Economic Value Added (EVA) Measuring Value

-Naveen
Khandelwal

EVALUATING BUSINESS INCOME

There are two concepts for evaluating business income-Accounting concept and
Economic concept.

According to accounting concept income is measured by deducting expenses incurred

from income earned during the period.

According to economic concept, business income is considered to be the maximum

amount which the business is capable of distributing to its shareholders while still
remaining in the same position at the end of the period as it was at the beginning.

Accounting concept do not take into account opportunity cost & risk adjusted return on
capital employed in the business.

In order to overcome limitations of accounting based measures of financial performance,

stern Stewart & co. adopted modified concept of economic income in 1990 named
Economic Value Added (EVA).

EVA measures whether the Operating Profit is sufficient enough to cover cost of capital.
Shareholders must earn sufficient returns for the risk they have taken in investing their
money in company’s capital. The return generated by the company for shareholders has
to me more than the cost of capital to justify risk taken by shareholders.

If a company’s EVA is negative, the firm is destroying shareholders wealth even though
it may be reporting a positive & growing EPS or ROE.

According to Business Standard-KPMG study based on 1997-98 results major

shareholder value generating companies were IOC, VSNL, Hindustan Lever, GAIL, ITC.
Whereas worst value destroyers are Essar Shipping, BSES, Flex Industries, Videocon
International.

CALCULATING EVA:

EVA can be calculated as follows:

EVA= OPAT- (TCE*WACC)

OPAT= Operating profit after tax. It excludes non-operating income like dividend,
interest and non- operating exp.
TCE= Total Capital Employed. TCE is sum of Shareholders fund plus Loan funds minus
investments.

WACC= Weighted average Cost of Capital. Cost of debt multiplied by percent of debt in
capital structure added to the cost of equity multiplied by percent of equity in capital
structure divided by total debt plus equity.

Cost of debt = Average rate of interest paid on average debt.

Cost of equity = Stern stewart & co recommends CAPM (Capital Asset pricing model)
for calculating cost of equity. According to this model cost of equity is risk free return for
stock market plus a risk premium representing volatility of the share price.

HOW TO IMPROVE EVA

Grow the business by taking on new investments that promise to earn more than the cost
of capital.

Improve efficiency thereby increasing operating profit without increasing the existing
capital.

From the existing business, capital is withdrawn or unprofitable assets are sold so as to
give a greater return than the cost of capital.

WEAKNESS IN EVA

EVA is biased against new assets. When an investment is made its full cost is taken at
capital employed. Depreciation on that reduces profit & EVA remains artificially low. As
investment depreciates capital employed and depreciation is reduced thereby increasing
profits and EVA.

EVA is biased in favour of large, low return investments. Large companies that earn
returns only slightly above cost of capital can have bigger EVA than small businesses
earning much higher return.

For example Company A has an Capital employed of Rs. 1000 with NOPAT of 12%
whereas WACC is 10%. EVA will be (1000*12%)-(1000*10%)= Rs.20

Whereas company B with capital employed of Rs. 100 wit NOPAT of 15% with WACC
of 10% will have EVA of (100*15%)-(100*10%)=Rs.5.

Thus even though Company B has higher rate of return than company A ,it has lower
EVA as compared to Company A.

CONCLUSION
To overcome the limitations of EVA consultants like BCG, Mckinsey and others have
come up with their own version of performance measurement. However EVA can let
companies know how successful they have been in generating or destroying the value for
their shareholders. Thus using EVA companies can plan towards devising strategies for
augmenting the shareholder value in future.

The author is a Chartered Accountant prcatising in Mumbai who also teaches in various
colleges in Mumbai

COST OF CAPITAL

The term "cost of capital" is used as a financial standard for evaluating the return from
investment in projects. The cost of capital is the rate at which a firm obtains capital. Since
there are different sources of capital, each with its own cost, for an investor, it is
necessary that he obtains capital judiciously and from sources which leads to the least
cost.

