Financial Analysis — reading what the company actually filed

Why an analyst needs the numbers

You have already learnt to look at a company from the outside — the economy, the industry, the management. The next step is to work out what all of that does to future profit, future cash flows and, in turn, the fair value of the shares.

That is what financial analysis is for. The workbook is careful to lower the barrier here: an analyst need not be a great accountant, but the analyst should be able to read and interpret the financial statements. Prior accounting knowledge is an advantage, not a requirement.

Financial statements also feed everything else you have studied. Bottom-up market sizing needs revenue numbers from the statements. Industry KPIs are built from statement line items. The financial strengths and weaknesses in a SWOT come from here too.

The four statements — and who prescribes them

In India, what a listed company must publish is governed by Schedule III of the Companies Act 2013 and IndAS 1.

One rule that gets tested: while presenting financial information, companies must provide comparable information for at least one prior period. Every statement carries the current period and the prior period. A company may voluntarily show longer.

Note the exception on formats. The Schedule III format applies to all industries except those with a separate requirement from their own regulator. So banking, insurance and utility companies follow a different format prescribed by their respective industry regulators.

Standalone or consolidated?

Every company is a separate registered entity in the eyes of law, so every company prepares its own stand-alone financial statement. For a group, that can be badly misleading.

The workbook's own example: Toyota Motor Corporation is Japanese and sells worldwide through subsidiaries. Its stand-alone statement shows only the sales of that one entity — Japan. Sales in China, India or North America made through subsidiaries simply do not appear. Indian examples given are Jio Platforms, majority owned and controlled by Reliance Industries Limited, and Toyota Kirloskar Motor Limited, majority owned by Toyota Motor Corporation, Japan.

So companies that have invested in subsidiaries must present both consolidated and standalone statements. Consolidated treats every controlled company as one group and combines them.

What counts as control? Owning more than 50% of the voting rights, or having the right to appoint the majority of the board of directors. And the workbook goes further: it is not necessary that a holding company owns more than 50%. If it has the power to control the strategy and operations of the subsidiary in a way that changes the returns and their timing, it is de-facto in control and must consolidate under Ind AS 110.

For equity analysis, consolidated statements are generally preferred because they give a more holistic picture of group performance.

But there is a case for reading standalone too. Sometimes a subsidiary cannot pass dividends up to the parent — because it sits in a geography with strict capital controls, or because it has agreed under a debt covenant not to pay any dividend. In that situation you must check whether the parent can fend for itself in a crisis.

The disclosure rule to memorise: SEBI requires listed companies to publish consolidated financial statements on an annual basis, and mandates stand-alone financial results on a quarterly basis. Consolidated quarterly numbers are not mandatory, though some companies publish them voluntarily. Where a group does not, analysts must contend with dated information, because the gap between two annual reports is almost a year.

The balance sheet, line by line

Assets are items expected to provide future benefits. But accounting only recognises assets that are quantifiable in monetary terms and have been paid for. That single rule explains a puzzle beginners always hit: an entity cannot recognise self-generated assets such as its own brand name. The brand of a large Indian FMCG company may be worth thousands of crores and appear nowhere.

Assets split into non-current (benefits over the long term, usually more than one year) and current (benefits within one operating cycle — usually taken as one year or less; where the operating cycle crosses one year, one year is the convention).

