11

Fundamental Analysis III: Company Analysis

Analysis of a company consists of measuring its performance and ascertaining the cause of this performance. When some companies have done well irrespective of economic or industry failures, this implies that there are certain unique characteristics for this particular company that had made it a success. The identification of these characteristics, whether quantitative or qualitative, is referred to as company analysis. Quantitative indicators of company analysis are the financial indicators and operational efficiency indicators. Financial indicators are the profitability indicators and financial position indicators analysed through the income and balance sheet statements, respectively, of the company.

 

Operational efficiency indicators are capacity utilisation and cost versus sales efficiency of the company, which includes the marketing edge of the company. These might not be revealed through financial statements, but can be inferred through the annual reports published by the company for the benefit of investors and the general public. An analysis of the published statements provides an analysis of the past. Usually the formats, as published by the companies, might not be directly understandable to investors. To overcome this, the investor has to identify the factors/variables that are needed separately. To help an investor in this task, many financial magazines, newsletters, and web sites supply consolidated reports of the companies. Such consolidated reports would provide items such as net sales, profit before tax, profit after tax, dividend payment, book value, debt equity components, liquidity position of the company, etc. An examination of these consolidated reports would also help the investors in analysing the performance of a company.

Graham B. and Dodd D.L (1996) have proved that a disproportionate decrease in sales is viewed negatively by analysts. Hawkins D., (1986) also supports this view. Bernstein L., and Siegel J., (1979) Fabozzi F., (1978) and Siegel J., (1982) have studied the earnings quality and its influence on stock price. Easton P., and Zmijewski M., (1989) and Kormendi R., and Lipe R., (1986) have proved earnings announcements impact on the stock market. Another interesting area is the use of current earnings to predict future earnings to help determine the stock returns. Benishay H., (1961) Fama E.F., Fisher L., Jensen M.C., and Roll R., (1969) and Miller M., and Modigliani F., (1961) have examined the impact of dividend payout and dividend announcements on share price behaviour. Most share valuation models are based on discounting the expected stream of future dividends.

Shiller R., (1981) Sorenson E., and Williamson D., (1985) Sharpe W.F., (1985) Jacobs B.I. and Levy K.N., (1989) have explored the influence of expected dividend payments on the market price. Ohlson J., (1988) has studied the impact of book value along with dividends and accounting earnings. Fazzari S., Hubbard G., and Peterson B., (1969) have examined the impact of debt on investment decisions. Liquidity needs and stock returns have been examined through inventory holdings. Blinder A., and Maccini L., (1991) Carroll T., Collins D., and Johnson B., (1991).

There is voluminous literature explaining the relationship between accounting information and stock prices in general. With specific reference to investment situations, Dyckman T.R., and Morse D., (1986) raise questions on how individuals use accounting information in an investment market setting and whether the investors are able to profit from the accounting information disclosed to the public. The use of fundamentals in predicting stock returns has been studied by Summers L.H., (1986), Holthausen R.W., and Larcker D.F., (1992), Reinganum M., (1988), Stober T.L., (1992), Greig A.C., (1992), Ou J.and Penman S.H., (1989), Oppenheimer H.R. (1981), and Lev B. and Thiagarajan S.R., (1993) to name a few. Studies that are country specific are Arnold J. and Mozier P., (1984), Day J.F.S., (1986), Vergoossen R.G.A., (1993), Arnold J., Mozier P., and Noreen E., (1984) Pike R., Meerjanssen J., and Chadwick L., (1993), and Chang L.S., Most K.S., and Brain C.W., (1983).

Besides these, an analysis of future prospects of the company is also to be carried out. The budgets and cash flow statements give the investors an insight into the future functioning of a company. Future profitability and operational efficiency can be worked out from these statements. Bernard V. and Stober T. (1989), and Wilson P. (1986) have reported empirical evidence on the use of these statements in predicting stock market returns. These performance indicators are also linked to the shares through ratio analysis to evaluate performance for investment purposes. The important measures are earnings per share, dividend per share, yield on shares, price earning multiple, and so on.

An earnings per share (EPS) is the net profit divided by the total number of shares. This indicates the amount earned by the company for every shareholder out of its operations. A dividend per share (DPS) is also computed similarly by dividing the dividend distributed by the total number of shares. The actual earnings per share paid to investors are arrived at through this ratio. Yield on shares (Yield) is dividend per share divided by market price per share. This is a measure of return on shares in terms of capital appreciation. Price earnings ratio (P/E) is defined as the closing market price of the share divided by the reported earnings per share for the latest period. Low P/Es are typically associated with low earnings growth and cyclical businesses, and high P/Es are associated with high earnings growth and non-cyclical businesses. This P/E multiplier is also used as a measure of forecast to estimate future earnings per share. Ball R., (1978), Larcker D., (1989), Basu S., (1983), Beaver W.H., and Morse D., (1978), and Ou J. and Penman S.H., (1989) are illustrative research studies on the influence of these variables on stock prices.

Malhotra S.V., (1994) gives a summary of Indian studies on the use of accounting information on stock price returns. According to his survey the most important determinants of equity prices in the Indian context are dividend per share and earnings per share though other accounting variables such as P/E multiplier, yield, interest cover, growth and so on, have been tested under Indian conditions. Some of the studies quoted by him are Zahir M.A., and Khanna Y., (1982), Balakrishnan (1984), Dixit R.K., (1986), and Kumar P. and Hundal R., (1986). Bhat R. and Pandey I. (1987) identified that use of accounting information in investment management is considered important. The inference and findings of this study relate only to market participants’ attitudes and perceptions in using accounting information to make a decision on the investment pattern. However, Barua S.K., and Raghunathan V. (1990), Sundaram S.M. (1991), and Obaidullah N. (1989) cast doubts on whether the observed price earnings ratios are consistent with fundamental factors like dividend growth and payout ratios.

Besides these quantitative factors, qualitative factors of a company also influence investment decisions to a large extent. Qualitative factors are the management reputation, name of the company, operational plans of the company for the future, and so on, as revealed in the Director’s/Auditor’s reports, as also information revealed by the management to the media. The notice to the annual general meeting supplies the investor with the transactions that are to be finalised by the board of directors hence is a prior indicator of company performance. A careful scrutiny of these notices and the follow up through the proceedings at the meeting would give a good idea of the future plans of the company. Similarly, the director’s report and auditor’s report scrutiny would help the investor in identifying the strong and weak points of the company. The media reports of the company, while providing a concise view of experts as well as insider information, are questionable in terms of reliability.

Gniewosz G., (1996) describes the use of accounting and other information in the share investment decision process of an institutional investor. The focus is on qualitative data, as revealed in the annual report—as in the director’s speech, rather than on quantitative data. He has concluded that the significance of qualitative data as an information source changes over a period of one year. It varies from serving as a primary information source to serving in a confirmatory role. Furthermore, rather than a source of information the annual report also acts as a stimulus for identifying specific questions. Other similar studies are Adhikari A., and Tondkar R., (1992), and Sheres M and Kent D., (1983) and Baker H.K., and Haslem J.A., (1973). Choi S.K. and Jeter D.C. (1992) have examined the information content of audit reports. Stickel S., (1990) examines the reliability of analysts’ recommendations of stock returns to investors. Jaffee J., (1974), Elliot J., Morse D., and Richardson G., (1976), Finnerty J.E. (1976), and Fisherman M.J., and Hagerty K.M., (1992) discuss the implications of information usage by insiders and its effect on stock prices.