The cost of capital or opportunity cost of capital must consider that the required rate of
return of any security is composed of two rates – a risk free rate and a risk premium. A
risk free security (for e.g. government bonds) will require compensation for time value
and its risk-premium will be zero. The higher is the risk of a security, the higher will be
its risk-premium, and therefore, a higher required rate of return.

Therefore, required rate of return = riskfree rate + risk premium

The riskfree rate compensates for time value of money while risk premium compensation
for risk. The required rate of return may also be called as the opportunity cost of capital
of comparable risk.

Opportunity Cost and Dividend Payout Ratio:

The firm may follow either a conservative or liberal dividend payout ratio. If dividend
payout ratio is preferred to be liberal, then company would not have much of retained
earnings left for future expansion. Under such a situation, shareholders are expected to be
prudent enough to reinvest the returns in securities so as to earn reasonable rate of returns
on such investments. However, it should be considered that investing pattern of
shareholders widely vary. Therefore knowing the exact rate of return which the
shareholders would earn on reinvesting is indeed difficult.

In case of conservative dividend pay out ratio, little cash outflow takes place. Therefore,
retained earnings has no explicit cost of capital. But they have a definite opportunity cost.
The opportunity cost of retained earnings is the rate of return which the common
shareholders would have earned on these funds if they would have been distributed as
dividends to them. That is, the firm must earn a rate of return of retained funds atleast
equal to the rate that shareholders could earn on these funds to justify their retention.

Overall cost of capital:

A firm may opt for various sources of funds. The cost of capital of such source is known
as specific cost of capital and the combined cost of capital is known as overall cost of
capital.

Firm may raise funds through various sources like Banks & Financial Institutions,
debentures, bonds, issue of shares or it may use its retained earnings.

A proper mix of debt and equity is necessary for making investments. e.g., say a firm has
estimated the cost of equity as 16% and cost of debt as 10% in a particular year. Now if
the firm considers two projects (say X and Y) having the same expected rate of return of
15%.

Under such a situation raising funds by way of debts would be more profitable as
expected rate of return is much higher than the cost of debt of 10%. After some time, the
company considers project Y which has the same risk as Project X with an expected rate
of return of 15%. If no borrowings are available to the firm since the firm has already
borrowed for Project X, the firm would be left with no option but to raise the funds by
way of equity. Under such a situation, expected rate of return from project Y would be
less than the cost of equity capital itself, which would result into rejection of the project.

This approach to investment has certain inherent disadvantages. The firm cannot maintain
a proper balance between debt and equity. It fails to consider relationships between
specific costs. The various sources of capital are related to each other. The firm’s
decision to use debt in a given period reduced its future borrowing capacity. As far as
shareholders are concerned they are benefited due to trading on equity as long as profits
show a rising trend and at the same time, run at a high risk as debt holds priority of
repayment over equity. As risk increases, the shareholders will require a higher rate of
return to compensate for the increased risk. Similarly, the firms decision to use equity
capital would enlarge its potential for borrowings in future.

Therefore there should be a proper balance between debt and equity called the firm’s
capital structure.

Now in the above e.g., if 30% is to be raised by debt and 70% by way of equity, then the
combined cost of capital would be,

30%*10% (for debt) +70%*16% (for equity) = 14.2%

Therefore, required rate of return after considering overall cost of capital is 14.2%.
Where as the expected rate of return is 15%. This implies that the firm should go for
both, project X and project Y.
Whenever investment in any project is made, it is made under the assumption that the
project involves minimal risk. However, the firm, in general, and investment projects, in
particular, are always exposed to a variety of risks. It is well known that forecasting
cannot be done with cent percent accuracy as it is based on future events which itself is
uncertain.

Conceptualizing an idea or a project for investment for a business enterprise is a very

exciting task. However, putting figures to the project is quiet complicated. For instance,
when a Net Present Value analysis is done for a project for deciding as to when, whether
in current year or in a succeeding year, investment should be made in a project, analysis
may show that the firm should introduce a new product next year.

