ProfitNama

ProfitNama

Chapter 8: Company Analysis – Financial Analysis

Chapter 8: Company Analysis – Financial Analysis – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book

Introduction to Financial Statements in India

In India, financial statements of listed companies are regulated by Schedule III of the Companies Act 2013 and IndAS 1. These statements provide comprehensive financial information about the company’s position, performance, changes in equity, and cash flow, along with detailed explanatory notes.

Topic Pointers:

Statement of Financial Position (Balance Sheet)

  • Purpose: Shows financial position at the end of the reporting period. 
  • Contains: Assets, Liabilities, and Equity
  • Significance: Indicates the company’s financial health and stability.

Statement of Profit and Loss Account

  • Purpose: Reflects financial performance over a specific period. 
  • Contents: Income, Expenses, and Profits
  • Also Includes: Other Comprehensive Income (OCI), which comprises gains or losses on account of fair value changes in assets and liabilities not recognized in the income and expense accounts.

Statement of Changes in Shareholder’s Equity

  • Purpose: Tracks changes in the equity owned by shareholders. 
  • Influences: Profits, dividends, share issuance, buybacks, and some income and OCI elements. 
  • Part of: Recognized as a segment of the balance sheet as per IndAS 1.

Cash Flow Statement

  • Purpose: Summarises sources and uses of cash. 
  • Importance: Assesses liquidity and financial flexibility.

Detailed Notes

  • Contents: Breakdown and explanation of accounting policies and information in the financial statements. 
  • Role: Provides clarity and context for the reported figures.

Comparative Information Requirement

  • Requirement: Financial statements must include data for the current and at least one prior period. 
  • Optional: Companies may present comparative financials for a longer period if preferred.

General Purpose Nature in India

  • Target Audience: Shareholders, lenders, employees/trade unions, government, vendors, and the general public. 
  • Contrast: In many other countries, financial statements are primarily aimed at investors.

Stand-alone and Consolidated Financial Statements

Stand-alone financial statements represent the individual financial data of a single company, while consolidated financial statements combine the financial data of a parent company and its subsidiaries, treating them as a single group.

Topic Pointers:

Separate Legal Entities

  • Each company is a distinct legal entity, even if controlled by another company. 
  • Example: Jio Platforms is separate but controlled by Reliance Industries Limited; Toyota Kirloskar Motor Limited is majority-owned by Toyota Motor Corporation, Japan.

Stand-alone Financial Statements

  • Reflects the financials of an individual company. 
  • Limitation: Can be misleading for large groups operating in multiple locations. For instance, Toyota’s stand-alone statements only show sales in Japan, excluding global operations.

Consolidated Financial Statements

  • Combine financial data of a parent company and its subsidiaries. 
  • Presents a unified financial performance of the entire group. 
  • Necessary for a comprehensive understanding of a company’s global operations.

Control and Ownership

  • Control is typically established by owning over 50% of voting rights or having the right to appoint the majority of the board of directors. 
  • The controlling entity is the ‘holding’ or ‘parent’ company, while the controlled entity is the ‘subsidiary’.

Preference in Equity Analysis

  • Consolidated statements are generally preferred for a holistic view of group performance. 
  • Stand-alone financials may not reflect the true financial health of a group.

Exceptions in Dividend Distribution

  • Subsidiaries may sometimes be unable to distribute dividends to the parent company due to capital controls or debt covenants. 
  • In such cases, analysing the stand-alone financial position of the parent company is crucial.

SEBI Regulations

  • Listed companies in India must publish consolidated financial statements annually. 
  • Stand-alone financial results are required on a quarterly basis. Some companies voluntarily publish consolidated statements quarterly.

Challenges for Equity Analysts

  • Difficulty in analysing groups not publishing consolidated quarterly numbers. 
  • Reliance on potentially outdated annual reports.

Balance Sheet

A balance sheet is a financial statement that summarises a company’s financial position at a specific point in time, detailing its assets, liabilities, and shareholders’ equity.

Topic Pointers:

  • Structure Regulation: Prescribed under Schedule 3 of the Companies Act 2013 for India, with additional requirements from IndAS 1 regarding changes in shareholders’ equity.
  • Industry-Specific Formats: Certain industries like banking, insurance, and utilities follow tailored formats set by their regulators.
  • Components of the Balance Sheet:
    • Assets: Divided into current and noncurrent assets, representing resources owned by the company.
    • Liabilities: Divided into current and non-current liabilities, representing obligations the company owes to others.
    • Equity: Reflects the residual interest in the assets of the company after deducting liabilities, including equity attributable to owners and non-controlling interests.
  • Consolidation: The balance sheet may be consolidated, reflecting the total financial position of a company and its subsidiaries.
  • Shareholders’ Equity Movements: Companies must report any changes in shareholders’ equity to reflect transactions such as issuance of new shares, dividends, or profits and losses.

Example: The exhibit provided shows the consolidated balance sheet of Bharti Airtel Limited for the year ending 31st March 2019, with key figures like:

  • Total Equity: INR 849,480 million
  • Non-current Liabilities: INR 872,454 million
  • Current Liabilities: INR 310,097 million
  • Total Assets: INR 2,751,987 million

These figures provide insights into Bharti Airtel’s financial standing as of the end of FY 2019, including its ability to cover liabilities with its assets and the value of equity held by shareholders. [CHECK BHARTI AIRTEL’S BALANCE SHEET FROM NISM RA BOOK]

Common Balance Sheet Line Items

Assets in Accounting

Assets are items expected to provide future benefits to a company. According to generally accepted accounting principles, assets must be quantifiable in monetary terms and paid for. Self-generated assets like a company’s own brand name are generally not recognized.

Topic Pointers:

Quantifiable and Paid For

  • To be recognized, assets must be measurable in monetary terms. 
  • The company must have incurred an expense to acquire them. 
  • Self-generated intangible assets, like a brand name created internally, are not typically recognized.

Classification of Assets: Assets are categorised into current and non-current assets.

Non-Current Assets: Definition

  • Assets likely to provide benefits over the long term. 
  • Criteria: Typically, all assets not classified as current assets fall into this category. 
  • Nature: Includes property, plant, equipment, long-term investments, etc.

Current Assets

  • Definition: Assets expected to bring benefits within one operating cycle. 
  • Operating Cycle: Often considered as one year. 
  • Types: Includes cash, inventory, accounts receivable, etc.

Non-Current Assets

Non-current assets are long-term assets that include physical assets, goodwill, intangible assets, investments in joint ventures or associates, and non-current financial assets. These assets are typically expected to provide benefits for more than one year.

Topic Pointers:

Property, Plant, and Equipment (PPE)

  • Comprises land, buildings, machinery, furniture, computers, etc. 
  • Valuation: Shown at historical cost, net of accumulated depreciation. 
  • Revaluation Option: Per IndAS 16, companies can revalue these assets periodically. 
  • Example: PPE value of Rs. 815.2 billion as of 31-Mar-2019.

Capital Work in Progress

  • Represents PPE under construction and not yet operational. 
  • Transfer: Once completed, these are transferred to PPE.

Goodwill

  • Arises from acquisitions, representing the excess payment over the fair value of net assets. 
  • Example: Bharti Airtel’s acquisition of Tigo Rwanda Ltd with Rs. 3,200 crores paid versus Rs. 2,838 crores fair value, resulting in goodwill. 
  • Treatment: Tested for impairment and written off if necessary.

Intangible Assets

  • Legal rights like acquired copyrights, patents, brand names
  • Valuation: Shown at cost minus accumulated amortisation. 
  • Note: Internally developed software can be recognized as an asset.

Intangible Assets Under Development

  • Intangible assets not yet operational. 
  • Transfer: Upon completion, moved to intangible assets.

Investment in Joint Ventures / Associates

  • Strategic investments not controlled by the company. 
  • Valuation: Equity method, including initial goodwill and less impairment. 
  • Application: Included only in consolidated financial statements.

Non-Current Financial Asset

  • Includes long-term investments, loans, advances, and financial claims
  • Valuation: Debt-type assets at amortised cost, others at fair market value.

Current Assets and Equity in Financial Statements

Current Assets are short-term assets expected to be converted into cash or used up within one year, including inventory, current financial assets, and other current assets. Equity represents the residual interest in a company, the value of assets minus liabilities, and includes various sub-components like share capital, share premium, retained earnings, and others.

