Shortcomings of Financial Statements

Financial statements are prepared by every company to gauge its performance, to report its performance to its shareholders and to comply by regulatory requirements. Though, financial statements provide wealth of information, but it has loads of shortcomings.

1. Financial statements rely everything on book value. They never give you a reflection of market value. They never tell you about the market value of assets it holds. Suppose, a company buys a fixed asset like land or building, it always gives the numbers in terms of original or historical cost. It never tells you  the present market value of that particular asset. Thus, for every asset, it always gives you the book value. It never gives you the market value.
2. Financial statement records the cost of the "bought" assets by the company in its statements. But it never records assets created by efforts of the company. For example, a company never records the value of the product or patent created by its Research and Development, though it'll record the value of a bought patent in its financial statements.
3. Financial statements categorise expenses as operating, financial and capital expenses. Financial statements often err while categorising a particular expense. For example, expenses made on fixed assets are considered as capital expenses by a company and are depreciated or amortised over a period of time. Patents are also assets, but expenses made on its R&D are considered as operating expenses. Similarly, operating leases are also considered as operating expenses which rather should be considered as financial expenses.
4. Financial statements report the assets on which investment has been already made, but they never tell us about assets on which investment is to be done. This later investment will open new growth avenues for the company. For example, fruits of R&D and patents can be considered as such assets.
5. Like assets, financial statements don't reflect the market value of liabilities, like debt and shareholders' equity. They simply reflect the book value as usual.
6. While financial statements are geared towards finding whether a company will be able to meet its obligations of debt and payments to suppliers, they don't throw any light on risk to equity investors.

Why stock market defies the natural law of economics?

In Economics, its stated that with higher prices, demand falls and when prices drops, demand increases. Its just the opposite when it comes to stock markets. People buy when prices are sky-rocket high and they stay away from stock markets when its cheap. People often turn a blind eye to stocks when the valuations are at dirt cheap and will rush to grab when the valuations are sheer nonsense. Its very difficult to comprehend this situation when people don't buy a dozen of banana at high prices, then why they happen to buy stocks at costly valuations. When people stop buying and consuming a kg of onion at Rs. 40-50 as part of their food, then how they were able to buy Suzlon Energy at Rs. 500, Educomp Solutions at Rs. 800 or DLF at Rs. 1200 prior to the recession of 2008-09. Currently, Suzlon Energy is trading at Rs. 15, Educomp Solutions at Rs. 158 and DLF at Rs. 205. And when people rush to buy a kg. of onion at Rs. 20-25, they were too sceptical to buy Hawkins Cookers at Rs. 130, TTK Prestige at Rs. 90 or Titan Industries at Rs. 35 during the downturn of 2008-09. Currently, Hawkins Cookers is trading at Rs. 1800, TTK Prestige at Rs. 3100 and Titan Industries at Rs. 275. This is where investors defy the basic law of Economics that with higher prices, demand falls and when prices drops, demand increases. People are all vice versa to that in respect to their stock investments. This is a question worth pondering over. I'm not able to find the answers. Perhaps people can. Kindly comment.

Dynamics of Profit and Loss Statement

The Profit and Loss Statement of a business or a company tells a lot about the business. Analysing the statement historically can give one important insights into the functioning of the business. The Profit and Loss statement tells us about what the business has done and what it has earned over a period of time. It tells us about the working dynamics of the business.

The Profit and Loss statement consists of following parts, in general:

1. Operating Revenue
2. Cost of Raw Materials
3. Purchase of Traded Goods
4. Salaries and Wages
5. Sales, Promotion and Marketing Expenditure
6. Other Expenditure
7. Depreciation
8. Financial Expenditure
9. Other Income
10. Taxation
11. Profit after Tax

Operating Margins

Every business has its characteristic Operating Margins. Operating Margins don't expand and retract radically with passing time. Its the level below which the business doesn't wish to sell. Operating margins are calculated after taking into account fixed operating costs. It simply can't be calculated straightaway. The level is reached after a number of internal assessments. In case of brands, supposed brand value is also incorporated into the margins. A healthy Operating Margin is essential for the growth of the business.

Operating Margin can't just be increased at will as it'll result in increment of prices taking into account that fixed operating costs is constant. Increased prices of products can result in your competition eating into your market share or customers turning away from you or cutting their discretionary spending. Increased Operating Margins from increase in prices shall be viewed with caution. Operating Margins can also improve from certain structural changes in fixed operating costs. Reduction in any kind of fixed operating costs can lead to improvement of Operating Margins which must be welcome.

