Analyzing a Company - What you need to look for in the company ?

Ask your self  are you ready to buy the whole company ?

Worth Reading

• If you get the conviction to invest Rs.1 lakh in a stock, then only invest in that stock, else forget that stock. Do not invest just for the sake of investing or to try your luck.
• Before buying any stock, write down the reasons why you are buying that stock and before selling review those points that you have noted down, then take a decision to sell.
• The trick of successful investors is to sell when they want to, not when they have to...
• One quick test is to imagine that you had to give a presentation on a stock that you want to buy to a room full of savvy industry veterans and then take their questions. If you could not do it, may be the purchase is not such a great idea. 
• Reminds what Mark Twain once said, “The man who does not read great books has no particular advantage over the man who cannot read them.”
• "It's good to have money and the things that money can buy, but it's good, too, to check up once in a while and make sure that you haven't lost the things that money can't buy." - George Lorimer
•  "If you could tell the future from a Balance Sheet then accountants and mathematicians would be the richest people in the world"
• More importantly, don't be too impressed with your own "analysis" either.
• Never bet too big on any single idea, no matter how compelling the story.... and always have your exits in place.
• "Investing is simple, but not easy." - Warren Buffet
• Bull markets knows no top, Bear markets knows no bottom
• Charlie Munger says to Warren Buffett , you might have to get good companies by paying a bit more.
• Its far better to buy a wonderful business at fair price than a fair business at wonderful price`
• Never ever regret selling a stock too early and never ever chase a stock. If you have a better options, then invest in other ideas where you have conviction.  

Free Cash Flow

Free Cash flow is the extra cash is hand from companies operations. This extra cash is the income after paying all cash expenses.

How to Calculate Free Cash Flow of a Company?

Lessons from Charlie Munger

Lessons from Charlie Munger- I

                                                                                          Courtesy:  www.equitymaster.com

Charles Thomas Munger. The name has an instant resonance. And with a blink, you recall another name- Warren Buffett. Both these names are inseparable. Sure, why not? Buffett has himself referred to both of them as "Siamese twins, practically". And Charlie Munger is often addressed as the legendary investor's alter ego. So while Buffett remains the face of Berkshire Hathaway, Munger has no lesser claim to credit for the fortunes of the company.

The Multi-disciplinarian

Both men have as many striking differences as similarities. One may typecast Buffett as purely an investor and philanthropist. And quite rightly so, for the man devotes his time almost exclusively to his business. Munger, on the other hand, is a generalist for whom investment is only one of a broad range of interests. In many ways, his personality has traces of his own hero-Benjamin Franklin, who along with being a great scientist and inventor, was also a leading author, statesman and philanthropist, and played four instruments. On similar lines, Munger hops around science, architecture, psychology and philanthropy with as much passion and curiosity as he does with business and investments.

Thinking errors and misjudgements

Munger very aptly follows this multidisciplinary approach in all kind of situations. He draws influences from fields as diverse as physics and psychology to his investment process. For long, he had been interested in standard thinking errors. Without diving much into academic psychology textbooks, he developed his own system of psychology more or less in the self-help style of Ben Franklin. In a series of articles that will follow, we will pick up insights from a speech that Munger gave on "24 Standard Causes of Human Misjudgment". But before we start discussing these thinking errors, let us tell you why these lessons have very powerful implications for investors.

Do we behave like ants?

We may take great pride in our evolutionary superiority over other creatures. But we also often behave like ants. Strange? Not really. Munger has pointed out some very intriguing observations about the behaviour of these social insects. Each ant, like each human, is composed of a living physical structure plus behavioural algorithms in its nerve cells. Mostly, the ant merely responds to stimuli with a few simple responses programmed into its nervous system by its genes. For instance, one type of ant, when it smells a pheromone given off by a dead ant's body in the hive, immediately responds by co-operating with other ants in carrying the dead body out of the hive. Harvard's great E.O. Wilson performed one of the best psychology experiments ever. He painted dead-ant pheromone on a live ant. Quite naturally, the other ants dragged this useful live ant out of the hive. This despite the poor creature kicked and protested throughout the entire process. Such is the brain of the ant.

Of course, our brain is far more complex and advanced. Ants don't design and fly airplanes. But under complex circumstances, don't we also find ourselves behaving counterproductively just like ants? And aren't stock markets a perfect playground for this kind of behaviour? We'll discuss this and a lot more in the forthcoming articles.

Lessons from Charlie Munger- II

In the previous introductory article, we briefly discussed Charlie Munger's multidisciplinary approach to investing. Starting with this article, we'll discuss his list of "24 Standard Causes of Human Misjudgment" and understand how they have powerful implication for investors.

Reward and Punishment Super-response Tendency

Why do we do what we do? Why are we tempted to do certain things while refraining from others? Well, all creatures seek their own self-interest. Our innate drive is to maximise pleasure, while at the same time avoiding or reducing pain. In any given circumstance, we assess the risks and the associated rewards and respond in a way that seems to best serve us. With this premise, it is imperative to understand the role of incentives and disincentives in changing cognition and behaviour.

The power of incentives

There is this interesting case of the logistics services major FedEx Corporation. The integrity of the FedEx system required that all packages be shifted rapidly among airplanes in one central airport each night. And the system had no integrity for the customers if the night work shift couldn't accomplish its assignment fast. And FedEx had a tough time getting the night shift to do the right thing. They tried moral persuasion. They tried everything in the world without luck. Finally, somebody thought it was foolish to pay the night shift by the hour. What the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. So maybe if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And that solution worked just perfectly. This is a classical case of the power of incentives and how they can be used to produce desirable behavioural changes.

The abuse of incentives

One of the most important consequences of incentives is what Munger calls "incentive-caused bias." The following example will explain the same. Early in the history of Xerox, Joseph Wilson, who was then in the government, had to go back to Xerox because he couldn't understand why its new machine was selling so poorly in relation to its older and inferior machine. When he got back to Xerox, he found out that the commission arrangement with the salesmen gave a large and perverse incentive to push the inferior machine on customers. An incentive-caused bias can tempt people into immoral behavior, like the salesmen at Xerox who harmed customers in order to maximize their sales commissions.

The story of mutual funds in India is quite similar to that of the Xerox case. Mutual funds that offer the maximum commission to distributors are the best sold funds. Also, consider your own stockbrokers. There will be seldom one who will not lure you to trade too often. And seldom will a management consultant's report not end with an advice like this one: "This problem needs more management consulting services." Such behavioural biases exist in most places and situations. And human nature, bedeviled by incentive-caused bias, causes a lot of ghastly abuse.

Some antidotes for investors

For you investors, we believe it is important to understand the motives and incentives of people and organisations you're dealing and investing with. Everyone ranging from the company you're investing in to your stockbroker, your mutual fund agent and your equity advisor (yes, even we) must pass your scrutiny.

Widespread incentive-caused bias requires that one should often distrust, or take with a grain of salt, the advice of one's professional advisor. The general antidotes here are:

1. Especially fear professional advice when it is especially good for the advisor.
2. Learn and use the basic elements of your advisor's trade as you deal with your advisor.
3. Double check, disbelieve, or replace much of what you're told, to the degree that seems appropriate after objective thought.

Lessons from Charlie Munger- III

In the previous article, we had discussed the influence of incentives at the level of individual firms and some antidotes for investors. In this article, we'll discuss the power of incentives in the context of economic systems.

We all are part of various systems or groups- from a micro-system like a family to a macro-system like an economy. If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives. They may be in the form of rules, regulations, norms, customs, traditions, mores or ethics. And you see them everywhere, don't you? Be it religion, politics or economics, every system is made up of these elements.

We'd like to point out to you how the success or failure of any economic system depends on how incentives and disincentives are designed. Let us explain.

What made the free-market economy work?

