Professional Documents
Culture Documents
CHAPTER 1
In your investment career, you must have received stock tips and
recommendations from your brokers, friends and family. Many a times, on
asking the rationale behind the same, the person giving the recommendation would
state the source of the tip as some ‘reliable’ source. Investors make decisions
based on certain factual information. Subsequently, they make future assumptions
based on and in support of those facts. As such, knowing how an industry and a
company functions is very important. In addition, it is equally important for one to
gain such information from proper and reliable sources.
In the second part of this series of articleson educating you on the basics of
investing in stocks, we present herewith a basic idea of where you can go about
looking for information on companies you wish to invest in.
Sources of information on companies
Offer documents: For a novice investor, it is always recommended that he
should understand a sector before jumping into understanding the working
of a particular company. One of the best sources for understanding a particular
sector or industry is the offer document of the company, if one can get hold to
one. Every company which gets listed first needs to file an offer document with
the Securities & Exchange Board of India (SEBI). Apart from facts and figures
about the company and its promoters, this document also contains
information relating to the working of the industry (the company is involved in).
One may refer to this linkto see the offer documents that have been issued
over the past few years.
Annual reports: In case of a company for which you cannot get hold of
the offer document given that the company has been listed on the stock
exchanges for long, the annual report comes in handy. The director’s report
and the management discussion and analysis (MD&A) sections of an annual
report provide good information related to the company and industry.
However, as compared to the offer document, this information is usually related
to the past year and the management’s views on the outlook for the next year.
It may be noted that one should not blindly take the management’s views
into consideration as more often than not, it tends to paint a rosy picture.
In the next article of this series, we shall take a deeper look into the constituents
of an annual report.
BSE/NSE announcements and company press releases: We at
Equitymaster have always believed in attaining information straight from a
company rather than from a third party. Even if an investor gets some
‘inside information’ on a particular company, how factual and accurate it
is, is something that cannot be determined. Apart from annual reports
(which are published on an annual basis), it is the official company documents
such as press releases, announcements and presentations which are
released in regular intervals. The source for such information is the
BSEor NSEwebsites (in their respective corporate announcement sections)
and the company’s website.
Business dailies and other media: Newspapers and news channel are a
great medium for gaining updates on companies. Interviews with
managements provide good information on the company’s views, plans
and strategies. However, information divulged from sources who do not wish
to be named can be dicey. Reporters and journalists may get such news
printed as they try to snoop around and find out stories relating to a
particular company. But there have been a handful of cases wherein companies
(on whom the news has been reported) have made announcements stating
that the information is speculative or not true. As such, it would only be
possible for an investor to judge the piece of news / information provided he is
well acquainted with the company and its working.
CHAPTER 2
CHAPTER 3
In this article, we shall go through the key constituents of the financial
statements - profit and loss account, balance sheet and cash flow statement.
Key financial statements
Profit & Loss account: The profit and loss account (P&L) shows a company’s
performance over a specific time frame, usually a financial year or a period of 12
months. In India, most companies follow a April to March financial year (as in April
2008 to March 2009 will be one financial year). The P&L account is also known as
the income statement. It presents information relating to a company’s
revenues, manufacturing costs, sales and general expenses, interest and
depreciation charges, tax costs, other income, net profits, and dividends.
A typical P&L statement is as hereunder (Source: Britannia).
The balance sheet: The balance sheet gives a snapshot of a company's financial
strength. The statement shows what a company owns or controls (assets) and what
it owes (liabilities plus equity). In accounting terminology, the balance sheet is broken
into two parts - ‘Sources of funds’ and ‘Application of funds’. ‘Sources of funds’ indicate
the total value of financing that a company has done, while ‘Application of funds’
indicates the areas the company has utilised these funds.
As such, sources of funds = application of funds.
Put in other words, assets = liabilities + equity.
As we are aware, every company has limited resources. What differentiates
a good company from an average one is the way in which it utilises such resources.
A typical balance sheet statement is displayed below.
the cash flow statement shows cash transactions during a particular time frame.
A company can generate or lose cash through its normal operations. Further,
it can raise or payback cash through financing activities. In addition, it can use cash
for investing in assets or receive cash through sales of assets or through dividends.
Being the various aspects of any business, these above-mentioned activities cover
most of the integral cash transactions of a company. As such, the cash flow statement
allows investors to understand how a particular company’s business is running,
how it has raised capital and how it is being spent.
A cash flow statement is typically broken into three broader parts:
Cash (used in)/ generated from operations
Net cash used in investing activities
Net cash from financing activities
An example of a cash flow statement is displayed below.
In the next article, we shall start our detailed discussion on the P&L statement
and its key constituents.
CHAPTER 4
In the previous article, we had taken a brief look at the key financial statements
that are found in a company’s annual report. In today’s article, we will take a look how
one should view and analyse the key revenue constituents of a profit and loss account (P&L).
Core vs non-core A handful of companies report the ‘total income’ earned by them
within a year as ‘sales’. We believe one should always take into consideration a
company’s integral earnings (core operations) as sales and not the income that is
generated from other operations. The latter could include items such income from
sale of scrap, income from interest and dividends, forex gains, profit on sale of assets,
export incentives, job charges, and miscellaneous receipts, amongst others.
While these items may not be a significant part of the total income, we believe it is
a good practice to follow, apart from knowing the precise figures. In fact, it would be
even better if one could further bifurcate such earnings under two heads – other
operating income and other income. Details regarding total income are found in
respective schedules.
Segment and region wise Revenues are generated from sales of goods or
services. However, for companies which have presence in various businesses,
a good practice would be to study the change in segment wise/ product wise /
businesswise revenues on a year on year basis. One can also take a look how the
income from each business segment (as a percentage of net sales) has changed
over the years. This gives a good judgment in knowing how a company’s
segments or businesses have been performing over a particular time frame.
and fertilizers (harvest season), hotels (vacation), air conditioners (summer season),
rain coats and umbrellas (monsoon season), amongst others. On the other hand, a
cyclical business is largely dependent on economic cycles. A classic example for the
same would be the cement business, wherein there is a high correlation between the
GDP growth and the growth in cement consumption.
As such, we would recommend investors to look at performance of such
companies over the long run.
In the next article, we shall take a look at the key expenditure constituents of
a P&L. It would be advisable for investors to not look at the P&L revenue constituents
on a standalone basis but to review the same in relation with the expenditure
constituents to gauge the overall impact.
CHAPTER 5
In the previous articleof this series, we had a brief look at how one could
analyse a company’s income over a particular period. In today’s article, we will take
a look at the key expenditure constituents (operating costs) of a company and how
one could view and analyse these over a particular period.
Operating expenses can be broadly segregated into cost of goods sold
(COGS) and selling, general and administrative expenses (SG&A).
COGS: COGS are direct costs that a company incurs for producing or providing a
product or service. These costs are directly attributable to the production of
goods or services. For example, costs of items such as flour, sugar, fats and oils
(various raw materials), laminations rolls (packaging material), amongst others will
be the COGS for a biscuit manufacturer.