The most important qualitative factors of a company are the management reputation and market position. Though it is difficult to measure the contribution of these factors, it is essential to know the worth of the company in terms of these aspects, since they can have a profound impact on how the company will perform in the future. Schipper K., (1991) summarises survey evidence that lists management as a key source of information for analysts. Schultz E. (1990) focuses on management relations as an important aspect to predict stock prices. Warner J.B., Watts R.L., and Wruck K.H., (1988) reiterate this point by examining the influence of management change on stock prices.

The scrutiny of management reputation should consider whether the management is strong, growth oriented, professional, the nature of its goals and principles, and so on. The past behaviour pattern of management actions are a good clue to assess these qualities of the management. Each company would have faced adverse situations at one time or the other. A strong, professional team would have faced the adversity better. The market position of the company should be analysed in terms of the product or service that it gives or provides to the community. The company’s goals and values will be revealed through an analysis of the image that these products and services carry to the consumer. Good customer reputation automatically implies that the company is doing well currently in terms of performance also.

TOOLS FOR COMPANY ANALYSIS

Company analysis involves choice of investment opportunities within a specific industry that comprises of several individual companies. The choice of an investible company broadly depends on the expectations about its future performance in general. Here, the business cycle that a company is undergoing is a very useful tool to assess the future performance from that company.

Company analysis ought to examine the levels of competition, demand, and other forces that affect the company’s ability to be profitable. Of these factors, understanding the competitive environment is most important.

A business faces five forces of competition (Porter’s Model); namely, seller’s competition, buyer’s competition, competition from new entrants, exit competition, and existing competition. Competitive forces include the power of those who sell to the business, those who buy from the business, how easily new businesses can enter the industry, how costly it is to exit, and finally, the competition from those already in that industry. How well a company deals with each of these forces will determine whether the company earns above or below average profits. Each of these forces are discussed below.

Threat of New Entrants

If the company is working in a niche market with high profits, there is always the threat that new competitors will enter the market. The high profit margins attract prospective players into the industry and need not necessarily be interpreted as danger signals for the company. The new entry also suggests that the possibility of profit is quite high. Prospects of healthy competition stepping into the industry will lead to higher growth rates.

In many instances, companies that are facing a tough time are continuously on the look out for diversification/consolidation. They will be on the watch and if they see an opportunity, they will utilise it. So, company analysis will have to consider the threat from new competition and find out how safe or risk free it is from this and examine if the company can cope up with such competitors. The new competitors, however will face entry barriers.

Determinants of Entry Barriers

• Economies of scale
• Brand identity
• Capital requirements
• Absolute cost advantages
• Government policy
• Product differences
• Switching costs
• Access to distribution
• Access to necessary inputs

Threat of Substitute Products and Services

The issue of whether the prospected goods or services are in danger and are likely to be substituted by new developed products is examined here. An indication from the market that consumers will change their preferences due to new developments is to be appraised. This indicates future business prospects as well as potential loss if the company is not flexible and is not able to adapt to changing market conditions.

Determinants of Substitution Threats

• Relative price performance of substitutes
• Switching costs
• Customer propensity to substitute

Bargaining Power of Suppliers

Supplier bargaining power to a large extent determines if cost reduction is possible within an organisation. It evaluates how strong the bargaining power of the suppliers is and how it will tend to develop in the near future. If there is complete competition between suppliers and new suppliers are likely to join the market, then there will be no risk of increasing costs of inputs. On the other hand, if there are very few suppliers then the company might face difficulties in the future.

Determinants of Supplier Power

• Differentiation of inputs
• Switching costs of suppliers
• Presence of substitute inputs
• Supplier concentration
• Importance of volume to supplier
• Cost relative to total purchases
• Cost differential of input quality differentiation
• Threat of backward integration

Customer Bargaining Power

The bargaining power of customers depends on the local competition, whether or not the buyers can move from one company to another or on their willingness to do so. The company’s capability to withstand this shift determines the superiority position occupied by a company in the market. A company that is subject to the threat from suppliers due to the following factors faces relatively more risk.

Determinants of Customer Power

• Bargaining strength
• Customer concentration
• Customer volume
• Customer switching costs
• Customer information
• Ability to backward integrate
• Substitute products
• Price sensitivity
• Product quality differences
• Brand visibility

Existing Rivalry

Existing rivalry indicates the extent of dependence of one company on the other. Many companies are mutually dependent on each other either in terms of products/customers/technology/investment etc. These relationships have to be examined to position the organisation with respect to others.

Rivalry Determinants

• Company growth
• Intermittent over capacity
• Brand visibility
• Concentration
• Diversity of competitors
• Fixed (or storage) costs
• Product differences
• Switching costs
• Informational complexity
• Corporate stakes

The consolidated presentation of this competitive strength analysis (referred to as Porter’s Competitive Strength Model) is given in Figure 11.1.

Though it is very difficult to estimate the qualitative advantage that a company is facing on a rough basis, ratio analysis is one useful tool that helps in the analysis of quantitative data published by the company in the form of balance sheet and income statement. Every company that is registered for trading in the stock exchange has to compulsorily disclose its quarterly earnings position and at the end of the financial year it has to make available to the investors the audited financial statements of the company. These quarterly reports as well as audited financial statements are the data bases on which investors perform the ratio analysis to segregate the best performers from the worst performers.

The Financial Statements of Companies

The financial statements of companies are the base data through which company analysis is performed. Financial statements reflect the nature of business of the company. Financial statements are presented in the form of the balance sheet and the income statement.

The balance sheet is one of the financial statements that companies prepare every year for their shareholders. It is like a financial snapshot, the company’s financial situation at a moment in time. It is prepared at the year end, listing the company’s current assets and liabilities.

It is given in two halves—the top half shows where the money is currently being used in the business (the net assets), and the bottom half shows where that money came from (the capital employed). The value of the two halves must be the same, ie, capital employed = net assets, hence the term balance sheet.

The money invested in the business may have been used to buy long term assets or short term assets. The long term assets are known as fixed assets, and help the firm to produce. Examples would be machinery, equipment, computers, and so on, none of which actually get consumed in the production process. The short term assets are known as current assets—assets that are used day to day by the firm. The current assets may include cash, stocks, and debtors.

The top half of the balance sheet [Figure 11.1 (a)], is made up of the total of the fixed and current assets, less any current liabilities the company may have (creditors, loans, and so on).

The bottom half of the balance sheet [Figure 11.1(b)] discloses the sources of this money. The main source of money for a company is the shares. This is termed as share capital—the money the original shareholders put into the business. From then on the assets of the company may be built up by ploughing profit back into the business. This is called retained profit, and is the other source of money usually included in the bottom half of the balance sheet.