Reliance Industries Limited - Steady and Still

Reliance Industries Limited (RIL) is one of the largest companies of India by market capitalization. The business has interests in petrochemicals, oil and gas exploration, textiles, retail. Reliance Industries has been a very dominant force in Indian industry circles. In March 2012, RIL did a sales of Rs. 3,58,501 crores, a growth of 34% over last year. RIL has Operating Margins of 11%. RoCE for RIL is 16.50%.

Despite such huge size and in engineering sector, RIL has excellent Operating Cash Flows. RIL gets its money from its customers within 17 days. RIL consumes its Inventories within 52 days. RIL pays its suppliers after 46 days. Overall, RIL is able to converts its money within 22 days, which most of the engineering goods companies in India will be jealous of. Debt/Equity for this company is at 0.48. This is possible because of the quick cash conversion by RIL as it provides liquidity at their hands.

RIL is sustaining and still growing stronger, despite its huge size, because of the quick cash conversion cycle. Its because of the positive Operating Cash Flows. Any company, big or small,  will suffer down the line if they fumble with their Operating Cash Flows. Thus, investors must pay dear attention to Operating Cash Flows.

Dish TV - sab par "Loss" sawaar hai - Dish karo yaa Ditch karo?

Dish TV was the first company in India to roll out DTH services in India. It roped in Shahrukh Khan as its brand ambassador. Ever since Dish TV initiated itself, it is beset with problems. For a long time, Dish TV suffered operating losses. In the mean time, they underwent equity dilution couple of times.

In financial year March 2012, revenue from operations was Rs. 1957 crores, an increase of over 36% on Rs. 1436 crores of revenues registered last year. Operating Profits greatly improved at Rs. 566.7 crores at a margin of 29% as compared to Rs. 360.66 crores at a margin of 25%. The Net Loss suffered by the company is mainly because of Depreciation and Interest costs. Loans have greatly increased to Rs. 1214 crores from Rs. 648 crores over last year, an increase of 87% which can be a bit of concern. RoCE is coming out to be 50% for this year, which is quiet impressive in terms of business returns. This is mainly because Dish TV operates on negative working capital. The company has good positive operating cash flows despite Net Loss, mainly on account of huge Depreciations in the Profit and Loss statements.

Which business will grow faster?

I'll give you case of two businesses. I'll first explain the situation around these businesses. 

Business 1: The revenue is growing at 25% annually. Similar is the growth of Profit After Tax. At present, the company has no debt. Return on Capital Employed (RoCE) is at 30%. Operating Cash Flows are 25% of the Operating Profits.

Business 2: The revenue is growing at 25% annually. Similar is the growth of Profit After Tax. At present, the company has no debt. Return on Capital Employed (RoCE) is at 30%. Operating Cash Flows are 120% of the Operating Profits. 

The difference between the above two instances is Operating Cash Flows. What is going to be the impact of Operating Cash Flows?

What Rakesh Jhunjhunwala saw in DB Realty?

Rakesh Jhunjhunwala recently made an investment into DB Realty. This is the same company whose Chairman, Shahid Balwa, was made a party to 2G accusations list a few months ago. The Chairman and the company was shown to have provided Mr. Sharad Pawar, Agriculture Minister with certain favours.

In financial year ending March 2012, DB Realty did an annual sales of Rs. 590.86 crores, almost half of what it did in the previous year. Operating Profit is at Rs. 124 crores at a margin of around 20%. Debt/Equity ratio is at 0.06. Total Assets of the company is at  Rs. 5191.08 crores. Working Capital of the company is Rs. 1363 crores. Fixed Assets is Rs. 245 crores. RoCE is 7.11%. Share price is Rs. 98.75.

What we can see from here id that DB Realty is very under-leveraged as compared to other real-estate companies. Debt is at a very comfortable situation. If we talk about Total Assets, Total Assets per share of the company is coming out to be Rs. 213.44 crores. If we talk about Capital Employed, Capital Employed per Share is at Rs. 66.11. In June quarter this year, the company did Sales of only Rs. 85 crores made a net loss. If we see just at Project Expenses only as a percentage of Sales, its ranging between 60-90% over several quarters.

So, what could have made Rakesh Jhunjhunwala commit an investment into this company. First, Total Assets per share of the company is way beyond the current Share price. Second, certain projects of the company have been recently completed and others are due completion in near months. Will one invest into it based upon these parameters? Will this company provide a steady stream of revenues, profits and operating cash flows?

The fizzling Suzlon Energy

In the financial year March 2005, Suzlon Energy did an Annual Sales of Rs. 1942.48 crores. They did an Operating Profit of Rs. 473.40 crores, the Operating Margins being 24.37%. Capital employed was Rs. 1300 crores. RoCE came out to be around 35%. Debt/Equity ratio was about 0.50.