Topic Pointers:

Inventory: Includes raw materials, work-in-progress, and unsold finished goods. Valuation: Lower of cost or market value.

Current Financial Assets

Comprises cash, cash equivalents, bank balances, short-term investments, receivables, and other financial claims due within one year

  • Cash and Cash Equivalents: Cash, current account balances, short-term bank deposits, and money market investments. 
  • Bank Balance: Balances in bank accounts, excluding cash equivalents. 
  • Receivables: Amounts due from customers, net of doubtful debts provision. 
  • Investments: Short-term investments valued at fair market value. 
  • Others: Other claims due within a year.

Other Current Assets: Assets likely to provide benefits within the next year. Includes prepaid expenses or benefits received in kind (goods/services) rather than cash.

Equity: The residual interest in a company after deducting liabilities. 

Components:

  • Share Capital: Face value of the company’s paid-up share capital.
  • Share Premium: Excess amount received over the face value of shares.
  • Retained Earnings: Profits not distributed as dividends or reserved for specific purposes.
  • General Reserve: Part of retained earnings set aside for future specific use.
  • Capital and Revaluation Reserve: Surplus from asset revaluation, generally not available for dividend distribution.
  • Minority Interest/Non-Controlling Interest: Equity in subsidiaries not owned by the parent company; shown in consolidated financial statements.

Non-Current Liabilities Analysis

Non-current liabilities are financial obligations of a company that are due after one year. They include long-term debt, lease liabilities, and derivative instruments that reflect commitments which extend beyond the current financial year.

Topic Pointers:

  1. Long-Term Debt:
    • It comprises loans and issuances like debentures, bonds, or notes payable beyond one year.
    • The portion due within the next year is listed separately as the current portion of long-term debt.
  2. Lease Liabilities:
    • Arise from lease agreements with a term of more than one year.
    • Calculated as the fair value of the lease or the present value of the lease payments, excluding interest.
  3. Derivative Instruments:
    • Liabilities represent the mark-to-market losses on derivative contracts.
    • Losses from contracts due in more than a year are included in non-current liabilities.
  4. Interest Accruals:
    • Accrued interest on borrowings is often shown separately.
    • Gives an indication of the additional cost to be incurred beyond the principal repayment.

Example: 

Borrowings -NoncurrentCategoryAs of 

March 31, 2019

As of 

March 31, 2018

SecuredTerm loans1,40316,836
Vehicle loans1029
Less: Current portion (A)-1,386-14,498
Less: Interest accrued but not due (refer note 21)-24-111
Subtotal Secured32,256
UnsecuredTerm loans175,55171,011
Non-convertible bonds253,741389,558
Non-convertible debentures32,32230,068
Deferred payment liabilities466,191455,602
Finance lease obligations47,72148,831
Less: Current portion (B)-70,346-119,848
Less: Interest accrued but not due (refer note 21)-32,729-28,058
Subtotal Unsecured872,451847,164
Current maturities of long-term borrowings (A+B)71,732134,346

In the provided exhibit, Bharti Airtel has reported long-term debt of Rs.872.45 billion, with an additional Rs.71.732 billion as the current portion of long-term debt, indicating the amount due within the next year and classified as a current liability.

Other Long-Term Financial Liabilities, Deferred Revenue, and Provisions

Other long-term financial liabilities are obligations payable beyond one year. Deferred revenue represents future obligations related to already completed revenue transactions. Provisions are amounts set aside for specific but not fully quantifiable liabilities.

Topic Pointers:

Other Long-Term Financial Liabilities: Represents monetary obligations due after one year.

Deferred Revenue

  • Income received for services/products to be provided in the future. 
  • Accounting Treatment: Recognized as revenue over the service period. 
  • Classification: Non-current liability if the obligation is beyond one year; current liability if within one year. Example: For a Rs.1,200 prepaid pack with 5 months remaining, Rs.1,000 (1,200 * 5/6) is recognized as deferred revenue.

Provisions

  • Funds set aside for specific, uncertain liabilities. Different from reserves, which are for unknown purposes. 
  • Common Examples: Retirement benefits, warranty obligations, pending legal liabilities. 
  • Classification: Non-current if the obligation is due beyond one year. Example: Provision for employee retirement benefits.

Current Liabilities

Current Liabilities are obligations a company must fulfill within one year. They include payables, short-term debt, and other short-term financial obligations.

Topic Pointers:

Payables

  • Amounts owed to suppliers for goods and services. 
  • Reflects short-term trade credit extended by suppliers. 

Short-Term Debt

  • Borrowings due within one year. Often, these debts are rolled over or refinanced, extending their actual tenure.

Other Current Liabilities

Include various short-term financial obligations:

  • Short-Term Provisions: Set aside for specific liabilities due within one year.
  • Current Portion of Long-Term Liability: The portion of long-term debts due within the next year.
  • Deferred Revenue: Income received for services/products to be delivered within one year.
  • Advances from Customers: Payments received in advance for goods/services to be delivered within a year.
  • Unpaid Expenses and Accrued Expenses: Expenses that have been incurred but not yet paid.

Balance Sheet Metrics

Balance sheets often do not accurately reflect the fair value of assets due to accounting conventions like the historical cost concept and the money measurement concept. This limitation leads analysts to compute additional metrics for more insightful analysis.

Topic Pointers:

Historical Cost Concept

  • Assets are recorded at their original purchase cost. 
  • Fails to reflect current market values, especially in inflationary environments.

Money Measurement Concept

  • Only items that can be quantified in monetary terms are included. 
  • Intangible assets and market conditions might not be adequately represented.

Limitations in Standard Categorization

  • Traditional balance sheet categories may not suit all types of analysis. 
  • Might not provide a complete picture of a company’s financial health.

Need for Additional Metrics

  • Analysts compute extra metrics to gain a more accurate understanding. 
  • These metrics adjust for limitations in standard financial reporting.

Analysis of Total Debt

Total debt in a company’s financial context is the sum of all obligations that require settlement through cash payments and carry an interest charge, reflecting the compensation for the time value of money. Unlike other liabilities, debt specifically represents borrowed funds that must be repaid and typically involves an interest cost.

Topic Pointers:

Components of Total Debt

Includes long-term debt, the current portion of long-term debt, short-term debt, financial lease obligations, and accrued interest.

Calculation of Total Debt

  • To find the total debt, sum up all the different types of debt listed in the company’s balance sheet. 
  • This calculation provides a comprehensive view of what the company owes to its creditors.

Significance of Total Debt

  • Understanding total debt is crucial for assessing a company’s financial leverage and risk profile. 
  • It gives insight into the company’s capital structure and its reliance on external financing.

Interest Component

  • The interest portion of debt is crucial as it impacts cash flows and cost of capital. 
  • Analysing debt with and without the interest component can give different insights into a company’s financial obligations.

Example: In the financial data provided, Bharti Airtel Ltd total debt at the end of March 31, 2019, is calculated at INR 12,87,036 million, which includes various forms of debt instruments and obligations, showcasing the company’s total financial liabilities in terms of borrowed funds.

Type of debt31-Mar-19 (INR million)31-Mar-18  (INR million)
Secured loans (including accrued interest)1,41316,865
Unsecured term loans1,75,55171,011
Non-convertible bond2,53,7413,89,558
Non-convertible debentures32,32230,068
Financial lease obligation47,72148,831
Deferred payment obligation4,66,1914,55,602
Short term borrowings3,10,0971,29,569
Total debt12,87,03611,41,504

Working Capital

Working capital is the amount of money tied up in the day-to-day operations of a business, calculated as current assets minus current liabilities.

Topic Pointers:

Concept of Working Capital

  • Represents the funds available for daily business operations. 
  • Essential for maintaining company liquidity and operational efficiency.

Calculation

  • Formula: Working Capital = Current Assets – Current Liabilities. 
  • Indicates the short-term financial health of a company.

Interpretation

  • Positive Working Capital: Suggests a company can cover its short-term liabilities with its short-term assets. 
  • Negative Working Capital: Implies current liabilities exceed current assets, which might indicate liquidity issues.

