Company Analysis – Financial Analysis

1The set of financial statements

Listed companies in India follow Schedule III of the Companies Act, 2013 and Ind AS 1. A complete set includes:

1. Balance sheet (statement of financial position): assets, liabilities and equity at the period end.
2. Statement of profit and loss: income, expenses and profit for the period, including other comprehensive income (OCI), the fair value gains and losses that bypass profit.
3. Statement of changes in equity: movements from profits, dividends, share issues, buybacks and OCI.
4. Cash flow statement: sources and uses of cash.
5. Notes: accounting policies and breakdowns.

Comparative figures for at least one prior period are required.

Remember

• Schedule III and Ind AS 1 govern format; OCI is part of the P&L statement.

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2Standalone and consolidated statements

Each company files its own standalone statements, but for groups these can mislead: a parent's standalone accounts miss sales made through subsidiaries abroad. Consolidated statements combine all controlled companies as one group.

Control usually means more than 50% of voting rights or the right to appoint a majority of the board, but under Ind AS 110 a parent that can direct a subsidiary's strategy and operations to affect its returns controls it even with less than 50%.

Equity analysts generally prefer consolidated figures. But check the parent's standalone position too when subsidiaries cannot pay dividends upward (capital controls, loan covenants). SEBI requires annual consolidated statements and quarterly standalone results; quarterly consolidated results are voluntary, and groups that skip them leave analysts with dated information.

Remember

• Consolidated preferred; standalone still matters if cash is trapped in subsidiaries.

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3Balance sheet line items

Banks, insurers and utilities use formats set by their regulators; others follow Schedule III.

Assets are items expected to give future benefits, recognised only if measurable and paid for (so self-built brands are not recorded). Non-current assets benefit beyond one year; current assets within one operating cycle (by convention one year).

Non-current assets:

• Property, plant and equipment (PPE): historical cost less depreciation, or revaluation under Ind AS 16 (applied to a whole class of assets).
• Capital work in progress: PPE under construction.
• Goodwill: price paid for an acquisition above the fair value of net assets (Airtel paid ₹3,200 crore for Tigo Rwanda with net assets of ₹2,838 crore). Tested for impairment, not amortised. Paying less than fair value creates a capital reserve.
• Intangible assets: acquired copyrights, patents and brands (and internally developed software), at cost less amortisation; intangibles under development are shown separately.
• Investments in JVs and associates: under the equity method: cost adjusted for the investor's share of profit and OCI, less dividends and impairment.
• Non-current financial assets: long-term investments, loans and claims; debt held to collect cash flows at amortised cost, others at fair value.

Current assets: inventory (raw materials, WIP, finished goods at the lower of cost and market value); current financial assets (cash and equivalents, bank balances, receivables net of doubtful-debt provisions, short-term investments at fair value); and other current assets such as prepaid expenses.

Equity is the residual interest (assets − liabilities): share capital (face value), share premium, retained earnings, general reserve, capital and revaluation reserves (usually not distributable), and, in consolidated accounts, non-controlling (minority) interest.

Non-current liabilities:

• Long-term debt (the part due within a year is shown as current maturities).
• Lease liability for right-of-use assets over a year; analysts often treat it as debt.
• Derivative liabilities (MTM losses settled after a year).
• Deferred revenue: advance payments for future service. A ₹1,200 six-month pack with five months left: ₹200 revenue, ₹1,000 deferred.
• Provisions: amounts for specific obligations not fully quantified (retirement benefits, warranties, pending legal claims); unlike reserves, which are not for a specific liability.

Current liabilities: trade payables, short-term debt (often rolled over), short-term provisions, current maturities of long-term debt, deferred revenue, customer advances and accrued expenses.

Remember

• Goodwill = price − fair value of net assets; impaired, not amortised.
• Provisions are for specific obligations; reserves are not.

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4Balance sheet metrics

Historical cost and money measurement mean balance sheets often miss fair values, so analysts compute their own measures:

• Total debt: long-term debt + current maturities + short-term debt + lease obligations + accrued interest. Debt differs from other liabilities because it carries interest. (Airtel's total debt was about ₹1,287 billion at March 2019.)
• Working capital: a firm spends first and is paid later, so capital is tied up through the cash-to-cash cycle. Accountants measure net working capital = current assets − current liabilities (Airtel: negative, as current liabilities far exceeded current assets).
• Core working capital = inventory + trade receivables − trade payables, excluding non-operating items such as short-term investments and current maturities of debt (some analysts add an operating cash balance). It shows the real need for working capital finance.

Remember

• Core working capital = inventory + receivables − payables.