In addition to these expenses, costs such as power and fuel, wages,
rent (of manufacturing unit), repair and maintenance (plant and machinery), amongst
others will also be a part of COGS as they are related to the manufacturing process.
To give a similar type of example for a service company, like an IT firm, costs of
software development will be its COGS. This will include costs of the software developers.
A common method to calculate COGS is shown below.
COGS = Opening stock of inventory + purchase of goods – closing stock of
inventory
COGS can be calculated by adding the opening stock of inventory with
the total amount of goods purchased in a particular period and subsequently,
deducting the ending inventory from it. This calculation gives the total amount of
inventory or, more specifically, the cost of this inventory, sold by the company
during the period.
For example, if a company starts with Rs 10 m worth of inventory, makes Rs 2 m in
purchases and ends the period with Rs 8 m in inventory, the its cost of goods for the
period would be Rs 4 m (Rs 10 m + Rs 2 m – Rs 8 m).
SG&A: The SG&A head includes costs that are not part of the manufacturing
process. As such, this category includes costs of items such as marketing, salaries,
electricity (office), travel, advertisement, office maintenance, rent (office), auditor
costs, and distribution charges, amongst others. To take forward the example of the
biscuit manufacturer, advertising costs, cost of distribution, the cost of labour used to
sell the biscuits would all be part of SG&A. For an IT firm, SG&A costs would include
cost of salaried employees which form part of the sales, marketing and admin teams.
How could one analyse operating costs?
For analysing operating expenses, a common method is to compare each cost
head to the sales of a particular period. We shall take help of an example to
understand this point better. Below we have given the breakup of the various cost
heads of Indian food major, Britannia Industries. We have compared each cost head to
the respective year’s sales figure also shown the change in expenses in absolute terms
and in terms of percentage (of sales).
Britannia Industries (Rs m)
FY07 FY08 Change
Items Amount % of Amount % of Amount % of
sales sales sales
Net Sales 21,993 100.0% 25,848 100.0% 17.5%
Expenditure
Consumption of Raw 14,004 63.7% 15,553 60.2% 11.1% -3.5%
Materials (i)
Employee costs (ii) 767 3.5% 905 3.5% 18.1% 0.0%
Advertising costs (iii) 1,357 6.2% 1,798 7.0% 32.5% 0.8%
Other expenditure (iv) 4,578 20.8% 5,274 20.4% 15.2% -0.4%
Total operating expenses 20,705 94.1% 23,531 91.0% 13.6% -3.1%
(i + ii+ iii +iv)
Source: Britannia FY08 annual report
During FY07, raw material costs firmed nearly 64% of sales. However, during
FY08, raw material costs increased by 11.1% YoY in absolute terms, but as a
percentage of sales, it dropped by 3.5% YoY. Further, employee costs increased by
18.1% YoY in absolute terms during FY08, but when compared to sales, these remained
flat at 3.5%. On the other hand, advertising costs increased by 32.5% YoY in absolute
terms during FY08.
As raw material form a major part of Britannia’s expenses, a slower increase
in their cost (as compared to sales) has helped the company boost its margins by
3.1% YoY. Similarly due to lower other expenses, the company was marginally able to
improve its operating margins. However, as advertising costs do not form a big part
of the company’s expenses, when compared to sales, these increased by a mere
0.8% YoY.
Likewise, if you can follow this method for companies over a long run,
it would help you analyse and view the trend expenses over a long period.
In the next article of this series, we will take a detailed look at interest
and depreciation costs and how one should analyse them .
CHAPTER 6
Source: CMIE, Equitymaster Research; * Trading companies; ^ Finished steel; # Including 2- and 4- wheeler manufacturers;
$ Non-food items
From the above table, we can notice that broadly, sectors such as telecom and
IT earn the highest operating margins, while sectors such as auto and FMCG garner
the lowest margins.
The telecom industry garners one of the highest margins mainly on account
of the advantage of operating leverage. As telecom companies need a selected amount
of mobile subscriptions (in turn, revenues) to cover its costs of networks, licences
and spectrum, any subscriber additions above that level will largely translate as profit
for the company.
On the other hand, the auto industry garners one of the lowest margins mainly
on account of stiff competition and high dependence on raw material costs
(in turn, realisations). An auto manufacturer may not be in a position to pass on the rise
in raw material cost to its customers to the full extent as it would end up its car sales
as customers would choose a cheaper alternative (stiff competition). For these reasons,
the auto industry remains a high-volume, low-margin business. Similar would be the case
for FMCG companies.
An example of a low-volume, high margin business would be that of software
products or heavy engineering. As software companies develop products in-house,
they are able to earn higher margins on their sales. But when compared to IT services,
the revenue is relatively much lower. Similarly for engineering companies,
when the component of pure engineering is high on a particular project,
the company tends to earn higher margins (on that particular project) as opposed
to pure construction or project activities.
It may be noted that these differences are largely intra-industry and not
inter-industry.
Conclusion We hope that you may have got a better understanding of operating
margins and their key determinants after reading this article. As we mention time and
again, we recommend investors to study and analyse operating performance of
companies from a long term perspective. In the next article of this series, we shall take a
look at interest and depreciation costs and how one could view them.
CHAPTER 7
In the previous article of this series, we had discussed how operating margins
vary from one sector to another. In today’s article, we will take a look at the items that
come below operating profits- depreciation and interest.
Depreciation: Overtime, assets lose their productive capacity due to reasons such as
wear and tear, obsolescence, amongst others. As s result, their values deplete.
Companies need to account for this depletion in value. This amount is called
depreciation expense. Depreciation can also be viewed as matching the use of an
asset to the income that it helped the company generate. It may be noted that
it only represents the deterioration in value. As such, this expense is not a direct
cash expense.
Under the written down value (WDV) method, companies depreciate the
value of assets using a fixed percentage on the written down value. The written down
value is the original cost less the depreciation value till the end of the previous year.
As such, this results in higher depreciation during the earlier life of the asset and
lesser depreciation in the later years. An example of the same is shown below:
A company buys an asset worth Rs 10 m in FY08. It will depreciate the value
of the asset by 15% each year (on the written down value).
The main difference between both these methods is the actual amount of
depreciation per year. However, it may be noted that the total depreciation costs
(over the life of the asset) will be the same using either of the methods.
Coming to the point of how much depreciation a company charges, it mainly
depends on the type of asset. As mentioned earlier, depreciation is charged on assets
due to reasons such as obsolesce, wear and tear, amongst others. Fixed assets
such as software and computers would be depreciated at the highest rate as they tend
to get obsolete rapidly due to technology upgrades and updates. Plant and machinery
would attract a lower depreciation rate due to their longer life. It may be noted
that companies do mention the depreciation rates they take on their fixed assets
in their annual reports.
Another point to be noted is that some companies show depreciation costs as
part of operating expenses. However, it does not form part of the core operations
of a company. As such, it would be a better method to calculate depreciation separately
(after calculating the operating income) and not as part of the operating expenses.