However, firm may decide to introduce the new product this year for several reasons,
such as, firm may have a corporate strategy of being a market leader in introducing new
products, or on account of competitive pressures.

Investment & Financing Decisions:

A firm may opt for several modes of finance such as debt or equity or partly by debt and
equity. Now the question which arises is,

"Should the proceeds of debt and equity and payments of interest, dividends and principal
be considered in computation of investments net cash flows?

Neither debt and equity proceeds nor the payments of interest, dividends and principal
should be treated as investments inflows and outflows respectively. The reason for this
lies in the definition of the opportunity cost of capital (i.e. the discount rate), which is
used for discounting the investments net cash flows.

The discount rate is the after tax weighted average cost of debt and equity. It is a blend of
expected dividend to shareholders and expected fixed payments to creditors. When we
discount an investment net cash flows by the weighted average cost of debt and equity,
we in fact ensure that the investment yields enough cash flows to make payment of
interest and repayment of principal to creditors and dividends to shareholders.

However one of the benefits of Net Present Value method is the fact that it takes into
consideration, time value of money. Net present value method of evaluating a investment
proposal considers the fact that cash flows arising at different periods of time differ in
values and are comparable only when adjustment is made for the time value of money.

Illustration on discounting:

Say Rs.200/- is invested by a firm in a two years project as initial each outlay. Let,
discounting factor be 10%. If inflows from the project at the end of year 1 and year 2 are
forecasted to be Rs.110 and Rs.112 respectively, then is the investment in project worth
while, or not ?

A] Present value of outflow (Rs.200*1) 200

B] Present value of inflow

Year forecasted Discounting Present value of

Outflows factor @10% inflows

1 110 100/110 = 0.909 100

2 112 100/121 = 0.827 92.56 192.56

Net Present Value 7.44

This implies that the proposal of investing in a project of Rs.200/- is not acceptable.

Though, condition of time value of money is taken care off, yet present values of inflows
at the end of two years is not sufficient to justify the initial investment.

When Rs.100/- is invested in a project then it results into an inflow of Rs.110/- at the end
of first year. This Rs.110/- after a year shall again be reinvested by the firm at the rate of
10% so as to ensure the investment yields enough cash flows to make payments of
interest and repayment of principal to creditors and dividend to shareholders.

However, in the above example, the forecasted cash flows after discounting the present
value of inflows is not sufficient to justify the initial cash outlay.

i.e. Rs.100/-, if invested today: should result into atleast Rs.121/- after 2 years (i.e. return
of capital of Rs.100/- and return on capital of Rs 21/- over a period of two years). As such
inflows of Rs 112/- after two years would require how much quantum of investment in
present terms.

= Rs 100 * Rs 112 = Rs 92.56/-

Rs 121

As such investment of Rs 100/- as initial cash outlay is not desirable as it gives to firm
only Rs 92.56/- in present terms.

It should be taken into consideration, that the positive net present value after servicing
debt and equity capital is an addition to the wealth of shareholders. As such, the rate at
which return from the project is equal to the cost of capital is the internal rate of return.
In conclusion, we may state that while sourcing funds for any project, it is essential that
an in-depth study of the various alternatives is made before making investment.

This article is contributed by Sunil Manmohan, a final year CA student.

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Financial Analysis

The most important quality for financial analysis is the passion to go for, go into and go
beyond numbers. Let us begin by unlearning some common misconceptions. Many
people relate financial analysis to number crunching. There are some others who have set
benchmarks for financial ratios and numbers, like a current ratio of 2 or debt to equity
ratio of 1, etc. Many have a tendency to calculate expected share price by multiplying
EPS with a normative P/E. Were financial analysis such simple arithmetic, we would
have given you a spreadsheet with pre-written formulae rather than this verbose piece.