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5Profit and loss line items

• Revenue from core operations (and other operating income incidental to them); other income is non-operating (investment income, asset sale gains).
• Expenses: employee cost, depreciation and finance cost everywhere; manufacturers also show cost of raw materials (purchases + opening stock − closing stock), purchase of stock-in-trade (goods resold unprocessed, typical of retail) and changes in inventory of WIP and finished goods. Indian disclosures detail raw materials but not other direct costs, so gross profit is hard to compute.
• Employee cost includes salaries, benefits, stock-based compensation and retirement provisions.
• Depreciation allocates the cost of tangible assets over their useful life; Ind AS 16 wants the method to match how the asset is used (a cab fleet by kilometres). Amortisation does the same for intangibles.
• Finance cost: interest, fees and amortised issue costs.
• Share of profit of equity-accounted entities, and exceptional items (calamity losses, one-time regulatory charges).
• Tax: current tax, MAT (an asset if credit is expected to be used, otherwise expensed) and deferred tax (non-cash, from timing differences).
• Profit attributable to non-controlling interest.
• EPS: basic (profit ÷ weighted average shares) and diluted (assuming in-the-money warrants, ESOPs and convertibles are converted, with profit adjusted). For loss-makers they are the same.
• OCI: revaluation surplus changes, remeasurement of defined benefit plans, foreign operation translation, fair value changes through OCI, and effective hedge gains or losses.

Example Opening finished goods and WIP of ₹320 lakh and a P&L "change in inventory" of −₹35 lakh (an expense credit means stock went up): closing inventory ≈ 320 + 35 = ₹355 lakh.

Remember

• Change in inventory shown as negative = inventory increased.
• Diluted EPS assumes conversion of potential shares.

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6Profit metrics

Many companies present a single-step P&L; analysts redraw it as multi-step to get:

• Gross profit = revenue − cost of goods sold (rarely computable in India).
• EBITDA: profit before interest (a financing choice), depreciation and amortisation (asset and accounting choices) and tax. Best for comparing firms across capital structures. Adjusted EBITDA also strips non-operating income. It is a rough proxy for operating cash profit, to be used cautiously.
• EBIT (operating profit): what is available for interest, tax and owners; used for interest coverage and free cash flow to the firm.
• PAT (net profit): what is left for shareholders.
• Adjusted PAT: excludes exceptional items net of their tax effect, for comparability. Judgement may be needed (Airtel paid large taxes in a loss year, making its effective tax rate meaningless).

Remember

• EBITDA ignores financing, asset and tax choices: good for comparisons.
• Adjust exceptional items net of tax.

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7Changes in equity and cash flows

Ind AS 1 requires a statement of changes in equity showing how each transaction affected each component of equity.

Cash flow: accrual accounting records income when earned and expenses when incurred, so profit can differ from cash. A business that buys for cash ₹80,000 and sells on credit for ₹1,00,000 shows ₹20,000 profit but has no cash, and could lose its capital if customers do not pay.

• Operating cash flow: from operations; start from net profit, add back non-cash items (depreciation, amortisation) and adjust for changes in receivables, payables and inventory.
• Investing cash flow: buying assets is an outflow, selling an inflow.
• Financing cash flow: borrowing or issuing equity is an inflow; repaying debt, buybacks and dividends are outflows. (This is where funds borrowed during the year appear.)

Persistent negative operating cash flow is a warning: the business needs continual funding and will either turn around or die. Kingfisher Airlines ran negative operating cash flows for years, borrowed to pay interest while EBIT fell short of interest, and stopped when lenders refused more money. Expansion funded mainly by borrowing needs caution, because assets may realise less than book value while debts must be paid in full.

Tips: net cash flow alone can mislead; analyse each stream separately; focus on sustainable, recurring cash flows; adjust for one-off items.

Example Fixed assets rise from ₹2,407 lakh to ₹2,412 lakh with depreciation of ₹241.2 lakh. Capex ≈ 2,412 − 2,407 + 241.2 = ₹246.2 lakh.

Remember

• Borrowings appear in financing cash flow.
• Capex ≈ change in net fixed assets + depreciation.

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8Notes, accounting policies and contingent liabilities

Accounting policies show how items are treated (for example straight-line or written-down-value depreciation). Changes must be disclosed; frequent policy changes deserve suspicion.

Contingent liabilities depend on uncertain future events and are disclosed in notes rather than recorded: lawsuits, tax disputes, bank guarantees given, warranty claims, pending investigations, and exposure to currency or policy changes. Management usually plays them down, so compare their size with the P&L and balance sheet.

Off-balance-sheet items include contingent liabilities, operating leases (as the workbook describes) and derivative contracts, which have threatened many businesses. Negative surprises here need close study.

Remember

• Large contingent liabilities relative to the company = caution.