Non-current assets

• Property, Plant and Equipment (PPE) — land, building, machinery, furniture, computers. Shown at historical cost net of accumulated depreciation. IndAS 16 permits a revaluation model, and if chosen it must be applied to an entire asset class. Bharti Airtel's PPE at 31-Mar-2019 was ₹815.2 billion.
• Capital work in progress — PPE under construction, not yet ready for operation. Transferred to PPE on completion.
• Goodwill — arises on acquiring a business: the consideration paid over and above the fair value of net assets taken over. Bharti Airtel acquired 100% of Tigo Rwanda Ltd for ₹3,200 crore when the fair value of net assets was ₹2,838 crore; the balance became goodwill. It is tested periodically for impairment, and if value in use falls below carrying value the difference is written off as impairment. If a company pays less than fair value, the difference goes to capital reserves on the liability side under equity.
• Intangible assets — generally in the form of a legal right: acquired copyrights, patents, brand names. Self-generated assets cannot be shown, but internally developed software programs can be recognised. Shown at cost less accumulated amortisation.
• Intangible assets under development — not yet ready for use.
• Investment in joint ventures / associates — strategic investments the company does not control, reported under the equity method: carrying amount adjusted for the investor's share of the investee's profit or loss and OCI, reduced by dividends received, and adjusted for impairment. It also includes initial goodwill less subsequent impairment.
• Non-current financial assets — long-term investments, loans, advances. Debt-type items held to collect interest and principal are carried at amortised cost; other assets at fair market value.

Current assets

• Inventory — raw material, work-in-progress and unsold finished goods, valued at cost price or market value, whichever is lower.
• Current financial assets — cash and cash equivalents (cash, current accounts, short-term bank deposits, money-market investments), other bank balances, receivables (shown net of provision for doubtful debts), short-term investments at fair market value, and others.
• Other current assets — prepaid expenses and anything where the benefit will come in kind rather than as cash.

Equity — the residual interest belonging to owners: assets minus liabilities.

Non-current liabilities — obligations due after one year.

• Long-term debt — loans, debentures, bonds, notes due beyond a year. The portion falling due within one year is shown separately as current portion of long-term debt, usually inside current liabilities. Bharti Airtel reported ₹872.45 billion of long-term debt plus ₹71.732 billion as the current portion; accrued interest is shown separately.
• Lease liability — recognised whenever the company acquires a right to use an asset under a lease for more than one year. Fair value of the lease minus amount repaid (excluding interest); where fair value is not determinable, the present value of lease payments. Analysts often treat lease liability as part of debt obligations.
• Derivative instruments — mark-to-market losses on derivative contracts. Contracts settling after a year sit in non-current liabilities; those settling within a year in current liabilities.
• Deferred revenue — an obligation created by receiving revenue in advance. The workbook's example: a customer buys a 6-month prepaid pack for ₹1,200 with 5 months validity left; the company recognises ₹200 as revenue for the first month and shows ₹1,000 (1,200 × 5 ÷ 6) as deferred revenue.
• Provisions — amounts set aside for a liability that is yet to be fully quantified. Retirement benefits, warranty obligations, legal liability not yet adjudicated.

Learn this distinction, it is examinable: reserves are set aside for an unknown purpose; provisions are set aside to meet a specific obligation that the company may not be able to fully quantify.

Current liabilities — due within one year: payables to suppliers, short-term debt (borrowed for less than a year, though in practice often rolled over or refinanced, so companies carry them longer), short-term provisions, current portion of long-term liability, deferred revenue, advances from customers, and unpaid or accrued expenses.

Two metrics analysts build off the balance sheet

Balance sheets often fail to reflect fair value because of accounting conventions such as historical cost and money measurement. So analysts compute their own numbers.

Total debt. Debt is different from every other liability: it is settled in cash and carries interest as compensation for the time value of money. Total debt = long-term debt + current portion of long-term debt + short-term debt + financial lease obligations + accrued interest. Bharti Airtel's consolidated total debt at 31-Mar-2019 was ₹12,87,036 million (₹11,41,504 million a year earlier).

Working capital. The accountant's version is current assets minus current liabilities. On that basis Bharti Airtel's working capital was negative ₹601.49 billion (current assets ₹329.06 billion, current liabilities ₹930.55 billion).