A financial analyst's job is akin to a surgeon. Just as each human body is different, every
case for financial analysis is different. You have some acquired knowledge and
techniques and then it is all upto your judgement and experience.

Yes, numbers are important. Financial analysis starts with numbers. But it does not end
there.

What Is A Ratio?

A ratio is nothing more than a simple division of two numbers. Often numbers by
themselves do not convey anything until they are related. It needs a contextual reference.

In our day-to-day life, we use ratios to analyze a variety of situations. For instance, in a
one day cricket match if somebody tells you that India has to make 70 runs to win the
match, it means nothing. Even if a kid is watching the game, he on his own would work
out the asking rate, which is runs required per balls remaining. 70 runs in 10 overs is a
more useful piece of information. You know that the asking rate is 7 runs per over. But is
that enough.

The same neighborhood kid watching the game will have some more interesting
questions to ask. Such as how many wickets are remaining? Is our star batsman Sachin
Tendulkar still batting? How many of the 10 overs remaining will be bowled by Saqlain
Mushtaq? Is the pitch playing true? And so on.

Similarly, in financial analysis, we need qualitative information and try to read between
the numbers. We have to ask all the right questions. Over the years, there are some ratios,
which have become more popular and handy for rule of thumb analysis of financial
statements. Our purpose in this note is not deride them but to advice the reader to use
them properly to derive the correct results.

How Not To Use Ratios?

Now, let us take an example and understand how a ratio by itself can be misleading. Take
an instance of a fast growing software company for which receivables as percentage of
sales increased from 25% last year to 50% this year. Is it bad? Many pundits would
immediately decree that the company's working capital management is poor, accounts
receivables are high, company will have cash problems, interests on working capital will
go up, etc etc.

Nobody dislikes businesses, which are growing very fast, legitimately. It is quite likely
that the sales towards the end of the year would be far greater than the average for the full
year and receivables as a percentage of sales calculated on the basis of total year would
be misleading. The company's receivables appear higher for this reason. In other words,
suppose sales for the full year was Rs100, of which last quarter sales was Rs50. Three
months credit period would result in receivables of Rs50 ie 50 % of annual sales or
equivalent to 6 months sales. In reality, they are only for 3 months sales. Also some
businesses are seasonal. Nestle has to stock up in winter for its milk as well as coffee
beans. These are critical raw materials and available in abundance only in winter, but
used throughout the year. So if the year end is in December, the actual working capital
figure will be significantly higher than the average for the year.

Key Limitation Of The Balance Sheet

While balance sheet is made at a certain point in time, profit and loss account is for a
period of time. Balance sheet, which is made to represent time period can easily be
window dressed. And therefore, while doing analysis of any type, keep this fact in the
back of your mind.

Key Objectives Of A Business

Before you look at different ratios, let us look at a firm's objectives in a capitalist market.
The one and only intention of any firm is to maximize shareholders value, which is
effectively done by getting a bigger bang out of the capital employed. Exceptional cases
like charity, passion, hobbies, etc also try to maximize return on capital employed, but
there the definition of capital is different. For the time being, let us stick to financial
capital.

While businesses claim to have multiple objectives such as market share, brand building
and even social objectives, at the end of the day, what really matters is how much money
one makes. All are strategies to maximize return on capital employed, which is the one
and only long term goal of all management. Obviously one will look at money made in
relation to one's investment. If you use 10 times as much capital and make 5 times more
money, it is of no good. If business A earns Rs10 on Rs 100 investment (10%), it is better
than another business B that earns Rs50 on Rs1000 (5%).

To analyze the performance of any business, the key ratio is therefore Return On Capital
Employed (ROCE). We can further analyze this ratio using a model popularly know as
The Du Pont model.