Example from Bharti Airtel Ltd: As per Exhibit 8D: Working Capital = Rs.329.06 billion (Current Assets) – Rs.930.55 billion (Current Liabilities) = Negative Rs.601.49 billion. This negative working capital suggests Bharti Airtel Ltd had more short-term liabilities than short-term assets at that time.

Example: The specific case of Bharti Airtel Ltd provided in the definition, with working capital calculated as negative Rs.601.49 billion.

Core Working Capital

Core working capital is a financial metric that represents the operating liquidity available to a business for its day-to-day operations. It is a more refined measure than traditional working capital, as it excludes short-term investments and obligations not related to the core operations of the company. This calculation includes only current assets and liabilities directly associated with the company’s main business activities.

Topic Pointers:

  • Current Assets: Includes short-term investments but for core working capital, only those assets related to core operations are considered (e.g., inventory and trade receivables).
  • Current Liabilities: Includes short-term obligations; however, for core working capital, it excludes obligations not arising from daily operations (e.g., current maturity of long-term debt).
  • Misleading Traditional Calculation: Simply subtracting current liabilities from current assets can be misleading because not all elements reflect the operational liquidity of a company.
  • Core Working Capital Formula: Calculated as Inventory + Trade Receivables – Trade Payables.
  • Importance: Offers a clearer view of the company’s short-term financial health in relation to its core business activities.

Example:

  • The core working capital for Bharti Airtel at the end of FY 2019 was calculated as follows:
    • Inventory: Rs. 884 million
    • Debtors (Trade Receivables): Rs. 43,006 million
    • Payables (Trade Payables): -Rs. 2,80,031 million
    • Total Core Working Capital: Rs. 884 million + Rs. 43,006 million – Rs. 2,80,031 million = -Rs. 2,36,141 million
  • This negative figure indicates that the company’s operational current liabilities exceed its operational current assets.
Category31-Mar-1931-Mar-18
Inventory884693
Debtors43,00658,830
(-) Payables-2,80,031-2,68,536
Total debt-2,36,141-2,09,013

Basics of Profit and Loss Account (P/L)

The Profit and Loss (P/L) statement, also known as the income statement, details a firm’s financial performance over a specific period. It reflects the company’s income, expenses, and net profit or loss. In India, the Companies Act, 2013 Schedule III outlines the P&L account format, which is further refined by IndAS 1 to include other comprehensive income below the net profit.

Topic Pointers:

  • Schedule III Compliance: Indian companies prepare their P&L according to the format prescribed in Schedule III of the Companies Act, 2013.
  • Inclusion of Comprehensive Income: As per IndAS 1, other comprehensive income must be included in the P&L statement and shown below net profit.
  • Industry-Specific Formats: The P&L statement format varies across industries like banking, insurance, and utilities as dictated by their respective regulators.
  • Components of P&L: Typically includes revenue, expenses, profit before and after tax, and comprehensive income.
  • Other Comprehensive Income (OCI): Represents items of income and expense that are not recognized in profit or loss as required by other IndAS.

Example:

  • Exhibit 8E from the provided material showcases Bharti Airtel Ltd’s consolidated profit and loss account for the financial year ending 31st March 2019.
  • The statement shows all components such as income, expenses, profit before and after depreciation, amortisation, exceptional items, tax expenses, and other comprehensive income.
  • Other comprehensive income includes items that will not be reclassified to profit or loss, such as re-measurement gains on defined benefit plans, and those that may be reclassified to profit or loss in the future, such as gains or losses on cash flow hedges.
  • The total comprehensive income for the year and the earnings per share (EPS) are also detailed at the bottom of the statement.

[CHECK BHARTI AIRTEL’S BALANCE SHEET FROM NISM RA BOOK]

Common Profit and Loss Account Line Items

This definition covers the various standard items found in a profit and loss account, including revenue, other income, expenses, and unique financial reporting aspects in India. It also discusses items like cost of raw materials, employee cost, depreciation, and others, with a focus on how they are reported and their significance in financial statements.

Topic Pointers:

Revenue:

  • Includes income from core and incidental operations.
  • Core operations revenue and incidental income might be reported separately, with the latter often labeled as ‘other operating income’.

Other Income:

  • Generally consists of non-operating income, like income from investments or profits from asset sales.
  • For example, Bharti Airtel reports it below the operating profit line.

Expenses:

  • Varies by industry, but common line items include employee cost, depreciation, and finance charges.
  • In manufacturing, additional items like cost of raw materials, purchase of stock-in-trade, and change in inventory are standard.
  • Other expenses include costs not large enough to be reported separately.

Expense Reporting in India:

  • Indian financial statements are general purpose, with specific disclosure requirements for certain items like raw materials.
  • This can lead to challenges in calculating gross profits due to incomplete disclosure of direct costs.

Cost of Raw Materials:

  • The amount used in production, calculated as Purchases + Opening Stock – Closing Stock of raw materials.

Purchase of Stock-in-Trade:

  • The amount spent on goods sold without additional processing, common in the retail sector.

Changes in Inventory of WIP and Finished Goods:

  • Represents the difference between opening and closing balances of work-in-progress and finished goods.

Employee Cost:

  • Includes salaries, benefits, stock-based compensation, and retirement benefits provisions.

Depreciation and Amortisation:

  • Depreciation: Reduction in asset value over time, varying by usage method.
  • Amortisation: Write-off of intangible assets over their lifespan.

Finance Cost:

  • Includes interest, processing fees, and expenses for security issuance amortisation.

Income from Equity Accounted Entities:

  • Represents a company’s share of profit from entities accounted under the equity method.

Exceptional/Non-Recurring Items:

  • Income or expenses that are unusual or infrequent, like losses from natural disasters.

Tax Components in India:

  • Includes Current Tax, Minimum Alternate Tax (MAT), and Deferred Tax.
  • MAT can be shown as an asset or expensed, depending on the company’s credit utilisation expectation.

Profit Allocated to Non-Controlling Interest:

  • Refers to profits belonging to external shareholders of a subsidiary.

Earnings Per Share (EPS):

  • Basic EPS: Net profit divided by weighted average number of shares.
  • Diluted EPS: Includes potential equity conversions, adjusting net profit and share count accordingly.

Other Comprehensive Income (OCI):

  • Income or expenses not passing through the profit and loss account.
  • Includes asset/liability value changes due to non-operating factors.

Example: In the case of Bharti Airtel, the company reports ‘Other Income’ below the operating profit line, differentiating it from core operational revenue. This highlights the importance of understanding each line item for accurate financial analysis and interpretation.

Key Metrics from Profit and Loss Account

A profit and loss account is a financial statement that summarises the revenues, costs, and expenses incurred during a specific period. It provides key metrics for analysing a company’s financial performance, including operating profit and net profit. A multi-step profit and loss account, unlike a single-step account, separates operating revenues and expenses from non-operating items, providing more detailed insights into a company’s financial activities.

Topic Pointers:

  • Single-Step P/L Account: This format adds all incomes and subtracts all expenses to arrive at the profit before tax, showing only the bottom-line net profit.
  • Multi-Step P/L Account: Offers a detailed view by separating operating from non-operating items, and calculating EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation).
  • EBITDA: Used to assess a company’s operational efficiency without the impact of financing decisions, accounting decisions, and tax environments.
  • Depreciation and Amortisation: Non-cash expenses that are subtracted to arrive at EBIT (Earnings Before Interest and Taxes).
  • Non-operating Items: Include incomes and expenses not related to the core business operations, such as finance income or costs, and share of profit from associates and joint ventures.
  • Exceptional Items: One-time costs or revenues that are excluded to calculate adjusted profit after tax, which reflects the company’s recurring profitability.
  • Sign Notation: Positive signs denote income, while negative signs denote expenses.
  • Effective Tax Rate: Indicates the average rate at which a corporation is taxed on its pre-tax income.