The workbook then tells you why that number misleads. Current assets include short-term investments not meant for operations; current liabilities include items like the current maturity of long-term debt that have nothing to do with day-to-day trade. So analysts compute core working capital = inventory + trade receivables − trade payables. For Bharti Airtel at FY2019 that was negative ₹2,36,141 million (inventory 884 + debtors 43,006 − payables 2,80,031). The workbook adds a sensible caveat: it is a good idea to include a reasonable cash balance too, because cash is needed for smooth operations.

The profit and loss account

The P&L shows performance for a period. Schedule III prescribes the format; IndAS 1 requires OCI to be included, shown below net profit. Again banking, insurance and utility companies follow their regulators' formats.

Revenue is what the company earns selling goods and services, including income incidental to core operations — often split into revenue and other operating income. Other income is typically non-operating: investment income, profit on sale of assets.

Expenses vary by industry. Common to all: employee cost, depreciation, finance charges. Manufacturers add three more: cost of raw materials, purchase of stock-in-trade, changes in inventory of finished goods.

Here is a genuinely important Indian quirk. Expense reporting in India differs significantly from the rest of the world. Raw material costs carry a high disclosure requirement, but other direct costs do not. The consequence: it is not possible to calculate gross profit for most Indian companies, because direct costs other than raw materials are never disclosed separately.

Tax has three components in an Indian company: current tax, MAT and deferred tax. MAT paid can be used as credit in future, so in theory it should appear as an asset; but if the company believes it cannot claim the credit within the allowed duration, it expenses it in the P&L. Deferred tax has no cash impact — it arises from timing mismatches between the income-tax authorities and accounting standards.

EPS. Basic EPS = net profit attributable to equity shareholders ÷ the weighted average number of shares outstanding, weighted by the time they were outstanding. Diluted EPS assumes every instrument convertible into equity without payment of full consideration is converted — in-the-money warrants, ESOPs, convertibles — and adjusts profit for the impact. The exam point: for loss-making companies, diluted EPS and basic EPS are one and the same.

Other Comprehensive Income (OCI) is income or expense that is required or permitted to by-pass the profit and loss account — mostly changes in the value of assets and liabilities from non-operating factors: changes in revaluation surplus, re-measurement gain or loss on defined benefit plans, gains or losses on translating foreign operations, changes in fair value of financial assets accounted through OCI, and gains or losses on effective hedges. The part of a subsidiary's OCI belonging to outside shareholders is allocated to non-controlling interest.

The profit waterfall

Most companies present a single-step P&L: add all income, subtract all expenses, get profit before tax. Some present multi-step. Analysts convert single-step into multi-step anyway.

• Gross profit = revenue − cost of goods sold. Suitable for manufacturing. Cannot be calculated for Indian companies because direct costs are not disclosed.
• EBITDA strips out interest (a funding choice) and depreciation and amortisation (driven by the infrastructure model and by accounting choices on method and useful life). That is why it is the right metric to compare two firms — it is not contaminated by capital structure and infrastructure choices. Adjusted EBITDA goes further and excludes investment and other non-operating income driven by treasury choices. EBITDA also serves as a proxy for cash profit from operations — but analysts should use it that way only as a last resort.
• EBIT, also called operating profit, measures the firm's ability to meet annual interest or financial expenses. It is the input for the Interest Coverage Ratio and for Free Cash Flow to the Firm in valuation.
• PAT / EAT / Net profit is the final profit available to shareholders, after lenders get interest and the government gets tax.
• Adjusted PAT removes exceptional and non-recurring items — and their tax impact. The workbook warns that this needs judgement: Bharti Airtel's FY2019 effective tax rate is meaningless because it paid huge taxes despite reporting losses. Good practice is to identify the specific exceptional item and apply the relevant tax rate for that item.

Cash flow: profit is an opinion, cash is a fact

Accounting is on an accrual basis — income is recognised when earned, not received; expenses when incurred, not paid. So profit and cash diverge.