Interest costs: Interest costs are the compensation that a company pays to
banks or lenders for using borrowed money. These costs are usually expressed as
an annual percentage of the principal, also known as the interest rate. As you may
be aware, interest rate is dependent of variety of factors such as the credit risk
of the company, time value of money, the prevailing global interest and inflation rates.
Any investor would prefer a company which is debt free. But that does
not make companies that have a certain amount of debt a bad investment. If a
company is easily able to cover its interest costs within a particular period, it could be
a safe bet. How can we know that? This is where the interest coverage ratio comes in. \
CHAPTER 8
The need for deferred tax accounting arises because companies often
postpone or pre-pay taxes on profits pertaining to a particular period. It may be
noted that when a company reports its profits/losses, it is not necessary that they
match the profits the taxman lays claim to. As such, if a company prepays taxes
relating to the future years, it will show up as deferred tax assets in the profit
and loss account. Similarly, if a company creates a provision for deferred tax liability,
it shows that it has postponed part of the tax of that period’s transactions to the future.
Net profits: After deducting the taxes from the PBT, we arrive at the profit after tax,
which is also called the net profit. One can say that the net profit is probably one of
the most sought after figures in the analyst community. It is the figure that each analyst
tries to derive using all the knowledge he or she possesses. After all, the earning per
share or the EPS is attained by dividing the net profits by the shares outstanding.
Net profit margin is a measurement of what proportion of a company's
revenue is leftover after paying for costs of production / services and costs
such as depreciation on assets and finances its takes to run or expand the company.
A higher net profit margin allows the company to pay out higher amounts of dividends
or plough back higher amount of money back into the business.
Net profit margin is calculated by dividing the net profits (for a particular period) by
the net sales of that respective period.
Net profit margins = (Profit before tax- Tax)/ Net sales * 100
Appropriation: A company can do two things with the profits that it earns. It
can either invest it back into the company (into reserves and surplus) and/or pay out
the amount as dividend. In addition, the tax on dividends is also included here.
To get a better understanding of how this functions, we can take a look at the
image below.
In the previous article of this series, we had discussed about items that are
found at the bottom of the profit and loss account - taxes, net profits and appropriation.
In this article, we shall discuss about dividends and its impact on investors.
There are two ways in which an investor can profit from his investment in stocks.
One, through stock price appreciation, which we know can remain depressed for a
long duration even if the fundamentals of the underlying company are strong
enough. Another way to profit from an investment in a stock is through dividends.
Dividends, unlike stock prices, do not depend on the whims and the fancies
of the investor community at large. If the business is performing well and generating
cash in excess of what is required for growth, dividends are paid out irrespective of the
stock price movement.
As mentioned in the earlier article, a company can do two things with the profits
that it earns. It can either invest it back into the company (into reserves and surplus)
and/or pay out the amount as dividend. As such, dividend payout depends a lot on the
cash (after meeting its capital expenditure and working capital requirements) a
company generates during a year.
It quite often happens that many companies will not need to reinvest much
into the business (in spite of having high return on investments), purely because they
don’t see the need for it. A classic example would be of companies from the FMCG sector.
The FMCG sector is a slow yet steady growing industry. Most of the companies garner
high return on their investments in this sector. But yet they choose to pay out huge
dividends due to the sector's slow growing nature as capex requirements are on the
lower side.
Now if we compare this to say a fast growing industry such as telecom, the
situation is quite different. We shall explain this with the help of an example.
Telecom major, Bharti Airtel recently announced its maiden dividend of Rs 2 per share.
It may be noted that this was after being listed for seven years. The reason for not
paying dividends all these years, as attributed by its management, was the huge
capital expenditure programme to spread its wings across the entire country.
So, what has made the company announce a dividend this time around?
Crossing the peak capex requirement, the management has indicated.
Do all dividend paying companies make a good investment? The answer
is understandably no. This is where the aspect of 'dividend yield' comes into picture.
Dividend yield is calculated by dividing the amount paid out as dividend within a year
by the company's share price. An example will help in understanding this better.
Assuming a company's stock is trading at a price of Rs 100 and during FY09
it has paid a dividend of Rs 5 per share in total. This stock would be having a dividend
yield of 5% at the current price. Assuming that the company is growing steadily
and is expected to pay dividends in the coming year, the investor could have
surety of earning at least a 5% return on his investment.
However, it may be noted that you should not purely go out and buy a stock
which has a high dividend yield. It is very important for you to study the company
before deciding to purchase a high dividend yield stock. It could be possible that a
company may not be in a position to pay dividends or it might pay lower dividend
in the future (as compared to earlier years) due to various reasons – an unprecedented
loss, higher capex requirements, diversification into newer areas, amongst others.
CHAPTER 10
Sources of Funds
‘Sources of funds’ indicates the total financing that a company has done.
In simple terms it shows how a company has got the funds which it has used to
purchase its assets. As such, Total assets = Shareholders’ equity + total liabilities
It may be noted that in the above ratio, total liabilities includes loans and current
liabilities. As current liabilities are found on the lower side of the balance sheet,
we will touch up on this topic in the next few articles.
Shareholders equity - To put in the simplest form, equity is that portion of the
balance sheet which purely belongs to the shareholders. An easy way to calculate
it is by using the above formula.
Shareholder’s equity = Total assets – total liabilities
Shareholder’s equity represents the total capital received from investors,
plus the accumulated earnings which are displayed in the form of reserves and surplus.
As such, Shareholders’ equity = Share capital + reserves and surplus
Share capital represents the funds that are raised by issuing shares. On
multiplying the face value of a share by the number of issued, subscribed and fully paid,
we get the value of share capital. The reason a company’s share capital remains constant
for years is on account of non-issuance of additional shares. When a company issues
more number of shares, the effect needs to be seen in the share capital.
The picture displayed below will help us understand this better.
Reserves and surplus, as the name suggests, are the accumulated profits that a
company has earned and retained overtime. Retained profits are the profits that are
left after paying the dividends to the shareholders. When a company reinvests money
back into itself, the reserves and surplus account will expand. Its complementary effect
will be seen in the assets side.
The reserves and surplus account is made up of different reserves such as
‘General Reserve’, ‘Profit and loss reserve’, amongst others. This also includes a
reserve which is called the ‘Share premium account’.
CHAPTER 11
In the previous article of this series, we took a look at one of the components
of a balance sheet - ‘Source of funds’ and what its key constituents are. In the next
few articles, we will take a look at the other component of the balance sheet -
‘Application of funds’ and some of its key constituents. As mentioned earlier,
‘Sources of funds’ indicates the total financing that a company has done. In simple
terms it shows how a company has got the funds which it has used to purchase its assets.
As such, Total assets = Shareholders’ equity + total liabilities
Assets in simple terms are resources owned by a company that help in
generating cash flows. In broader terms, assets are of two types – Tangible and
intangible. Tangible assets are assets that have a physical form. In short they can be
seen or touched. Such assets include fixed assets and current assets. Intangible assets
on the other hand are assets that have an economic value to an organisation but do not
have a physical nature. A classic example of an intangible asset would be brand value.