The success of the free-market system as an economic system comes from its inherent reward-punishment mechanism. Owners have a strong incentive to prevent all waste in operations. Their businesses will perish in the face of brutal competition if they are not efficient. Replace such owners by salaried government employees and you will normally get a substantial reduction in overall efficiency.

Communism has failed due to the absence of exactly those incentives that have motivated private enterprises to flourish in democracies. The fall of the Soviet communists is a glaring example of wrong system design. But one may also point the knife at the US- the epitome of free-market economy, for bringing in one of the worst financial crises ever. What really went wrong? Well, there is not just one simple answer to this. But we'll restrict our discussion to the main theme of the article.

The US financial crisis: an outcome of wrong incentives and absence of disincentives

It is fashionable to bash up the US Fed and the big investment banks for all the menace they created. But blaming them alone would do us more harm than good; because the crisis was a failure of the entire system and not the outcome of a few crooks alone. In one part, the financial crisis was a result of a series of incentives that induced unscrupulous behaviour across the entire system. The other major mishap was a complete dearth of penalties for wrong behaviour. Looking back, the evidence comes out pouring, often overwhelming.

Though it is not widely discussed, the original subprime lenders of the 1990s had already gone bust by turn of the century. A child could point and say, "Don't make loans to people who can't repay them." Simple. But amusingly and frighteningly, the lesson learnt was a bit complicated: "Keep making such loans; just don't keep them on your books." The lenders made the loans, and then sold them off to the fixed income departments of big Wall Street investment banks. These investment banks in turn packaged them into bonds and sold them off to investors. So the originator of loans had little incentive to bother at all about creditworthiness. On the other hand, there was hardly any penalty to curb his recklessness. As Mr. Raghuram Rajan, a leading economist who saw the crisis unfolding as early as 2005 noted, "Incentives were horribly skewed in the financial sector, with the workers reaping rich rewards for making money but being only lightly penalized for losses."

Also, the problem was not that no one warned about the dangers. It was that those who benefited from an over-heated economy- which included a lot of people- had little incentive to listen. So everyone enjoyed this "passing the parcel (read atom bomb)" game as long as the music played. And we all know what happened after the music stopped.

India 2010: A carnival of scams

We just emphasised the omnipotence of incentives and how a flawed reward-punishment mechanism can bring about the collapse of a giant system. It is quite clear that man responds more often and more easily to incentives than to reason and conscience. Didn't we see this axiom crystallizing before our own eyes with the cracking of a series of scams last year? Again, we will not arrive at an effective solution if the issue is not addressed at the most fundamental level. Firstly, we have to accept that man is fallible and corruptible, if the situation so allows. So the solution does not lie in moralising individuals alone, but more importantly, in creating robust systems that reward fair and ethical behaviour and deter deceitful practices. 

Lessons from Charlie Munger – IV

In the previous article, we had discussed how a wrong set of incentives across the entire economic system was responsible for the US financial crisis. Today, please do not panic, for we are going to talk about love.

Liking and loving tendency

Love is one of the most basic of emotions. The very first manifestation of it is between a mother and the new-born child. For a child, this earliest experience has far reaching effects. The child learns to love and to be loved in return. It becomes a kind of a programming device. And it extends not only towards people, but also towards things, ideas and concepts. Of course, the child learns to dislike and hate as well. But we’ll limit this piece to our tendency to love and to like.

This tendency to love has its own set of side effects. It acts as a conditioning device and often distorts our perceptions. To make it simple, think of someone you love- your spouse, your kid, your favourite actor or cricketer. You could also think of any idea or belief that is very dear to you. Now ask yourself these questions:

• Do you tend to ignore their faults? Do you readily comply with their wishes?
• Do you favour people, products, and actions merely associated with them?
• Do you distort any unpleasant facts about them?

Now why are we talking about all this? Has it got anything to do with investments and stocks? Most certainly yes! We are firmly of the belief that being a successful investor requires discipline and a sound emotional make-up.

Have a look at your stock portfolio. There is one very common error that most investors do with stocks that they own. Once they have bought a stock, they automatically start developing a feeling of affection towards it. Don’t we often hear people raving about certain blue chips with an admiration that borders around reverence? Any negative comment about them will either be ignored, dismissed or defended. It almost seems like a marriage brimming with loyalty and affection. Take the so-called "hot" sector stocks. Don’t they often cause many a feeble hearts to melt? And what happens to all thoughts about business and valuation? Well, well, well... You know best. We dislike challenging and reasoning with things and ideas that we love.

Our bottom line is this. Do fall in love, but not with your stocks. Love your capital and do the best you can to protect it and to help it grow. And what better of doing that than being a disciplined value investor!

Lessons from Charlie Munger – V

In the previous article, we had discussed how loving your stocks too much can distort your perception and in turn be a threat to stock investing. Today, we shall discuss the other extreme of the emotional spectrum: how feelings of dislike and hatred too can derail your investments.

Disliking and hating tendency

Take the recent Cricket World Cup. Rewind back to the semi-final match between India and Pakistan. Was it a cricket match? Or was it war? War it was! The high-voltage match that ended with India beating Pakistan saw our feelings of patriotism and national pride touch the sky. But it's not pride for India alone that makes us so jingoistic. There's also an intense hatred towards Pakistan that equally nourishes that feeling. So we get back to where we started- emotions and biases.

From the time we are born, we learn to dislike and hate the same way as we develop tendencies to like and love. The history of human evolution boasts of almost continuous wars. Neither religion, nor advancements in civil life have done much to change the basic savage instinct. And wars are not the only way in which hatreds find expression. In more sophisticated societies, hatreds and dislikes find expression in more non-lethal things such as elections, sports and even stock markets.

Charlie Munger has very aptly explained how the "disliking & hating tendency" acts as a conditioning device:

• We ignore virtues in the object of dislike
• We dislike people, products, and actions merely associated with the object of dislike
• We even tend to distort other facts so as to justify our hatred.

Do you recall a promising stock that you had fallen for faltering miserably? There may have been some unfortunate event or probably a cyclical downturn. Maybe your timing wasn't right. Or maybe, the markets were just too pessimistic and overreacting at that moment. But your instinctive reaction could have been that of disappointment and anger. In your fury, you may have even decided never to put money in such a money-sucking monster.

This kind of biased approach to investing could be very detrimental to your stock portfolio. While negative events should be viewed diligently, you will be better off if you fairly consider the pros and cons of every situation. You never know, your blind dislike for a certain stock or sector could destroy a potential multibagger

Lessons from Charlie Munger - VI

In the previous article, we had discussed how the 'disliking and hating' tendency can be a threat to your investments. Today, we shall discuss a very important human tendency that every investor should undoubtedly not avoid.

Doubt-avoidance tendency

The name itself is quite self-explanatory. Doesn't our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion? It surely does, and at times to our own disadvantage. Charlie Munger presents an evolutionary perspective about how this tendency must have developed in humans from their non-human ancestors. He asserts that it would be suicidal for a prey animal threatened by a predator to take a long time to decide what to do. The development of this tendency has come as a survival tactic in times of stress and confusion. Much of religious propaganda has in fact taken advantage of this tendency. How otherwise would you explain the immense faith displayed by people in religious decrees that will otherwise find difficulty to get past the check-post of logic?

So the evolutionary justification of this tendency is reasonable. But the problem with any kind of psychological tendency or mental programming is that it doesn't work well in all situations. Say, a person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision. Yet, more often than not we find ourselves doing exactly the opposite.

Doubt-avoidance tendency in stock markets

Have you observed the doubt-avoidance tendency manifesting itself in the stock markets? The answer is a loud 'yes' in our view. How often do you trade on impulse without asking the right questions? How open are you to hear negative things about stocks that you are very optimistic about? When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising. The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided. Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity.

Without any exaggeration, we strongly believe that if you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

Lessons from Charlie Munger - VII

In the previous article, we had discussed the roots and the consequences of the 'doubt-avoidance' tendency. Today, we shall discuss another extremely important human tendency that every serious investor should be well aware of.

