400 + 150 = 593.7 units 2000 . The prefinancing margin is therefore calculated by dividing earnings before interest and tax by sales. this is calculated on the income before tax and expressed as a percentage of sales. the Pretax Margin Earnings Before interest and Tax X100 Sales PreFinancing margin In the earlier example of Kumar Wheels Ltd. In short.e.(lakh) Sales 8000 Less : Cost of sales 6000 Gross Income 2000 1200 Less : Expenses Operating income 800 Add : Profit on sale of factory 50 Earning before interest and tax 850 Less : Interest charges 150 Earnings before tax 700 Breakeven margin = 1200 + 150 = 675 units 2000 / 1000 Kumar Wheels Ltd. in the example of Kumar Wheels Ltd. Any unit sold above this would yield a profit.2. This is an important management ratio. and vice versa. selling expenses were 400.Which Company? meet these expenses.50 x 100 = 10 8000 This is a good measure for comparing the profitability of organizations. This is done because selling cost are connected with sales and no selling expenses would be incurred if no sales are made. i. too. These also vary on account of the method of financing. by the gross income per unit. at present costs. The breakeven margin is an important measure as it indicates exactly how many units need to be sold by a company before it can begin to make profit. If. Pretax margin is not a fair measure of profitability and comparison as the manner of funding. Non-recurring or unusual profits must be excluded from the calculation. The reason for excluding financing costs is that these vary from organization. the breakeven margin would be calculated as: 1200 . In that case. The company would lose Rs.25% 8000 It would be more appropriate to calculate the prefinancing margin after excluding non-recurring income or expenses.50 lakh profit on the sale of a factory should be deducted and the margin would be: 850 .

75% 8000 The return after tax to shareholders on sales was 3.700 lakh. Sales Earnings before interest and tax Pretax margin would be 8000 = 700 x 100 = 8.50 x 100 = 8. the pretax income was Rs.350 lakh. It indicates the rate on sales Net Profit Margin that is available for appropriation after all Net Income Excluding Non-Recuring items After Tax R expenses and commitSales ments have been met. On the other hand.75%. It can however be used effectively for comparing the performance of a company over several years. a company earning high margins may face falling demand for its products. Non-recurring income was Rs.50 lakh. If tax was Rs. The net profit margin also enables a shareholder to determine the additional earnings available to him on increases in sales. A company may opt to work on very low margins to achieve volumes. non-recurring income or expense should not be included in the calculation as it would distort comparisons. thus help both in understanding the cost structure of a business and evaluation of its performance.50 x 100 = 3.125% 8000 Margins. vary from company to company. order to facilitate comparison and to get a true picture. If the Rs. 132 Ratios Ratios 133 . It is important to remember that low margins are not always bad nor high margins always good.(lakh) 8000 700 Summary As mentioned earlier. financing costs.Which Company? Pretax Margin Kumar Wheels Ltd. The net profit margin therefore was 350 . Investors must always check into the reasons for variations and the various measures mentioned in this chapter will point out to the investor the possible reasons. the pretax income would be Rs. In Net Profit Margin In Kumar Wheels Ltd. non-recurring income and expense should be excluded in the calculation.350 lakh. the margin would reduce to 8.75% Rs.125% as follows: 700 .50 lakh of non-recurring income is omitted. Net profit margin Net profit margin shows the aftertax rate a company earns on sales.

92 lakh to finance its current assets. Shareholders do not realize this when they look at the published profits in the financial statements of companies. For example. in effect. other income of Rs.927.56 lakh withdrawn from a revaluation reserve. and generally accepted accounting principles liberally interpreted or ignored by companies in order to show profits. the company paid its dividend on preference shares not out of current Cash flow 135 . the profit changes to a loss of Rs. Its importance has been recognized in the United States and in many European countries where it is mandatory for a company to publish with its Annual Report.108. provisions created or written back.112. however. profit on sale of fixed assets of Rs. a cash flow statement. This included.88 lakh and an amount of Rs.12 lakh. and its Sources and Uses of Funds (S & U) for the year ended 31 March 2004 detailed in Table III.247. This occurs when a company is unable to obtain finance or pay its creditors. The S & U statement shows that the company had a deficit cash flow in 2004. It comes therefore as a surprise when a regular profit making company suddenly downs its shutters and goes into liquidation. History is strewn with such examples and investors must always check: How much is the company's cash earnings? How is the company being financed? How is the company using its finance? Cash flow CHAPTER EIGHT 134 Cash flow The answers to the above can be determined by preparing a statement of sources and uses of funds. and that it had to borrow Rs. a sum- mary of changes in financial statements which is. accounting principles are changed. A statement of sources and uses begins with the profit for the year to which are added the increases in liability accounts (sources) and from which are reduced the increases in asset accounts (uses).291.06 lakh. If these are deducted.Which Company? I n this age of creative accounting.1.74 lakh.38. The net result shows whether there has been an excess or deficit of funds and how this was financed. The changes in Fundamental's Balance Sheet are summarized in Table I. as shown in Table 1 Fundamental and Company Limited (Fundamental) reported a profit before tax of Rs. As it had made a loss.

