Balance Sheet

How To Read An Annual Report

This is one of the many "how to do…" series, which you encounter daily in different places. But this one is different. Because we have tried to encapsulate a few hard learned chapters from our lives into this. By this we mean that this is not a funda session from a bookish point of view but real life analysis of some companies. This (hopefully!) will help you when a balance sheet lands on your able. This is also not an exhaustive compilation but just a few interesting pointers set you off….

We shall now see through a case study, how one can apply the basic concepts explained in Somu’s Tea Business to any business, large or small. Let us take the example of one of India's largest corporate Hindustan Lever Ltd (1998).

What is the first thing that you read when you pick up an annual report?

The Director's report. The Directors report is the management's statement, communicating to the shareholder's about the year that was - the company's performance, achievement of goals or the reasons for inability to achieve them.

It is also a statement of the company's future - what the management plans for tomorrow, expansion programs, perception of the business environment, etc. More importantly, the contents of an the director's report gives an indication as to how much information the management is willing to share with you - the shareholder.

Financial numbers can tell you a lot. There are things which are apparent on the face of the financial statement of accounts - such as sales, profit, dividend, equity, debt, assets, etc. And there are several more things these numbers can tell you, if you dig into them a little more.

Financial numbers for a single year, cannot always give a complete picture about a business. A five year time frame is always a better barometer for checking out the performance of a business.

Let us begin by looking at HLL's profit and loss account for the last five years. The seventh column (CAGR) in the table gives the compounded annual growth rate during the last five years.

Growth HLL has recorded a CAGR of 35.3% in net sales during the last five years. Doesn't a sustained 30% + growth seem highly unrealistic for a company which in the business of selling soaps, detergents, toothpaste and like products. Looking at the yoy

 

growth figures of HLL's sales, you see an abnormally high growth rate of 96% in 1996. If you go into past annual reports, you will find that the abnormal growth has been due to the merger of Brooke Bond Lipton India (BBLIL) with the company. An adjustment for the merger, reveals a normal sales growth of 18-19% pa.

Margins The company's operating margins have remained more or less at similar levels in the last five years. This indicates that in a competitive world, even dominating players like HLL cannot significantly stretch its margins. A steadily rising advertising budget from 3.9% of net sales in 1994 to 7.1% of net sales in 1998, reiterates the competitive pressures faced by the company.

Costs A look at the company's cost structure reveals that while raw material cost recorded a lower CAGR of 28.3% against 35% CAGR in sales. Purchase of finished goods recorded a high CAGR of 54%, indicating increased outsourcing by the company. Higher outsourcing reduces pressure on other overheads, as reflected in the reducing component of other costs.

The company has kept interest costs under strict control. Interest cost rose in 1996, when the company had to absorb the debt of the amalgamating company. However it was again bought under control in the last two years.

Depreciation Depreciation which had more than doubled in 1996 (again the impact of the BBLIL merger), witnessed a further jump from Rs580mn in 1997 to Rs1010mn in 1998. Has the company suddenly become aggressive in capital investments?

A look at the fixed assets schedule (page 41 of the annual report) reveals that Rs191mn increase in depreciation is due to the Ponds amalgamation. Besides, the company has followed the conservative concept of amortizing the recently acquired Lakme trademarks over a four year period. This has lead to an additional amortization charge of Rs206mn.

Cash flow statement The cash flow statement gives a clear indication of the health of a company.

How much cash does the company’s business generate?

How much is utilized in operating activities, ie working capital needs of the company.

What have been investments in fixed assets over the last few years?

How much cash has been poured into investments or given as loans and advances?

If internal cash generation has been inadequate to meet the above requirements, what are the sources that have been used to raise funds? Has the company raised equity or debt? Or is it repaying debt?

All these questions are answered if you look at a company’s cash flow statement.

HLL's ability to aggressively invest in brand building and to acquire large businesses, stems from a basic strength, ie consistent generation of huge cash resources. In 1998, HLL generated cash profits of Rs9bn. The company has had a negative working capital during the last three years. Year end cash balance stood at Rs6.6bn, that too after paying out Rs5.3bn to shareholders in the form of dividends.

Ratios Ratios are useful tools that enable intra-year comparison within a company. Ratios also enable us to make inter-firm comparison for a group of companies.

HLL's return on net worth (RONW) has consistently improved from 35.3% in 1994 to 48.9% in 1998. Return on capital employed has also been high and was 58.7% in 1998.

However one must keep in mind that FMCG companies typically have high RONW and ROCE as their key assets (ie brands) do not appear in the balance sheet.

But beware! Ratios can sometimes also mislead. If you look at HLL's current ratio - the measure of liquidity of a company, it has steadily declined from 1.5x four years ago to 1.1x today. Now isn't a declining current ratio an issue of concern? Is it likely, that HLL, which generates huge cash flows every year and has a year end cash balance of over Rs6bn, is facing a liquidity crunch! Therefore looking at the component composition of the ratio being analyzed is also very important.