The workbook's clean illustration: a business makes cash purchases of ₹80,000 and cash sales of ₹1,00,000. Profit ₹20,000, and the cash is in hand. Now make the sales on credit. The P&L still shows ₹20,000 profit — but there is no money. If the dues are never collected, there is no profit and even the ₹80,000 of capital is likely to be lost.

Cash flows split three ways:

• Operating cash flows — from business operations (P&L items). Net profit is converted to operating cash flow by adding back non-cash expenditure such as depreciation and amortisation and adjusting for changes in receivables and payables.
• Investing cash flows — from assets (balance sheet items). Buying assets is negative, selling is positive.
• Financing cash flows — from liabilities. Borrowing or issuing equity is positive; redeeming debt or equity is negative.

Continuously negative operating cash flow is an alarming signal of risk. Such a business needs continuous doses of stimulus — borrowing or equity expansion — to keep going. Over time it either turns positive or dies when investors and lenders refuse to pump in further cash.

The workbook names the case: Kingfisher Airlines ran negative operating cash flows for years.

The airline was borrowing money to pay interest, because EBIT was far below its interest obligation for years. Then lenders stopped. The workbook's conclusion is worth memorising: no business can run on continuous expansion of borrowed money.

Four rules for reading cash flows:

1. Looking at net cash flows could be deceptive.
2. Operating, investing and financing streams must each be analysed independently.
3. The objective is to focus on sustainable and recurring cash flows.
4. Non-recurring and extraordinary items must be recognised and adjusted.

Notes to accounts — where the risk hides

Significant accounting policies. There are multiple ways to account for the same item — straight line versus written down value depreciation, for instance. The analyst must know which the company chose. Companies must clearly state any change in accounting policy versus the previous year, and a company that continuously changes its accounting policies is a reason for suspicion and closer scrutiny of possible manipulation.

Contingent liabilities are liabilities that may be incurred depending on an uncertain future event. They are not recorded in the accounts — they sit in the notes. Examples given: outstanding lawsuits, disputes with tax authorities, bank guarantees provided, product warranty claims, pending investigations or cases, and changes in FX or government policies. Management will almost always say it does not expect the liability to settle against them. Look at the quantum relative to the size of the P&L and balance sheet — if it is large, exercise caution.

Off-balance sheet items are any asset or liability that does not appear on the balance sheet. An operating lease is an alternative way of financing an asset and is off-balance sheet. Contingent liabilities are also off-balance sheet items. A derivative contract entered to trade or hedge does not appear on the balance sheet and shows up only as a note. Because the existence of so many businesses worldwide has been threatened by derivative transactions, all off-balance sheet items deserve detailed analysis. Positive surprises are fine; negative ones are the risks.

The audit report. Management prepares the accounts; auditors verify that the statements present a true and fair view, and their opinion is based on the information provided to them. Auditors cannot vouch for accuracy — the volume of transactions makes checking everything impossible. So they verify whether adequate control systems exist, whether they were properly implemented, and then whether accounting standards and principles were followed.

In a disclaimer or a qualified report, auditors elaborate on the reason.

Ratio analysis

A number on its own means little. Bharti Airtel's FY2019 EBIT of ₹47.62 billion looks large — until you set it against revenue of ₹807.8 billion, at which point it looks small, or against interest expense of over ₹110 billion, at which point it is clearly inadequate even to service the interest.

Ratio analysis expresses one line item as a percentage or multiple of another related line item. The only requirement: the two numbers being compared must be related in some way. It is used for three purposes:

1. Descriptive — adds a sense of proportion. Not "EBIT of ₹47 billion" but "EBIT is 5.8% of revenue".
2. Diagnostic — explains what worked or failed. Bharti Airtel's revenue fell about 2% but EBITDA fell about 14%. Expressing expenses as a percentage of revenue shows why: network operating expense went from 23.8% to 27.6% of revenue, while the others barely moved.
3. Predictive — studies the behaviour of data. Expenses that stay constant as a percentage of sales move with sales; one that rises sharply as a percentage when sales fall is largely fixed in nature and independent of sales.