Example:

  • The provided exhibit shows Bharti Airtel Ltd’s multi-step profit and loss statement for the financial years 2019 and 2018
  • It details the calculation of EBITDA, EBIT, and adjusted profit after tax, using positive and negative signs to differentiate between incomes and expenses. 
  • For FY 2019, Bharti Airtel reported an EBITDA of INR 2,61,101 million and an adjusted profit after tax of -INR 12,413 million, indicating a loss after adjustments for exceptional items and tax impacts. 
  • The effective tax rate is noted as ‘Not meaningful‘ for 2019, contrasting with the previous year’s 33%.
Item DescriptionFor Financial Year 2019 (in INR million)For Financial Year 2018 (in INR million)
Revenue8,07,8028,26,388
Other Operating Income2,9122,488
Total Revenue8,10,7198,28,876
Expenses
Network Operating Expenses(2,23,900)(1,97,520)
Access Charges-93,521-90,446
License Fee / Spectrum Charges-69,426-75,558
Employee Benefit Expenses-37,975-39,771
Sales and Marketing Expenses-41,277-45,275
Other Expenses-83,514-77,027
EBITDA2,61,1013,03,279
Depreciation and Amortisation(2,13,475)(1,92,431)
ENT (Earnings Before Interest, Tax, and Exceptional Items)97,6261,10,848
Finance Costs(1,10,134)-93,255
Finance Income14,24012,540
Non-operating Expenses-1,894-141
Share of Profit of Associates and Joint Ventures3,55610,609
Profit Before Tax and Exceptional Items-46,60690,601
Exceptional Items29,288-7,931
Profit Before Tax-17,31832,670
Less: Current Tax-19,391-18,230
Less: Deferred Tax Expense53,5847,395
Profit After Tax16,87521,835
Exceptional Items Impact on Tax-2,630
Adjusted Profit After Tax-12,41327,136
Effective Tax RateNot meaningful33%

Gross Profit

Gross profit is calculated by subtracting the cost of goods sold (COGS) from revenue. It represents the surplus available to cover fixed expenses and is particularly relevant for manufacturing businesses.

Topic Pointers:

Calculation of Gross Profit

  • Formula: Gross Profit = Revenue – Cost of Goods Sold (COGS)
  • Reflects the efficiency of production and sales processes.

Relevance in Manufacturing

  • Particularly useful for manufacturing businesses. 
  • Helps in assessing the profitability of production activities.

Use of Gross Profit

  • Indicates the amount available to cover fixed expenses like rent, salaries, and utilities. 
  • A key metric for evaluating a company’s operational performance.

Limitation in Indian Context

  • Indian companies often do not disclose direct costs separately, except for raw material costs. 
  • This lack of detailed disclosure can make it challenging to accurately calculate gross profit for these companies.

Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA)

EBITDA represents a company’s earnings before the deduction of interest expenses, taxes, depreciation, and amortisation. It is used to compare the operating performance of different companies by eliminating the effects of financing and accounting decisions.

Topic Pointers:

Components Excluded in EBITDA

  • Interest Expense: Relates to the company’s funding choices. 
  • Depreciation and Amortisation: Reflect accounting choices such as methodology and estimates of assets’ useful life. 
  • Taxes: The tax impact is also excluded to focus solely on operational efficiency.

Purpose of EBITDA

  • Facilitates a more accurate comparison of operating performance between companies. 
  • Adjusts for factors that vary significantly due to management’s strategic decisions.

EBITDA as a Proxy for Cash Profit

  • Serves as an indicator of the cash profit generated from operations. 
  • Useful in assessing a company’s core profitability.

Adjusted EBITDA

  • Analysts often compute an adjusted EBITDA. 
  • Excludes non-operating income (like investment income) driven by treasury management choices. 
  • Provides a clearer picture of operational earnings.

Earnings Before Interest and Taxes (EBIT)

Earnings Before Interest and Taxes (EBIT) is a financial metric that calculates a company’s profit including all expenses except interest and taxes. It considers the impact of depreciation and amortisation, offering a more comprehensive view of operational costs compared to EBITDA.

Topic Pointers:

Inclusion of Depreciation and Amortisation

  • EBIT includes expenses related to depreciation and amortisation
  • Acknowledges the impact of capital expenditures, even those recurring in nature.

Comparison with EBITDA

  • EBITDA omits depreciation and amortisation, potentially overlooking capital expenditures. 
  • EBIT provides a more realistic view of operational costs by including these expenses.

Relevance of EBIT

  • Often referred to as operating profit
  • Offers a clearer picture of a company’s operational profitability.

Variability in Interpretation

  • Not strictly defined by accounting standards. 
  • Different interpretations of ‘operating profit’ can exist.

Adjusted Profit After Tax

Adjusted profit after tax is a financial metric that recalculates net profit by excluding the effects of exceptional and non-recurring items, along with their tax impacts, to enhance the comparability of a company’s profitability.

Topic Pointers:

Purpose of Adjustment

  • To eliminate the impact of exceptional and non-recurring items for better comparability. 
  • Provides a clearer view of a company’s consistent earning capacity.

Calculation Involving Tax Impact

  • Exceptional items are adjusted for their tax effect. 
  • Effective Tax Rate: Calculated as tax expense divided by net profit.

Challenges in Calculation

  • May involve arbitrary adjustments due to the unavailability of necessary data. 
  • Requires analyst judgement in certain cases.

Example with Bharti Airtel

For FY 2019, the effective tax rate calculation for Bharti Airtel is not straightforward due to significant taxes paid despite reporting losses. Analysts may need to make judgement calls to factor in the tax impact under such circumstances.

Example: The specific case of Bharti Airtel for FY 2019 is mentioned, highlighting the complexity in calculating the effective tax rate.

Statement of Changes in Shareholder’s Equity

The statement of changes in shareholder’s equity is a financial statement that details the movements in the equity section of a company’s balance sheet over a period. It shows the changes in the value of shareholders’ equity through such things as earnings, dividends, issuance of new shares, and other comprehensive income as required by IndAS 1.

Topic Pointers:

  • IndAS 1 Requirement: Mandates the inclusion of a statement showing changes in shareholder’s equity in the financial reports.
  • Purpose: To reveal the impact of various financial transactions on different components of shareholder’s equity throughout the financial year.
  • Components of Shareholder’s Equity: May include issued capital, share premium, retained earnings, other reserves, and non-controlling interest.
  • Transactions Impacting Equity: Typically includes comprehensive income, dividends paid, changes due to share-based payments, adjustments due to changes in accounting policies, and corrections of errors from prior periods.
  • Presentation Format: Generally presented in tabular form, outlining the opening balance, changes during the period, and the closing balance for each component of equity.

Basics of Cash Flows

Cash flows are a crucial aspect of a firm’s long-term survival. They differ from the profit and loss statement and balance sheet, which are based on accrual accounting. In accrual accounting, income and expenses are recognized when earned or incurred, not necessarily when cash is received or paid. This can create a discrepancy between reported profits and actual cash flow.

Topic Pointers:

  • Accrual Basis vs. Cash Basis: Accrual accounting recognizes income when earned and expenses when incurred, irrespective of actual cash flow. This can lead to a difference between reported profits and real cash flow.
  • Importance of Cash Flow Analysis: While profit and loss statements and balance sheets are essential, they may not accurately reflect a firm’s cash position. Assessing cash flows is critical for understanding the actual liquidity and financial health of a business.
  • Example of Cash vs. Credit Transactions: A business with cash transactions shows a direct correlation between profits and cash availability. In contrast, credit transactions may show profits without actual cash inflow, posing risks to the business’s capital and sustainability.
  • Categories of Cash Flows:
    • Operating Cash Flows: Derived from business operations. Positive when cash is incoming, negative when cash is outgoing. Adjustments like adding back non-cash expenditures (depreciation, amortisation) and changes in receivables and payables are made to derive the operating cash flow from net profit.
    • Investing Cash Flows: Related to assets. Buying assets represents a negative cash flow, while selling assets is a positive cash flow.
    • Financing Cash Flows: This pertains to liabilities. Borrowing money or issuing equity is a positive cash flow, whereas repaying debt or equity is a negative cash flow.

Cash Flow Analysis in Businesses

Cash flow statements reflect the inflows and outflows of cash in a business, providing insights into its operational efficiency, investment activities, and financial strategy. Continuous negative operating cash flows indicate potential financial distress, signalling the need for external funding to sustain operations.