In the financial year March 2012, Suzlon Energy did an Annual Sales of Rs. 21,082.37 crores. They grew their Sales by 10 times from 2005. Operating Profit came out to be Rs. 1544.36 crores with the margin percentage being 7.33%. Capital Employed is around Rs. 15,500 crores. RoCE is at around 10%. Debt/Equity ratio is 2.

The maximum Sales was recorded in the year 2009 at Rs. 26,081 crore. Maximum debt was also acquired in the same financial year of 2009 as debt jumped 4 times from Rs. 390 crores in financial year 2005 to Rs. 14,700 crores. Most of the debt was meant for fixed assets for fixed assets walloped 3 times to Rs. 13,281 crores from Rs. 4568 crores. Capital Employed for that year is Rs. 24,500 crores. Operating Profit for the same year is Rs. 2849.71 crores at margin of 11%. RoCE came out to be around 10%.

Mismatch between Operating Cash Flows and Return on Capital Employed (RoCE)

Return on Capital Employed (RoCE) is the return on Fixed Assets as well as Working Capital. It indicates towards the efficient use of the two forms of capital. RoCE indicates towards the efficiency of the business. It indicates towards effective capital allocation. A company/business with higher RoCE is deemed good.

Operating Cash flows is the actual amount of money emerging from the business. It takes into stock money stuck in inventories, with customers and money given as advances or paid as loans. Thus, operating Cash Flow is pure cash coming out of the business within a period of time. Net Profits or Operating Profits is just profits or money on paper, while Operating Cash Flows is the crude cash coming out of the business. Operating Cash Flows as a proportion of Net Profits or Operating Profits is an effective indicator of the Cash Conversion Cycle of the business.

Thus, even though a business or company might have a higher RoCE, it doesn't necessarily mean that they're generating actual Cash. If a business isn't able to churn out actual cash, then it will have to take Working Capital Loans to maintain the running of business, thus incurring interest expenses and lowering of Net Profits. So, a lone look at RoCE doesn't actually work.

Working Capital and Return on Capital Employed (RoCE)

Working Capital or Net Current Assets is the difference between Current Assets and Current Liabilities. This is the money with which the business is run. Working Capital makes Sales happen. Working Capital is arranged in the form of Inventories, Sundry Debtors or Account Receivables and Sundry Creditors or Account Payables. The distribution of the capital between the three items becomes the face of any business. This distribution is characteristic of a particular business and  a business is seldom able to change this structure over its lifetime. This distribution of capital is indicative to investors to be worthy of investment. Everybody will like to be invested in business which lower distribution of capital in Inventories and Sundry Debtors. This indicates that inventory is readily consumed and sale money is not stuck with customers.

As I said earlier, Working Capital makes Sales happen. Working Capital is the money with which we buy Inventories, process it, then sell it, receive the cash from customers and pay the suppliers of the inventories. The ratio of Sales and Working Capital indicates the efficient use of Working Capital. Its an important indicator which an investor must pay attention to.

Return on Capital Employed (RoCE) is simply Operating Profits over Capital Employed. Capital Employed is the addition of Fixed Assets and Working Capital. RoCE is an effective indication of the returns being generated from the business. It indicates the effective use of Fixed Assets and Working Capital.

Thus, a better RoCE is mainly reliant upon the effective use of Working Capital. The arrangement of the capital across the components of Working Capital and RoCE indicates towards the quality of the business.

The sad story of Educomp Solutions

People hear about rags to riches story a lot. We're going to talk about Educomp Solutions. Educomp Solutions was the first mover in the digital educational content provider space. In short span of time, it grew tremedously providing a booster to shareholders' value. Something around the end of 2008 started going wrong for the company. Satyam fiasco happened at that time. Satyam was accused of inflating its revenues and its Chairman  Ramlinga Raju accepted the fraud committed by him. Around that time, CBI also started looking into Educomp. Though, nothing emerged concretely but it was rumoured that Educomp Solutions was cooking its books similarly to Satyam. It was inflating its revenues to drive the share prices. Educomp must had some political connections to get the CBI off its back. Then, after some time, SEBI summoned the Chairman Shantanu Prakash for some insider trading antics. SEBI and Shantanu Prakash reached a non-disclosure agreement by paying SEBI a certain amount of fine. It was rumoured that the Chairman and other high-end employees of the company were involved in insider trading. In 2009-2010, they raised Rs. 607 crores through private placements and diluted shareholders' equity. In 2011, an Income-Tax raid happened on Educomp Solution premises. Meanwhile, Chairman Shantanu Prakash started having bitter relations with his then CFO, Sangeeta Gulati, who resigned from Educomp Solutions very recently. It was rumoured in Educomp Solutions workplace that Sangeeta Gulati wielded more influence on Educomp Solutions than the Chairman himself. In the beginning of 2012, the company was able to raise money to pay off the burdensome FCCBs overseas. In 2011, they were able to securitise certain of their fixed assets with the help of the banks to improve their operating cash flows. But nothing much happened to that extent, as the company was laden with debts and with operating cash flows still struggling. Meanwhile, other big players entered this sector and have now almost commoditised this sector with the revenue per unit falling down.