The income statement differs significantly from the balance sheet in that it is a record of the firm’s trading activities over a period of time, whereas the balance sheet is the financial position at a moment in time.

Share capital	100
Retained profit	70
Capital Employed		170
Long term loan	50
11% Debentures	50	100
Total Capital Employed		270

Figure 11.1(b) Sample Balance Sheet—Capital Employed

The income statement discloses how well the company has performed over the time period concerned (usually the last quarter, 6 months or year). It basically shows how much the firm has earned from selling its product or service, and how much it has paid out in costs (production costs, salaries, and so on). The net of these two is the amount of profit the compnay has earned.

Income statement would usually be made up as in Figure 11.2.

Particulars	Amount
Turnover (sales revenue)	500
Less: Cost of goods sold	(250)
Gross profit	250
Less: other costs (overheads)	(150)
Trading/operating profit	100
Add: Extraordinary income over expenses	10
Profit for shareholders (dividends)	75
Retained profit	35

Figure 11.2 Sample Income Statement

The extraordinary income/expenses may include profits/loss from selling assets or parts of the company, and so on. The final retained profit figure is the one that goes to the balance sheet as a source of funds for the company to use. This retained profit may be used to buy fixed assets (machinery, equipment, etc) or it may remain as current assets (cash in bank balances).

The contents of the statements differ according to the nature of business of the company. Broadly, the tools that are used for company analysis can be distinguished in terms of whether they are manufacturing companies, financial service companies, trading companies, or multinational companies.

Manufacturing Companies

Manufacturing companies have the distinguishing feature of the item “capital work in progress”, which indicates the amount of capital locked up in their varied projects. Manufacturing companies’ expenditure statements also have another prominent item called the “inventory”. The inventory holding in many instances becomes inevitable due to manufacturing schedules. However, certain manufacturing companies with a “just-in-time” management method might hold very little or near zero quantum of inventory in their books. The sample balance sheet and income statements of a manufacturing company, Asian Paints (India), Limited, is given below in Table 11.2 and Table 11.3.

 

Table 11.2 Balance Sheet of Asian Paints (India) Limited

(Rs. IN MILLONS)

	31.3.2003	31.3.2002
Funds Employed
Shareholder’s Funds	641.86	641.86
Reserves and Surplus	4,124.32	3,463.72
	4,766.18	4,105.58
Deferred Tax Liability	581.59	611.75
Loan Funds
Secured Loans	641.64	764.59
Unsecured Loans	394.54	343.12
	1,036.18	1,107.71
Total	6,383.95	5,825.04
Application of Funds
Fixed Asses
Gross Block	6,175.26	5958.83
Less Depreciation	2,559.98	2139.60
Net Block	3,615.28	3,819.23
Capital work-in-progress	18.64	24.28
	3,633.92	3,819.23
Investments	1,476.94	633.36
Current Assets, Loans and Advances
Interest Accrued	0.93	9.63
Inventories	2,068.96	1,559.45
Sundry debtors	1,198.79	1,189.58
Cash and bankbalances	271.93	221.30
Other receivables	86.01	67.83
Loans and advances	624.98	714.05
Advance payment of Taxes	95.50	—
	4,347.10	3,761.84
Less current Liabilities and Provision	3,102.52	2,465.11
Net current Assets	1,244.58	1,296.73
Deferred Reserve Expenditure	28.51	51.44
	6,383.95	5,825.04

 

Table 11.3 Profit and Loss Account of Asian Paints (India) Limited

(Rs. MILLIONS)

	31.3.2003	31.3.2002
Income
Sales and operating income	18,089.83	15,945.99
Less Excise	2,352.00	1,981.11
Net Sales	15,737.83	13,964.88
Other Income	142.24	147.37
Expenditure	15,880.07	14,112.25
Materials consumed	8,475.21	7527.65
Employees remuneration and benefits	1,064.18	920.42
Manufacturing, administration, selling and	3,557.46	3,286.44
distribution expenses
	13,096.85	11.734.51
Profit before interest, Depreciation and Tax	2,783.22	2,377.74
Less: Interest	83.48	145.80
Less: Depreciation	451.25	417.84
Profit B efore Tax	2,248.49	1,814.10
Less: Provision forcurrenttax	845.00	598.00
Less: Provision for Deferred tax	(30.16)	62.85
Profit after tax and Prior Period Items Add: B alance brought forward from previous year	1,420.10 620.00	1,143.09 520.00
Disposable profit	2,040.10	1,663.09
Disposal of above profit
Dividend
Equity Share-Interim	288.84	224.65
Final	417.21	353.03
Tax on dividend	53.45	22.91
Transfer to general reserve	560.60	442.50
B alance c arried to B alance Sheet	720.00	620.00
	2040.10	1663.09
Earnings per Share	22.12	17.81

 

The analysis of similar companies will concentrate on ratios such as the following.

Performance Ratios: Leverage ratio, liquidity ratio, cost of personnel, turnover days of inventory, collection period and payment period, and fixed asset turnover ratio.

Profitability ratios: Return on equity, return on total assets, net profit margin, payout ratio, and operating profit margin.

Market/valuation ratios: Book value per share, earnings per share, price earning multiplier, and yield ratio.

Trading Companies

Trading companies do not have manufacturing cycles, on the other hand they have trading cycles. The trading cycles highlight the quantum of capital locked up in assets for trading purposes. Usually, these companies do not have a large base of fixed assets in the form of manufacturing equipment. This characteristic distinguishes a financial statement of a trading company. The income/expenditure statement also does not have several manufacturing costs that are peculiar to manufacturing companies. Sample financial statements of trading companies may be similar to the format of Haria Exports Ltd., given in Table 11.4 and Table 11.5.

 

Table 11.4 Balance Sheet of Haria Exports Ltd.

(Rs. CRORE)

	2002	2001
Sources of Funds
Equity share capital	4.10	4.10
Reserves and surplus	24.87	24.55
Loan Funds
Secured Loan	10.41	10.65
Total Liabilities	39.38	39.30
Fixed Assets
Gross block	12.55	12.57
Less: Accumulated Depreciation	6.04	5.14
Net Block	6.51	7.43
Capital work-in-progress	1.07	1.06
Investments	0.01	0.01
Net current Assets
Current Assets, Loans and advances	51.38	78.67
Less: Current Liabilities and Provisions	19.66	47.99
Total Net current assets	31.72	30.67
Miscellaneous expenses not written off	0.07	0.14
Total Assets	39.38	39.30

 

Financial ratios for analysis of such trading companies include.

Balance sheet ratios: Current ratio, quick ratio, debt-equity ratio, and interest coverage ratio.

Profit ratios: Net profit margin and return on investment and dividend payout ratio.

Value ratios: P/E multiplier, Earnings per share, yield ratio, and Book value per share.

Service Companies

Service companies do not manufacture and provide products in the form of services. Several sectors of service companies like hotels, entertainment and so on belong to this category. The financial statements of such companies predominantly display current assets and liabilities. A sample balance sheet of a service company in the entertainment sector, Zee Telefilms, is given in Table 11.6.

The following ratios can be used to analyse the financial statements of service companies.

Profitability Ratios: Net profit ratio, return on investments, return on capital, and dividend payout ratio.