Some other examples that can be included in this list are goodwill, software and
technical know-how.
In today’s article, we will focus mainly on fixed assets. In the next few articles,
we will take a look at the other components of ‘Application of funds’ – current assets,
current liabilities, investments and miscellaneous items.
What are fixed assets? Fixed assets are assets that help companies reap
economic benefits over a period of time. Assets such as land, building, plant and
machinery are all fixed assets. The general consensus is that fixed assets cannot
be liquidated easily. This is quite apparent when compared to current assets such as cash
and bank account and inventories, which can be liquated or converted into cash
relatively easily. It may be noted that intangible assets can also be part of this head
as they benefit companies over a long period of time. Few more examples of the same
would be trademarks, designs and patents.
Assets overtime lose their productive capacity due to reasons such as wear
and tear, obsolescence, amongst others. As a result, their values deplete. Companies
need to account for this depletion in value on a yearly basis. This amount is called
as a 'depreciation expense'and is shown in the profit and loss account. It may be noted
that it only represents deterioration in value and is not a direct cash expense. In due
course of time, assets lose their value on account of depreciation on a year on year basis.
As such, these amounts are accumulated and are reduced from cost of the asset.
Let us take up an example to understand the concept better. Below is the fixed
assets schedule from Nestle’s annual report for CY08. We can see three columns
– gross block, depreciation and net block.
Gross block is the total value of all of the assets that a company owns. The
value is determined by the amount it cost to acquire these assets. Any addition made to
this gross block is what companies call as ‘capital expenditure’ or ‘capex’. Deletions
and other adjustments are largely on account of sale of fixed assets. As companies
buy and sell assets on a regular basis, the gross block figures change every year.
In Nestle’s case, gross block as 31st December 2008 (being a calendar year
ending company) stood at Rs 14 bn. At the end of CY07, i.e. as on 31st December 2007,
the company has a gross block of Rs 11.8 bn. As such, we can see that the company
incurred a capex of about Rs 2.4 bn (not including asset deletions and adjustments),
which was largely expended towards plant & machinery (Rs 1.9 bn) and buildings (Rs 412 m).
not yet commissioned or capital advances. This amount (CWIP), when added to the
net block amount gives the total fixed assets of a company for a year. In case
of Nestle, during CY08 it had a net block of Rs 8.6 bn.
CHAPTER 12
and had an inventory of Rs 15 bn. This means that if company XYZ maintains the
level of inventory throughout the year, it will take nearly three years to clear the
inventory level it currently has. This indirectly indicates that the inventory management
has been poor as the company's management has locked in a lot of funds
towards inventories.
It may be noted that one could also calculate inventory turnover by dividing
the inventory by the cost of goods sold (COGS)during the year. The reason we can
calculate it with COGS is because the inventories are valued at cost and not on sale
prices.
Another popular metric that is used is that of 'inventory days'. This is
calculated as follows:
Inventory days = 365/ Inventory turnover
or
Inventory days = 365/ (Sales/inventory)
As such, Inventory days = Inventory/Sales *365
While inventory turnover measures the number of times (on an average) the
inventory is sold during the period, inventory days is a ratio which indicates the
number of days it takes a company to sell its inventory. That is the reason for the
division of 365/inventory turnover.
Before we move on to the next current asset, we would like to mention that it
would only make sense for one to compare this parameter between companies that
are present in the same or similar businesses.
What are sundry debtors? In simple terms, debtors are persons who owe money
to the company. Typically, such debts are on goods and services that are sold on
credit. Sundry debtors can also be termed as 'accounts receivable'. The reason
sundry debtors are recorded as assets to a company is because the money belongs
to the company, which it expects to receive within a short period.
From an investor's perspective, it would help to analyse the speed at
which a company is able to collect the money from its debtors. If a company's
collection period is long or is expanding, it is not a good sign. Apart from meeting
daily expenses, a company would also prefer having low debtor days
(mentioned below) to avoid the risk of defaults.
Similar to inventory days, there is a ratio which helps in analysing the number
of days it takes a company to collect payments from its debtors. This ratio is
termed as 'debtor days'. The formula for the same is:
Debtor days = Debtors/Sales * 365
What are loans and advances? Loans and advances include various items
such as advance to suppliers and vendors (in accounting terminology it is
known as 'advances recoverable'), advance tax payments (income tax, wealth and
fringe benefit tax), loans to employees, deposits, balance with customs, amongst others.
In the next article, we shall take a look at current liabilities and also briefly
glance through the topic of working capital. To read the previous articles in this
series, click on 'Investing: Back to basics'.
CHAPTER 13
CHAPTER 14
In the previous article of this series, we discussed about current liabilities and
working capital. In this article, we shall conclude our discussion about the components
that make up a balance sheet by taking up the topic of 'investments' and the different
types of investments found in companies' balance sheets.
As defined in Accounting Standard 13 (AS-13) - "Investments are assets held
by an enterprise for earning income by way of dividends, interest, and rentals, for
capital appreciation, or for other benefits to the investing enterprise. Assets held as
stock-in-trade are not 'investments'."
Some of the investments found in companies' balance sheets include stocks,
bonds, mutual funds and investments made towards their subsidiaries or
associate companies.
Broadly investments can be categorised into four categories. They are as follows:
Current and long-term investments
Quoted and unquoted investments
Current and long-term investments: On a broader basis, investments are
classified as long-term and short terms investments. Current investments are
investments that are not intended to be held on for more than a year from the
date of purchase. An example of the same would be an investment in a liquid fund.
On the other hand, AS-13 states that an investment other than a current
investment is termed as a long term investment.
In the financial statements, current investments are valued at the lower of
cost and fair value. However, in the case of long term assets, it should be valued
at cost. However, it is mandatory for companies to make a provision for diminution
in value if there is a decline in the value of the investment. AS-13 has defined
fair value as - "Fair value is the amount for which an asset could be exchanged
between a knowledgeable, willing buyer and a knowledgeable, willing seller in
an arm's length transaction. Under appropriate circumstances, market value or net
realisable value provides an evidence of fair value." Apart from the actual cost of
the asset, the cost of an investment also includes acquisition charges such as brokerage,
fees and duties.
Further, as values of investments fluctuate from time to time, companies
need account for the same in their books (profit and loss account). It is
mandatory for companies to report the aggregate amount of quoted and
unquoted investments. They should also give the aggregate market value of
quoted investments as on the date of reporting.
You may also notice investments termed 'investment property' annual reports
of in some companies. This is nothing but an investment in land or buildings which
are not intended to be used or occupied by the investee. Such an investment is
considered as a long term investment.
Quoted and unquoted investments: Quoted investments are investments whose
value is easily assessable. Investment in the stock of companies which are listed on
stock exchanges would be the best example of quoted investments. This is because
market prices give these instruments a readily assessable value. Investment in
mutual funds would also classify as a quoted investment. On the other hand,
un-quoted investments are investments which do not have a readily available price.
Many a times you will find that companies have invested in stocks that are not listed
on any stock exchange. For such kind of investments, other means are used to
determine fair value.
