There are primarily three financial statements:
1. Profit & Loss Statement
2. Balance Sheet
3. Cash Flow Statement
These three statements are vital in understanding the company’s performance.
An annual report includes all three statements. These annual reports can be downloaded from either the company’s website or the BSE website. Ideally, you should do performance analysis for at least ten years. You have to move past the colourful pages and spend time on the facts; it’s more like a detective job.
Charlie Munger once said that when you analyze a company, look for reasons to reject rather than accept. This way, you will develop counter-intuitiveness and avoid a bad investment. For example, “I am using Airtel connection and so do my friends, Airtel must be a good company,” “I have never worn or seen people wear Relaxo footwear, may not be worth investing.” A good investment must be evaluated based on the numbers and not on your personal views. Go ahead and compare the stock price performance of Airtel (10% per annum over five years) versus Relaxo (37% per annum over five years).
The balance sheet tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. The income statement tells how much the company made or lost in accounting profits during a year or a quarter. The balance sheet is a snapshot of the company’s financial health at a point in time, and the income statement provides details of revenues and expenses over a specific period.
The last financial statement is the cash flow statement, which includes all the cash that comes into a business and all the cash that goes out.
The reason we have a cash flow statement is because of the nature of transactions getting captured. The balance sheet and profit and loss statement are based on accrual accounting. Companies record sales when a service or a good is provided to the buyer, regardless of when the buyer pays. As long as the company is reasonably sure that the buyer will pay the outstanding, the sale can be included in the income statement. On the other hand, the cash flow statement includes transactions when cash is received or goes out.
Let’s use a simple illustration to explain the working of various statements. An entrepreneur wants to open a Coffee shop; let’s call him VG. The operations need him to have at least Rs 1 lakhs, so he goes to a government bank, Socialist Bank of India, to borrow Rs 1 lakh.
1. Borrow Rs 1 lakh from Socialist Bank of India
VG spends Rs 70,000 to set up his shop, including a coffee machine, toaster etc. Then he buys supplies for Rs 20,000 worth of coffee beans, milk, cookies etc. He keeps the remaining Rs 10,000 as cash.
2. Purchase property, plant, and equipment (PP&E) and inventory
VG opens for business and sells 300 coffee cups, each costing Rs 100. Half the milk, coffee beans, and cookies are gone by noon, so VG’s “cost of goods sold” is Rs 10,000, or half of the Rs 20,000 he spent to buy supplies. Ten people didn’t have any cash on them, so VG let them buy their coffee on credit—which means we need to record Rs 1,000 in accounts receivable, which is the money that folks owe to VG.
3. Sells 300 coffee cups for Rs 100 each (Rs 10,000 worth of inventory), with Rs 1,000 worth being sold on credit (cash not received yet).
VG ran out of milk in the middle of the day, so he ran over to the grocery store to buy more. He forgot to carry his wallet and told the grocer that he would pay later. He owed Rs 5,000 to the grocery store; this is accounts payable, which VG owes to the grocery store for the milk.
4. Buys Rs 5,000 worth of milk on credit
At the end of the week, VG realises that his coffee machine has stopped working, and it’s making an unusual sound when the machine is operational. We call this wear-and-tear depreciation, which lets us record that VG’s equipment isn’t as productive as it used to be. Depreciation is a cost of doing business because VG will eventually have to buy another coffee machine. All expenses have to be recorded—we post Rs 3,000 to depreciation.
5. Record wear and tear on the coffee machine
Net profit for the coffee shop is Ra 17,000; however, cash went up by Rs 29,000. To understand how much cash VG’s business generated, we start with his Rs 17,000 in net profits. We then add back the Rs 3,000 depreciation. Depreciation is a charge, but we are not making any payment; it's more like an accounting entry.
Next, we need to consider that VG used up half his original milk inventory and bought Rs 5000 worth of additional milk. His inventory went from Rs 20000 to Rs 10000 and back to Rs 15000. This net decrease in inventory from Rs 20,000 to Rs 15,000 is a source of cash. VG had Rs 20,000 of capital tied up in inventory at the start of the week, but now he has only Rs 15,000 of capital invested in inventory. As a result, he converted Rs 5,000 in inventory to Rs 5000 in cash. However, VG also owes Rs 5000 for milk that he didn’t pay.
VG still owes the grocer Rs 5000 for the milk he bought. Because VG received something without paying out cash for it, his cash account increases by Rs 5000.