Liquidity Ratios: Current ratio and quick ratio.

 

Table 11.5 Profit and Loss Account (Haria Exports Ltd.)

(Rs. CRORE)

	2002	2001
Income
Net operating income	72.36	106.81
Total income	72.36	106.81
Expenses
Administrative expenses	67.54	100.60
Managerial expenses	0.13	0.13
Selling expenses	1.77	1.82
Depreciation	0.80	0.77
Interest expenses	1.09	0.73
Total expenses	71.33	104.05
Profit before tax	1.03	2.76
Tax provision	0.08	0.27
Profit aftertax	0.95	2.49
Appropriations
Equity dividend	0.41	1.23
Profit transferred to balance sheet	0.54	1.26

 

Table 11.6 Balance Sheet of Zee Telefilms

(Rs. MILLION)

	2003	2002
Sources of Funds
Shareholders’ Funds
Share Capital	412	412
Reserves and surplus	38,655	40,140
Deferred Tax B alance	39,067 70	40,552 171
Loan Funds	2,641	2,441
Secured Loans	1,402	1,543
	4,043	3,984
Total	43,180	44,707
Application of Funds
Fixed Assets Gross Block	1,381	1,352
Less: Depreciation up-to-date	277	199
Net Block	1,104	1,153
Capital Work-in progress	200	103
	1,304	1,256
Investments	34,356	35,369
Current Assets, Loss and Advances.
Inventories	1,405	1,352 12
Sundry debtors	3,107	2,743
Cash and bank balances	421	1,269
Loans and Advances	5,555	4,971
Less:	10,518	10,335
Current Liabilities and Provisions
Current Liabilities	2,366	1,974
Provisions	762	488
	3,128	2,462
Net current Assets	7,390	7873
Miscellaneous Expenditure	130	209
Total	43,180	44,707

Financial Results of Zee Telefilms		(Rs. Millions)
	2003	2002
Sales and Services	4796	4065
Other Income	701	767
Total Income	5497	4832
Total Expresses	4002	3488
Profit before tax	1495	1344
Provision in Taxation	532	371
Profit aftertax before exceptional Items	963	973
Less: Exceptional items and Prior period adjustments	20	175
Profit aftertax	943	798
Add: Balance brought forward	3489	3,218
Add: Profit/loss adjustment on
account of amalgamation	41	-
Amount available for appropriation	4,473	4,016
Appropriations:
Dividend
Tax on dividend	227	227
General Reserve	29	-
Balance carried forward	300	300
	3917	3489

Leverage Ratio: Debt/equity ratio.

Value Ratios: Book value per share, earnings per share, price earnings multiplier, and yield ratio.

Financial Companies (Banking)

Banking companies’ predominant income is interest income. Its expenditure is also predominantly interest expenditure. This is what differentiates a banking company from other companies. Apart from this banking companies come into existence under a separate regulation, namely Banking Companies Act, 1949 while other companies are formed under the Companies Act, 1956. The financial statements of a banking company can be illustrated through a sample balance sheet and profit and loss statement of the State Bank of India as shown in Table 11.7 and Table 11.8.

 

Table 11.7 Balance Sheet of State Bank of India

(Rs. 000)

	2003	2002
Capital and Liabilities
Capital	526,29,89	526,29,89
Reserves and surplus	16677,08,35	14698,08,04
Deposits	296123,28,24	270560,14,37
Borrowings	9303,61,94	9323,94,46
Other Liabilities and Provisions	53246,21,41	53119,78,07
Total	375876,49,83	348228,24,83
Assets
Cash and balances with RBI	12738,46,84	21872,53,47
Balances with banks and money at call and short notice	32442,55,61	43057,63,16
Investments	172347,90,72	145142,03,17
Advances	137758,45,82	120806,46,53
Fixed assets	2388,54,83	2415,22,73
Other assets	18200,56,01	14934,35,77
Total	375876,49,83	348228,24,83
Contingent Liabilities	106105,89,60	102212,98,48
Bill for collection	7571,28,46	10176,60,49

 

Financial statement analysis of banking companies should include

Profitability Ratios: Interest Expenses/Total Income, Non-interest Expenses/Total Income, Non-interest Income/Non-interest Expenses, Interest Income/Total Assets, and Interest Expenses/Total Assets.

Performance Ratios: Net Interest Margin (NIM) = Net Interest Income (NII) Total Assets, Profit Margin = Net Profit/Total Income, Asset Utilization = Total Income/Total Assets, Other Income/Total Assets, Equity Multiplier = Total Assets/Equity, Return on Assets = Net Profit/Total Assets, and Return on Equity = Net Profit/Equity.

Sustenance Ratios: Capital to Risk Weighted Assets (CRAR) = Total Capital/(RWAs), Core CRAR = Tier I Capital/RWAs, and Adjusted CRAR = (Total Capital - Net NPAs)/(RWAs - Net NPAs).

Staff Productivity: Net Total Income/Number of Employees, Profit per Employee = Net Profit/Number of Employees, Business per Employee = (Advances + Deposits)/Number of Employees, and Break even Volume of Incremental Cost per Employee = Cost per Employee/NIM.

Asset Quality: Gross NPAs/Gross Advances, Gross NPAs/Total Assets, Net NPAs/Net Advances, Net NPAs/Total Assets, Provisions for loan losses/Gross Advances, Incremental RWAs/Incremental Total Assets, and Provisions for loans and investments/Total Assets.

 

Table 11.8 Profit and Loss Account (State Bank of India)

(RS.000)

	2003	2002
Income
Interest earned	31087,01,79	29810,08,63
Other income	5740,26,07	4174,48,50
Total	36827,27,86	33984,57,1
Expenditure
Interest expended	21109,46,09	20728,84,13
Operating expenses	7942,42,02	7210,90,11
Provisions and contingencies	4670,39,75	3613,21,06
Total	33722,27,86	31552,95,30
Profit
Net profit for the year	3105,00,00	2431,61,83
Profit brought forward	33,65	33,55
Total	3105,33,65	2431,95,38
Appropriations
Transfer to statutory reserves	997,84,87	1892,04,09
Transfer to other reserves	1602,47,37	223,79,71
Transfer to proposed dividend	447,35,90	315,77,93
Transfer to tax on dividend	57,31,79	0
Balance carried over to balance sheet	33,72	33,65
Total	3105,33,65	2431,95,38

Financial Companies (Insurance)

Insurance companies also come under a separate regulation, ie, the Insurance Regulation Act. The financial statements of insurance companies have premiums as their major income. A sample financial statement of an insurance company is given in Table 11.9.

The following ratio should be considered while carrying out a financial analysis of insurance companies.

Profitability Ratios: Adjusted net profit margin, cash profit margin, gross profit margin, operating profit margin, profit before interest and tax margin, return on capital employed, and return on net worth

Spread Ratios: Premium ceded/total funds, premium income/total funds, net premium income/total funds, net profit/total funds, other income/total funds, operating expense/total funds, profit before provision/total funds

Management Efficiency Ratios Fixed assets turnover ratio, loans turnover ratio, asset turnover ratio, total income/capital employed.