From 2008 to 2012, Educomp Soplutions has trebled its debt. From 2010 onwards, profits have suffered a lot for this company. They have almost halved. For 2012, profits are already down. EPS has halfed from 2011 onwards. Despite securitisation programme, fixed assets are continuously growing up. Net Cash Flows have turned negative from 2010 onwards. Recently, the company announced that it needed to borrow money again. And, revenue per unit is falling down in wake of new entrants entering this sector. Stock prices are ever falling down. From highs of Rs. 600 in 2010 to dismal lows of Rs. 128 in 2012, this company is witnessing a gradual decline. In late 2011, Chairman Shantanu Prakash was talking about selling some of the fixed assets like schools to compensate for required money.

We can just hope that this company doesn't become a riches-to-rags story.

Behind the concept of Discounted Cash Flows

Discounted Cash Flow is all about valuing future cash flows from a business and then discounting it by a percentage value to the current value of those future cash flows. The percentage value can be your minimum expected returns or any current safe guaranteed returns from fixed deposits or bonds. If the current value of those future cash flows comes out to be higher than the amount you're going to invest  in the present, then its deemed a safe investment. Now there are three variables in this concept. 

1. First, it is the time frame for which you'll be calculating the future cash flows, 
2. then its the growth percentage which you'll factor in to guess out the future cash flows every year, and 
3. the discount percentage.

These variables are vulnerable to individual's perception about a business and as it is, future can't be correctly stated.

But the question is about the preeminence of  Discounted Cash Flow? Why investors all over the globe fall for this concept? Why value investors kneel before it and swear allegiance to it?

Discounted Cash Flows isn't simply about the guesswork of future cash flows from a business. Existing cash flows from any business go back into the company's Balance Sheet as Cash and Bank Balances, ready to be used for the company's purposes or growth or expansion. They're not meant there to be idle. Over a course of time, these incoming cash flows will be used to fuel growth. These cash flows will become assets for the company in future, Fixed Assets or Working Capital, and will aid in further expansion of business and will lead to increased future cash flows from the business.

So, if one is calculating future cash flows in present, he'll able to calculate cash flows only from the existing business or existing level of business. One'll not be able to gauge the growth in business from the utility of the future cash flows. Now, since future cash flows will get converted into assets for the company, the investor ultimately pays for the future total assets of the company or business which will in turn dole out further future cash flows. Thats why an investor valuing a business using Discounted Cash Flow model pays so much attention to the management antics as the perfect utility of the future cash flows depends upon the will and capacity of the management.

In a way, Discounted Cash Flow is a very strong, potent and conservative way of valuing any business. It really discounts the business for any growth resulting from the ensuing cash flows by sticking to the present condition of the business. If valued appropriately using Discounted Cash Flow model, an investor must reap rich dividends (in both forms).

The Curious Case of Mr. Robert Vadra "Gandhi"

The recent news reflecting upon supposed financial misdemeanor by DLF and Robert Vadra is coming to the point of "Loans and Advances" by DLF and Robert Vadra's companies. DLF gave Mr. Robert Vadra Rs. 60 crores interest-free to Robert Vadra through "Loans and Advances" items on Balance-Sheet. And as viewed from certain newspaper reports, Robert Vadra's companies gave supposed salaries to Robert Vadra through "Loans and Advances". The issue of Loans and Advances seems devious ones..

Often one can find huge sums of Loans and Advances on a company's Balance-Sheet and there's little or negligible information regarding that in the Schedules of the Balance-Sheet. It was always supposed that Loans and Advances can be mismanaged to one's benefits and the current case of Robert Vadra and DLF is pointing towards the same.

Its time the companies come forward in a more transparent way towards the same and the shareholders must take the habit of questioning them.

Why one should be wary of ESOPs?

ESOPs or Employee Stock Options are a modern instruments of incentivising employees by corporations or companies. But as we move forward, ESOPs are becoming controversial regarding their usage both from the point of shareholders as well as employees.