Inconsistency-avoidance tendency

Imagine what it would be like if you woke up every day and had to learn all the physical and mental tasks from scratch. It's impossible to even imagine such a situation. Thanks to the human brain, we don't have to bother about most tasks every single day. Through countless sets of programs, the human brain ensures our smooth and consistent functioning. Habits, which are patterns of behaviour which routinely repeat themselves subconsciously, are also a result of this process. While habits can be good, and good habits doubly so, there are several disadvantages as well. Habits often come in the way of any kind of change or transformation. As Charlie Munger puts it very aptly, "People tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong."

This brings us to the inconsistency-avoidance tendency which is very rampant amongst human beings. In simple words, we filter away any piece of information which may be inconsistent to our ideas and beliefs. You may have read as students how many great scientists and discoverers were often discredited and ridiculed for their so-called lunacies. Many were acknowledged for their great work only after their death. Do you see how the inconsistency-avoidance tendency works? Not just history, even our day-to-day life is filled with such stories.

Inconsistency-avoidance tendency in stock markets

Our aim is not to profess psychology for its own sake but to attempt to relate it to human behaviour in the stock markets. Stock markets are largely driven by sentiment. So you must do your best to be as objective as you can and guard yourself from the lures of greed and fear.

Getting back to inconsistency-avoidance tendency, can you remember instances when you have used this tendency to your own peril? We'll point out a few for your benefit:

Have you lost money on your favourite stock that had once been an outperformer? The company's prospects may have changed, it may no longer be worth putting your money into, but you still couldn't let go of it. Why? Because letting go of it would be inconsistent with your original beliefs about it. So you did everything to console and convince yourself that nothing was wrong. But your portfolio losses have a different story to say, don't they?

Each investor will have innumerable such instances to share. Now the more important question, how exactly do you get rid of this tendency? There are several ways to do that, but more than anything else, you need to be very disciplined with your approach. One great way is to play the devil's advocate. If you find a prospective company very compelling, first start with rejecting the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good, then it has passed the bar. You can also take a good lesson from the court of law. Law courts have processes and procedures in place that tend to minimise hasty and biased decision-making, which can cost someone's life. As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in your mind. Always remember, stock markets will always keep swinging higher and lower. Investing opportunities will be there. We can assure you that if you can tackle with your inconsistency-avoidance tendency, money will consistently keep pouring into your bank accounts.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

Lessons from Charlie Munger - VIII

In the previous article, we had discussed how you can make consistent stock returns by understanding and avoiding the trap of inconsistency-avoidance tendency. Today, we shall discuss a very basic tendency that often drives our thoughts and actions and is very relevant to our behaviour in stock markets. And in doing so, our aim is to help you identify dysfunctional behaviour patterns and thinking errors that may be hampering your stock market investments.

Envy / jealousy tendency

What do the words envy and jealousy bring to mind? Whatever they bring to mind, we often try our best to dissociate ourselves from them. Such is the taboo attached to these emotions that we do not want to link our behaviour and actions with them. Yet these very emotions are so innate to human nature that it is almost impossible to get rid of them. More importantly, given the crucial role that these emotions play in the human world, you could risk ignoring them at your own peril.

So let's ponder a bit about the roots of envy and jealousy. Charlie Munger gives a very interesting evolutionary perspective on this, "A member of a species designed through evolutionary process to want often-scarce food is going to be driven strongly toward getting food when it first sees food. And this is going to occur often and tend to create some conflict when the food is seen in the possession of another member of the same species. This is probably the evolutionary origin of the envy/jealousy tendency that lies so deep in human nature." If these lines sound very geeky and clinical, let us elaborate in simple words. Food is very basic to the survival of any life-form. Without nutrition, no life can exist. So the chief life-long struggle of any creature is about securing the supply of food. Throughout history, the availability of food has dictated the survival or extinction of species. Given the utmost importance of this vital resource, a creature will be instinctively driven to possess the food the moment it notices it. The conflict arises when it sees food in the possession of another creature. This explanation, though difficult to verify accurately, does broadly explain the origin of envy and jealousy. And it extends to all other things other than food as well.

Envy and jealousy tendency in stock markets

It is often said that stock markets are driven by greed and fear. Sounds pretty neat, isn't it? But legendary investor and Charlie Munger's 'Siamese twin,' Warren Buffett, has an important interruption to make here. He very wisely points out, "It is not greed that drives the world, but envy."A patient contemplation of this sentence will reveal to you its utmost significance. While 'greed' refers to an excessive desire to possess something, 'envy' is a desire to possess what the other person is possessing. And more often than not, greed is fuelled by envy. A lot of times, we desire something simply because we see someone else enjoying it. Such human tendency of envy and jealousy is very well orchestrated in the stock markets, albeit in overwhelming proportions. Everyone is here not just to make money, but to make more money than what the next person is making. Comparison and competition is intense, creating a perfect recipe for jealousy tendency. Let us give you a couple of examples to elaborate our point:

a) Mr Gupta made 25% annual gain on his stock portfolio in 2007. He is quite satisfied. But then he learns that his colleague Mr Agarwal made a whopping gain of 300% that same here. Now Mr Gupta is distressed and feeling left out. His 25% gain now looks paltry in comparison to Mr Agarwal's triple-digit gains. He gets desperate to replicate his friend's success. In his frenzy, he ends up playing some stupid bets and loses quite a lot of money.

b) Mr Rao has made a lot of money on certain stocks in recent times. Mr Desai, whose portfolio hasn't fared too well, is secretly disturbed, or in other words, jealous of his friend's prosperity. He decides to do exactly as his friend does, so that he would be as successful as him. Around this time, Mr Trivedi is extremely bullish on silver and places big bets on silver futures. Mr Sharma is tempted to copy. Despite not being in a very sound financial position, he jumps on the bandwagon and ends up burning his fingers.

It is clear that it was jealousy that motivated wrong behaviour in both these cases. The list of such cases is long. The important point to take home is to not let such negative emotions affect your investment decisions. But isn't it a little too difficult to not feel bad if your friends and colleagues make a lot more money than you do? It is indeed difficult. So the best antidote in such a case is to avoid discussions that would trigger feelings of jealousy. In fact, some of the best investors in the world keep extremely low profile and keep their discussions limited to stock ideas and business fundamentals. In the absence of such external disturbances, they are able to make more rational investment decisions.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

Lessons from Charlie Munger - IX

In the previous article, we had discussed how a simple emotion like jealousy could prompt you into making irrational investment decisions. Today, we shall discuss our innate tendency to be over-optimistic and how it affects our view of the economy and the stock markets. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.

Over-optimism tendency

It is indeed commendable how humans and other creatures have evolved and survived over millions of years of evolution. Forget millions of years. Just look at all that has happened in the last 100 years, a period which saw two major world wars and a series of economic and political crises across the globe. Yet we continue to look forward to a better future. What is it that allows man to endure the many trials and tribulations that life presents? Hope, isn't it?

Charlie Munger shares a very interesting perspective in this regard. He opines that an excess of optimism is the normal human condition. And this tendency to be over-optimistic not only manifests when man is in pain, but also when he is doing well and there is no threat of pain whatsoever. A famous Greek orator by the name of Demosthenes is known to have said these very fitting lines more than 2,000 years ago-"What a man wishes, that also will he believe."

Over-optimism tendency in stock markets

It is not at all difficult to understand how this tendency drives not just stock markets but the entire world of finance and economics. Why otherwise would we have booms and bubbles with such amazing regularity? Why do people continue to flock to the financial markets despite the regular crises and busts that torment the markets? In fact, all the malaise troubling the global economy today, from the debt crises in the developed economies to the high inflation and slowing growth in emerging economies like India, do have roots in excessive optimism. The problem is that when things are good, we expect them to get better and better in a linear fashion. And even when things are bad and getting worse, we often expect that the situation will turn good again sometime in the future.