Profit and Loss account Ratios: Premium ceded/Premium earned, other expense/total income, other income/total income.

Liquidity and solvency Ratio: Debt equity ratio, long term debt equity ratio.

 

Table 11.9 Balance Sheet of Life Insurance Corporation of India

(RS. LACS)

	2003	2002
Sources of Funds
Shareholders funds
Share capital	500.00	500.00
Reserves and surplus	11674.92	10787.75
	12174.92	11287.75
Borrowings
Policyholders Funds	—	—
Credit/(Debit) fair value change account	171434.98	304142.49
Policy liabilities	27299385.91	22939514.45
Insurance reserves	239360.23	239429.47
Provision for linked liabilities	590.30	361.74
	27710771.42	23483448.15
Funds for future appropriations	520.36	350217.67
Total	27723466.70	23844953.57
Application of Funds
Investment
Shareholders	10753.26	10500.00
Policy holders	22638007.40	18641460.48
Assets held to cover Linked liabilities	—	—
Loans	3707474.07	3426789.80
Fixed Assets	106318.75	94450.43
Current Assets
Cash and bank balances	981697.48	716962.04
Advances and other assets	1618182.78	1375797.95
Total current assets	2599880.26	2092759.99
Current liabilities	474076.67	377682.20
Provisions	864890.37	43324.93
Total current liabilities	1338967.04	421007.13
Net Current assets	1260913.22	1671752.86
Miscellaneous expenditure	—	—
Total	27723466.70	23844953.57

Balance sheet Ratios Advance/total funds.

Efficiency Ratio

Pure loss ratio [Expense (excluding losses, loss adjusting expenses and policyholders dividends)/earned premium]

Expenses ratio or loss adjustment ratio [expected incurred expenses/expected written premium]

Divided ratio [policyholder dividends/earned premiums].

Combined Ratio [Pure loss ratio + Expenses ratio + dividend ratio]

Growth Ratios: Cash growth ratio, Credit growth ratio, investment ratio.

Multinational Companies

Multinational companies, however, might belong to either one of the above categories and have to be analysed for investment purposes due their diversified products/markets. Divisional performances as well as overall impact have an important bearing on such companies. Along with this aspect, the analysis has to consider the foreign exchange impact on the balances of these companies. An illustration of a financial statement analysis of a multinational company is given in Table 11.10 and Table 11.11.

 

 

Table 11.11 Balance sheet - Indian GAAP of Infosys

(Rs. CRORE)

	2003	2002
Sources of Funds
Shareholder’s funds
Share capital	33.12	33.09
Reserves and surplus	2,827.53	2,047.22
	2,860.65	2,080.31
Application of Funds
Fixed Assets
Original cost	1,273.31	960.60
Less: Depreciation and amortisation	577.15	393.03
Net book value	696.16	567.57
Add: capital work-in-progress	76.56	150.67
	772.72	718.24
Investments	33.20	44.44
Deferred tax assets	36.81	24.22
Current Assets, Loans and Advances
Sundry Debtors	512.14	336.73
Cash and bankbalances	1,336.23	772.22
Loans and advances	872.78	643.87
	2,721.15	1,752.82
Less: current liabilities	315.25	126.11
Provisions	387.98	333.30
Net current assets	2,017.92	1,293.41
	2,860.65	2,080.31

 

Multinational companies present consolidated statements of all their operations and also their individual countries’ results separately. This is because each country sets its own accounting standards in tune with their respective business and accounting principles and conventions. Companies also present a reconciliation statement showing the reason for the difference in profits caused due to the different accounting standards followed between home country and foreign country.

Analysis of multinational companies will use similar ratios depending on the type of business that is performed by it. Ratios are the most often used tools to analyse the financial performance of individual companies. Ratios, since they are relative measures, help investors to evaluate firms across industry and time. Along with this such multinational companies publish segment accounts distributing their revenue from regions.

Accounting Ratios

Ratios for investment purposes can be classified into profitability ratios, turnover ratios, and leverage ratios. Profitability ratios are the most popular ratios since investors prefer to measure the present profit performance and use this information to forecast the future strength of the company. The most often used profitability ratios are return on assets, price earnings multiplier, price to book value, price to cash flow, price to sales, dividend yield, return on equity, present value of cash flows, and profit margins.

 

Table 11.12 Profit and Loss Account Infosys

(RS. CRORE)

	2003	2002
Income
Software services and products
Overseas	3,543.51	2,552.47
Domestic	79.18	51.12
	3,622.69	2,603.59
Software Development expenses	1,813.30	1,224.82
Gross profit	1,809.39	1,378,77
Selling and marketing expenses	266.98	129.79
General and administrative expenses	270.37	211.35
	537.35	341.14
Operating profit before interest, depreciation	1,272.04	1,037.63
and amortisation
Interest	—	—
Depreciation and amortisation	188.95	160.65
	1,083.09	876.98
Operating profit after interest, depreciation	99.61	66.41
and amortisation
Other income	23.77	—
Provision for investments	1,158.93	943.39
Profit before tax
Provision for tax	201.00	135.43
Net profit after tax	957.93	807.96
Amount available for appropriation	957.93	807.96
Dividend
Interim	82.76	49.63
Final (proposed)	96.05	82.73
Dividend tax	12.30	5.06
Amount transferred to general reserve	766.82	670.54
Basic Earnings Per Share	957.93	807.96

 

Reconciliation of Indian and US GAAP financial statements

(Rs. CRORE)

	2003	2004
Net profit as per Indian GAAP	957.93	807.96
Less: Amortisation of deferred stock compensation expense	(23.20)	(23.92)
Deferred income taxes	(0.90)	—
Profit/(loss) from Progeon Limited	(3.10)	—
Add: Deferred taxes	—	1.78
Gain on forward exchange contracts	2.40	—
Net provisions for investments	9.10	—
Consolidated net income as per the US GAAP	942.23	785.82

Return on Assets (ROA)

Return on assets (ROA) is computed as the product of the net profit margin and the total asset turnover ratios.

This ratio indicates the firm’s strategic success. Companies can have one of two strategies: cost leadership, or product differentiation. ROA should be rising or keeping pace with the company’s competitors if the company is successfully pursuing either of these strategies, but how ROA rises will depend on the company’s strategy. ROA should rise with a successful cost leadership strategy because of the company’s increasing operating efficiency. An example is an increasing total asset turnover ratio as the company expands into new markets, increasing its market share. The company may achieve leadership by using its assets more efficiently.

With a successful product differentiation strategy, ROA will rise because of a rising profit margin. The company can charge a premium price for its product, control costs, or dispose off less profitable operations.

Return on Investment (ROI)

ROI is the return on capital invested in business, ie, if an investment Rs 1 crore in men, machines, land and material is made to generate Rs. 25 lakhs of net profit, then the ROI is 25%. Again, the expected ROI by market analysts could differ from industry to industry. For the software industry it could be as high as 35–40 per cent, whereas for a capital intensive industry it could be just 10–15 per cent.