It may be noted that some companies also report investments as trade and
non-trade investments. Also, an investor may get confused as to why certain
investments are shown in a company's standalone statement, but are missing
from its consolidated balance sheet. The answer lies in the fact that a
company's consolidated numbers include those of its subsidiaries and associate
companies, the latter companies do not appear separately as investments in the
balance sheet.
In the next article, we shall take a look at some of the key ratios associated
with the profit and loss account and the balance sheet. To read the previous articles
in this series, click on ‘Investing: Back to basics’.
CHAPTER 15
the total capital employed is because it is not actually employed in the business.
Return on total assets (ROA) – ROA is another ratio which helps in indicating
the management efficiency. This ratio gives an idea as to how efficiently a
company’s management is using its assets to earn the profits it is generation. It is
calculated by dividing the profit after tax by the total assets as at the end of that
year/period. As such,
ROA = Profit after tax / total assets * 100
It measures how profitably the assets of the company have been utilised.
Companies with high asset base in capital-intensive industry such as fertilisers and
steel tend to have a lower ROA than companies selling branded products such as
toothpaste and soaps, which may have a lower asset base. As such, it is important
for one to compare the ROAs of companies involved in similar businesses/ industries.
Asset turnover – The asset turnover ratio indicates how well the company is
sweating its assets. In other words, it shows how much many rupees a company
generates with every rupee invested in assets. This ratio is a measure of how efficiently
the company has been in generating sales from the assets at its disposal. It is calculated
by dividing the sales by the total assets.
Asset turnover = Sales / Assets
Let us take up an example to understand this well. Suppose company ‘A’ has
assets worth Rs 10 bn on its books. At the end of the year, the company recorded a
topline of Rs 25 bn. That means the company has an asset turnover of 2.5.
This indirectly gives an indication that the company would be able to increase its
revenues by Rs 2.5 with every rupee invested in as assets.
Naturally, the higher the assets turnover, the better it is for a company.
However, it largely depends on the strategy a company is following. It is likely
that a company with lower margins and higher volumes will have a higher asset
turnover than a company involved in a low volume – high margin business.
Debt/Equity ratio – This ratio indicates how much the company is leveraged
(in debt) by comparing what is owed to what is owned. As mentioned in the earlier
part of this series, a company can broadly have two sources for employing funds
into its business – from the owners and from third parties, i.e. loan funds.
As such, to get an idea as to how much of the funds employed into a business is
in the form of loans, we use the debt to equity ratio. It is calculated by dividing the
debt by the shareholders funds (or equity). As such,
Debt to equity ratio = Debt on books / Shareholders funds (Equity)
This ratio is probably one of the most observed ratios as it indicates the
extent to which a company’s management is willing to fund its operation with debt.
Naturally, a high debt to equity ratio is considered bad for a company as it would have
to pay the necessary interest on the borrowings.
But that does not make companies that have a certain amount of debt
a bad investment. If a company is easily able to cover its interest costs within
a particular period, it could be a safe bet. For the same, one should also gauge at
the interest coverage ratio.
Interest coverage ratio - The interest coverage ratio is used to determine how
comfortably a company is placed in terms of payment of interest on outstanding debt.
It is calculated by dividing a company's earnings before interest and taxes
(EBIT) by its interest expense for a given period. As such,
Interest coverage ratio = EBIT/ Interest expense
For example, if a company has a profit before tax (PBT) of Rs 100 m and is
paying an interest of Rs 20 m, its interest coverage ratio would be 6
(Rs 100 m + Rs 20 m / Rs 20 m). The lower the ratio, the greater are the risks.
We hope that the series of articles so far would have helped you analyse
companies’ numbers better. In the next article of this series, we shall take up the
topic of cash flows. To read the previous articles in this series, click on
‘Investing: Back to basics’.
CHAPTER 16
In the previous article of this series, we took a look at some of the key
financial ratios associated with the profit and loss account and the balance sheet.
In today’s article, we shall take a look at the cash flow statement.
What is a cash flow statement?
In simple terms, a cash flow statement indicates how (and how much of) cash
has left or entered a company during a particular time period. It helps the investor assess
the ability of a company to generate cash.
Broadly, there are three ways a company can generate and use its cash. This is in
fact how a cash flow statement is arranged. The first and most obvious way a company
can earn money (or even lose) is through its basic business operations. The second way
is through borrowing and repaying loans or by raising capital (through issuing shares
and debentures). The third way is by selling or purchasing assets and investments.
A cash flow statement is thus typically broken into three parts:
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
These three aspects need to be looked at individually as they are all important
to a firm. We shall discuss these topics one by one with the help of a few examples.
Cash flow from operations
As per Accounting Standard 3 (or AS3), "Operating activities are the
principal revenue-producing activities of the enterprise and other activities that
are not investing or financing activities."
As the name suggests, this head shows the amount of money the company
makes (or loses) through its operations. However, it must be noted that only
the “core” operations must be taken into consideration.
A cash flow statement begins with the profit before tax (PBT) figure. This is
because this figure takes into consideration the revenues and expenses related
it’s a company’s operations. This figure also includes depreciation and
interest costs. However, PBT should be adjusted for non-cash items (such as
depreciation) and financing expenses (such as interest costs), amongst others.
The reason depreciation expenses are added back is that there is no actual outgo
of cash. It is just an accounting entry that is recorded to recognise the cost of the
asset over a period of time.
After making these adjustments, we arrive at a figure which is termed
as the 'operating profit before working capital changes'.
Working capital is again, a part of the company's core operations. As
such, any changes in the same needs to be accounted for. After arriving at the
'operating profit before working capital changes' figure one must account for:
The decrease/ (increase) in sundry debtors
The decrease/ (increase) in inventories
The increase / (decrease) in sundry creditors
It helps in knowing how a company has unblocked or blocked a certain
amount towards meeting its working capital requirements. It does the same by
blocking less cash in current assets or by increasing its current liabilities. When the
reverse takes place, it means that more money has been blocked in meeting working
capital requirements.
In the previous article of this series, we had taken a look at one of the
components of cash flow statement - cash flow from operations. In this article,
we shall discuss one of the other components of the cash flow statement -
cash flow from investing activities.
Cash flow from investing activities As per Account Standard 3 (or AS3),
"Investing activities are the acquisition and disposal of long-term assets
As you can see, there are some figures which are in brackets. This indicates
that the money is going out of the company. On the other hand, the amounts which are
not in brackets indicate the inflow of money. It must be noted that the figures in
the above image are in Rs '000 (thousand).
As such, during FY09, Bharti Airtel invested about Rs 137 bn on fixed assets.
The same figure during the previous year stood at Rs 136 bn. Further, during
FY09 Bharti Airtel purchased investments of about Rs 394 bn. During the same year,
it sold investment worth about Rs 421 bn.
The other transactions can be viewed in a similar manner. On adding up all
the figures, the total comes up to about Rs 152 bn. This means that Bharti Airtel
invested Rs 152 bn in items that fall under the category of 'investing activities'.