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9Reading financials and the audit report

Numbers can be flattered by assumptions or creative accounting; read the auditors' qualifications (the fine print), watch for changes in accounting period and one-off items. The best companies grow sales, profits and net worth, cut debt, improve margins and raise return on net worth year after year.

Management prepares the accounts; auditors check that they give a true and fair view, based on the information given. They cannot check every transaction, so they test internal controls, check they work, then check compliance with accounting standards. Opinions:

• Clean (unqualified): no issues; standard wording, apart from items under the Companies (Auditor's Report) Order.
• Disclaimer: auditors could not verify part of the accounts for lack of information.
• Qualified: auditors believe all or part of the statements do not give a true and fair view (disagreement on policy or serious discrepancies).

Disclaimers and qualifications explain their reasons; always read the audit report.

Remember

• Disclaimer = could not verify. Qualified = not true and fair.

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10Why ratios

A number alone means little: Airtel's FY2019 EBIT looks large until compared with revenue (about 5.8% of it) and interest (about ₹110 billion, which EBIT did not cover). Ratios express one item relative to a related one, for three purposes:

• Descriptive: giving proportion.
• Diagnostic: explaining what changed. Airtel's revenue fell about 2% but EBITDA about 14%, mainly because network operating expenses rose from about 23.8% to 27.6% of revenue.
• Predictive: most expenses moved with sales, but network costs behaved as fixed costs, which helps forecasting.

Only compare related numbers.

Remember

• Descriptive, diagnostic, predictive.

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11Profitability ratios

Analysts also use non-financial metrics (capacity utilisation, occupancy). High profitability in competitive industries does not last; entry barriers or an early lead in a sunrise industry help.

Formula EBITDA margin = EBITDA ÷ Net sales; PAT margin = PAT ÷ Net sales; NOPAT = EBIT × (1 − tax rate)

EBITDA margin shows operating efficiency, free of depreciation, financing and tax choices (Airtel: about 32.2% in FY2019, down about 440 bps from 36.6%). PAT margin shows what is left for shareholders (Airtel: about 2.1%).

Example Company A FY 2XX9: revenue 9,100; PBT 4,093.1 + finance cost 180.4 + depreciation 241.2 = EBITDA 4,514.7 → margin ≈ 49.6%. Company B: 2,929.6 + 195.2 + 218.6 = 3,343.4 on revenue 7,524 → ≈ 44.4%. A's margin is about 518 bps higher. B's operating profit (EBIT) = PBT + finance cost = ₹3,124.8 lakh.

Remember

• EBITDA = PBT + finance cost + D&A (if no other income).
• EBIT = PBT + finance cost.

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12Return ratios

Formula ROE = PAT ÷ Average net worth (net worth = share capital + reserves and surplus)

ROE (or return on net worth) is the single most important starting point for equity investors: it shows how well equity capital is used. Use average balances (opening + closing ÷ 2), since profit is for a period and net worth is at a date. (Airtel FY2019: about 2.1%.)

Example P/E 10 and P/BV 5 → ROE = EPS ÷ BV = (P ÷ BV) ÷ (P ÷ EPS) = 5 ÷ 10 = 50%.

Formula ROCE = EBIT ÷ Average capital employed; capital employed = total assets − non-interest-bearing current liabilities = equity + debt

ROCE is a pre-tax return to all capital providers; multiply by (1 − tax rate) for post-tax. (Airtel FY2019: about 2.4%.)

Remember

• ROE = P/BV ÷ P/E.
• Use average balances for return ratios.

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13Leverage ratios

Heavy debt is dangerous in downturns: assets may fail to earn, but debts must still be paid.

Formula Debt/equity = Total adjusted debt ÷ Net worth; Interest coverage = EBIT ÷ Interest expense

Adjusted debt includes all interest-bearing liabilities, short and long term, plus items such as pension deficits and convertibles; some analysts use long-term or net debt (debt − cash). Conservatively, a D/E of 1 or less is a benchmark, adjusted for industry and track record. (Airtel FY2019: about 1.52x.) Interest coverage below 1 or negative means earnings do not cover interest, as with Kingfisher.

Exam trap To compare leverage between firms, use a ratio such as debt ÷ assets, not the absolute amount of debt or finance cost.

Remember

• D/E ≤ 1 is a conservative benchmark.
• Interest coverage < 1 = danger.

14Liquidity ratios

Formula Current ratio = Current assets ÷ Current liabilities; Quick ratio = (Current assets − Inventories) ÷ Current liabilities

The current (working capital) ratio shows the ability to meet short-term obligations. High finished goods may mean slowing sales; high raw material stock, poor planning; high receivables, collection problems; high payables, strong bargaining power with suppliers. A ratio below 1 is not always bad: firms that collect cash on sales and pay suppliers on credit are funded by customers, and strong companies may prefer negative working capital as interest-free funding (Airtel's current ratio was about 0.35). A very high ratio may signal poor management of inventory, receivables and cash. The quick ratio excludes inventory.