The computation of return on investment is as follows:

The definition of equity investments could vary between investors. Usually equity investments refer to amount contributed as paid up capital by the owners of the funds in addition to the capital reserves that are due to the owners. These investments are related to net profit to identify the return on investment.

Return on Equity

Return on equity measures how much an equity shareholder’s investment is actually earning. The return on equity tells the investor how much the invested rupee is earning from the company. The higher the number, the better is the performance of the company and suggests the usefulness of the projects the company has invested in.

The computation of return on equity is as follows:

The return on equity, mentioned above, could be categorically computed for different types of owners’ capital, namely common shareholders’ return and preference shareholders’ return. Accordingly, the denominator will change in the above equation. Equity often implies common equity shareholders’ funds and their specific reserves. Return on preference equity will have the denominator of preference shareholders’ funds and any reserves that are due to preference shareholders’ alone.

Earnings Per Share (EPS)

This ratio determines what the company is earning for every share. For many investors, earnings is the most important tool. EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. The computation of EPS is as follows:

Net profit implies profit that is available to the shareholders. When there are different types of owners, earnings per share must be computed in terms of specific ownership type for better interpretation.

Thus, if AB Limited has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an EPS of Rs 2. Apart from EPS, the actual growth in EPS is a better measure for the investors to shortlist the companies. The companies in the top list ranked according to growth in EPS would be good investment avenues for the investors.

Dividend Per Share (DPS)

The extent of payment of dividend to the shareholders is measured in the form of dividend per share. The dividend per share gives the amount of cash flow from the company to the owners and is calculated as follows:

The payment of dividend can have several interpretations to the shareholder. The distribution of dividend could be thought of as the distribution of excess profits/abnormal profits by the company. On the other hand, it could also be negatively interpreted as lack of investment opportunities. In all, dividend payout gives the extent of inflows to the shareholders from the company.

Payout Ratio From the profits of each company a cash flow called dividend is distributed among its shareholders. This is the continuous stream of cash flow to the owners of shares, apart from the price differentials (capital gains) in the market. The return to the shareholders, in the form of dividend, out of the company’s profit is measured through the payout ratio. The payout ratio is computed as follows:

The percentage of payout ratio can also be used to compute the percentage of retained earnings. The profits available for distribution are either paid as dividends or retained internally for business growth opportunities. Hence, when dividends are not declared, the entire profit is ploughed back into the business for its future investments. The computation of retained earnings ratio (Retention Rate) is as follows:

For example, if the company has an EPS of Rs 15 and declares a DPS of Rs 5, the payout ratio is computed as (5/15) * 100 = 33.33 per cent. The retention rate is hence (10/15)*100 or 1–33.33, per cent ie, 66.67 per cent.

Dividend Yield Dividend yield is computed by relating the dividend per share to the market price of the share. The market place provides opportunities for the investor to buy the company’s share at any point of time. The price at which the share has been bought from the market is the actual cost of the investment to the shareholder. The market price is to be taken as the cum-dividend price. Dividend yield relates the actual cost to the cash flows received from the company. The computation of dividend yield is as follows:

High dividend yield ratios are usually interpreted as undervalued companies in the market. The market price is a measure of future discounted values, while the dividend per share is the present return from the investment. Hence, a high dividend yield implies that the share has been underpriced in the market. On the other hand a low dividend yield need not be interpreted as overvaluation of shares. A company that does not pay out dividends will not have a dividend yield and the real measure of the market price will be in terms of earnings per share and not through the dividend payments.

Price/Earnings Ratio (PIE)

The P/E multiplier or the price earnings ratio relates the current market price of the share to the earnings per share. This is computed as follows:

The current market price is expected to reflect the value of shares at present and when compared to the earnings per share, a low P/E multiplier has the implication that the current market price is too low for the earnings declared by the company. Many investors prefer to buy the company’s shares at a low P/E ratio since the general interpretation is that the market is undervaluing the share and there will be a correction in the market price sooner or later.

A very high P/E ratio on the other hand implies that the company’s shares are overvalued and the investor can benefit by selling the shares at this high market price. However, P/E multiplier alone will not accurately predict the future price movements of the share.

P/E ration alone does not give a complete and true picture about the company. If AB limited is currently trading at Rs 20 a share with Rs 4 of earnings per share (EPS), it would have a P/E of 5. When a share’s P/ E ratio is high, the majority of investors consider it as expensive or overvalued. Shares with low P/E’s are typically considered better investment options.

A company that currently earns Re 1 per share and expects its earnings to grow at 20 per cent p.a and would be expected to have an earnings of Rs 2.50 at the end of five years (ie, Re 1 compounded at 20 per cent p.a. for 5 years). Also assume that the normal P/E ratio is 15. If the share is selling at a normal P/E ratio of 15 times then the market prices could go up to Rs 37.50 (ie, Rs 2.5*15).

Thus, if this company expects its earnings to grow by 20 per cent per year in the future, investors might be immediately willing to pay an amount based on those future earnings of the shares. In such instances, the investors could push the share price dramatically with a very high P/E ratio, relative to its present earnings.

Investors can use the P/E as a tool to determine a reasonable price to pay for the share by comparing its present P/E to its past levels of P/E ratio. The identification of a high or low P/E for the company, could be by comparing the P/E ratio of the company with that of the market. An average P/E ratio over time can also be used to help judge the reasonableness of the present levels of prices.

Hence, an investor who attempts to purchase a share close to what is considered as a reasonable P/E ratio, would not lose in the market. Besides P/E estimates and earnings growth, a higher share price could also be due to management potential and high quality of operations.

Book Value Per Share

The book value per share is computed as per the balance sheet of the company. The book value per share gives a historical valuation of the company and sometimes book value indicates the exact amount that the shareholders’ hold as their stake in the company. The computation of book value per share is as follows:

The book value per share is sometimes referred to as the cost of assets held in the business as on a specific day. It is a more realistic measure of the under valuation/over valuation of a company in the market. The company’s shares are expected to have at least the book value as a starting point. However, this measure is subject to a lot of criticism since book value is a historical accounting measure and need not necessarily reflect the true worth of the company. It is more subject to accounting policies and procedures rather than the liquidation value or the true worth of the company.

Gross Profit Ratio

A company’s basic strength is its core business activity performance. This is the gross profit measure. Gross profit is the operating profit for the business enterprise. The operating profit as a percentage of net income is the gross profit ratio. Net income usually represents the gross income less excise duty, that is, legal obligation on sale price. Gross profit ratio is usually stated in percentage form. The calculation of gross profit ratio is as follows:

The higher the gross profit ratio, the better the performance of the company. The gross profit ratio highlights the core business competence of a company. The company has to have operational cost advantage if it has to have a competitive edge in the market. Hence, higher gross profit ratios, when compared to the industry standards, imply that the company is performing well and can be expected to show good results even when the industry is down. This highlights the bottom line performance of the business.

Net Profit Ratio

Net profit ratio identifies the earnings of the business. Net profit is computed after deducting all expenses, including depreciation, interest, and tax. The net profit ratio is also stated as a percentage figure and is calculated as follows:

The net profit ratio is resultant business profits. Hence, a business has to perform on all aspects to show a good net profit margin. Sometimes the net profit margin can also be misleading. The company could have shown a gross loss, but could manage to end with a net profit through income other than core business such as investment income or revaluation income. Hence, while evaluating the net profit ratio, care must be taken to evaluate the source of the net profit rather than merely analyse the calculated ratio.