In many cases, companies may have negative overall cash flow
during a particular period. However, on looking at the numbers in detail, one may
notice that this may be the case despite a positive cash generation at the operating
level. In such cases it is likely that the overall cash flow position is negative on the
back of higher investments. This may not particularly be a bad news for the company.
In the next article of this series, we will look at the third component of the
cash flow statement, cash flow from financing activities. To read the previous
articles of this series, click on 'Investing: Back to basics'.
CHAPTER 18
In the previous article of this series, we had taken a look at one of the
components of cash flow statement - cash flow from investing activities. In this
article, we shall discuss the last component of the cash flow statement -
cash flow from financing activities. Cash flow from financing activities
As per Account Standard 3 (or AS3), "Financing activities are activities that result in
changes in the size and composition of the owners' capital (including preference
share capital in the case of a company) and borrowings of the enterprise. " As you
must be aware, a balance sheet is broadly made up of two components. One side shows
what a company owns or controls (assets) and the other, what it owes (liabilities plus
equity). In accounting terminology, it is termed as 'Application of funds' and 'Sources
of funds'. 'Sources of funds' indicate the total value of financing that a company has
done. 'Application of funds' displays how a company has utilised these funds.
As such, one can say that 'cash from financing activities' is related to the
'Sources of funds' aspect of the balance sheet. This is where a company reports
whether it took in money or paid out money to finance its activities. Whenever a
company changes the size or the structure of its 'Sources of funds', it is recorded
under this cash flow head. As such, any increase in debt, be it long term or
short term is recorded here. Similarly, transactions relating to repayments are
also shown under this head. Interest costs relating to loans taken form a part of
'cash flow from financing activities' as well. This is because it is considered as the
cost of obtaining financial resources or returns on investments. Moving on, details
relating to funds raised by issuance of more shares are recorded here as well.
This may include proceeds from issuance of shares though preferential allotments,
QIPs, amongst others. It would also include increase in share capital through
issuance of ESOPs. Cash transactions relating to repurchase or buyback of shares
are shown under this head as well. The cash flow from financing activities also
includes outflow of cash in the form of dividends. As dividend can be considered as
a cost for obtaining financial services, it is required to be shown here. Unlike the
'cash flow from operations', a positive cash flow from financing activities
would not necessarily be a good thing. A positive cash flow from financing activities
indicates that a company has taken on more debt or is diluting equity by issuing
more shares. This is not necessarily something that would make an investor happy.
Similarly a negative cash flow would not also be harmful as it could mean that a
company is paying out dividend (cash outflow). Let us take up an example to understand
this well. Shown below is the 'cash flow from financing activities' portion of
Britannia's FY09 cash flow statement.
As you can see, there are some figures which are in brackets. This indicates
that the money is going out of the company. On the other hand, the amounts which are
not in brackets indicate the inflow of money. It must be noted that the figures in the
above image are in Rs '000 (thousand).
During FY09, Britannia's cash outflow from financing activities stood at
Rs 1.1 bn. This negative cash flow from financing activities is largely due to
repayment of unsecured loans (Rs 3.1 bn). However, the company has also received
certain funds from borrowings. The net figure however stands at a negative figure of
Rs 396 m (Rs 3,063 m - 2,337 m - 330 m), indicating that the amount that was
repaid was higher. In addition, due to interest payment and dividend payment
(including the dividend tax), the overall net cash flow from financing activities increased
to Rs 1.1 bn.
In the next article of this series, we shall look at some of the key ratios relating
to cash flow statements. To read the previous articles of this series,
click on 'Investing: Back to basics'.
CHAPTER 19
In the previous article of this series, we had taken a look at one of the
components of cash flow statement - cash flow from financing activities. In this
article, we shall discuss some of the key ratios relating to the cash flow statement.
It is very common that investors give more focus and attention to balance
sheets and profit and loss statements. More often than not, novice investors may
ignore a company's cash flow statement on account of its relatively complex nature.
This is true, when compared to the other two financial statements - balance sheet and
profit and loss account.
In the last few articles, we have tried to educate readers about the basics of a
cash flow statement. Since we have completed our discussion about some of the
technical terms that are found in the cash flow statement, we shall discuss some of the
key ratios associated with it.
A cash flow statement is probably the most useful too for judging or
testing a company’s liquidity position. In addition, it can also help in testing a
company's financial health.
We are not implying that the ratios which we discussed earlier related to the other
two statements are not useful. All ratios have different usages in terms of
testing a company's financial performance.
Free cash flow per share (FCF/ Share): Free Cash Flow (FCF) is the cash earned
by the company that can be actually distributed to the shareholders. It signals a
company's ability to repay debt, pay dividends and buy back stock -
all important undertakings from an investor's point of view.
FCF takes into account not only the earnings of the company but also
the past (depreciation) and present capital expenditures and investment in
working capital. Growing free cash flows are frequently a prelude to increased
earnings. Companies that experience surging FCF due to revenue growth,
efficiency improvements, cost reductions can reward investors in the future. Better
free cash flows are therefore a reason for the investment community to cherish.
On the other hand, an insufficient FCF for earnings growth can force a company
to boost its debt levels. Even worse, a company without enough FCF may not have
the liquidity to stay in business
An in-depth methodology would be to adjust a company's increase or decrease
in net working capital (current assets less current liabilities) to the above figure.
Free cash flow increases if the company manages to improve efficiency and
consequently reduce the required working capital. This ratio implies the amount of free
cash available per share. It is calculated as follows:
FCF = Net Profit + Depreciation - Capital expenditure - Changes in working capital
Therefore, FCF/share = (Net Profit + Depreciation - Capital expenditure -
Changes in working capital) \ Shares outstanding
Price to free cash flow (P/FCF) is a valuation method which allows one to compare
the FCF generated per share to its share price. The higher the result, the more
expensive is the stock.
Operating cash flow ratio (OCF): OCF is calculated by dividing the cash flow
from operations by the current liabilities. This ratio helps in knowing how well
short term liabilities of a company are covered by the cash flow from operations.
Short term liabilities in this case would be current liabilities.
As such, operating cash flow = cash flow from operations / current liabilities
You may have by now guessed that this ratio helps in ascertaining a
company’s liquidity position. But so are ratios such as the
current ratio and the quick ratio, you may ask. The OCF ratio helps in assessing
whether a company’s operating cash flow generations are enough to cover
its current liabilities. If the ratio falls below 1.0, it means that the company is not
generating enough cash to meet its short term liabilities. In order to judge
whether a company's OCF is out of line, one should look at comparable ratios
for the company's industry peers.
Capital expenditure ratio: This ratio helps in ascertaining how much operating
cash flow a company generates as compared to the capital expenditure it incurs.
It would always be better to look at the numbers for a particular period as
compared to a single or particular year.
CHAPTER 20
In the previous article of this series, we had discussed some of the key
ratios relating to the cash flow statement. With that, we concluded our discussion
on financial statements. However, we have till now discussed the financial statement
for non-financial companies. Non-financial companies include firms involved in
manufacturing and providing services.
