Read the balance sheet, the profit and loss account and the cash flow, then turn them into ratios that tell a story.
Chapters 5 to 7 looked at the economy, the industry and the company's business. Financial analysis turns all that into the company's likely profits, cash flows and, finally, the fair value of its shares. Financial statements also supply the numbers for market sizing (6.4), industry KPIs (6.7) and strengths and weaknesses (7.5).
In India, the statements and their format are governed by Schedule III of the Companies Act, 2013 and Ind AS 1. A complete set under Ind AS 1:
Statement of financial position: assets, liabilities and equity at the end of the period. A snapshot.
Income, expenses and profit for the period. Must include other comprehensive income (OCI).
How shareholders' funds changed: profit, dividends, new shares, buybacks, OCI.
Sources and uses of cash.
Accounting policies and break-ups of the figures.
Each statement must show figures for at least one prior period for comparison. Companies may show more.
Every company is a separate legal entity and prepares its own standalone statements. But for groups these can mislead: Toyota Motor Corporation's standalone accounts show only sales of that entity in Japan, not sales through subsidiaries in China, India or North America.
Consolidated statements treat all companies controlled by the parent as one group and combine their results.
It gives a more holistic picture of the group.
Subsidiaries cannot pass dividends to the parent: strict capital controls in their country, or a debt covenant banning dividends. Then ask: can the parent stand on its own in a crisis?
Format: Schedule III of the Companies Act, 2013. Banks, insurers and utilities follow formats set by their own regulators. The book uses Bharti Airtel's consolidated balance sheet for 31 March 2019 as its example.
Assets are items expected to give future benefits. A company can show only assets that can be measured in money and have been paid for. So a company generally cannot show its own self-generated brand.
| Line item | What it is | How it is shown |
|---|---|---|
| Property, plant and equipment (PPE) | Land, buildings, machines, furniture, computers | Historical cost less accumulated depreciation. Ind AS 16 allows a revaluation model, applied to a whole class of assets |
| Capital work in progress | PPE still under construction | Moved to PPE when ready to operate |
| Goodwill | Price paid for a business above the fair value of net assets taken over | Tested for impairment; any shortfall written off |
| Intangible assets | Legal rights: acquired copyrights, patents, brands. Internally developed software can be shown; other self-generated assets cannot | Cost less accumulated amortisation |
| Intangibles under development | Intangibles not yet ready | Moved to intangibles when ready |
| Investment in joint ventures and associates | Strategic stakes the company does not control | Equity method: adjusted for its share of profit and OCI, reduced by dividends received |
| Non-current financial assets | Long-term investments, loans, advances | Debt held to collect interest and principal: amortised cost. Others: fair value |
| Inventory | Raw material, work in progress, unsold finished goods | Lower of cost or market value |
| Current financial assets | Cash and cash equivalents, bank balances, receivables, short-term investments | Receivables net of provision for doubtful debts. Investments at fair value |
| Other current assets | Prepaid expenses; benefits received in kind within a year |
Equity = assets minus liabilities. Its parts:
Balance sheets often miss fair value because of the historical cost and money measurement concepts. So analysts compute extra metrics.
Long-term debt + current portion of long-term debt + short-term debt + finance lease obligations + accrued interest.
Debt is settled in cash and carries interest, unlike other liabilities.
Current assets − current liabilities. The accountant's measure.
Bharti Airtel FY 2019: 329.06 − 930.55 = minus Rs 601.49 billion.
Inventory + trade receivables − trade payables.
Only items from core operations. Helps judge the need for bank working capital finance. The book suggests also including a reasonable cash balance.
Shows performance for a period. Format: Schedule III; Ind AS 1 adds OCI, shown below net profit. Banks, insurers and utilities use their regulators' formats.
| Line item | Meaning |
|---|---|
| Revenue | Sales of goods and services from core and incidental operations. Some show incidental income as "other operating income" |
| Other income | Non-operating income: investment income, profit on sale of assets |
| Cost of raw materials | Purchases + opening stock − closing stock of raw materials |
| Purchase of stock-in-trade | Goods bought and resold without processing. Most retail purchases |
| Change in inventory of WIP and finished goods | Opening minus closing balance of WIP and finished goods |
| Employee cost | Salaries, benefits, stock-based compensation, staff welfare, annual retirement provision |
| Depreciation | Allocates the cost of tangible assets over their useful life. Ind AS 16: method should reflect how the asset is used (a cab fleet by distance) |
| Amortisation | Gradual write-off of intangible assets |
| Finance cost | Interest, processing fees, amortised cost of issuing securities |
| Income from equity-accounted entities | Share of profit of joint ventures and associates |
| Exceptional items | Not from the normal course of business: natural calamity losses, one-time regulatory charges |
| Tax | Current tax, MAT, deferred tax. Deferred tax has no cash impact |
| Non-controlling interest | Subsidiary profit belonging to outside shareholders |
Diluted EPS assumes all instruments that could become shares without full payment are converted: in-the-money warrants, ESOPs, convertibles. Profit is adjusted for the effect too. For a loss-making company, basic and diluted EPS are the same.