Interest Coverage Ratio

One of the prominent expenses for a business is interest. The interest obligations of a company have to be met promptly. The ability of the company to meet such fixed rate obligations is measured through the interest coverage ratio. The fixed obligations include both interest and principal payments made by the company for the accounting year. The computations of interest coverage ratio is as follows:

A high interest coverage ratio indicates the safe position of the company to pay all its fixed obligations. The high ratio gives confidence to the investors that the pre-interest and pretax income from the company is adequate to pay the fixed short term obligations of the company. A low, or less than one, ratio indicates that the company may get into a liquidity crisis.

Current Ratio The testing of liquidity of the business is through the current ratio. A company that manages its current obligations through its current holdings will be able to match its asset-liability structure profitably. The computation of the current ratio is given below:

Current assets and current liabilities are classified on the basis of the time duration that these assets are expected to be in the books of a company. Current assets are rotated in the business quiet often and they do not retain the same form for more than twelve months. Hence they are termed as current assets. Examples of current assets are inventory, cash and bank balances, net debtors position, bills receivables, and other short term assets that the company has acquired during the course of business. Current liabilities are similarly obligations that the company has to repay within an accounting year. Examples of current liabilities are short term borrowings like bank overdraft facilities, credit facilities, creditors in the books, bills payable that the company has drawn, and so on.

A current ratio indicates the extent of current assets held at a point of time compared to the current obligations of the company. A ratio of one indicates that for every one rupee of current obligations, the company has one rupee of current assets. Here, the liquidity position of the company could be stated as tight and, if the current assets do not give back the exact amount, the company ought to use long-term funds to pay its current obligations.

Any current ratio that is very high relative to the industry standards would also imply that the company is not handling its liquidity position very well. Very high current ratios compared to the industry standards point out that too much of current assets are locked up in short yielding assets and could be invested profitably for higher yielding project/investment opportunities.

Quick Ratio (Acid Test Ratio) Another measure of liquidity of a company is the quick ratio or the acid test ratio. This relates quick assets to current liabilities to test the critical liquidity position of a company. The computation of quick ratio is as follows:

Quick assets are the assets that can be easily converted into cash or cash equivalents. The current asset that is a major problem to business enterprises is the inventory. Inventory has to be converted into sales to make it a cash equivalent. Till then the value of the inventory can not be considered as a cash equivalent. Hence current assets excluding inventory is termed as quick assets. The quick assets may be equal to the current liabilities of a company. A very low ratio indicates the short-term debt trap of a company and a very high ratio compared to industry standards indicates too much of asset holding that do not yield high returns to the company.

Debt-to-Equity Ratio

This measures how much debt a company has compared to its equity. The debt-to-equity ratio is computed by dividing the total debt of the company with the equity capital. If it is 1, then the company still has the equity backup to borrow further. A D/E ratio of more than 2 is considered risky. It means that the company has a high interest burden, which could eventually affect the bottom line. If interest payments are using only a small portion of the company’s revenues, then the company is better off by employing debt to increase growth. Also capital intensive industries tend to have a higher debt/equity ratio, hence the interpretation of D/E ratio must be through a comparison of industry average.

Asset Turnover Ratio

Asset utilisation is another aspect that a business can be tested on. For every rupee invested in assets, the resultant income generated by the asset is the asset utilisation power. The computation of this ratio is as follows:

A relatively larger asset turnover ratio than industry standards indicates the superiority of the company. The implication is that the company is able to utilise the assets more profitability than an average company in the industry. A low ratio implies assets have not been fully utilised for generating the company’s income.

Inventory Turnover Ratio/Inventory Holding Period

The specific inventory holding period or the utilisation of inventory in the company can be ascertained through the inventory turnover ratio. The computation of inventory turnover ratio and the holding period are as follows:

Inventory turnover ratio relates the average inventory held on a day in the company to the total cost of goods that were converted into sales. Similar to the fixed assets turnover ratio, this also indicates the utilisation of inventory. The larger the turnover of inventory into sales in a specific year, the better will be the profit performance of the company. When stated in terms of the holding period, this give the number of days (months) inventory is held on an average in an accounting year. A high inventory turnover ratio increases the denominator, hence, the time duration of holding of inventory will be very little. A low inventory turnover ratio indicates that inventory is held for a longer duration before it gets converted into sales.

The best way to interpret this ratio will be to compare it with industry average. Lower holding periods than the industry average will indicate best performing companies. On the other hand, higher holding period companies may not have the competitive strength to survive business slowdowns.

Debtors Turnover Ratio/Collection Period

Credit sales results in uncollected amounts in the form of debtors and bills receivable. The debtors turnover ratio relates these measures to interpret the utilisation of credit policy of the company. The computation of these ratios are as follows:

Average collectibles are computed by averaging and the opening debtors and bills receivables and the closing debtors and bills receivables in an accounting period. The assumption is that the debtors and bills receivables are formed and collected uniformly throughout the year.

Average collectibles = (Opening Debtors and bills Receivables + closing Debtors and bills receivables)/2.

A high debtors turnover ratio indicates fast collections from credit sales. A low debtors turnover ratio implies that credit sales are not quickly converting into cash. The collection period precisely states this in the number of days or months. This ratio is also best used when compared to industry average. Most of the times the credit policy of companies depends to a large extent, on industry practices. The higher the company’s collection period than the industry average, the more imperative it is for the company to give serious consideration to the revision of present credit policy measures taken by it. On the other hand a lower than industry average collection period puts the company’s position on a higher plane than its competitors.

Creditors Turnover Ratio/Payment Period

Creditors arise out of credit purchases made by the company for its raw material and similar assets. These creditors are to be paid promptly and the overall success of the credit policy of the company can be identified only when the credit allowed by the suppliers is taken into consideration. The computation of these ratios are as follows:

Average credit obligations are computed using opening value of creditors and bills payable and closing value of creditors and bills payable in an accounting period.

Average credit obligations = (opening creditors and bills payable

+ closing creditors and bills payable)/2.

A higher collection period than the payment period will result in a negative position of the asset liability structure of the company. The implication is that payments are made quickly while the company takes a longer duration to convert its sales into cash. A higher payment period compared to collection period is always preferable to a company since the payment of current liabilities such as creditors can be made out of receipts from debtors. However, every industry has its own average and besides indicating the overall efficiency of the credit policy, these ratios can be used to indicate the relative payment position of a company.

Cash Conversion Cycle (or Net Operating Cycle)

A composite measure of the holding period, the collection period, and the payment period can be combined as the cash conversion cycle or net operating cycle of the business. The computation is as follows:

Cash Conversion Cycle = Average Inventory Period

                                                  + Average Receivables Period

                                                  − Average Payables Period

The cash conversion cycle, or net operating cycle, simply indicates the duration of time it takes the company to convert its activities requiring cash into cash flows. As highlighted earlier, this ratio is important since it represents the number of days a company’s cash is occupied with its operations. Naturally, a company would expect this cycle to be as short as possible. Therefore, a decline in this cycle over time is a positive signal while an upward trend is a negative signal.