Topic Pointers:

  • Negative Operating Cash Flows: Persistent negative operating cash flows suggest a business is spending more to operate than it is earning, requiring external cash injections to continue.
  • Sustainability of Operations: A business must eventually generate positive operating cash flows or face the risk of ceasing operations if external financing dries up.
  • Financing through Borrowing: Dependence on borrowing to cover operating costs is unsustainable; businesses must service debts, which can become impossible without positive cash flows.
  • Investing and Financing Cash Flows: Negative investing cash flows are typical for expanding businesses but should be funded through positive operating cash flows, reserves, or sustainable financial cash flows.
  • Asset-Liability Mismatch: Assets may be overvalued on the balance sheet, while liabilities need to be paid in full, requiring careful analysis of cash flow statements.
  • Cash Flow Streams Analysis: It’s crucial to analyse operating, investing, and financing cash flows separately to gauge the business’s financial health.
  • Focus on Sustainable Cash Flows: The goal is to identify reliable and recurring cash flows, adjusting for any non-recurring or extraordinary items that may skew the analysis.

Example:

  • Bharti Airtel Limited’s Cash Flow Statement: Exhibits the company’s cash flows from operating, investing, and financing activities over two fiscal years, highlighting the importance of positive operating cash flow and the risks of negative trends.
  • Kingfisher Airlines’ Financials: Illustrates the consequences of sustained negative operating cash flows and reliance on borrowing, ultimately leading to the airline’s collapse when additional funding was unavailable.

Notes to Accounts

Notes to accounts are explanatory notes provided by a company alongside its financial statements. These notes detail the company’s accounting policies and elaborate on the information contained within the main financial statements.

Topic Pointers:

Function of Notes to Accounts

  • Provide clarity and context to the data in the financial statements. 
  • Essential for a comprehensive understanding of the financial reports.

Contents of Notes to Accounts:

  • Description of Accounting Policies: Explains the principles and methodologies used in preparing the financial statements.
  • Detailing Information: Breaks down and elaborates on the figures and items presented in the financial statements.

Importance in Financial Analysis

  • Helps in better understanding the company’s financial position and performance. 
  • Assists analysts and investors in making informed decisions.

Significant Accounting Policies

Significant accounting policies refer to the specific methodologies and principles a company adopts to account for various items in its Profit & Loss statement and Balance Sheet.

Topic Pointers:

Variability in Accounting Methods

  • Different methods can be used for the same accounting item (e.g., straight line vs. written down value method for depreciation). 
  • Choice of methodology affects how financial items are represented.

Disclosure in Annual Reports

  • Companies must clearly define their accounting policies in their annual reports. 
  • This disclosure is crucial for understanding how a company treats various financial items.

Importance for Analysts

  • Understanding a company’s accounting policies is essential for accurate financial analysis. 
  • Analysts can better assess the financial health and performance of the company.

Reporting Changes in Accounting Policies

  • Companies are required to report any changes in their accounting policies compared to the previous year. 
  • Frequent changes might indicate potential financial manipulation, warranting closer scrutiny.

Contingent Liabilities

Contingent liabilities are potential liabilities that an entity might incur, depending on the outcome of an uncertain future event. These are not recorded in the company’s main accounts but are often noted in the notes to accounts.

Topic Pointers:

Nature of Contingent Liabilities

  • Depend on future events with uncertain outcomes. 
  • Not definitive obligations but possible liabilities based on future occurrences.

Examples of Contingent Liabilities

  • Outstanding lawsuits. 
  • Disputes with tax authorities. 
  • Bank guarantees provided. 
  • Product warranty claims. 
  • Pending investigations or cases. 
  • Effects of changes in foreign exchange rates, government policies, etc.

Reporting in Financial Statements

  • Typically not included in the main financial statements. 
  • Recorded in the notes to account for transparency.

Management’s Outlook

  • Management often expresses optimism about the outcomes of these contingencies. 
  • However, analysts need to independently assess the potential impact.

Importance in Financial Analysis

  • The size of contingent liabilities should be compared to the company’s Profit & Loss statement and Balance Sheet
  • Large contingent liabilities, relative to the company’s financials, warrant caution in analysis.

Off-Balance Sheet Items

Off-balance sheet items are assets or liabilities that are not recorded on a company’s balance sheet. These include various forms of financing, contingent liabilities, and derivative contracts, which are instead often disclosed in the notes to the annual report.

Topic Pointers:

Nature of Off-Balance Sheet Items

  • Not directly recorded on the balance sheet. 
  • Can significantly impact a company’s financial health.

Examples of Off-Balance Sheet Items

  • Operating leases: A form of asset financing not shown on the balance sheet. 
  • Contingent liabilities: Potential liabilities based on uncertain future events. 
  • Derivative contracts: Used for trading or hedging, not appearing on the balance sheet.

Reporting and Disclosure

  • Often covered in notes to accounts in the Annual Report. 
  • Requires careful analysis for a true understanding of a company’s financial position.

Significance in Financial Analysis

  • Analysts must scrutinise off-balance sheet items to assess hidden risks. 
  • Large off-balance sheet items can pose significant threats to business stability. 
  • Both positive and negative surprises in off-balance sheet items carry implications for the company’s future.

Key Considerations in Financial Statement Analysis

Financial statement analysis involves evaluating a company’s financial data to understand its performance. The process can seem daunting due to complex terminologies, but becomes more approachable and insightful when the language of finance is understood.

Topic Pointers:

Understanding Financial Terminologies

  • Mastery of financial language is essential for effective analysis. 
  • The complexity of financial statements is less intimidating with proper knowledge.

Potential for Manipulation

  • Financial numbers can be influenced by assumptions or creative accounting. 
  • Critical to be aware of these potential distortions.

Significance of Auditors’ Qualifications

  • Notes to accounts often contain important observations from auditors. 
  • These insights are crucial in understanding the true financial position of the company.

Accounting Period Changes

  • Alterations in accounting periods can complicate year-on-year comparisons. 
  • Adjustments may be required for accurate comparative analysis.

Impact of One-Off Items

  • Extraordinary or one-off items can skew profit figures. 
  • Necessary to identify and account for these to maintain the integrity of the analysis.

Consistent Performance Indicators

  • Steady growth in sales, profits, and net worth. 
  • Reduction in debt and improvement in profit margins. 
  • Enhancement in Return on Net-worth (RONW) is favourable for investors.

Value Creation in the Long Term

  • Companies demonstrating consistent performance are more likely to create long-term value.

Understanding the Quality of Accounting through Audit Reports

An audit report is an evaluation by auditors of a company’s financial statements to ensure they present a true and fair view of the company’s financial condition. The report reflects the auditors’ opinion based on the information provided to them and their assessment of the company’s accounting controls and practices.

Topic Pointers:

Role of Auditors

  • Responsible for verifying the accounts prepared by a company’s management. 
  • Ensure financial statements are accurate and fair.

Limitations of Audit Engagements

  • Due to the volume of transactions, auditors cannot check every single transaction. 
  • Focus on whether the company has adequate control systems for accurate recording.

Audit Process

  • Verification of control systems’ adequacy and implementation. 
  • Assessment of adherence to accounting standards and principles.

Types of Audit Reports:

  • Clean Report: Indicates no issues with the financial statements.
  • Disclaimer: Issued when auditors cannot verify parts of the financials due to lack of information.
  • Qualified Report: Given when financial statements are not entirely accurate or fair, often due to disagreements over accounting policies or other discrepancies.

Importance for Analysts: Analysts should carefully review the auditor’s report for any reservations or qualifications. The type of audit report can provide critical insights into the quality of a company’s financial reporting.

Financial Statement Analysis Using Ratios

Ratio analysis is a quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by comparing information contained in its financial statements.

Topic Pointers:

  • Understanding Scale and Context: Ratios help in understanding how large or small a financial figure is in context. For example, operating profit might seem large in absolute terms but small when compared to total revenue.
  • Ratio Analysis Purposes:
    • Descriptive Studies: Adds perspective by comparing financial figures in relation to one another, providing a sense of proportion.
    • Diagnostic Studies: Helps in pinpointing areas of strength or concern by highlighting disproportionate changes between related financial figures.
    • Predictive Analysis: Assists in forecasting future financial performance by studying the behaviour of financial figures over time.
  • Types of Ratios:
    • Growth Rates: Year-over-year comparison of revenues and profits.
    • Expense Ratios: Expenses as a percentage of revenue to assess cost efficiency.
  • Interpreting Financial Health: By looking at the ratio of operating profit to revenue and interest expenses, one can gauge the company’s ability to service its debt.
  • Fixed versus Variable Expenses: Identifying whether expenses vary with sales or remain constant irrespective of sales, indicating their nature as fixed or variable.