This tendency is so often displayed by company managements. During good times, they tend to get over-optimistic and take up massive debt-funded expansion plans by way of capacity additions or wasteful mergers and acquisitions. When the cycle turns and things turn sour, you see red ink all over their financial statements. What is surprising is that even in bad times, a lot of companies are extremely shy to admit that things are not going too well. They tend to project and hope only what they wish to see and not what there is really.

As investors, the best way to deal with this bias is to acknowledge that it exists in the first place. That is half solution done because most of the times we are not aware of our own biases. Then a very effective antidote to over-optimism is to challenge your views by asking yourself as many questions as possible. If your views cannot stand the attack of reason, you know which tendency is to be blamed.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

Lessons from Charlie Munger - X

In the previous article, we had discussed how our tendency to be over-optimistic distorts our view of reality and as a result, we often end up making wrong investment decisions. Today, we shall discuss a very important human tendency which is prevalent in all walks of our social life and has a tremendous influence on how we think and behave. Our aim is to help you understand the workings of your mind better so that you do not let your biases and thinking errors jeopardise your investments.

Social proof tendency

We would like you to contemplate a bit about the below questions before we share our views on them:

• Have you ever commuted on Mumbai's local trains? If you have, you will most certainly agree about how a harmless looking gentleman can so quickly transform into a savage beast to plough his way into the train and onto a seat.
• What causes riots? How are terrorists created? What do you think prompts an otherwise normal person to pick up weapons and brutalise unarmed strangers?
• What was the reason for the success of Anna Hazare's movement against corruption? Why did an otherwise indifferent middle class go all out in support of Team Anna, sometimes even referring to the episode as India's second freedom struggle?
• Why are Indians cleaner and more disciplined abroad than at home?

Though there may be other reasons as well, but the one important common thread among all these is the social proof tendency. What is social proof tendency? Well, it is an automatic tendency to think and act the way people around you are thinking and acting.

In the first instance, an otherwise gentleman turns rash in a Mumbai local train. Since everyone is doing the same, it seems socially acceptable to him. While he may not display that kind of behaviour in most other places, pushing and suffocating others in a local train appears pardonable to him. At least that is what it seems to him from the behaviour of others. Meaning, there is social proof.

The social proof tendency works in both positive and negative situations. Be it riots and terrorists. Or be it the massive support that came in for Anna Hazare. This tendency most readily occurs in the presence of puzzlement or stress, or both.

Social proof tendency and corruption in India

Charlie Munger points out one interesting aspect of the social proof tendency which very well explains why corruption in India is so deeply rooted. The "Serpico Syndrome" is named in the memory of Frank Serpico who once entered a highly corrupt New York police division. Unlike others, he resisted to be consumed by the contagion of corruption. And for that resistance, he was almost about to lose his life. Isn't this reminiscent of the many Indian films wherein the protagonist is the honest police officer who challenges the corrupt system? In the film, of course, the good cop reigns over his adversaries. In real life, however, that is seldom the case. As it is evident, the evil of corruption continues to persist in our country because of this very Serpico Syndrome, which is created by the social proof tendency and the power of incentives.

Akin to the other spheres of life, social proof tendency is present in overwhelming proportions in the world of business and finance. It dominates how investors behave in stock markets, how company managements do business and so on. We will discuss this is more detail in the next article of this series.

Lessons from Charlie Munger - XI

In the previous article, we discussed the social proof tendency in day-to-day life and also explained why corruption in India is so deeply rooted. Today, we shall discuss the social proof tendency in the context of business and finance.

The Institutional Imperative

Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions. Even the legendary investor Warren Buffett had the same notion when he entered the world of business. But through time and experience, he realised that more often than not, despite all the qualifications and experience, it was not the case. A deadly force which he calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses.

What does institutional imperative mean? The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. A simpler term that comes to mind is peer pressure. However surprising it may seem, even CEOs are subject to this pressure which forces them to make stupid mistakes.

The evidence is almost everywhere. Say for instance, if some companies in a certain sector go on a capacity expansion spree, others are quite likely to follow, even though the overall economic situation may be hinting otherwise. What is the excuse such companies provide when the initiative goes for a toss? It's not difficult to guess- 'Everybody was doing that'.

From his own mistakes, Buffett realised how important it was to not fall victim to this force. As an antidote to this problem, he introduced a technique at Berkshire Hathaway that has been quite effective in dealing with institutional imperative. To idea is simple- Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake.

The tendency to fall prey to the social proof tendency is also seen among investors. Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. What should investors do to avoid such mistakes? Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series.

Lessons from Charlie Munger - XII

In the previous article, we discussed the social proof tendency and explained how often company managements and investors get bitten by the bug of 'institutional imperative'. Today we shall discuss another important psychological tendency that often causes massive misjudgments and bad investment decisions.

Contrast Misreaction tendency

How do we really perceive things? For instance, how does our brain figure that an elephant is a big fat creature? Or, how do we know that a tortoise is very slow? The answer to both these questions is relative comparison. We perceive everything in relative terms. That is, an elephant seems big in comparison to our own selves and most other creatures. A tortoise seems to be moving slower when compared to a hare. Of course, this mode of perception is not just restricted to how we look at animals. But it extends to all things in life, and very evidently in investments and stock markets. It influences how we think about economic news and information, corporate performance, stock prices, and so on.

The reason why we tend to perceive things in relative terms is that it is impossible for the human nervous system to measure everything in absolute scientific units. So we use our senses to identify things by comparing them with other things. It is the relative contrast that gives things their specific characteristics. This is a simple program that the human mind follows. But like all psychological processes, if a mental program is allowed to run without due diligence, it can cause thinking errors and misjudgements. In this specific case, it can lead to contrast misreaction tendency.

What is contrast misreaction tendency? Contrast misreaction causes people to make wrong judgments based on misleading contrasts between two or more things and situations. Charlie Munger cites an interesting example where this tendency is often misused- A person is shifting to another city and looking for a new house for his family. To get some quick help, he goes to a real estate broker. First, the salesman takes him around and shows him some really terrible homes for insanely high prices. Then, he takes the person to a merely bad house at a slightly lower price. Need we mention what happens next! What exactly went amiss in this case? How did the home buyer fall into the saleman's psychological trap? Blame it on the contrast misreaction tendency. When the person was shown the last property, he compared the house and its price to the horrible ones he saw before. Because of this comparison, he was ready to buy the not-so-good-house at a pretty high price.

Contrast misreaction tendency in the stock markets

Do investors also make wrong investment decisions because of the contrast misreaction tendency? The answer is yes, very often. The following instance will explain how investors enter this psychological trap.

Expensive at 140, attractive at 300!

Mr Chandra was an active investor. He was suggested by a friend to buy shares of XYZ Ltd when the stock price was Rs 90 per share. Instead of buying immediately, he decided to wait for some time. But in just a matter of few weeks the stock price mounted to Rs 140 per share. That was a whopping rise of nearly 56%. Obviously, Mr Chandra was very distressed. He cursed himself for not buying when the stock was trading at Rs 90. But now, he couldn't get himself to invest in the stock. It's way too expensive, he thought.

In the meanwhile, the stock continued to rally. In just a few months, the stock price was hovering around Rs 400. Mr Chandra had never felt so miserable. He had missed such a big opportunity. But then the stock price faced some selling pressure and corrected by about 25%. At Rs 300, what do you think Mr Chandra must have done? He invested heavily into the stock.

Why did he not buy the stock at Rs 140? What forced him to buy the same stock at Rs 300? The answer in both cases is contrast misreaction tendency. Rs 140 seemed very expensive in contrast to Rs 90, the price at which his friend had suggested. However, Rs 300 seemed cheaper relative to the high of Rs 400 that the stock had witnessed.

A similar mistake also occurs with valuation multiples. For instance, if a stock has commanded a price to earnings (P/E) multiple of 50 times in the past, it doesn't mean that a P/E of 30 times is a lucrative buying opportunity.