38 1350. expenditure 287.91 334.88) (92.86 1713.68 65.06 65.12 1315.92 136 Cash flow Cash flow 137 .50 88.85 3264.86 14.14 867. crore) Movement 0.40 (323. Balance Sheet as at 31 March 2004 SOURCE Share Capital Reserves Loan funds APPLICATION Net Fixed assets Investments Current assets (net) 230.23 121.90 4.08 79.89 1194.91 TABLE II : Dynamic Iron and Steel Company Ltd.78 2878.92 1725.77 469. crore) Movement 0.86 322.75 3083.61 988. the possibility that the company was unable to get rid of its surplus stock cannot be ignored.62) 160.09) 147.53 92.14 1834.37 3130.86 (Rs. The Dynamic Iron and Steel Company Ltd.43) 1927.36 2051.50 61.37 4878.25 3434.32 5058.Which Company? profits but from reserves.19 248.34 3100.79 571.92 1913.22 1183.92 138.30) 1913.21 2607.78 2003 229.52 1614.25 2003 282.75 3559.55 988.30 3596.34 (Rs. Further.14 8410. as inventories and other current assets increased. expenditure written off Profit on sale of fixed assets APPLICATION Purchase of Fixed Assets(net) Purchase of investments Increase in Inventories Increase in sundry debtors Increase in other current assets Increase in loans to subsidiary companies Increase in loans to others Decrease in provisions Decrease in reserves Net increase (deficit) FINANCED BY Shares Capital 0.45 8410.55 (139.06 (202.99 205.75 2607. lakh) SOURCES Operating Income (loss) Add depreciation Less Profit on sale of fixed assets Operating Income (loss) Other Income Increase in liabilities Misc. Sources and Uses of funds for the year ended 31 March 2004 (Rs. Ltd.25 (112.25) 247.05) 1927.22 6496. (DISCO) (See Tables III & IV) also had a cash flow deficit TABLE II : Fundamental & Co.22 (61.04 (14. Balance Sheet as at 31 March 2004 SOURCES Share Capital Reserves Loan funds APPLICATIONS Net Fixed assets Investments Net Current assets Misc.82 3596.74 1485.98 1725.55 Increase in cash and bank balances Increase in loan funds 513.43 TABLE 1: Dynamic Iron and Steel Company Ltd.92 1164.52 1141.47 26.98 26.30 132.75 6496.79 3069.

77 156.37 867.55 (41. Conclusion 139 138 Cash flow .44 323.09 0.72 although the company made a cash profit of Rs. the dividend of Rs.55 lakh was once again financed by loans.20 24.85 827.55 164. crore) SOURCES Operating Net Income Less payments to employees for prior periods Add : Depreciation Funds from Operations Sale of Investments Decrease in other current assets Increase in liabilities Increase in provisions Total Sources USES Net purchases of fixed assets Increase in Inventories Increase in sundry debtors Increase in loans and advances Total applications Excess (deficit) FINANCED BY Issue of shares Increase in loans Increases in cash and bank balances 278.34 73. Investors must be concerned if a company is financing either its inventories or paying dividends from borrowings without real growth as that shows a deterioration.44 crore.72 1.16 (13. In short.Which Company? TABLE IV: Dynamic Iron and Steel Company Limited Sources and Uses of funds for the year ended 31 March 2004 (Rs.89 429.20 904.80.61) 264. If one assumes this was used to finance the increase in inventories and partially finance assets.20) 827. the cash flow or sources and uses of funds statement strips the accounting creativeness from financial statements.13 1329.29 221.59 1731.06 78. Investors must examine a company's cash flow as it reveals exactly where the money came from and how it was utilized.429.