Example:

  • The exhibit shows Bharti Airtel’s financial metrics for FY 2018 and 2019, including revenue decline (-2.19%) and a more significant EBITDA decline (-13.9%).
  • The analysis highlights the network operating expense as a substantial factor in EBITDA reduction, suggesting its fixed nature as it increased as a percentage of sales even when sales declined.
  • Ratio analysis for Bharti Airtel elucidates that while most expenditure items remained stable as a percentage of sales, the network operating expense ratio increased, indicating it does not vary with sales and is likely a fixed expense.
Item DescriptionFor Financial Year
(in INR million)20182019
Income Statement
Revenue8,26,3888,07,802
Other Operating Income2,4882,912
Total Revenue8,28,8768,10,714
Expenses
Network Operating Expenses1,97,5202,23,900
Access Charges-90,446-93,521
License Fee / Spectrum Charges-75,558-69,426
Employee Benefit Expenses-39,771-37,975
Sales and Marketing Expenses-45,27541,277
Other Expenses-77,027-83,514
EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortisation)3,03,2792,61,101
Ratio Analysis
Growth Rates
Revenue Growth-2.19%
EBITDA Growth-13.90%
Expense as Percentage of Revenue
Network Operating Expense (%)23.80%27.60%
Access Charges (%)10.90%11.50%
License Fee / Spectrum Charges (%)9.10%8.60%
Employee Benefit Expenses (%)4.80%4.70%
Sales and Marketing Expenses (%)5.50%5.10%
Other Expenses (%)9.30%10.30%

Commonly Used Ratios in Financial Analysis

In financial analysis, ratios are used to assess various aspects of a company’s performance and health by comparing two related financial metrics. These ratios provide insights into the company’s operational efficiency, financial stability, and profitability.

Topic Pointers:

Purpose of Ratios in Analysis

  • Help in evaluating different financial aspects of a company. 
  • Ratios are chosen based on the nature of the company and the objectives of the analysis.

Inclusion of Non-Financial Metrics

  • Analysts may also consider non-financial operating metrics like capacity utilisation or occupancy rate. 
  • These provide additional context and understanding of operational efficiency.

Criteria for Effective Ratios

  • Essential to compare related financial numbers. 
  • Comparing unrelated figures can lead to misleading conclusions.

Common Financial Ratios

  • Ratios often used include profitability ratios, liquidity ratios, efficiency ratios, and solvency ratios. 
  • Each ratio type focuses on a specific aspect of the company’s financial health.

Importance in Financial Decision-Making

  • Ratios provide a quick and comparative measure of a company’s performance. 
  • Crucial for investors and analysts in making informed decisions.

Profitability Ratios

Profitability ratios are financial metrics used to assess how profitable a company’s operations are in relation to its sales. These ratios reflect the company’s ability to generate earnings as a percentage of sales, assets, equity, or other financial figures.

Topic Pointers:

Industry Influence on Profitability: Highly competitive industries with pricing pressures tend to have lower profitability. Unique businesses with significant entry barriers or early entrants in growing industries usually enjoy higher profitability.

Sustainability of High Profitability: Exceptionally high profitability levels are often temporary. Over time, new competition and market saturation can moderate revenues and profits.

Evaluating Profitability at Different Levels: Profitability can be assessed at various stages of the Profit & Loss (P/L) statement.

Key Profitability Ratios: EBITDA Margin: Measures a company’s operating profitability as a percentage of its total revenue. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation divided by total revenue. Net Profit Margin (NPM) or Profit After Tax (PAT) Margin: Reflects the percentage of net income to total revenue, showing how much profit a company makes for each rupee of sales after all expenses are accounted for.

EBITDA Margin

EBITDA Margin is a profitability ratio that measures a company’s earnings before interest, taxes, depreciation, and amortisation (EBITDA) as a percentage of its net sales. It focuses on the profitability generated from a company’s core operations.

Topic Pointers:

Calculation of EBITDA Margin

  • Formula: EBITDA Margin = EBITDA / Net Sales
  • Represents the efficiency of a company’s core operations.

Interpreting EBITDA Margin

  • A higher EBITDA margin indicates better operational efficiency compared to peers. 
  • Reflects how well a company is managing its direct operational costs.

Advantages of EBITDA Margin

  • Unaffected by differences in depreciation policies, funding decisions, and taxation rates among companies. 
  • Useful for analysing profitability trends within an industry.

Example: Bharti Airtel FY 2019: EBITDA Margin = 32.2% (Calculated as 2,61,101 / 8,10,714). This represents a decrease of approximately 440 basis points from 36.6% in FY 2018, indicating a reduction in operational efficiency or increased direct costs relative to sales.

PAT Margin (Profit After Tax Margin)

PAT Margin, or Profit After Tax Margin, is a financial ratio that measures the percentage of net sales that translates into profits after all expenses, including taxes, have been paid. It reflects the amount of profit a company generates for its shareholders from its total sales.

Topic Pointers:

Calculation of PAT Margin: Formula: PAT Margin = Profit After Tax (PAT) / Net Sales. Indicates the profitability available to shareholders after all obligations are met.

Significance of PAT Margin: A higher PAT Margin suggests greater efficiency in managing costs and generating profits. Essential for shareholders to understand their share of the company’s profits.

Indicator of Financial Health: An increasing trend in PAT Margin is indicative of improving profitability. Reflects a company’s ability to convert sales into net income effectively.

Example: Bharti Airtel FY 2019: PAT Margin = 2.1% (Calculated as 16,875 / 8,10,714). This figure represents the proportion of net sales that remains as profit after all expenses for the financial year 2019.

Return Ratios in Financial Analysis

Return Ratios, specifically Return on Equity (ROE) and Return on Capital Employed (ROCE), are crucial financial metrics used to evaluate how efficiently a company uses its capital to generate profits. ROE assesses returns generated on shareholders’ equity, while ROCE measures returns from both equity and debt capital employed in the business.

Topic Pointers:

Return on Equity (ROE)

  • ROE = PAT (Profit After Tax) / Net-worth
  • Net-worth = Equity Capital + Reserves & Surplus. Indicates the efficiency in allocating capital and generating returns. 
  • Higher ROE signals better performance. 
  • Du Pont Analysis for ROE: Breaks down ROE into Net Profit Margin, Asset Turnover, and Equity Multiplier. 
  • Reflects operating efficiency, asset utilisation, and financial leverage.

Calculating ROE

  • Use average net-worth during the period, not just end-of-period figures. 
  • Average net-worth is often the average of opening and closing balances.

Return on Capital Employed (ROCE)

  • ROCE = EBIT (Earnings Before Interest and Taxes) / Capital Employed
  • Capital Employed = Total Assets – Current Liabilities or Total Equity + Total Debt. 
  • Measures returns from all capital employed, including debt. 
  • Higher ROCE indicates efficient use of all capital in generating returns.

ROCE Calculation Specifics

  • Like ROE, ROCE uses average values for balance sheet items. 
  • Can be adjusted to post-tax rate by multiplying with (1 – Tax rate).

Example: Bharti Airtel FY 2019

  • Average Net-worth = Rs 8,16,485 [(Rs 8,49,486 + Rs 7,83,483) / 2]. 
  • ROE = 2.1% [16,875 (PAT) / 8,16,485 (Net-worth)]. 
  • Total Capital = Rs 21,03,763 (FY 2019). 
  • ROCE = 2.38% [47,626 EBIT / Average of (Rs 18,96,818 and Rs 21,03,763)].

Example: Bharti Airtel’s financial data for FY 2019 is used to illustrate the calculation of ROE and ROCE, demonstrating the application of these return ratios.

Return on Equity (ROE)

Return on Equity (ROE) is a financial ratio that measures the return generated on the shareholders’ equity. It is a key indicator of how efficiently a company uses equity capital to generate profits and is often considered the most important metric for investors assessing a company’s financial health.

Topic Pointers:

Calculation of ROE

  • Formula: ROE = PAT (Profit After Tax) / Net-worth
  • Net-worth = Equity Capital + Reserves & Surplus.

Interpreting ROE

  • Higher ROE indicates a more efficient allocation of capital and better business quality. 
  • Low ROE may suggest poor capital management or underperformance.