How can investors avoid such thinking errors? We believe the principles of value investing are a perfect antidote for the contrast misreaction tendency. Never judge the value of a company based on its past stock price performance or P/E multiples. Look at the company's business fundamentals and its past financial track record. How are the future growth prospects? What are the risks and opportunities to the business? Do the company's managers behave like owners? Valuing the company based on such important parameters will help you avoid false comparisons.

We will continue to discuss some more thinking errors and psychological tendencies that can affect your investment decisions in the subsequent articles of this series. 

Courtesy:  www.equitymaster.com (These are a series of articles collected from Dec 2010 to Mar 2012)

Investing: Back to basics

(These are a series of articles on equitymaster.com between Mar 2009 through Mar 2010)

Investing: Back to basics

While the future is unfolding at a gradual pace or so it seems, we wonder how fast we have traveled the distance since the beginning of 2008, when the skies above the stock markets were blue, and investors thought that the tree called stock markets could grow to touch the sky. It has never happened this way in the past. And this time was no different.

As far as the corporate world is concerned, there has been a sea change in the attitude of companies and their managements. While not many of them (companies) were talking about any business concerns then (January 2008 and before), disclosures are flooding in these days - disclosures relating to hidden losses, pledged shares, cash that never was, cooked up books, and many like these.

Another contrast can be seen in the behaviour of stock prices to bad news. While such ill doings were not given any air and were casually passed off in the heydays of 2008 and before, these days even a hint of negative news sets a company's stock to plummet.

One of Warren Buffett's famous quotes is - "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." Imagine if that actually happened. And that too in the first week of January 2008! Most of us would have loved it considering that it was the peak of the bull-run.

Or to put things in a different perspective, imagine if there was a lock in period on every stock purchase - say, a five year lock-in period. A greater proportion of us would have been wiser in our stock picking.

Coming back to the earlier point about the change in attitudes, with the occurrence of the slowdown, investors' focus is expected to shift on companies' long term performance rather than short-term performance. As such, the managements and their long term plans would be looked at with more detail.

We hope this brings about a change in investors' approach towards investing. The lost art of carefully studying a stock before making the purchase, we believe, needs to make comeback. Understanding the nuances of profit and loss accounts, balance sheets, and cash flow statements has always been pertinent, more now than ever before.

So, let's begin the journey to educate ourselves towards a fruitful investing experience. In a series of articles following this, we will try to bring to you the basics of investing by acting as guideposts to unraveling the mystery behind the financial statements.

While soft qualitative metrics like corporate governance and management quality will continue to be clouded under subjectivity, our effort will be to arm you with a better understanding of the ways companies can be researched.

Investing: Back to basics-I 

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 articles on 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

1. 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 link to see the offer documents that have been issued over the past few years. 

2. 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. 
3. 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 BSE or NSE websites (in their respective corporate announcement sections) and the company’s website. 
4. 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. 
5. Equitymaster database: You can also visit Equitymaster’s database by clicking on this link. Here you will be able to view information relating to companies’ historical numbers and business profile. You will also be able to view reports on key sectors.

Investing: Back to basics-II

An annual report is probably amongst the most viewed company publications. It is the most comprehensive means of communication between a company and its shareholders. It is a report that each company must provide to each of its shareholder at the end of the financial year. To put it differently, it is a report that each shareholder must read.

But what is its use if one does not understand or refer to it?

As a shareholder of a company, you need to know its performance over the past financial year and the management's view on the same. You also need to know what is the company's future plan and strategies. As a shareholder, you need to know what does the management intends to do to attain those targets.

In the third part of this series, we present to you a brief on what the key constituents of an annual report are.

Key constituents of an annual report

1. Director's report: The director's report comprises of the events that take place in the reporting period. This includes a summary of financials, analysis of operational performance, details of new ventures and business, performance of subsidiaries, details of change in share capital, and details of dividends. In short, shareholders can get a gist of the fiscal year from this section.
   
2. Management discussion and analysis (MD&A): More often than not, the MD&A starts off with the management giving its view on the economy. It is then followed by a perspective on the sector in which the company is present. Any major changes like inflation, government policies, competition, tax structures, amongst others are highlighted and discussed in this report. It also includes the business strategy the management intends to follow. Details regarding different segments are provided in this section. The company also gives a brief SWOT (strength, weakness, opportunity, and threat) analysis and business outlook for the coming fiscal.
   This can aid the shareholder to understand what major changes are likely to affect the company going forward. However, as mentioned earlier, an investor should not blindly believe what the management has to say. While it tends to paint a rosy picture, one needs to judge the sanity behind the rationale.
   
3. Report on corporate governance: The report on corporate governance covers all aspects that are essential to the shareholder of a company and are not part of the daily operations of the company. It includes details regarding the directors and management of a company. These include details such as their background and their remuneration. This report also provides data regarding board meetings - how many directors attended the how many meetings. It also provides general shareholder information such as correspondence details, details of annual general meetings, dividend payment details, stock performance, details of registrar and transfer agents and the shareholding pattern.
   
4. Financial statements and schedules: Finally, we arrive at the crux of the annual report, the financial statements. Financial statements, as you are aware, provide details regarding the operational performance of a company during the reporting period. In addition, it also depicts the financial strength of a company. The key constituents of the financial statement include the profit and loss account, the balance sheet, the cash flow statement and the schedules.
   In the next article, we shall briefly take a look at the key constituents of the financial statements. Thereafter, we will go through each of the statements in further detail.

Investing: Back to basics-III

As we had discussed in the previous article of this series on investing basics, financial statements are among the most important sections of an annual report. For a novice investor, reading and understanding a company's financial statement is quite intimidating at first sight. However, to study and make good investing decisions, it is necessary for one to understand the same.

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).

Sourced from Britannia Industries' FY08 annual report

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.

Sourced from Britannia Industries' FY08 annual report

Reworked FY08 balance sheet to simplify the understanding

Total Assets	Rs m	Total liabilities	Rs m
Net fixed assets	2,507	Current liabilities	3,477
Inventories	3,808	Shareholders' funds	7,558
Deferred tax asset (net)	24	Loan funds	1,061
Current assets	5,525
Miscellaneous exp	232
Total	12,096	Total	12,096

Cash flow statement

Put in simple terms, a cash flow statement shows the amount of cash and cash equivalents that enter and leave a company. Just as the P&L statement, 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.

Sourced from Britannia Industries' FY08 annual report

In the next article, we shall start our detailed discussion on the P&L statement and its key constituents.

Investing: Back to basics-IV

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.

Source: Company

Companies enter new businesses for two main reasons -to diversify their revenue streams and de-risk their business from a presence in a single segment. Further it also helps to capitalise on the opportunities in fast growing segments. A classic example would be ITC Limited's entrance into other business (hotels, agri, non-FMCG, papers, etc.) Over time, this move has helped it reduce dependence on its cigarettes business. The adjacent chart shows gives an idea as to how the scenario has changed for the company over the past few years.

Another way a company can diversify itself is by having presence across geographies. An investor can study a company's revenue pattern (from each zone, region or country) over the years. Companies having transnational presence have the option of focusing on the high growth areas or areas that are relatively resilient to an economic slowdown. In addition, if its operations in a certain country/region are witnessing a problem, it could curb the fall in revenue by focusing on operations in other countries/regions.

Seasonal and cyclical businesses
The revenue volatility would remain high for companies that are present in seasonal or cyclical businesses, especially if viewed on a quarterly basis. A seasonal business is a business for which certain seasons of the year are far more profitable than others. These include businesses such as seeds 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.

Investing: Back to basics-V

In the previous article of 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 sales	Amount	% of sales	Amount	% of sales
Net Sales	21,993	100.0%	25,848	100.0%	17.5%
Expenditure
Consumption of Raw Materials (i)	14,004	63.7%	15,553	60.2%	11.1%	-3.5%
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 (i + ii+ iii +iv)	20,705	94.1%	23,531	91.0%	13.6%	-3.1%

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.