When the cash conversion cycle shortens, cash is released for other uses such as investing in new projects, spending on equipment and infrastructure, as well as preparing for possible investment avenues in the future. When the cycle, over a period of time, becomes longer, ie, when the cash conversion cycle lengthens, cash remains tied up in the company’s core operations, leaving little scope for other uses of this cash flow.

While analysing the cash conversion cycle, attention must be highlighted to the trend of all its three general components, with special emphasis on the payables period. Sometimes, shorter periods for inventory and/or receivables can be largely offset by increases in the period for credit payables. The period for credit payables will increase if the company is paying its creditors and suppliers at a slower rate.

Interpreting the Cash Flows of the Business

Besides ratio analysis, disclosure requirements also make the preparation of cash flow statements compulsory for companies. Cash flows are distinctly shown as operational cash flows, cash flows from investment activities, and cash flows from financing activities. The matching of these headings gives the investor a view of the past performance and what can be expected from the company in the near future. When the cash outflows are more in operational activities, the investor can easily conclude that the profit performance of the company has been very bad. Cash inflow from investment activities has to be interpreted carefully, going into detail regarding the causes for such inflows. Cash inflows from financing activities are an indicator of future obligations of the company, either in the form of dividend payments or interest payments. Cash outflows from investment activities could indicate additional investment in ongoing projects for the company.

A graphical representation of the cash flows for a company is given in Figure 11.3.

Other Measures to Analyse the Performance of the Company

Revenues/Sales Growth

Revenues are how much the company has earned over a given period. Sales are the direct performance indicators for companies. The rate of growth of sales over the previous years indicates the forward momentum of the company, which will have a positive impact on the share’s performance evaluation by an investor.

An illustrative cash flow statement is given below in Table 11.13.

 

Table 11.13 Sample Cash Flow Statement

	Rs ‘000	Rs ‘000
Cash Flows from operating activities
Cash generated from operations	84,000
Income tax paid	(15,000)
Cash flow from extraordinary item (insurance claim receipt)	3,000
Net Cash provided by operating activities		72,000
Cash flows from investing activities
Purchase of plant and machinery	(173,000)
Sale of plant and machinery	22,000
Purchase of investments	(26,000)
Sale of investments	42,000
Interest received	7,000
Net Cash used in investing activities		(128,000)
Cash flows from financing activities
Issuance of share capital	100,000
Repayment of unsecured loan	(1,000)
Redemption of secured loan	(27,000)
Dividend paid	(25,000)
Interest paid	(22,000)
Net Cash provided by financing activities		25,000
Net decrease in Cash and cash equivalents		(31,000)
Cash and cash equivalents at the beginning		51,000
Cash and cash equivalents at the end		20,000

Bottom-line Growth

The bottom-line is the operating profit of a company. The growth in operating profit indicates the attractiveness of the share for an investor. The expected growth rate might differ from industry to industry. Comparing the company’s bottom-line growth with that of the industry average would help the investor to identify good performance.

Company Management

The quality of the top management is the most important of all resources that a company has. An investor has to make a careful assessment of the competence of the company management, as evidenced by the top management’s dynamism and vision. If the company’s board includes certain directors who are well known for their efficiency, honesty, and integrity, and are associated with other companies of proven excellence, an investor can consider it as favourable. Among the directors, the Managing Director (MD) Chairman is the most prominent person. It is essential to know whether the top executive is a person of proven competence. Besides the top executives credentials other factors that may be considered to qualitatively evaluate the worth of a company could be stated as follows:

History of the company and line of business

Product portfolio’s strength

Market share

Intrinsic values for assets like patents and trademarks

Foreign collaboration, its need and availability for future

Quality of competition in the market, present, and future

Future business plans and projects

Market tags like index heavy weights and so on

SUMMARY

There may be situations were the industry is very attractive but a few companies within it might not be doing all that well; similarly there may be one or two companies that may be doing exceedingly well while the rest of the companies in the industry might be facing difficulties. An investor will have to consider both the financial and non-financial factors so as to form an overall impression about a company.

Investors, while deciding on the best company, should focus on factors such as:

• Market leaders who dominate their product segment
• Companies that register earnings that are growing, at an increasing rate, consistently
• Revenue growth that exceeds the industry average, and
• Effective management

CONCEPTS

• Efficiency Ratios	• ROI
• Cash conversion cycle	• Bottom line growth
• Growth stocks	• Capital adequacy
• Ratio analysis	• Cash flow analysis
• Investment activities	• Financing activities
• Operating activities

SHORT QUESTIONS

1. What are fundamentals?
2. What are the basic assumptions of fundamental analysis?
3. State the objective of company analysis.
4. What are financial ratios?
5. State the limitations of ratio analysis.
6. What qualitative information is useful for company analysis?

ESSAY QUESTIONS

1. Explain how ratios help in the performance analysis of a company.
2. What ratios are relevant for the analysis of financial companies/service companies and MNCs?
3. Explain the steps for performing company analysis.
4. How does company analysis help investors in choosing securities?

APPENDIX

BANKING COMPANY TERMINOLOGY

Tier-I Capital

• Paid-up capital
• Statutory reserves
• Disclosed free reserves
• Capital reserves representing surplus arising out of sale proceeds of assets

Tier-II Capital

Besides Tier-I capital the following are included to compute Tier-II capital.

• Undisclosed reserves and Cumulative Perpetual Preference Shares
• Revaluation reserves
• General provisions and loss reserves

Operating Cost

The intermediation costs of a bank refer to the operating cost of the bank and include all the administration and operational costs incurred while offering its services. The ratio of the intermediation costs of thebank to the total assets should be kept low to ensure greater profitability. A technology savvy bank will always be in abetter position to reduce its operating costs.

Net Interest Income

Net interest income is the difference between interest received and interest paid. Net interest income (Spread) to the total assets gives the net interest margin of the bank. This ratio is the actual measure of the bank’s performance as an intermediary, as it examines the bank’s ability in mobilising lower cost funds and investing them at a reasonably higher interest.

Asset Quality—N PA Burden

The asset quality of banks can be examined by considering the Non Performing Assets (NPAs). These NPAs should be considered against not just total assets but also against the advances, because this is where the NPAs primarily arise. When NPAs arise, banks have to make provision for the same as per the regulatory prescriptions. When the provisions are adjusted against the Gross NPAs it gives rise to the net NPAs. Provisions reduce the risk exposure arising due to the NPAs to areasonable extent as they ensure that banks sustain the possible loss arising from these assets.

Capital Adequacy Ratio

The one important parameter that essentially relates to the bank’s ability to sustain losses due to risk exposures is the bank’s capital. The intermediation activity exposes the bank to a variety of risks. Considering this, it is essential to examine the capital against its risk weighted assets (RWA). This is the Capital to Risk Weighted Assets Ratio (CRAR), as given by the Basle Committee 1997. The statutory prescription for CRAR is 9 per cent, which has been well surpassed by most banks.