Du Pont Analysis

  • Decomposes ROE into three components: Net Profit Margin, Asset Turnover, and Equity Multiplier. 
  • Formula: ROE = (PAT / Net Sales) * (Net Sales / Fixed Assets) * (Fixed Assets / Net-worth)
  • Assesses operating efficiency, asset usage efficiency, and financial leverage.

Using Average Net-worth for ROE

  • Average net-worth during the period is used instead of end-of-period figures. 
  • Calculated as the average of the opening and closing balances of equity.

Example: Bharti Airtel FY 2019

  • Average Net-worth = Rs 8,16,485 [(Rs 8,49,486 + Rs 7,83,483) / 2]. 
  • ROE = 2.1% [16,875 (PAT) / 8,16,485 (Net-worth)].

Example: The example provided is the calculation of ROE for Bharti Airtel in FY 2019, which is 2.1%, based on the average net-worth during that fiscal year.

Return on Capital Employed (ROCE)

ROCE is a financial ratio that measures a company’s profitability and the efficiency with which its capital is employed. It is calculated by dividing EBIT (Earnings Before Interest and Taxes) by capital employed and is expressed as a percentage.

Topic Pointers:

  • Formula: ROCE = EBIT / Capital Employed
  • Capital Employed Calculation: Can be calculated as Total Assets – Current Liabilities or Total Equity + Total Debt.
  • Interpretation: A higher ROCE indicates that a company is generating more earnings from its capital, implying efficient use of capital.
  • Comparative Analysis: Useful for comparing the financial performance of companies of different sizes within the same industry.
  • Average Capital Employed: For the calculation, the average of the opening and closing capital employed figures is used to account for any variations within the period.
  • Post-Tax Adjustment: To arrive at the post-tax return, the ROCE is multiplied by (1 – Tax rate).

Example: Based on the table provided for Bharti Airtel’s total capital in FY 2018 and FY 2019:

  • Total Capital for FY 2018: INR 18,96,818 million
  • Total Capital for FY 2019: INR 21,03,763 million
  • Average Capital Employed: *(INR 18,96,818 million + INR 21,03,763 million) / 2

With EBIT of INR 47,626 million for FY 2019:

  • ROCE for FY 2019:

This percentage represents the pre-tax return on the average capital employed by Bharti Airtel for the fiscal year 2019.

Financial YearTotal EquityLong Term BorrowingsShort Term BorrowingsCurrent Maturities of Long Term BorrowingsTotal Capital
FY 20187,83,4838,49,4201,29,5691,34,34618,96,818
FY 20198,49,4808,72,4543,10,09771,73221,03,763

Leverage Ratios

Leverage Ratios are financial metrics used to assess the extent of a company’s use of debt (leverage) in its funding and its ability to meet the resulting financial obligations. Key leverage ratios include the Debt-to-Equity (D/E) ratio and the Interest Coverage Ratio.

Topic Pointers:

Debt-to-Equity (D/E) Ratio

  • Indicates the level of debt used in comparison to shareholders’ equity. 
  • High D/E can be risky, especially if assets financed by debt don’t generate expected returns. 
  • Benchmark: A D/E of 1 or less is generally considered conservative. 
  • Formula: D/E Ratio = Long Term Debt / Net-worth.

Risks of High Leverage

  • High levels of debt can lead to bankruptcy if the company cannot meet its obligations. 
  • Particularly dangerous during economic downturns when revenues and profitability may decline.

Interest Coverage Ratio

  • Measures a company’s ability to cover interest payments with its earnings. 
  • Formula: Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expense
  • A high ratio indicates a comfortable position in covering interest obligations. 
  • Ratios less than one or negative suggest earnings are insufficient to cover interest, indicating potential financial distress.

Example: Bharti Airtel FY 2019: D/E Ratio = 12,54,283 / 8,49,480 = 1.48X. This indicates Bharti Airtel’s leverage relative to its equity for the fiscal year 2019.

Example: Bharti Airtel’s D/E Ratio for FY 2019 and the concept of Kingfisher Airlines’ financial issues are used as examples to illustrate the application and implications of leverage ratios.

Liquidity Ratios

Liquidity Ratios are financial metrics used to assess a company’s ability to meet its short-term obligations. The two primary liquidity ratios are the Current Ratio and the Quick Ratio, each measuring the company’s immediate financial health in different ways.

Topic Pointers:

Current Ratio

  • Measures liquidity by comparing current assets to current liabilities. 
  • Formula: Current Ratio = Current Assets / Current Liabilities
  • Indicates the ability to meet short-term liabilities with short-term assets. 
  • A ratio over 1 suggests sufficient assets to cover liabilities. 
  • Factors influencing the ratio include inventory levels, trade receivables, and trade payables. 
  • High inventory or receivables might indicate sales slowdown or credit issues. 
  • Conversely, high payables might reflect good credit terms from suppliers.

Implications of Current Ratio Values

  • A high ratio could indicate underutilised working capital. 
  • A low ratio (even below 1) might not always be a concern if the company efficiently manages working capital with strong bargaining power.

Example: Bharti Airtel FY 2019

  • Current Ratio = 0.35 (329,057 / 930,549). 
  • While seemingly low, this might not be negative for firms with strong bargaining power.

Quick Ratio

  • A stricter measure of liquidity, excluding less liquid assets like inventories. 
  • Formula: Quick Ratio = (Current Assets – Inventories) / Current Liabilities
  • Includes cash, accounts receivable, and liquid investments. 
  • A higher ratio indicates better immediate liquidity. 
  • However, excessive liquidity may mean lower returns as cash and equivalents typically yield less.

Example: Bharti Airtel’s current ratio in FY 2019 is given as an example to illustrate the application of liquidity ratios in financial analysis.

Efficiency Ratios in Business Operations

Efficiency Ratios are financial metrics used to assess how effectively a business manages its operational resources like accounts receivable, accounts payable, assets, and inventory to generate revenue and maintain cash flow.

Topic Pointers:

Accounts Receivable Turnover

  • Measures how quickly sales are converted into cash. 
  • Formula: Accounts Receivable Turnover = Revenue / Accounts Receivable
  • A higher ratio indicates efficient credit and collections processes.

Accounts Payable Turnover

  • Indicates the rate at which a company pays off its suppliers. 
  • Formula: Accounts Payable Turnover = Purchases / Accounts Payable
  • A lower ratio can imply longer credit periods from suppliers, possibly due to strong bargaining power or financial constraints.

Asset Turnover

  • Assesses the effectiveness of asset utilization in generating revenue. 
  • Formula: Asset Turnover = Net Sales / Total Assets
  • A higher ratio suggests more efficient use of assets. 
  • Integral to Du Pont Analysis for decomposing Return on Equity (ROE).

Inventory Turnover

  • Measures how often inventory is sold and replaced over a period. 
  • Formula: Inventory Turnover = Sales / Inventory
  • A higher ratio indicates efficient inventory management and sales. 
  • Varies across industries; typically higher for FMCG and lower for capital goods companies.

Dupont Analysis

Dupont analysis is a performance measurement approach that decomposes return on equity (ROE) into three component ratios: net profit margin, asset turnover, and financial leverage, to provide insight into the factors driving a company’s return on equity.

Topic Pointers:

  • ROE Decomposition: ROE is expressed as the product of three components: Net Profit Margin (Net Profit/Sales), Asset Turnover Ratio (Sales/Assets), and Leverage (Assets/Equity).
  • Components of Dupont Analysis:
    • Net Profit Margin: Indicates how much profit a company makes for every unit of sales.
    • Asset Turnover Ratio: Measures the efficiency of a company’s use of its assets to generate sales.
    • Leverage (Equity Multiplier): Shows how much a company is financing its operations through debt compared to equity.
  • Interpretation of ROE:
    • An increase in ROE due to higher net profit margins or asset turnover is generally positive.
    • An increase in ROE driven by higher leverage is not always positive due to the increased financial risk.
  • Risk Consideration: Higher leverage indicates higher financial risk, which may not be favourable despite a higher ROE.

Example: The Dupont analysis of HighLevCo and LowLevCo shows:

  • HighLevCo: Higher ROE at 92.3%, driven by higher leverage (Asset/Equity ratio of 2.0x).
  • LowLevCo: Lower ROE at 52.4%, with better performance in asset turnover (2.4x) and net profit margin (22%).