Investing: Back to basics-VI

In the previous article of this series on investing, we had briefly looked at how one could analyse a company's expenses over a particular period. In today's article, we will discuss the operating margins, which is a residual profit a company has after deducting its operating expenses from sales.

Before we go further into details, we should broadly take a look at the various expense components that determine a company's operating margin. These include variable expenses, semi-variable expenses and fixed costs. Variable expenses are expenses that change in proportion with the sales or business activity. Fixed costs are expenses that a company incurs regardless of the business activity. Semi-variable expenses are a mixture of fixed and variable components. For most of the manufacturing companies, costs are fixed until production is at a certain level. If production exceeds that level, the costs tend to become variable.

Example of fixed costs include interest costs, salaries (office employees), electricity (office), amongst others. Examples of variable costs are raw materials, sales and marketing costs, amongst others. A very common example of a semi-variable cost is that of wages. A company needs to pay its labourers a fixed amount, even if there is very little production or no production activity taking place. However, if and when production activity accelerates, the staff may tend to work overtime. Subsequently, they will get paid for the same. The overtime wages, in this case, is the semi-variable cost.

Operating margin: It is a measurement of what proportion of a company's revenue is leftover after paying for variable costs of production. A healthy operating margin is required for a company to be able to pay for its fixed costs. The higher the margin, the better it is for the company as it indicates its operating efficiency. Operating margin is calculated by subtracting the operating expenses from sales, and then dividing the balance by the sales figure. The formula is shown below -

Operating margins = (Net sales - Total operating expenses)/ Net sales * 100

Now that we have a basic idea of what an operating margin is, we shall take a look at some factors that determine a company's or an industry's operating margin.

It may be noted that operating margins differ for each industry. The reasons behind the same are various. Some of them may include the regulatory nature of the business, the intensity of competition, the phase of the industry (life cycle), segmental presence within an industry (niche businesses), geographical presence, brand power, bargaining power of buyers and suppliers, raw material procuring policies and their impact on realisations, amongst others. Many a times, these factors coincide and complement each other. It may be noted that operating margins differ for companies within a particular industry. This is basically what ascertains the leaders from the inefficient players.

To give an idea of how margins differ within each industry, we can take a look at the table below.

Sector	Operating margin range
Engineering	10% to 20%
Cement	13% to 33%
Retail*	7% to 11%
Pharma	10% to 24%
FMCG$	13% to 15%
IT	26% to 30%
Telecom	27% to 37%
Hotels	18% to 40%
Power	15% to 20%
Automobiles#	8% to 16%
Steel^	9% to 28%
Construction	12% to 23%

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.

Investing: Back to basics-VII

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.

Depreciation can be accounted in broadly two methods – straight line and written down value. The straight line value method divides the cost of an asset equally over its lifetime. An example will help us understand the process better. Suppose a company buys an equipment worth Rs 10 m in FY08, and it expects it to have a lifeline of 10 years, the depreciation rate would be 10% i.e. Rs 1 m (Rs 10 m * 10%). As such, the company will show depreciation charge (for that asset) as Rs 1 m each year.

Year	Value of asset	Depreciation amount
FY08	10,000,000	1,000,000
FY09	9,000,000	1,000,000
FY10	8,000,000	1,000,000
FY11	7,000,000	1,000,000
FY12	6,000,000	1,000,000
FY13	5,000,000	1,000,000
FY14	4,000,000	1,000,000
FY15	3,000,000	1,000,000
FY16	2,000,000	1,000,000
FY17	1,000,000	1,000,000
FY18	0	-

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).

Year	WDV of asset	Depreciation amount
FY08	10,000,000	1,500,000
FY09	8,500,000	1,275,000
FY10	7,225,000	1,083,750
FY11	6,141,250	921,188
FY12	5,220,063	783,009
FY13	4,437,053	665,558
FY14	3,771,495	565,724
FY15	3,205,771	480,866
FY16	2,724,905	408,736
FY17	2,316,169	347,425
FY18	1,968,744	295,312

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. 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.

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.

Investing: Back to basics-VIII

In the previous article of this series, we had discussed about depreciation and interest expenses. In today's article, we will take a look at the items that come below these – taxes, net profits and appropriation.

Taxes: There are different types of taxes that a company pays. The ones that are commonly found in annual reports are current income tax, fringe benefit tax, wealth tax and deferred income tax.

Corporate income tax is the tax which a company pays on the profits it makes. Currently, the domestic corporate income tax rate stands at 30% (A surcharge of 10% of the income tax is levied, if the taxable income exceeds Rs 1 m). It may be noted that the tax structure for foreign companies operating in India is different.

After adding other income and deducting the interest and depreciation charges from the operating profits, we arrive at a number which is known as the profit before tax (PBT). On dividing the current income tax (for the particular year) by the PBT (also known as the net taxable income) we get a figure which is called the 'effective tax rate'.

Fringe benefit tax is the tax which a company pays on certain benefits which its employees get. This includes items such as employee stock options (ESOPs), expenses on travel, entertainment, amongst others. It may be noted that the employer needs to cover the cost of these items for them to be accounted as a fringe benefits.

Wealth tax is levied on the benefits derived from ownership of certain non-productive assets that a company owns. As such, assets like shares, debentures, bank deposits and investments in mutual funds, being productive assets, are exempt from wealth tax. Non-productive assets include jewellery, bullion, motorcars, aircraft and urban land, amongst others.

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.

Source: Britannia FY08 annual report.

Investing: Back to basics-IX

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.

Investing: Back to basics-X

A lot of emphasis was given on companies' revenues and profits during the high growth phase (FY04 to FY08) as virtually every company was growing at a strong pace. However, with the events that occurred in the past 18 months, the focus on the relatively ignored part of the annual report, the balance sheet, has increased. And in the process it has made many investors realise the need of a good balance sheet.

In the past few articles of this series, we discussed about the various aspects of a profit and loss account, right from the topline till the appropriation items. In the next few articles, we will touch upon few of the key constituents of a balance sheet.

What is a balance sheet?
A 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). The balance sheet is broken into two parts - 'Sources of funds' and 'Application of funds' - as they are called in accounting terminology. We shall first look into the key constituents of the head 'sources of funds', after which we will cover the head 'application of funds'.

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.

Sourced from Nestle's CY08 annual report

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'.

When a company issues shares, the instrument would have to carry a denomination, called as the face value. For example, let us assume that the face value of a company's shares is Rs 10 per share. It fixes the issue price at Rs 100 per share. Now, out of each share that is issued, Rs 10 will go in the share capital account (as explained above) and the balance Rs 90 will go to the 'Share premium account'.

Loans and borrowings is the other major component of the 'Sources of funds' side. When a company is in need of capital (for any purpose), but is not able to generate enough internally, it would look to borrow funds. These could vary from meeting capital expenditure requirements to meeting working capital requirement, amongst others.

Loans can be of various types. They could be short term (working capital loans) or long term (term loans) in nature. You would also find terms such as 'secured loans' and 'unsecured loans' in companies' annual reports. Secured loans are loans that are secured by collateral to reduce the risk associated with lending.

In the next article of this series, we will take a look at the key constituents of the 'Application of funds' head.

Investing: Back to basics-XI

In the previous article of this series, we initiated our discussion on the financial statements of banks. We discussed how different is a profit and loss statement of a financial company as against that of a non-financial company. In this article, we shall discuss some of the key ratios related to a bank's profit and loss statement.

As a bank's accounts are very different from that of a manufacturing firm, it would be necessary for an investor to understand some of the key performance ratios. As you must be aware, analysis of a bank's accounts differs significantly from any other company due to their structure and operating systems. Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank. Some of these key ratios are:

• Net interest margin (NIM)
• Operating profit margin (OPM)
• Cost to income ratio
• Other income to total income ratio

Net interest margin (NIM): Just as we calculate and measure performances of non-financial companies on the basis of their operating performance (EBITDA margins), the performance of banks is largely dependent on the NIM for the year. The difference between interest income and interest expense is known as net interest income. It is the income, which the bank earns from its core business of lending.