Net Profit = Rs 17,000
+ Depreciation = Rs 3,000
+ Inventory (coffee sold) = Rs 10,000
- Inventory (extra milk purchased) = Rs 5,000
- Accounts Receivable (money owed to VG) = Rs 1,000
+ Accounts Payable (money owed by VG) = Rs 5,000
= Rs 29,000 in operating cash flow
As you can see, the Rs 29,000 in operating cash flow differs from the Rs 17,000 in net income because of the choices VG made in running his business. For example, if VG hadn’t let anyone buy on credit but had the same amount of sales, his cash flow would have been Rs 29,000. If the grocer had forced VG to pay cash for the milk, VG’s cash flow would have been Rs 24000 (29k minus 5k). In both cases, however, VG’s net profits would have remained 17k.
The income statement and cash flow statement tell us different stories. The income statement tries to match revenues and expenses. But the cash flow statement cares only about the bills that go in and out, regardless of the timing of the actions that generated those bills. If you look only at the income statement without checking to see how much cash a company is creating, you won’t be getting the whole story by a long shot. This simple concept—the difference between accounting profits and cash profits—is the key to understanding almost everything to know how a business works and separate great companies from poor ones.
Each set of financial statements, especially the annual report, are followed by few details, called notes to financial statements. It is pretty essential to go through these notes. Each company has a different level of detail; companies that provide as much detail as possible can be considered shareholder-friendly companies.
Now we move forward and develop inferences from these statements and notes. This process is called historical company analysis.
Growth is a component of value. It can enhance or diminish the value of a company – growing a business with inadequate returns is simply sending good money after bad. But when a company has superior returns on capital employed and a source of growth that enables reinvesting a substantial portion of those returns, the result is compound growth in its value and share price over time.
Simply speaking, how much a return is made on a certain level of investment.
Return on Capital Employed (ROCE) = Earnings Before Interest & Taxes (EBIT) / Capital Employed
Capital Employed = Debt + Equity
A long-term record of consistently high ROCE is the single most crucial aspect to identify quality companies. Businesses that do not generate high ROCE may not be able to deliver high share price performance.
From Warren Buffett's 1992 Berkshire Hathaway shareholder letter:
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important and difficult to deal with, the difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons."
Now, think about it, a business that can generate high profit and high cash flows will command higher valuation.
ROCE or return on capital employed is a pre-tax return metric. On its own, ROCE provides a proper perspective on the performance of the company. However, you are still relying on the reported numbers.
Return on Invested Capital (ROIC) is a better metric than ROCE but requires extra work. You have to read the annual report especially notes to financial statements. ROIC helps in understanding the return on the core operations of the business.
ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital
You have to create the profit & loss account to calculate NOPAT. You start with revenue, which is usually operating and associated with the core operations. You deduct ‘cost of goods sold, and that will give you the ‘gross margin’. You then proceed to look at sales and general administrative expenses; this includes employee costs as well. Depending upon the reporting, excluding items that are not associated with the running of core operations of the company. Then you move the ‘other expenses’ bucket that indicates all the other expenses. Often has items related to non-operating businesses, for example, loss due to foreign exchange, settlement of legal dispute etc. Deducting these items from the gross margin will give you an operating margin. You deduct depreciation related to plant, property and equipment. You should also deduct amortisation on the operating intangibles such as computer software etc. You will get Earnings Before Interest & taxes (EBIT) after deducting depreciation and amortisation. You apply the statutory tax rate to get Net Operating Profit After Taxes (NOPAT).
Invested Capital is the summation of the use of capital by the business. Instead of using debt and equity, you focus on using that capital, say, buying machinery, land, inventory etc. Invested Capital includes plant, property & equipment, capital work in progress, inventory and accounts receivable. You deduct other operating liabilities and accounts payable to get invested capital.
ROCE is based on capital employed, whereas ROIC is based on invested capital. ROCE considers the total capital employed, a total of debt and equity financing less short-term liabilities. ROIC is more refined, and it calculates the return of a company based on how the capital used in the business.
ROIC break up also indicates what is driving the performance of the company.
In case of Amrutanjan Healthcare Ltd, the EBIT margin of the company has ranged between 8% - 13%. When you see commodity-based businesses, margin ranges may be too broad.
Look at Bharti Airtel’s ROIC profile, which ranges between 8% - 18%. Airtel is required to invest regularly to be relevant. However, Amrutanjan may not have to lay out so much capital unless the company wants to grow, requiring capital outlay. In the case of Airtel, even to grow at 0%, they need to invest. However, Amrutanjan can continue to generate cash flows without investing.