However, financial statements of financial firms such as banks are very
different. In the next few articles, we will talk about the financial statements for
such firms. On the back of banking regulations, banks' accounts are presented in a
different manner. As such, one needs to analyze the same in a different manner.
Before we get into a detailed discussion, we think it would be better to start
right at the basics. For this, we will see the difference between the financial statements
of a financial organization and a non-financial organization.
Profit and Loss account
Let’s start with the profit and loss account. A non-financial company, say a
manufacturing company, derives revenues from product sales. The expenses
for the company would include that of raw materials, labour, power and fuel,
salaries and wages, administrative costs, amongst others.
For a bank it is quite different. The basic function of a bank is to accept deposits
and give out loans. On the loans that it gives out, it charges an interest rate.
This interest earned is the key revenue source for a bank. This term is known as
‘interest income’.
Apart from interest income from loans advanced, it also earns interest
from certain investments that it makes. In addition, a bank is also required to keep a
certain amount of its cash reserves with the RBI. However, it must be noted that
a bank’s interest income from investments depends upon some key factors
like monetary policies (Cash reserve ratio and statutory liquidity ratio limits)and
credit demand.
Cash reserve ratio (CRR) is a certain percentage of deposits which a bank is
mandated to maintain with the RBI. Statutory liquidity ratio (SLR) is the second
part of regulatory requirement, which requires banks to invest in G-Secs.
The bank’s revenues are basically derived from the interest it earns from the loans
it gives out as well as from the fixed income investments it makes. If credit demand is
lower, the bank increases the quantum of investments.
Apart from interest income being the key revenue source for a bank, it also
earns income in the form of fees that it charges for the various services it provides.
These services include processing fees for loans and forex transactions, amongst others.
It is believed that banks derive nearly 50% of revenues from this stream in
developed economies. In India, the story is very different. This stream of
revenues contributes about 15% to the overall revenues.
Now that we have covered the income part of the profit and loss account,
we shall move on to the expenditure aspect of the same. The key expense of a
bank is interest on deposits that are made with it. These could be in the form of
term (fixed) or savings bank account deposits. The second biggest expense head for
a bank would be its operating expenses. This head would include all operational costs,
which even non-financial companies expend. Some of include employee costs,
advertisement and publicity costs, administrative costs, rent, lighting and stationary.
Under expenses, there is also an item called ‘provisions and contingencies’
that is included. In the simplest terms, these are liabilities that are of uncertain
timing or amount. This includes provisions for unrecoverable assets. In accounting
terms, such provisions are called as ‘Provisions for Non-performing assets (NPAs)’.
Apart from NPAs, these provisions also include provision for tax and also depreciation
in the value of investments.
After removing these heads from the income generated, we simply arrive at
the profits figure. The process of appropriation thereafter is similar to that of
non-financial companies.
We shall take up an example to understand this. Displayed below is the profit
and loss account of HDFC Bank.
The total income generated by the bank during FY09 was Rs 198 bn. Of this,
interest income was Rs 163 bn. The balance was contributed by other income.
Out of the Rs 163 bn of interest income, HDFC Bank earned about Rs 121 bn
from interest on loans advanced/ bills. The income from investments during the year
stood at Rs 40 bn, while interest from the balance with RBI and other inter-bank funds
stood at Rs 2 bn.
During FY09, HDFC Bank earned revenues of Rs 34 bn as other income.
The largest contributor here was fee income (Commission, exchange and brokerage)
to the tune of Rs 26 bn. This translates as 13% of the total income during the year.
Other major contributors were profit on sale of investments and exchange transactions.
Moving on to the bank’s expense account. The total interest expended stood at
Rs 89 bn. The interest on deposits stood at Rs 80 bn , while interest on borrowings from
other sources such as the RBI and other bank borrowings stood at Rs 6 bn.
Operating expenses during the year stood at Rs 56 bn. The major contributor
to this head was employee costs (Rs 23 bn). Provision and contingencies amount stood
at Rs 29 bn.
In the next article of this series, we shall continue our discussion on the
financial statements of banks. To read the previous articles of this series, click on
‘Investing: Back to basics’.
CHAPTER 21
We will first calculate HDFC Bank's NIM for the year FY09. As mentioned above,
for calculating NIM, one needs to divide the net interest income by the average
earning assets.
Or, NIM = (Interest income - interest expenses) / average earnings assets
The interest income during FY09 stood at Rs 163 bn. The interest expended
during the year was Rs 89 bn. Therefore the net interest income is Rs 74 bn
(Rs 163 - Rs 89 bn).
Average earnings assets for the bank for the year stood at Rs 1,753 bn.
It is calculated by adding the cash and balances with Reserve Bank of India
(Rs 135 bn), balances with banks and money at call and short notice (Rs 40 bn),
investments (Rs 587 bn) and advances (Rs 990 bn).
Therefore the NIM for the year FY09 was 4.2% (Rs 74 bn / Rs 1,753 bn)
Now moving on to the OPM for HDFC Bank - Net interest income for the year
stood at Rs 74 bn. The operating expenses for the year were about Rs 56 bn. Total
interest income for the year was Rs 163 bn. Therefore, the OPM for the year stood at,
OPM = (Net interest income (NII) - operating expenses) / total interest income
= Rs 74 bn - Rs 56 bn / Rs 163 bn. This is equal to about 11%.
Moving on the cost to income ratio for HDFC Bank - As mentioned above, it is
calculated by operating expenses by the total of the net interest income and the
non-interest income.
Or, Cost to income ratio = Operating expenses / (NII + non-interest income)
Operating expenses for the bank during the year stood at Rs 56 bn.
Non-interest income, which is basically the other income, stood at Rs 36 bn. NII, as
calculated above, was Rs 74 bn. Putting all this together, we get the following:
= Rs 56 bn / (Rs 74 bn + 36 bn)
= 50.9%. The cost to income ratio stood at almost 51% for the year FY09.
The last ratio is the other income to total income ratio. It is a very
straight forward ratio. The other income for the year FY09 stood at Rs 34 bn.
The total income for the year was about Rs 198 bn. Therefore HDFC Bank's other
income to total income ratio for the year FY09 was about 17%.
In the next article of this series, we shall continue our discussion on the
financial statements of banks. To read the previous articles of this series, click on
'Investing: Back to basics'.
CHAPTER 22
In the previous article of this series, we discussed some of the key ratios related
to a bank’s profit and loss account. We shall take forward our discussion on how the
accounts of financial organisations are different as compared to those of
non-manufacturing organisations. In this article, we will discuss a bank’s other
financial statement, the balance sheet.
A balance sheet of a manufacturing firm is broadly divided into two parts –
‘Sources of funds’ and ‘Application of funds’. For a bank these are termed as
‘Capital and liabilities’ and ‘Assets’ respectively. We shall first discuss the
‘Capital and liabilities’ portion of the balance sheet.
Capital and Liabilities
The ‘capital and liabilities’ head, as the name suggests is made up of
the three portions – the net worth, which is the ‘capital’ and the ‘reserve and surplus’,
the liabilities, which is the money that a bank owes. This money is in the form of
‘deposits and borrowings’. The third portion is the ‘other liabilities and provisions’.