As such, NIM is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call. As such it is calculated as,

NIM = (Interest income - interest expenses) / average earnings assets

Operating profit margin (OPM): A bank's operating profit is calculated after deducting operating expenses from the net interest income. Operating expenses for a bank would mainly be more of administrative expenses. The main expense heads would include salaries, marketing and advertising and rent, amongst others. Operating margins are profits earned by the bank on its total interest income. As such,

OPM = (Net interest income (NII) - operating expenses) / total interest income

Cost to income ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its return on equity. Salaries, branch rationalisation and technology upgradation account for a major part of operating expenses for new generation banks. Even though these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based income).

Cost to income ratio = Operating expenses / (NII + non-interest income)

Other income to total income: Fee based income accounts for a major portion of a bank's other income. A bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenue is not depended on the bank's capital adequacy and consequently, the potential to generate the income is immense. The higher ratio indicates increasing proportion of fee-based income. The ratio is also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.

Let's take up an example to understand this well. Below, we have displayed HDFC Bank's FY09 profit and loss account. We shall calculate the above mentioned ratios for the bank.

Source: HDFC Bank’s FY09 annual report.

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.

Investing: Back to basics-XII

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.

Investing: Back to basics-XIII

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 the quantum of investments in G-Sec.

The other investment would be somewhat common between all firms. They could include investment in joint ventures, subsidiaries, bonds and debentures, units, certificate of deposits, amongst others.

Advances
Advance in the simplest term can be defined as loans given to a bank's customers, which could be retail or corporate clients. The growth in advance, coupled with the prevailing interest rates is what drives the banks interest income.

Advances are broadly of three types - Bills purchased & discounted, cash credits, overdrafts & loans repayable on demand and term loans. Term loans, followed by cash credits, overdraft and loans repayable on demand tend to have a larger share in this head.

Further, banks are also required to show how these assets have been covered. They can be either covered by tangible assets or bank/government guarantees. Banks also give unsecured loans to their customers. However, these types of loans would constitute a much less portion (as compared to the secured loans) of the advance pie.

Banks are also required to broadly show where they have made their advances. While more details can be sought from various reports, including annual reports, under the advance schedule, they are required to show what portion is advanced in and outside India. Further bifurcation is made as to how much has been advanced to the priority sector, public sector, other banks, etc.

Fixed assets and other assets
Fixed assets for a bank would mainly include premises, land, assets on lease and furniture & fixtures. The 'other assets' portion includes various items such as the interest accrued, advance tax paid, stationary and stamps, non banking assets acquired in satisfaction of claims, security deposits for commercial and residential property, deferred tax assets, amongst others.

It must be noted that banks are also required to disclose their contingent liabilities, which as the name suggests, are possible future liabilities that will only become certain on the occurrence of some future event. More often than not, liability on account of outstanding forward exchange and derivative contracts form the majority portion of this.

In the next article of this series, we shall continue our discussion on the financial statements of banks.

Investing: Back to basics-XIV

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

Credit to deposit ratio (CD 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.

Capital adequacy ratio (CAR): 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.

CAR = Tier I capital + Tier II capital / Risk weighted assets

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.

Tier I Capital funds include paid-up equity capital, statutory and capital reserves, and perpetual debt instruments eligible for inclusion in Tier I capital. Tier II capital is the secondary bank capital which includes items such as undisclosed reserves, general loss reserves, subordinated term debt, amongst others.

Non-performing asset (NPA) ratio: The net NPA to loans (advances) ratio is used as a measure of the overall quality of the bank's loan book. An NPA are those assets for which interest is overdue for more than 90 days (or 3 months).

Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad quality of loans.

NPA ratio = Net non-performing assets / Loans given

Provision coverage ratio: The key relationship in analysing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip).

Provision coverage ratio = Cumulative provisions / Gross NPAs

Return on assets (ROA): Returns on asset ratio is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned by the bank on its total net worth.

ROA = Net profits / Avg. total assets

We shall continue with our discussion on banks financial statements in the next article of this series.

Investing: Back to basics-XV

In the previous article of this series, we concluded our discussion about the components that make up a balance sheet. In this article of this series, we shall go though some of the key financial ratios associated with the profit and loss account and the balance sheet.

Some of the key financial ratios are:

• Return on equity (ROE)
• Return on capital employed (ROCE)
• Return on invested capital (ROIC)
• Return on total assets (ROA)
• Asset Turnover
• Debt to equity ratio (D/E)
• Interest coverage ratio

Return on equity (ROE) - ROE is probably the most important ratio in the investing world. It helps in measuring the efficiency with which a company utilises the equity capital. ROE reflects the efficiency with which the management has utilized the shareholders funds. It is calculated by dividing the 'profit after tax' earned in an accounting year with the 'equity capital' as mentioned in the balance sheet of the company. The result of this calculation should be multiplied into 100.

Return on equity = profit after tax / shareholders funds * 100

One could also take the average equity capital i.e. the average equity of a particular financial year and its preceding financial year. The ratio is also known as the return on net worth (RONW).

It is important to note that this ratio should be compared within companies of a particular industry or intra-industry rather than inter-industry. This exercise helps in knowing which companies have better operating efficiencies and consequently, which managements have been utilising their shareholders' funds more efficiently. An inter-industry comparison does not really make sense as characteristics of different industries vary.

Return on capital employed (ROCE) - Capital employed in simple terms is the value of all assets employed in a business. It can be calculated in two ways -from the 'Application of funds' side and the 'Sources of funds' side of the balance sheet. In case of the former, capital employed would the total assets minus the current liabilities. For the latter, one can simply add the shareholders funds and the loan funds.

ROCE is calculated by dividing the earnings before interest and tax (EBIT) by the capital employed. As such,

ROCE = EBIT / Capital employed * 100

This ratio helps in assessing the returns that a company realises from the capital employed by it. In other words, it represents the efficiency with which capital is being utilized to generate revenue.

Return on invested capital (ROIC) - ROIC shows the returns that a company earns on the capital that is actually invested in the business. It is an important tool which helps in determining how well a company's management is able to allocate capital into its operations for future growth. It is calculated as:

ROIC = (EBIT)*(1 - effective tax rate) / (Capital employed - cash in hand) * 100

As we can see form the above ratio, after reducing the tax from the earnings before interest and tax figure (EBIT), we divide the result by the capital employed (net of the idle cash on hand). The reason we take the EBIT figure is because it includes the PAT and depreciation (which is a non-cash expense). Surplus cash is subtracted from 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.

Investing: Back to basics-XVI

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.

Nestle's CY08 cash flow statement

Source: Company's CY08 annual report

Let us take up an example to understand this well. Above, we have displayed Nestle's CY08 cash flow statement. After making the necessary adjustments, Nestle's 'operating profits before working capital changes' stood at Rs 8.7 bn at the end of 2008. However, as we move further down, we can see that the company's 'cash generated from operations' is higher. The difference between the two figures is Rs 550 m (Rs 9258.8 - Rs 8709.5 m). This means that the company was able to improve its working capital position over the year. In fact, it was able to unblock funds to the tune of Rs 550 m during CY08 as compared to the previous year. After we arrive at the 'cash generated from operations figure' we need to deduct the direct taxes.

In the next article of this series, we shall discuss one of the other two heads - cash flow from investing activities.

Investing: Back to basics-XVII

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 and other investments not included in cash equivalents."

Cash transactions used for acquiring assets which help in generation of future income fall under this category. This disclosure is quite necessary for an investor. This is because it gives an idea as to how much expenditure has been made towards acquiring resources intended for future income generation. The amount of money received from sale of such investments is recorded here as well.