Income or expense that bypasses the P&L, mostly changes in value from non-operating factors: revaluation surplus changes; remeasurement of defined benefit plans; translation of foreign operations; fair value changes of certain financial assets or liabilities; gains or losses on derivatives that hedge risk.
Most companies present a single-step P&L (all income minus all expenses = profit before tax). Some, like Bharti Airtel, present a multi-step P&L showing EBITDA. Analysts often redraw single-step statements into multi-step ones.
Revenue − cost of goods sold. Not computable for most Indian companies
Before interest, tax, depreciation, amortisation
"Operating profit"
Net profit for shareholders
Required by Ind AS 1. Shows how each type of transaction changed each part of shareholders' equity.
Accounts use the accrual basis: income counts when earned, not when received; expenses when incurred, not when paid. So profit and cash can differ a lot.
Net profit + non-cash expenses (depreciation, amortisation) ± changes in receivables and payables.
Buying assets: negative. Selling assets: positive.
Borrowing or issuing equity: positive. Repaying debt or buying back equity: negative.
A business with negative operating cash flow for years needs constant doses of borrowing or new equity. In the end it either turns cash-positive or dies when lenders and investors stop. The book's example (Rs crore, source moneycontrol.com):
| Rs crore | 2013 | 2012 | 2011 | 2010 | 2009 |
|---|---|---|---|---|---|
| Net profit before tax | −4,301.12 | −3,446.09 | −1,520.78 | −2,417.92 | −2,155.21 |
| Net cash from operating activities | −1,390.86 | −885.55 | −2.23 | −1,665.09 | −645.78 |
EBIT stayed far below interest for years, so it borrowed to pay interest, until lenders refused.
Expansion (negative investing cash flow) is funded by operating cash, past cash balances, or financing. Be cautious with firms that rely heavily on borrowing to expand: assets may realise less than book value, but liabilities must be paid in full.
There are several ways to account for an item, for example straight-line or written-down value depreciation. The policies show which way the company chose. Companies must state any change from last year. Frequent changes in policy are a reason for suspicion of manipulation.
Liabilities that arise only if an uncertain future event goes against the company. They are not recorded in the accounts, only in the notes. Examples: outstanding lawsuits, tax disputes, bank guarantees given, product warranty claims, pending investigations, changes in FX or government policy.
Any asset or liability that does not appear on the balance sheet. The book's examples: operating leases, contingent liabilities, and derivative contracts (shown only in notes). Derivatives have threatened many businesses worldwide, so analyse these in detail, especially negative surprises.
Management prepares the accounts; auditors check that they give a true and fair view. Auditors work on the information given to them and cannot vouch for every transaction. So they check, in order: are adequate control systems in place; were they properly implemented; were accounting standards followed in measuring and disclosing items?
Standard format, looks much the same across companies.
Auditors could not verify part of the financials because information was not available.
Auditors believe all or part of the statements do not give a true and fair view: they disagree with a policy, or see serious discrepancies.
For a disclaimer or a qualified report, auditors explain their reasons. Always read the audit report for reservations.
A number alone means little. Bharti Airtel's FY 2019 EBIT of Rs 47.62 billion sounds large, until you compare it with revenue of Rs 807.8 billion (only 5.8%), or with interest expense of over Rs 110 billion (not enough to pay it). Ratio analysis expresses one line item as a percentage or multiple of a related one. Only compare numbers that are related.
Adds a sense of proportion: operating profit was 5.8% of revenue.
Finds what went wrong: revenue fell 2.19% but EBITDA fell 13.9%. Network operating expense rose from 23.8% to 27.6% of revenue.
Shows how costs behave: most costs stayed a steady % of sales (they move with sales); network costs rose as sales fell, so they are largely fixed. Two years of data is too little; more data gives more confidence.