Revenue growth was −2.19% and EBITDA growth −13.9%. The other expense ratios for FY2018 → FY2019: access charges 10.9% → 11.5%, licence fee and spectrum charges 9.1% → 8.6%, employee benefits 4.8% → 4.7%, sales and marketing 5.5% → 5.1%, other expenses 9.3% → 10.3%.

The workbook is honest about the limitation: two years of data is inadequate to do a proper assessment. A larger data set raises confidence.

The ratios themselves

Profitability ratios — profit per rupee of sales.

• EBITDA Margin = EBITDA ÷ Net Sales. A higher margin than peers indicates greater efficiency. Useful for identifying gross profitability trends across an industry because it is not affected by depreciation policies, funding decisions or tax rates. Bharti Airtel FY2019: 32.2%, about 440 basis points lower than 36.6% in FY2018.
• PAT Margin = PAT ÷ Net Sales. Shareholders are paid last, so this is what is left for them. A higher ratio means more efficiency at managing direct costs, asset utilisation and financing. Bharti Airtel FY2019: 2.1%.
• EBIT margin is the operating profit margin. For valuation, NOPAT margin uses EBIT × (1 − Tax rate).

A point worth carrying into industry analysis: a very high level of profitability will not sustain over a long period — new entrants and competition pull revenues and profits down to moderate levels.

Return ratios — profit per rupee of capital.

• ROE = PAT ÷ Net-worth, where Net-worth = Equity Share Capital (at face value) + Reserves & Surplus. Also called RoNW. The workbook calls ROE the single most important parameter for an equity investor to start digging. Higher is better.
• ROCE = EBIT ÷ Capital Employed, where Capital Employed = Total Assets − Current Liabilities (non-interest bearing), or equivalently total book value of equity + total book value of debt. It lets you compare companies of different sizes in the same industry. It is a pre-tax measure; analysts may multiply by (1 − tax rate) for a post-tax figure.

There is a timing rule that costs marks. Sales and net profit are for a period; net-worth and assets are at a date. So use the average balance-sheet figure, normally the average of opening and closing balances — and the opening balance is last year's closing balance. Bharti Airtel FY2019: average net-worth ₹8,16,485 million = (8,49,486 + 7,83,483) ÷ 2, giving ROE = 16,875 ÷ 8,16,485 = 2.1%. ROCE = 47,626 ÷ average of (18,96,818 and 21,03,763) = 2.38%.

Leverage ratios

• D/E Ratio = Total adjusted Debt ÷ Net-worth. Adjusted debt includes all interest-bearing liabilities, short or long term, plus gaps on pension deficits and convertibles. Bharti Airtel FY2019: 12,87,036 ÷ 8,49,480 = 1.52x. The workbook's guidance: on a most conservative basis, a D/E of 1 or less should be considered the benchmark, and the decision then depends on industry, track record, capital required and project details.
• Interest Coverage Ratio = EBIT ÷ Interest Expense. High is comfortable. Less than one or negative means earnings are below interest or negative while interest obligations exist — the Kingfisher situation.

Liquidity ratios

• Current Ratio = Current Assets ÷ Current Liabilities, also called the Working Capital Ratio. Bharti Airtel FY2019: 3,29,057 ÷ 9,30,549 = 0.35. And here is a distinction the exam loves: a current ratio below 1 is not automatically a red flag. A company that takes cash on sales and pays on credit will show a ratio below 1, and that is a very good situation in which the company's working is funded by its customers. Equally, a high ratio may indicate poor management of inventory, receivables and cash.
• Quick Ratio = (Current Assets − Inventories) ÷ Current Liabilities. The stricter version, because inventory cannot be converted to cash immediately. Receivables, cash and investments in liquid funds are included.