Similarly, a high fixed asset turnover ratio may indicate efficient utilization of assets. However it is also likely that the ratio appears high because of a low denominator base due to old, worn out and depreciated assets.

After a blue chip company, let us see the other side of corporate India.

Jindal Iron & Steel company Ltd (Jisco) 1994-95 Annual Report

Jisco manufactures hot and cold rolled steel strips/ coils and galvanized steel sheets using slabs as input. In FY95, Jisco announced a PAT of Rs927mn, up about 200%. This translated

into an EPS of Rs26.87 (weighted capital basis).

At the first glance, things could not have been better. The company's prospects looked rosy and you would have called your friendly neighborhood broker and placed a buy order. So where is the catch?

The first thing is not to get carried away by growth but try and read beyond the obvious. Sales growth was from expansion with massive capital spending. In a good year, you will make profit. But in a bad year (in a cyclical industry bad years follow good ones like night follows day), it is enhanced risk. But in case of this company, what is most intriguing and disturbing is management's desperate attempt to jack up profits even when operating environment was favorable. Most conservative companies do the reverse. In a good year, they clean up the rot (provide for all slow moving), write off all doubtful, make additional provisions etc.

Before we go further, a word about tax outgo. One who pays tax, is a good citizen. Barring exception circumstances, in most cases you will find good corporate citizens pay tax. The companies that continuously expand, incur capex to get tax shield call for extra caution.

In FY95, sales grew by 120%, but the growth in other income was even more impressive at 192%, and the ratio of other income to total income also increased from 22% to 29%. This should raise a flag.

EBITDA margin is a key ratio that reflects the operating efficiency of the company. Compare this ratio with other year data and also across companies in the same sector. Generally in a commodity business, EBITDA margins should remain same unless there is a good reason, like saving on power costs, better utilization, etc. EBITDA margin increased from 14.9% to 19%. This was caused due to commissioning of CR mill and an overall buoyant steel market.

Jisco's tax outgo in both FY94 and FY95 was miniscule. Link that with depreciation and additions to gross block. This was plugged by the government's implementation of MAT. Earlier, all Indian companies used to increase their balance sheet size and defer tax outgo.

Interest expense is a net figure, ie interest income is netted off against interest expense to get a net number. This does not speak highly of their quality of disclosures (check the balance sheet of Infosys, you'll get what I mean). This will distort interest cover ratio.

Coming to yet another interesting ratio, check working capital to sales ratio. In FY95, working capital zoomed 322% to reach Rs3814mn, caused by an increase in debtors and loans and

advances. This may indicate that company is trying to push sales. Loans and advances is a mysterious item as it can be used to mask transfer of funds for any private use including playing on stock markets through group's investment companies, ICDs, loans to subsidiaries, sister companies and also advances for asset build up. Keep a watch on this.

Also look out for investments in subsidiaries, equities, etc. These are all not the best ways to put cash to productive use. Also check for the differences between book value of investments and market value of the same.

Amongst ratios, our all time favorite is ROCE and RONW. Like in this case, RONW will not reflect interesting adjustments. As reported net profits are inflated with suppression of interest. Even ROCE will fail to report adjustments done till operating profit level. But still, they are the best indicators of how best the company is using capital. Check its ROCE, which is at 11.3% and 9.0% for FY94 and FY95 respectively. About 33% (12%) of capital employed was investments, 35% (32%) was working capital and about 32% (56%) was net fixed assets. Figures in brackets indicate FY94 numbers. RONW for the same period was higher because of interest capitalization, and resultant higher reported PAT figures.

Read all notes to accounts and auditors' qualifications. What the company did was to change the way expenses are accounted for. A glance at the accounting policies (pg 33-37) highlights the same. The first comment "Excise Modvat credit of Rs40mn availed in respect of capital goods has been considered as an addition to the cost of fixed assets and the same is recognized as income during the year. This is not strictly in consonance with accounting standard regarding accounting for fixed assets issued by the Institute of chartered accountants of India".

Jisco also capitalized interest (Rs186mn) payable on loans and short term borrowings as CWIP and took on credit income of Rs144mn, being interest earned on funds raised for implementing projects without following the recommended practice of setting it off against the CWIP. This has an obvious impact of increasing the profit.

In general, FY96 balance would have vindicated all that we said in earlier paragraphs. Net profit fell by 43% as the company began complying with Indian GAAP. Quality of disclosures gives a good assessment of how management likes to treat its shareholders. Prudent and consistent accounting policies generally tend to attract a higher discounting in the bourses. Things like other income, equity investments, investments/ loans to sister companies, capitalizing interest expenses, not paying taxes (no longer valid) and other techniques are used to boost PAT figure. This may give an inkling that the company wants to issue fresh shares and therefore wants to boost it price and take the gullible investor for a ride. It used to happen regularly in the past and will

continue to happen in the future also.