The model starts with analysis of ROCE in its two constituents

Profit margin on sales

Sales per unit of capital invested
To give an example, say business A is one in which Rs100 capital invested in a year
generates sales of Rs100 with net profit margin of 10%. Whereas, in business B a Rs100
investment generates a turnover of Rs500 but with a net profit margin of only 4%.
As you can see, in business B, net profit margin can be lower but is more than
compensated by the fact that turnover generated per unit of capital invested is
significantly higher or capital turnover ratio is higher. Return on capital invested is the
product of sales margin and capital turnover ratio.

The same can be presented in the formula as follows.

(Net profit/ sales) * (sales/ capital employed) = Return on capital employed

The above two are the mother of all ratios. Let us look at their children.

Profit Margin

We all know that profit is revenue minus cost. Each element of cost can be presented as a
% of revenue and at different levels of costs, we have different versions of profit, ie
EBIDTA, EBIT, EBT, etc. EBITDA margin is a good indicator of operational efficiency
of any company.

Even revenue can be broken up for the purpose of analysis, which is of use in a multi
product, multi division entity. Typically, analysts look at the relative share of other
income, because this item is where most Indian companies show extra ordinary profits to
boost their bottom line.

Asset Turnover Ratio

The total asset turnover ratio can be divided into fixed assets to turnover and working
capital to turnover ratios. Working capital to turnover ratio can further be divided into
various components of working capital namely inventories, receivables, sundry creditors,
etc.

When we calculate inventories and receivables turnover ratio, we can also present them
in a different manner ie in terms of number of days of various components of working
capital. The basic understanding is that sales happen over 365 days, and so each item of
working capital can be interpreted in number of days. If your receivables are 25% of
annual sales, this is equivalent to saying that your receivables are three months' sales. The
ratio gives us an idea about the credit extended by the business.

Inventories Valued At Cost

For inventory turnover ratio, it would be better to consider cost of goods sold rather than
sales value. Let us take an example. Suppose the cost of manufacturing is Rs50 per unit
and selling price is Rs100 and you have sales of 100 units in a year, your sales revenue
will be Rs10,000. At the end of the year if you have a stock of 25 units which is
equivalent to 3 months sales in terms of volume, but in terms of costing, it will be
equivalent to only one and half months.
A sum of Rs1,250 which is 1/8th of the sales or one and half months inventory is
calculated by dividing inventories with cost of goods sold. To remove this anomaly
inventory turnover ratio is calculated on as inventory divided by cost of sales. If you
multiply this fraction by 12 you get the number of months.
If you multiply this fraction by 365 you will get number of days.

Return Ratios

There are two types of providers of capital, owners and lenders. As returns to lenders are
fixed, we don't have to calculate any return ratio on debt as the same is predetermined.
From owners' perspective, the key ratio is return on networth. Networth represents
owners' funds, paid up capital and retained profits called as reserves. As an owner, you
would also be interested in knowing how much return is being generated by the total
capital employed.

Capital employed consists of networth plus debt, ie owned and owed money. So when we
calculate this ratio we have to add back the cost of debt, ie adjust for interest expenses.

This ratio is calculated primarily on pre-tax basis and it is equivalent to EBIT (Earnings
Before Interest and Tax) divided by total capital employed. If we want to calculate it on
post-tax basis, we will have to add interest adjusted for tax ie

EBT + interest*(1-T)/ capital employed, where T is the tax rate.

Why Should Interest Be Adjusted For Tax ?

Under tax laws, interest is tax deductible. Say your tax rate is 35%. You have two
alternatives, in both cases, say your profits are Rs200. In one, you have to pay an interest
of Rs100 and in the other zero.

Post tax profits of the two businesses will be

A
B
Difference

Pre interest/ tax

Rs200
Rs200
-

Interest
(Rs100)
-
(Rs100)
Taxable profits
Rs100
Rs200
(Rs100)

Tax (@35%)
(Rs35)
(Rs70)
(Rs35)

Post-tax
Rs65
Rs130
(Rs65)

The difference of Rs100 is narrowed to Rs65, due to the benefit of tax deduction on
interest expense. In other words the business which pays a tax of Rs100 has a post-tax
profit lower by only Rs65 because of a lower tax, therefore this is called a tax shield. The
effective cost of interest is only Rs65 and not Rs100. So when we have to add back
interest we also have to add back interest adjusted for tax.