Firstly, ESOPs straightaway dilute the equity of the company, thus hampering shareholders' interests. Nobody likes to see his stake being diluted.

Secondly, as a motivational instrument too, ESOPs are becoming controversial. If an employee is issued ESOPs, then the benefit that employee will have from ESOPs will be reliant on the overall performance of the company and that'll come from the collective performances of all the employees or co-workers. Why should an employee's special efforts be put ransom to the efforts of other employees? In a way, ESOPs are unfair to employees too. Rather, they should be compensated straightaway in form of salary raises, bonuses, perks or incentives. So, ESOPs fail this purpose too.

Thirdly, the expense on ESOPs are not accounted in the expense sheet, thus inflating profits and artificial stock price increases.

Thus, budding investors must be wary of ESOPs and must ask the management regarding its true utility.

Is it worth buying Cash?

I was checking into Piramal Enterprises Limited. This company was in news after it sold to Abbott its formulation business for a huge sum of money. Kudos were levied upon Mr. Ajay Piramal for selling the business so high. He's now being regarded as India's biggest "value investor". He's considered a brilliant manager by almost all investors in India. His company Piramal Enterprises Limited has been considered as a "value" bet by a management guru from Gurgaon and he talks about adding Mr. Ajay Piramal as a manager  to this bet. Sounds convincing...

Bajaj Corp

A newspaper article..

http://timesofindia.indiatimes.com/business/india-business/Bajaj-Almond-Drops-volume-growth-to-sustain-at-18-20-levels-Analysts/articleshow/16641521.cms

Speciality Restaurants Limited - Mainland China

Last night I was looking over the recently concluded IPO launch of Speciality Restaurants a.k.a. Mainland China. From the front, it immediately reminds you of Jubilant FoodWorks a.k.a. Domino's Pizza and it bullish run in past two years. Speciality Restaurants owns a number of other brands too like Oh!Calcutta, Bengali Sweets, Flame n' Grills etc. They have disclosed their statements from 2009 to 2012.

What's wrong with various stock investment forums?

There are lots of stock investment forums on internet and their owners work very hard in operating and maintaining them. Most of them are investment professionals and have long stints in stock markets. Some of them have even turned activists, often taking business managements to their tasks. But something is missing with these stock investment forums.

What's "value" for value investor?

A "Value Investor" in its conservative sense relies only on numbers in absolute terms. For him the underlying value has utmost importance. Now, this underlying value might derive from unlocked assets, cash or maybe future growth. For a value investor, everything needs to be optimum: the buying price, growth and future cash flows. He come to a value based upon these suppositions. From the outside, you might feel that a value investor is only relying on the present value in the business. But this isn't so. His present value takes into consideration the future cash flows. The "Discounted Cash Flow" model is based upon this supposition of which a value investor is a die-hard fan. But here is the pitfall too.

What is Margin of Safety?

Yesterday, I read Seth Klarman's book "Margin of Safety". I approached that book to answer some of my questions. But, rather, it increased my doubts on numerous accounts. Seth Klarman tries to dig deep into the concept of "Value Investing" and then through Margin of Safety, tries to discuss on value investment approaches. Primarily, it was all about "Discounted Cash Flow " model. The only shortcoming which I felt was that Seth Klarman didn't talk anything about business models. He didn't say anything about "Why a certain business model must be favoured?". Though he talked about the importance of cash flows, but he ignored discussing about the choice of businesses.

How long to stay invested in a stock?

Yesterday night, I was speaking with a very respected friend, elder and we discussed about investments & businesses. We started talking about strategy and then he revealed that he was invested in two stocks. I definitely endorsed his strategy, since I, myself am invested in a single business and am enjoying the benefits of that greatly. We started talking about his picks and then I realized that both of his stocks were pretty richly valued in terms of PE. I, then suggested, him to move to a stock which was equally good & of high quality but quoting at undervalued prices. Later, I realized that this was worth writing an article.

What is an ideal business?

What's a business meant to be? Surely, its not for emotional gratification. Its meant to earn you money more than what you invested in raising the business over a period. You expect returns. 

You can't alone run a business. You need co-operative efforts of employees for which they get paid. So, employees are a great asset for the business, but not at the cost of returns from the business. So, definitely, business isn't welfare. Any incompetency & any expensive labour needs to be sorted out.

Business is also run by machines and machines need buildings and buildings are erected upon lands. These all comprise "fixed assets". Their expense come up firsthand while initiating an enterprise. The amount paid for the "fixed assets" must be conducive enough for the profitability of the business. Lets us take the example of land. If the land cost is so prohibitive, then it can affect the expansion of the business which relies upon setting up manufacturing units for itself. Second is the case of machines/technology.