Despite HighLevCo’s higher ROE, LowLevCo may be the better performer operationally due to higher margins and turnover, and lower risk due to less leverage.

High Lev CoLow Lev Co
Revenue12,000.0011,800.00
Net Profit2,400.002,620.00
Assets5,200.005,000.00
Equity2,600.005,000.00
Liability2,600.00
ROE92.30%52.40%
Asset Turnover Ratio2.3 x2.4 x
Net Profit Margin20%22%
Asset/Equity2.0 x1.0 x

Forecasting Using Ratio Analysis

Forecasting using ratio analysis involves analysing historical financial ratios to understand interrelationships between different financial metrics and using this insight to project future financial performance. However, it’s crucial to recognize that past trends may not always accurately predict future outcomes.

Topic Pointers:

Basis of Forecasting

  • Utilises historical data and ratios to predict future financial performance. 
  • Assumes past trends and behaviours are indicative of future results.

Limitations of Historical Data

  • Past performance may not always be a reliable indicator of future outcomes. 
  • Changing market conditions can significantly alter future business performance.

Analyst Judgement in Forecasting

  • Adjustments based on analyst judgement are often necessary to account for future changes. 
  • Analysts should consider potential shifts in business dynamics and industry trends.

Importance of Contextual Understanding

  • Analysts need to analyse how future business scenarios might differ from the past. 
  • Example: Suzlon’s changing competitive landscape in the mid-2000s altered its market position.

Views of Prominent Investors

  • Warren Buffett emphasises the importance of track records over projections. 
  • Charlie Munger warns against the bias and fallacy in projections. 
  • Graham and Dodd view past trends as only a rough index to the future, not definitive predictors.

Example: The case of Suzlon Energy and its changing market dynamics is used to illustrate the need for careful analysis beyond historical data in forecasting. Additionally, the perspectives of Warren Buffett, Charlie Munger, and Graham and Dodd on the limitations of financial projections are discussed.

Peer Comparison in Financial Analysis

Peer comparison in financial analysis involves comparing a company’s financial performance and ratios with those of its industry peers. This comparison helps to understand the company’s competitive position within its industry.

Topic Pointers:

Purpose of Peer Comparison

  • To evaluate a company’s performance relative to its industry counterparts. 
  • Helps in assessing competitive strengths and weaknesses.

Comparative Metrics

  • Involves comparing various financial ratios and valuation metrics. 
  • Includes profitability, efficiency, leverage, and liquidity ratios, among others.

Understanding Competitive Positioning

  • Enables analysts to determine where a company stands in relation to its competitors. 
  • Identifies areas where the company excels or lags behind its peers.

Use in Research Reports

  • Critical for analysts creating research reports on companies and industries. 
  • Provides a broader context for evaluating a company’s financial health.

Availability of Data

  • Various databases provide quick access to financial metrics for peer comparison. 
  • Enables efficient and comprehensive analysis of comparative performance.

Other aspects to study from financial reports

History of Equity Expansion

Equity expansion refers to the process of a company issuing additional shares to raise funds, which can affect the shareholder’s value and ownership stake. It encompasses various methods of issuing new shares, each with different implications for existing shareholders.

Topic Pointers:

  • Fund Raising and Shareholder Value: Companies raise funds to finance growth or operations, and the cost of these funds can impact shareholder value.
  • Equity Issuance Impact: Issuing new equity can dilute existing shareholders’ stakes unless it’s done through a rights issue, which offers shares proportionally to current holdings.
  • Models of Issuing Shares:
    • Rights Issue: Least dilutive if existing shareholders participate fully.
    • Public Issue: Includes IPOs or further public offerings, usually leading to dilution.
    • Private Placement: Can be preferential issues to selected investors or qualified institutional placements (QIPs), both leading to potential dilution.
  • Preferential Issue: Often at a premium and can be value accretive if done at favourable valuations.
  • Qualified Institutional Placements: Indicates institutional investor confidence but also causes dilution.
  • Dilution Analysis: Investors should analyse the company’s history of equity expansion to understand potential future dilution.
  • Financing Growth: Companies that finance growth through internal accruals pose less dilution risk than those frequently issuing new equity.
  • Regulatory Perspective: Regulators may set minimum prices for private placements to protect minority shareholders.

Dividend and Earnings History Analysis

Dividend and earnings history analysis involves examining a company’s past dividend payments and earnings performance to understand its approach to shareholder value creation. This analysis helps in assessing how the company balances profit distribution with growth and how it signals its financial health and future strategies to investors.

Topic Pointers:

Significance of Dividend Policy

  • Dividends are a key component of shareholder returns, alongside capital gains. 
  • Understanding a company’s dividend policy helps gauge its approach to sharing profits with shareholders.

Dividend Policy in Different Business Phases:

  • Growth phase: Companies often reinvest profits for expansion, leading to lower or no dividends.
  • Maturity phase: As growth stabilises, shareholders may expect regular and timely dividends.

Dividend Yield and Stability

  • High dividend yields attract long-term investors seeking periodic income. 
  • Stability and predictability of dividends are crucial, especially for mature companies.

Industry Influence on Dividend Predictability

  • Defensive industries often provide more predictable dividends. 
  • Example: Companies like Colgate Palmolive or Britannia regularly offering interim dividends.

Managing Dividends in Variable Performances

  • Companies build reserves in good times to maintain dividend payments during downturns. 
  • Indicates active dividend management to provide consistency to shareholders.

Share Buybacks as a Profit Distribution Method

  • Alongside dividends, share buybacks are another way to return value to shareholders. 
  • Preferred for tax advantages or to provide investors with a choice to increase their stake.

Signals from Dividend Changes

  • Changes in dividend payments can indicate a company’s investment plans or expectations of future challenges. 
  • Significant deviation from past dividend patterns warrants investigation into the reasons.

Analyst Considerations

  • Requires analysing the company’s dividend history, policy, and contextual factors. 
  • Understanding management’s rationale behind dividend decisions is crucial.

Understanding the Impact of Corporate Actions on Share Price

Corporate actions, such as dividends, bonuses, stock splits, and rights issues, are decisions taken by a company’s management that can have significant effects on its share price and shareholder value.

Topic Pointers:

Types of Corporate Actions:

  • Dividends: Distribution of earnings to shareholders, impacting share price and total shareholder return.
  • Bonuses: Issuance of additional shares to existing shareholders, often influencing the stock price.
  • Splits: Division of a company’s existing shares into multiple ones, affecting the share price and liquidity.
  • Rights Issues: Offering new shares to existing shareholders at a discount, impacting share dilution and price.

Impact on Share Price: These actions can lead to adjustments in the company’s stock price. For example, dividends often result in a decrease in share price post the ex-dividend date.

Investor Perception and Response: Corporate actions are closely watched by investors as indicators of a company’s financial health and future prospects. They can influence investor decisions based on perceived value and confidence in management.

Strategic Implications: Each corporate action has strategic reasons behind it, reflecting the company’s operational, financial, and growth strategies.

Consideration of Market Dynamics: The market’s response to these actions can vary depending on the overall economic environment and sector-specific factors.

Analysing Ownership and Insiders’ Stock Transactions

Analysis of ownership and insiders’ sales and purchase of stocks involves examining the stock market activities of a company’s insiders, such as owners, executives, and other key stakeholders, to gauge their confidence and expectations regarding the company’s future performance.

Topic Pointers:

Insider Knowledge Advantage: Insiders, being closely associated with the company, have a deeper understanding of its operations and future prospects. Their actions in the stock market are often seen as indicative of their confidence in the company’s performance.

Regulated Transactions: Insiders’ transactions are governed by regulations set by market authorities like SEBI to prevent misuse of privileged information.

Analysing Insiders’ Market Actions: Tracking the buying and selling patterns of insiders can provide valuable insights. Increased buying by insiders can be a positive signal, suggesting potential future profitability.

Peter Lynch’s Perspective: As noted by Peter Lynch, while insiders may sell shares for various reasons, insider buying typically indicates a belief in the company’s future success.

Interpreting Insider Sales: Insider selling should not automatically be viewed as a negative sign but warrants investigation into the possible reasons.

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