Must We Add Back Interest For ROCE?

Yes, while calculating ROCE, we have to add back interest. This ratio calculates the
returns to all the providers of capital. As mentioned earlier, capital can be debt or equity.
On debt, we pay interest while entire PAT belongs to equity holders. Therefore, when we
calculate return on capital employed, we have to do so before any payment is made to the
providers of capital. So if we do not add back interest we will be taking profits after
making some payment to the provider of capital thereby distorting the real picture.

Pay Out Ratios

Out of PAT, a part is distributed as dividend to equity shareholders. The ratio of

dividends paid to total PAT is called dividend pay out ratio, which indicates how much of
funds is being paid out and how much is being retained within the company to further its
prospects.

Liquidity Ratios

In the normal course of business, a firm will have short-term as well as long-term
liabilities. If you fund long-term commitments by short-term funds you may run into
asset liability mismatch. You may have access to long term funds yet in the short-term
you may fail to meet your outflow obligations, resulting in problems. Working capital is
current assets net of current liabilities. Current assets refer to assets which are likely to be
realized into cash in less than a year's time. Current liabilities will have to be paid back in
cash in a less than year's time. Traditional accountants have also taken a view that current
assets should be more than twice the current liabilities so that whenever current liabilities
arise for payment there is no liquidity crunch. This ratio is called current ratio defined as
current assets divided by current liabilities.

In current assets, we have financial assets like receivables/ bills, realization of which is
already quantified and timing broadly predetermined. The same cannot be said about
inventory. In order to have a more stringent test, one can remove inventory from current
assets and then look at a relationship with current liabilities. This is quantified in quick
ratio which is defined as quick assets divided by quick liabilities. Quick liabilities are
similar to current liabilities but quick assets are current assets minus inventory, a
reflection of the company's "cash" position. This is also known as the acid test ratio.

Although many people recommend current ratio of 2x and a quick ratio of 1x, there is no
sanctity to these numbers. In many cases you will find that a high current ratio, in terms
of textbook might indicate strong short-term liquidity, is in fact reflecting the reverse. It
might be due to significant amount of funds blocked in inventories, slow moving items,
etc. Also it may reflect poor working capital management and therefore lowering of
return on capital employed and return on networth.

Debt equity ratio (a very commonly used ratio) is defined as long-term debt divided by
networth or equity holders funds. This reflects the extent of financial leverage of the firm.
A high debt equity ratio indicates higher risk, as your profits can fluctuate but your
commitment to pay interest to lenders is fixed.

The interest cover ratio is an indicator of the company's ability to meet its interest
outflow, which is fixed. This is defined as EBIT divided by interest payable. A high
interest cover ratio gives comfort to the lender that his money will be repaid. All lenders
focus at this ratio. In other words, if you have an interest liability of Rs100 and if you
have profit before inter est and tax of Rs400, then your interest cover ratio is 4, which is
obviously better than an interest cover ratio of 2. The higher the ratio, the greater the
comfort for the lender. Some people add back depreciation to the numerator to arrive at a
modified interest coverage ratio.

Operating And Financial Leverage

Archimedes once said "Give me a lever long enough and I will move the whole earth
around me". Similarly any businessman if given leverage large enough, can move the
whole world around him. Neither Archimedes nor any businessman could ever get access
to a lever long enough. Leveraging refers to the risk which will have a multiplying effect
on your earnings, on the upside as well as downside.

Let us take an example from our daily life. Say, for travelling from your house to office
requires a return railway ticket of Rs10 per day whereas a monthly season ticket costs
Rs100. If you do not travel even for a single day, the decision to buy a monthly pass
would mean a loss of Rs100 but on the other hand if you travel everyday in a month you
would save Rs200. By buying a railway season pass you are increasing your fixed costs
or in terms of financial analyst, you are increasing your leverage.