Efficiency ratios

DuPont analysis

Reading ratios together produces insight none of them gives alone. If sales are growing but the collection period is lengthening too, the company is probably being lenient on credit terms to boost sales.

DuPont breaks ROE into three:

ROE = Net Profit ÷ Equity = (Net Profit ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity)

That is Net profit margin × Asset turnover × Equity multiplier (leverage).

So ROE can rise for three quite different reasons. Higher margin or higher efficiency is a reason to cheer. Higher leverage is not — leverage brings higher risk with it.

The workbook's illustration:

On the face of it HighLevCo wins. Decompose it and the picture reverses: LowLevCo is marginally better on asset turnover and reasonably better on margin. Its only weakness is low leverage — which is also lower risk. LowLevCo is the better operator.

Forecasting, peer comparison and the rest of the annual report

Forecasting from ratios assumes past behaviour fairly represents the future — and that need not hold good. The workbook's example is Suzlon, the only wind turbine manufacturer with great pricing power until it faced heavy domestic and offshore competition from the middle of the 2000s. Projecting Suzlon purely on history would have been a blunder.

Three quotations the workbook includes, worth knowing:

Peer comparison puts a company's competitive position in context. All the ratios above, compared across companies of the same sector, show where a company stands. Peer comparison is critical for analysts to investigate while making any research report.

History of equity expansion. When a company raises fresh funds, the cost is borne by the business, and raising funds at a competitive price is critical to value creation. A company may issue shares through a rights issue, a public issue (IPO or FPO), a private placement (preferential issue or qualified institutional placement), on exercise of warrants, or under ESOPs / sweat equity.

Every route other than a rights issue reduces the ownership stake of existing shareholders. A rights issue does not cause major dilution because shares are offered to existing shareholders in proportion to their holding — it dilutes only those who do not exercise their rights.

Preferential allotment increases the stake of the chosen investor and reduces everybody else's. Two ways to read it: a risk of dilution, or a signal that certain investors may be able to bail the company out through equity infusion in a crisis. Consider the circumstances and the valuation — regulators set a minimum price, but pricing at a premium is value accretive to minority shareholders and poses less dilution risk. A QIP also dilutes but likely points to institutional confidence in fundamentals.

Dividend and earnings history. Dividends are one component of total return, alongside capital gains. Read them against the business phase: companies in the growth phase pay little or nothing because they need funds, and shareholders may not mind because the company earns more on those funds than shareholders' expected return. As business matures and incremental returns decline, shareholders expect timely dividends.

For mature companies look at dividend yield and at the predictability or stability of the dividend. Matured companies in defensive industries are more predictable and most offer interim dividends — the workbook names Colgate Palmolive and Britannia. Other companies build reserves in good years and use them to pay dividends in bad years.

Also count share buy-backs (other than those to meet stock-based compensation) as profit distribution. Companies may prefer buy-back if the tax treatment is favourable in the hands of investors or the company, and a buy-back lets investors choose between encashing and increasing their stake.

Signals are ambiguous and need context. A well-performing company retaining more profit than usual may be planning a major investment — or expecting a challenging environment. A high-growth company raising its dividend may be signalling reduced growth opportunities. Where a dividend announcement deviates significantly from the past, ask management why.

Ownership and insider transactions. Owners are closest to the business and best informed, and they buy and sell under SEBI's guidelines. The workbook quotes Peter Lynch: "insiders can sell for a variety of reasons and it not necessarily ring alarm bells, but if insiders are buying, then there can be only one reason that the company is likely to make huge profits in future."

What good looks like

The workbook's own summary of the company that creates long-term value: one that continues to grow sales, increase profits, increase net-worth, reduce debt, improve margins and finally improve Return on Net-worth. And a warning to go with it: numbers can be made to look good by making assumptions or by creative accounting, so auditors' qualifications in the notes — the fine print — are a very useful part of the annual report. A change in accounting period can also confuse year-on-year comparison.