Net worth: Net worth is made up of the ‘share capital’ and the ‘reserves and surplus’.
While the net worth of banks is quite similar to that of a non-financial institution,
there are some balances that a bank needs to maintain in its balance sheet, which one
will not find in a non-financial institution. One such reserve is the ‘statutory reserve’,
which is not a free reserve for the bank. Unlike this there are free reserves that
banks maintain, but their proportions are quite subjective as they differ from bank
to bank. Such reserves include ‘Investment Reserve Account’ and
‘Foreign Currency Translation Account’.
Liabilities: As it is a bank’s business to raise funds and lend the same, the debt
to equity ratio is typically 10 to 20 times, much higher than that of non-financial firms.
Banks also need funds for investing. The liabilities are usually in various forms.
They can either be deposits or borrowings. Deposits are again broadly of three
kinds – demand deposits (current accounts), savings bank deposits (saving accounts)
and term deposits (fixed deposits).
As compared to the interest paid on fixed deposits (term deposits), the interest
offered on demand and savings bank deposits (popularly known as CASA or current
account and savings accounts) is very low. As such, when banks mention that they are
trying to increase the share of low cost funds, it means that they are trying to garner
more funds in the form of CASA. This would eventually help them improve their
net interest margins (NIMs).
As for borrowings, they are somewhat similar to the debt that non-financial
companies take. Apart from deposits, banks can also borrow funds through loans from
other sources. These can include the Reserve Bank of India (RBI) as well as other
institutions and agencies, be it domestic or foreign.
Other liabilities and provisions: This head is similar to that of a ‘current liabilities’
portion of a non-financial company. The items can fall under this head are the
short term obligations of a bank during a particular year. The items that can fall under
this category include bills payable, interest accrued, provision for dividend,
contingent provisions etc.
In the next article of this series, we shall continue our discussion on the financial statements of
banks. To read the previous articles of this series, click on
'Investing: Back to basics'.
CHAPTER 23
In the previous article of this series, we discussed the 'Capital and Liabilities'
portion of a financial firm's balance sheet. In this article, we will discuss the other part
of the balance sheet - Assets.
Just to brush up the readers, a balance sheet of a manufacturing firm is
divided into two parts - 'Sources of funds' and 'Application of funds'. For a bank these
are termed as 'Capital and liabilities' and 'Assets' respectively.
Assets
While the 'Capital and Liabilities' is the portion from where the bank sources
the money to lend as loans, the 'Asset's portion indicates where all and how the
bank has utilised the money. Apart from advances, a bank needs to put aside a portion
of its assets in various forms. These can be in the form of investments, deposits with
the RBI, cash balances, amongst others. It must be noted that a bank needs
to follow regulations made by India's central bank, the Reserve Bank of India (RBI).
We shall discuss these later on in this article.
Cash and bank balances with the RBI As the name suggest, this head includes
the cash in hand and in ATMs that a bank maintains as well as the amount of
money deposited with the RBI. A bank will need to reserve a certain amount to
satisfy withdrawal demands. The proportion of deposits that a bank needs to keep
with the RBI is determined by the prevailing 'cash reserve ratio' (CRR). As such,
CRR is essentially the percentage of cash reserves to total deposits. The rate of the
same is determined by the RBI in its monetary policies.
Balances with Banks and Money at Call and Short notice This head again has
two parts - balance with other banks (which can be in the form of current account
or other deposit accounts) and money at call and short notice. Banks do show these
types of balances with institutions that are in and outside India separately.
These funds are those which banks provide (or take) to (or from) other
financial institutions at inter-bank rates. These types of loans are very short in nature,
usually lasting no longer than a week. More often than not, these funds are used
for helping banks meet reserve requirements.
Investments This head is again divided into two parts - investments in and
outside India. Investments in government securities (G-Secs) take the cake in this
head. A bank is required to invest in G-Secs. The amount that needs to be
invested is the dependent on the prevailing statutory liquidity ratio (SLR).
As mentioned in one of our earlier articles, a bank's revenues are basically
derived from the interest it earns from the loans it gives out as well as from the
fixed income investments it makes. If credit demand is lower, the bank increases
CHAPTER 24
In the previous few articles of this series, we discussed the
two key sections - the 'Capital and Liabilities' and ‘Assets’ - of a
financial firm’s balance sheet. Prior to that we discussed the ‘Profit
and loss statement’ of a financial firm and some of the key ratios
related to it. In this article, we shall discuss some of the key ratios
related to a bank's balance sheet statement.
While the article related to the key ‘profit and loss statement’
ratios was more to do with the performance of a bank, the following
ratios are more to do with the financial stability of a bank. In addition,
we shall also compare the following ratios of India’s largest banks.
Some of these key ratios are:
* Credit to deposit ratio
* Capital adequacy ratio
* Non-performing asset ratio
* Provision coverage ratio
* Return on assets ratio
In one of our recent articles, we discussed about some of the key ratios relating to a bank's balance sheet
statement. Just to brush up our readers, some of the ratios that were discussed included:
Credit to deposit ratio
Capital adequacy ratio
Non-performing asset ratio
Provision coverage ratio
Return on assets ratio
We thought it would be an interesting idea to look and compare these numbers for the leading private (HDFC
Bank, ICICI Bank and Axis Bank) and public sector (SBI, Punjab National Bank and Bank of Baroda) banks. In
addition, we will also see how the same ratios have changed over the past few years.
Credit to deposit ratio: This ratio indicates how much of the advances lent by banks is done through deposits.
It is the proportion of loan-assets created by banks from the deposits received. The higher the ratio, the higher
the loan-assets created from deposits. Deposits would be in the form of current and saving account as well as
term deposits. The outcome of this ratio reflects the ability of the bank to make optimal use of the available
resources.
Source Data: Equitymaster research
If we see the following chart, ICICI Bank distinctly stands out from its peers. A strong reason for the same would
be its aggressive nature. Further, PSU banks and Axis Bank have seen their ratios increase gradually over the
years. The credit to deposit ratio of HDFC Bank on the other hand, has been fairly stable.
Capital adequacy ratio: A bank's capital ratio is the ratio of qualifying capital to risk adjusted (or weighted)
assets. The RBI has set the minimum capital adequacy ratio at 9% for all banks. A ratio below the minimum
indicates that the bank is not adequately capitalized to expand its operations. The ratio ensures that the bank do
not expand their business without having adequate capital.
It must be noted that it would be difficult for an investor to calculate this ratio as banks do not disclose the details
required for calculating the denominator (risk weighted average) of this ratio in detail. As such, banks provide
their CAR from time to time.
Considering that the Indian banking sector has been growing at a strong pace, all the leading banks, both private
and public have been expanding operations at a strong pace. As such, their CAR ratios are well above the
prescribed limit of 9%. Private banks such as HDFC Bank, Axis Bank and ICICI Bank have in fact increased their
CAR over the past four to five years.