What Is Break Even Volume?

In theory, all costs can be divided into two categories - fixed and variable. For
incremental volumes, you incur only variable cost. Difference in selling price and
variable cost is contribution. Contribution minus fixed costs is net profit. With volumes,
your sales revenues and variable costs both rise. Fixed costs are static and therefore net
profits will rise disproportionately with increase in volumes. Similarly with a fall in
volumes, revenues, variable costs and contribution margins will fall in proportion but
fixed costs will remain static. Net profit will fall disproportionately. Break even volume
is the volume at which your net profit is equal to zero ie is your contribution is equal to
fixed costs. You can calculate break even volumes by dividing fixed costs by contribution
per unit. This formula will give you volumes required to break even ie make contribution
equal to fixed costs or net profit equal to zero. As you are converting a part of your
variable operating cost to fixed costs for upto a particular capacity (30 days in our
example, after the break even point (in our example 10 days travel) the risk pays off and
you gain significantly. On the other hand if you operate at less than breakeven point you
are the loser.

Operating Leverage

Operating leverage refers to change in earnings before interest and tax (EBIT) in relation
to change in volume, i.e. if volume grows by 10% and your EBIT grows by 20%, your
operating leverage is 2.

Financial Leverage

If you have Rs1000 of own money and can take up a risky project whose returns can vary
between 0% and 30%. You can double the scale by borrowing Rs1000. If the return is
less than 15%, (which is what you have committed to pay the lender), the loss on your
own money will be high. In other case if your actual return is higher than 15%, you
would be able to benefit from the leveraging and return on your own capital will increase
significantly.

Financial leverage therefore refers to the extent a firm has fixed financing costs due to
use of debt. While interest costs remain fixed, a change in EBIT results in
disproportionate change in EBT. For instance if your EBIT is 1000 and interest cost is
500, 10% change in EBIT will lead to 20% change in EBT. But if interest cost is 100,
same change leads to only 17.5% change in EBT.

Total leverage is multiplication of operating leverage and financial leverage. These

concepts enable us to understand how net profits would react to changes in volumes and
EBIT, and hence an indicator of risk.
Per Share Ratios

An equity share is a legal document representing ownership of any entity. Shares of listed
companies trade in stock markets. It, therefore makes sense to look at most profitability
indicators on a per share basis. The key ratio is earnings per share which is net profit (if
the company has issued preference capital, then one must remove preference dividend to
reflect what belongs to the common equity holders only) divided by number of
outstanding shares (outstanding shares refers to total shares issued by the company).

One variant of this ratio of cash earnings per share which is cash profit divided by
number of outstanding shares. Cash profit is equivalent to profit after tax plus
depreciation and other non cash charges.

Should Depreciation Also Be Adjusted For Tax While Calculating Cash Profits?

No. What we are looking for in cash profits is the total cash accrual to the business. You
might turn around and argue whether capital expenditure and other outflows should be
adjusted for. The answer is a big no, as capital items and revenue items are treated
separately. A good way to look at the overall cash position of the company is to draw a
cash flow table, where all sources and uses of cash get highlighted.

Dividend per share

The owner can allow profits to remain within business or can withdraw it for other or his
personal use. When he withdraws, it is analogous to dividend payout. In a company, the
management decides on behalf of the owner, whether or not to retain a part of profits
within the company (that is called retained earnings) and gives back a part of profits to
the pwners called dividends.

Dividend per share is the total dividend paid per equity share. In case there was a fresh
issue of equity capital in the year, most companies make pro rata payment, ie supposing
in a financial year (April to March) there was an issue of equity shares on October 1. The
new shares which were issued on Oct 1, will be entitled for only 50% dividend as
compared to other shareholders who were there for the full year.