ambition. This was eloquently stated by Gerald Loeb. Its strength lies in the fact that the information analyzed is real as opposed to hunches or assumptions. Market values are fixed only in part by balance sheets and income statements. while fundamental analysis deals with tangible facts. fundamental analysis ensures that one does not recklessly buy or sell shares . All systems require thought and some assumptions. much more by hopes and fears of humanity.Which Company? undamental analysis holds that no investment decision should be made without processing and analyzing all relevant information. And this where there can be differences in value . weather. financial stress and strain. “A dozen experts will arrive at 12 different conclusions. and a host of other factors. their knowledge and their gut feel of the market. No system has consistently outperformed the market. Happy Investing! 141 140 Which Company? Which Company? . invention. fashion and numberless other causes impossible to be listed without omission". One should buy a share only if its intrinsic value is higher than its book value. There is no system that does not call for human judgement and input. it does tend to ignore the fact that human beings do not always act rationally. speculation. This also protects one against possible loss since one would dispose of a share whose market value is higher than its intrinsic value. “There is no such thing as a final answer to security values.especially buy. of all the systems that I have experimented with and tried. discovery. On the other hand. their maturity. Prices rise or fall due to insider trading. rumour. Market prices do sometimes deviate from fundamentals. Hence fundamental analysis supports and encourages safe investing. This is true to an extent but the strength of fundamental analysis is F that an investment decision is arrived at after analyzing information and making logical assumptions and deductions.the assumptions made by different analyst would differ. Furthermore. the one I am most comfortable with is fundamental analysis as it is the most logical and the most meaningful. However. And this is the system I would urge you to consider as an investor. who wrote. acts of God. It often happens that a few moments later each would alter his verdict if given a chance to reconsider because of a changed condition. by greed. Their reasoning will be based on their exposure to the market. No system is fool proof. the author of The Battle for Investment Survival.

Phoenix Mills Compound. MAPIN 100008375. BSE:Cash-INB010622230.Check the industry or industries in which the company operates. check its intrinsic value. Ltd. F&O-INF010622230. The ratios should be analyzed and the cash flow checked. . PMS INP000000662.Which Company? Quick check List 1. 5. SSKI Investor Services Pvt. MAPIN 100008383. Sharekhan Commodities Pvt. This document is for Private circulation only A-206. SSKI Investor Services Pvt. please read the SEBI prescribed Risk Disclosure Document before investing. The views expressed in this book are that of the author. Check the political situation. Ltd. . What is revealed by the economic indicators? Is the growth rate reasonable? Have export improved? How comfortable is the balance of payment position? 3. CSDL-IN-DP-CSDL-271-2004. The views expressed may not be suitable for all investors Any review. The factors one should look at is its management and its annual report. Is it safe? Are there problems? Could the government be overthrown and could there by difficulties as a consequence? 2. before purchasing or selling a share. Phoenix House.com S S Kantilal Ishwarlal Securities Pvt.Then check the company. NCDEX-00132. Ltd.BSE: Cash-INB011073351. MCX-10080. Each recipient of this book should make such investigations as it deems necessary to arrive at an independent evaluation of an investment avenue referred to in this document and determine the merits and risks of such an investment. Lower Parel. retransmission. Senapati Bapat Marg.NSE: INB/INF 231022931. Fundamental Analysis DISCLAIMER As investment in Equity related securities involves high risk. LTd. reproduction or any other use is prohibited. A decision should only be taken after this is done. DP: NSDL-INDP-NSDL-233-2003.Finally. At what stage of the cycle is the company in? What is its competition? How easy is it to enter or exit the business? 4. reprinting. F&O-INF011073351. Although all efforts have been directed towards explaining the features pertaining to fundamental analysis and related aspects. Mumbai 400 013 Phone: 022-24982000 Email: info@sharekhan.(SHAREKHAN) does not in any way do not claim that the author has explained all aspects exhaustively. MAPIN 100013912 142 Fundamental analysis quick check list . This document is prepared for assistance only and is not intended to be and must not alone be taken as the basis for an investment decision.

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