Margins are thin in a competitive industry with pricing pressure. They are high when a business is unique with big entry barriers, or an early entrant in a sunrise industry. But very high profitability rarely lasts: new entrants and competition pull it back to moderate levels. Ratios that compare a period figure (sales, profit) with a balance sheet figure (equity, assets) should use the average balance, usually the average of opening and closing.
| Ratio | Formula | Reading it |
|---|---|---|
| Profitability | ||
| EBITDA margin | EBITDA ÷ Net sales | Operating efficiency; not affected by depreciation policy, funding or tax. Bharti: 32.2% (FY18: 36.6%) |
| PAT margin | PAT ÷ Net sales | Share of sales left for shareholders. Bharti: 2.1% |
| NOPAT | EBIT × (1 − tax rate) | Used in valuation (later chapters) |
| Return | ||
| ROE (RoNW) | PAT ÷ Net worth | "Single most important parameter" for equity investors. Net worth = share capital + reserves and surplus. Bharti: 2.1% |
| ROCE | EBIT ÷ Capital employed | Capital employed = total assets − non-interest-bearing current liabilities, or equity + debt (book values). Pre-tax. Bharti: 2.38% |
| Leverage | ||
| Debt / Equity | Total adjusted debt ÷ Net worth | Most conservative benchmark: 1 or less. Bharti: 1.52x |
| Interest coverage | EBIT ÷ Interest expense | Below 1 or negative: earnings do not cover interest |
| Liquidity | ||
| Current ratio | Current assets ÷ Current liabilities | Also called working capital ratio. Bharti: 0.35 |
| Quick ratio | (Current assets − Inventories) ÷ Current liabilities | Stricter: inventory cannot become cash immediately |
| Efficiency | ||
| Receivable turnover | Revenue ÷ Average receivables | Higher is better: faster collection. Low may mean credit is too easy, or money is hard to recover |
| Payable turnover | Purchases ÷ Accounts payable | Low means long supplier credit: strength, or lack of cash |
| Asset turnover | Net sales ÷ Total assets | Higher is better: assets put to work. Used in DuPont |
| Inventory turnover | Sales ÷ Inventory | Higher is better. Slow stock locks up money, and perishables can spoil. High for FMCG, low for capital goods |
The book notes several versions of ROCE and D/E are used in the industry (for example, net debt = total debt minus cash). For the exam, use the formulas in the sheet above.
Reading ratios together gives more insight. For example, sales rising while the collection period lengthens suggests lenient credit to push sales. DuPont analysis breaks ROE into three parts:
Profitability
Efficiency
Leverage
The book's comparison. HighLevCo: ROE 92.3% = 20% margin × 2.3x turnover × 2.0x leverage. LowLevCo: ROE 52.4% = 22% margin × 2.4x turnover × 1.0x leverage (no debt). LowLevCo is the better operator, with higher margin and slightly higher turnover. Its ROE is lower only because it uses no debt, which also means less risk.
Analysts use how items behaved in the past to forecast. But that assumes the past represents the future, which need not hold. Apply judgement and adjust for changes.
Quotes from the book: Warren Buffett has "no use whatsoever for projections or forecasts" and looks deeply at track records. Charlie Munger says projections "do more harm than good". Graham and Dodd: a past trend is a fact, a future trend only an assumption, and the past is only a "rough index" to the future.
Comparing a company's ratios with those of peers in the same sector shows its competitive position. The book calls peer comparison critical for any research report. Databases give quick peer snapshots.
Raising money costs the business; if raised expensively, existing shareholders bear it. Debt costs are clear from the contract; the cost of issuing equity is harder to see. Ways to issue shares:
No major dilution: offered to all in proportion. Dilutes only those who do not take up their rights.
Raises the chosen investor's stake, cuts everyone else's. Two views: dilution risk, or a sign that someone may bail the company out in a crisis. Check the situation and price: a premium price is value-accretive for minorities.
Dilutes, but likely shows institutional confidence in fundamentals.
Growth funded from the company's own profits: very little dilution concern.
Dividends, bonuses, splits and rights affect the share price. Chapter 9 covers them.
Owners know the business best, and trade within SEBI's guidelines. Their trades can give insight. Peter Lynch, quoted in the book: insiders sell for many reasons, which need not 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".
The book's text gives Bharti Airtel's total debt as "Rs.12.87 billion" and core working capital as "negative Rs.2.36 billion", but its own tables (in Rs million) show 12,87,036 and minus 2,36,141. The quiz does not use these two figures.
Tap the card to flip. On a keyboard: space flips, right arrow = got it, left arrow = again.
Scoring works like the real exam: +1 for a right answer, minus 0.25 for a wrong one, 0 for a skip. Skipping is allowed.