Remember

• Current ratio measures short-term solvency.
• Quick ratio excludes inventory.

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15Efficiency ratios

Formula Receivables turnover = Revenue ÷ Average receivables; Payables turnover = Purchases ÷ Payables; Asset turnover = Net sales ÷ Total assets; Inventory turnover = Sales ÷ Inventory

• Receivables turnover: higher is better (little credit, good collection).
• Payables turnover: low means long supplier credit, which may reflect bargaining power or shortage of cash; good companies pay on time.
• Asset turnover: higher means assets are used intensively; also part of DuPont.
• Inventory turnover: higher is better; high for FMCG, low for capital goods.

Remember

• Inventory turnover: FMCG high, capital goods low.

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16DuPont analysis

Ratios read together give more insight (sales growth with lengthening collection periods suggests loose credit). DuPont analysis splits ROE into three drivers:

Formula ROE = (Net profit ÷ Sales) × (Sales ÷ Assets) × (Assets ÷ Equity) = net profit margin × asset turnover × equity multiplier

Higher ROE from margins or efficiency is good news; from leverage, it brings more risk.

Example HighLevCo: revenue 12,000, profit 2,400, assets 5,200, equity 2,600 → margin 20%, turnover 2.3x, multiplier 2.0x, ROE 92.3%. LowLevCo: revenue 11,800, profit 2,620, assets and equity 5,000 → margin 22%, turnover 2.4x, multiplier 1.0x, ROE 52.4%. LowLevCo is the better operator; its lower ROE comes only from lower debt (and lower risk).

Remember

• ROE = margin × turnover × leverage.
• Leverage-driven ROE is lower quality.

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17Forecasting and peer comparison

Forecasts based on ratios assume the past represents the future, which may not hold, so analysts adjust for changes. Suzlon was the only Indian wind turbine maker with strong pricing power until competition arrived in the mid-2000s; projecting its past would have been a blunder. Buffett distrusts projections and prefers track records; Munger says projections do more harm than good; Graham and Dodd say a past trend is a fact but a future trend only an assumption.

Example Revenue grew from 8,642 to 9,100 (5.3%); at the same rate next year ≈ 9,582. With revenue guided at 9,500 and EBITDA margin 25 bps lower than 49.61% (about 49.36%), EBITDA ≈ 4,689. Keeping net working capital at 25% of revenue (2,275 ÷ 9,100), it rises to 2,375, an increase of ₹100 lakh. Interest rate ≈ 180.4 ÷ average debt of 1,619.6 ≈ 11.1%; repaying 200 mid-year leaves average debt of about 1,540.5, so finance cost ≈ ₹172 lakh. Equity of 3,046.6 + profit 3,200 − dividends 1,900 ≈ ₹4,347 lakh.

Peer comparison: compare ratios across companies in the same sector to see competitive position; databases make this quick. It is essential in research reports.

Remember

• Forecasts need judgement, not just extrapolation.
• Closing equity = opening + profit − dividends (with no other changes).

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18Equity issuance, dividends, corporate actions and insider trades

Equity expansion: raising funds expensively hurts existing holders. Shares can be issued through rights, public issues, private placements (preferential issues, QIPs), warrants, ESOPs or sweat equity. All except a rights issue dilute existing holders' stakes (a rights issue dilutes only those who do not take up their rights). Growth funded by internal accruals raises little dilution concern. Preferential allotments dilute others but may show a backer willing to support the company in a crisis; issues at a premium are value-accretive for minorities. QIPs dilute but suggest institutional confidence. Past behaviour is a guide to future dilution.

Dividends: part of total return. Growth companies pay little (they earn more on retained funds); mature ones are expected to pay regularly. Look at yield and stability; defensive mature companies (Colgate, Britannia) pay predictable interim dividends; some companies build reserves in good years to smooth payouts. Buybacks are also distributions, sometimes more tax-efficient, and let investors choose whether to sell. Signals need context: retaining more profit may mean a big investment ahead or tough times; a high-growth firm raising dividends may see fewer growth opportunities. Ask management about sharp departures from past policy.

Corporate actions (dividends, bonuses, splits, rights) affect share prices and are covered separately.

Insider trades: promoters and insiders know the business best and trade under SEBI rules. Peter Lynch: insiders sell for many reasons, but they buy for only one: they expect the company to do well.

Remember

• Rights issues dilute only those who do not subscribe.
• Insider buying is a stronger signal than insider selling.

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