Payments- towards acquiring fixed assets fall under this category. This also includes intangible assets. In fact, this would probably be the most common entry found under this head. Costs on capitalised research and development and self-constructed assets would also fall under this category.

Further, cash receipts and payments towards acquiring or selling shares of others enterprises need to be shown here as well. These include investments in shares and also acquisition and investments in subsidiaries and joint ventures. Instruments such as warrants and debt instruments of other enterprises are included here.

It must be noted that instruments considered as cash equivalents or even those held for dealing or trading purposes should not be a part this head.

A company needs to record the income - in the form of interest and dividends - that is derived from such instruments as well. However, their classification depends on the business of the company. For a financial enterprise, this would be routine activity. As such it would be recorded as a cash flow from operations. However, such income for a non-financial company would fall under cash flow from investing activities. At the same time, interest payments (outflow) would be classified as cash flows from financing activities.

Let us take up an example to understand this well. Shown below is the 'cash flow from investing activities' portion of Bharti Airtel's FY09 cash flow statement.

Source: Company's FY09 Annual Report; Figures in Rs '000

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.

Investing: Back to basics-XVIII

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.

Source: Company's FY09 Annual Report; Figures in Rs '000

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.

Investing: Back to basics-XIX

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.

It is calculated by dividing the cash flow from operations by the capital expenditure. Therefore:

Capital expenditure ratio = cash flow from operations / capital expenditure

This ratio measures the capital available for internal reinvestment and for payments on existing debt. If the ratio exceeds 1.0, it indicates that the company has enough funds to meet its capex requirements. As such, higher the value, the more spare cash the company has to service and repay debt. One will usually find lower ratios in fast growing companies on the back of high capital investments.

Investing: Back to basics-XX

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.

Source: HDFC Bank's FY09 annual report.

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.

Investing: Back to basics-XXI

In the previous article of this series, we initiated our discussion on the financial statements of banks. We discussed how different is a profit and loss statement of a financial company as against that of a non-financial company. In this article, we shall discuss some of the key ratios related to a bank's profit and loss statement.

As a bank's accounts are very different from that of a manufacturing firm, it would be necessary for an investor to understand some of the key performance ratios. As you must be aware, analysis of a bank's accounts differs significantly from any other company due to their structure and operating systems. Those key operating and financial ratios, which one would normally evaluate before investing in company, may not hold true for a bank. Some of these key ratios are:

• Net interest margin (NIM)
• Operating profit margin (OPM)
• Cost to income ratio
• Other income to total income ratio

Net interest margin (NIM): Just as we calculate and measure performances of non-financial companies on the basis of their operating performance (EBITDA margins), the performance of banks is largely dependent on the NIM for the year. The difference between interest income and interest expense is known as net interest income. It is the income, which the bank earns from its core business of lending.

As such, NIM is the net interest income earned by the bank on its average earning assets. These assets comprises of advances, investments, balance with the RBI and money at call. As such it is calculated as,

NIM = (Interest income - interest expenses) / average earnings assets

Operating profit margin (OPM): A bank's operating profit is calculated after deducting operating expenses from the net interest income. Operating expenses for a bank would mainly be more of administrative expenses. The main expense heads would include salaries, marketing and advertising and rent, amongst others. Operating margins are profits earned by the bank on its total interest income. As such,

OPM = (Net interest income (NII) - operating expenses) / total interest income

Cost to income ratio: Be it a bank or a manufacturing firm, controlling overheads costs is a critical part of any organisation. In case of banks, keeping a close watch on overheads would enable it to enhance its return on equity. Salaries, branch rationalisation and technology upgradation account for a major part of operating expenses for new generation banks. Even though these expenses result in higher cost to income ratio, in long term they help the bank in improving its return on equity. The ratio is calculated as a proportion of operating profit including non-interest income (fee based income).

Cost to income ratio = Operating expenses / (NII + non-interest income)

Other income to total income: Fee based income accounts for a major portion of a bank's other income. A bank generates higher fee income through innovative products and adapting the technology for sustained service levels. This stream of revenue is not depended on the bank's capital adequacy and consequently, the potential to generate the income is immense. The higher ratio indicates increasing proportion of fee-based income. The ratio is also influenced by gains on government securities, which fluctuates depending on interest rate movement in the economy.

Let's take up an example to understand this well. Below, we have displayed HDFC Bank's FY09 profit and loss account. We shall calculate the above mentioned ratios for the bank.

Source: HDFC Bank’s FY09 annual report.

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.

Investing: Back to basics-XXII

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.

Investing: Back to basics-XXIII

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 the quantum of investments in G-Sec.

The other investment would be somewhat common between all firms. They could include investment in joint ventures, subsidiaries, bonds and debentures, units, certificate of deposits, amongst others.

Advances
Advance in the simplest term can be defined as loans given to a bank's customers, which could be retail or corporate clients. The growth in advance, coupled with the prevailing interest rates is what drives the banks interest income.

Advances are broadly of three types - Bills purchased & discounted, cash credits, overdrafts & loans repayable on demand and term loans. Term loans, followed by cash credits, overdraft and loans repayable on demand tend to have a larger share in this head.

Further, banks are also required to show how these assets have been covered. They can be either covered by tangible assets or bank/government guarantees. Banks also give unsecured loans to their customers. However, these types of loans would constitute a much less portion (as compared to the secured loans) of the advance pie.

Banks are also required to broadly show where they have made their advances. While more details can be sought from various reports, including annual reports, under the advance schedule, they are required to show what portion is advanced in and outside India. Further bifurcation is made as to how much has been advanced to the priority sector, public sector, other banks, etc.

Fixed assets and other assets
Fixed assets for a bank would mainly include premises, land, assets on lease and furniture & fixtures. The 'other assets' portion includes various items such as the interest accrued, advance tax paid, stationary and stamps, non banking assets acquired in satisfaction of claims, security deposits for commercial and residential property, deferred tax assets, amongst others.

It must be noted that banks are also required to disclose their contingent liabilities, which as the name suggests, are possible future liabilities that will only become certain on the occurrence of some future event. More often than not, liability on account of outstanding forward exchange and derivative contracts form the majority portion of this.

In the next article of this series, we shall continue our discussion on the financial statements of banks.

Investing: Back to basics-XXIV

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

Credit to deposit ratio (CD 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.

Capital adequacy ratio (CAR): 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.

CAR = Tier I capital + Tier II capital / Risk weighted assets

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.

Tier I Capital funds include paid-up equity capital, statutory and capital reserves, and perpetual debt instruments eligible for inclusion in Tier I capital. Tier II capital is the secondary bank capital which includes items such as undisclosed reserves, general loss reserves, subordinated term debt, amongst others.

Non-performing asset (NPA) ratio: The net NPA to loans (advances) ratio is used as a measure of the overall quality of the bank's loan book. An NPA are those assets for which interest is overdue for more than 90 days (or 3 months).

Net NPAs are calculated by reducing cumulative balance of provisions outstanding at a period end from gross NPAs. Higher ratio reflects rising bad quality of loans.

NPA ratio = Net non-performing assets / Loans given

Provision coverage ratio: The key relationship in analysing asset quality of the bank is between the cumulative provision balances of the bank as on a particular date to gross NPAs. It is a measure that indicates the extent to which the bank has provided against the troubled part of its loan portfolio. A high ratio suggests that additional provisions to be made by the bank in the coming years would be relatively low (if gross non-performing assets do not rise at a faster clip).

Provision coverage ratio = Cumulative provisions / Gross NPAs

Return on assets (ROA): Returns on asset ratio is the net income (profits) generated by the bank on its total assets (including fixed assets). The higher the proportion of average earnings assets, the better would be the resulting returns on total assets. Similarly, ROE (returns on equity) indicates returns earned by the bank on its total net worth.

ROA = Net profits / Avg. total assets

We shall continue with our discussion on banks financial statements in the next article of this series.

Courtesy:  www.equitymaster.com (These are a series of articles collected from Mar 2009 to Mar 2010)