Quantitative Ratios

Till now we have looked only at financial numbers. Quantitative numbers are as
important ie number of units sold or number of units consumed as raw material. One can
look at unit realization ie unit selling price. However in most cases quantitative numbers
for a particular category are given in lots and unit realization numbers to that extent are
not reflective.

Trends In Some Key Ratios

By trends we mean progress year after year. So one can look at trends in sales, fixed
assets, working capital and trends in various ratios.

Trends in some key performance ratios such as operating margin, return on networth also
convey meaningful results. For instance, operating margin which was 8% last year and
9% this year, is a welcome trend, assuming ceteris paribus (other things remaining the
same).

Annualizing Numbers

Many a time, companies change their accounting years and during transition, the
accounting year is not for 12 months. One has to but apply common sense to understand
where annualizing is needed. Annualizing is required only when accounting period is not
12 months.

If any ratio has one component that is for full period, it would require annualization. But
if both the components (numerator as well as denominator) are for the same time period,
no adjustment is required. Also, if both the constituents of ratio represent values at a
given point in time and not for the entire year or accounting period, you do not have to
annualize.

Let us take an instance of a company that has changed it accounting year from March to
December. The accounting period is now for 9 months only. Return on networth would
require annualization as profit after tax is for 9 months and networth, the denominator is
as on December 31, a point in time. Book value does not require annualization because
both the figures numerator as well as denominator are as on December 31, a point in
time.

Beneath The Numbers

One obviously has to look at qualitative factors underlying the numbers. For instance
working capital turnover ratio might appear high if there was a transporters strike in the
last week of the year. A business which has just started may record abnormally high
growth in the first few years. On the enlarged base, growth may slow down but that is not
negative reflection on the management. A small company can achieve a growth, of say
200-300% but a company which is already a market leader cannot achieve that kind of
growth because of base effect. That does not mean that the management of the company
that has achieved 200% growth is superior to that of the large company. Also, there may
be inevitable circumstances like fire or disruption which can adversely affect the
performance in any single year.

Comparison

One can make comparisons across years in terms of trends in margins, growth or
comparison across companies within a sector or across a sector, by comparing large
companies in both the sectors or sector aggregates. As mentioned earlier, these numbers
are just a starting point. Another type of comparison is inter firm comparison ie firms of
the same industry are compared on various parameters. For instance you can compare
operating margins of Gujarat Cement, Madras Cement and analyze the reason for
differences. One can look at aggregate numbers of one industry and compare them with
aggregate numbers of another industry to understand the differences in performance of
various industries. For instance, if you look at the consumer durable industry which
might be generating a return on networth of 8-10%, whereas software industry may be
generating a return on networth of 40-50%. So one can easily conclude that software
industry is doing significantly better than the consumer durables industry.

Per Share Ratios

In stock market, a fraction of ownership known as shares are traded. Therefore in order to
arrive or get a proper picture of the worth of a share (one unit of the company), we should
look at numbers calculated on a per share basis. Earnings per share is profit after tax
(adjusted for preference dividend if any) divided by number of outstanding shares.
Similarly, you can calculate cash profit per share, sales per share, etc. This will facilitate
valuation and comparison with other companies.

The most famous of the valuation ratios is the Price earnings ratio (P/E ratio), which is
the current market price of the share divided by the earnings per share. Also see the
chapter on investing for a detailed discussion of the same.

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Entrepreneur MBA

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.

Illustration: Common Income Statement

Net Sales 2,600.00

Cost of Goods Sold -1,400.00

SG&A Expenses -400.00

Depreciation -150.00

Other Operating Expenses -100.00

Operating income 550.00

Interest Expenses -200.00

Income Before Tax 350.00

Income Tax (40%) -140.00

Net Profit After Taxes 210.00

Slide 8 of 21

Illustration: Common Balance Sheet

ASSETS LIABILITIES

Current Assets Current Liabilities

Cash 50.00 Accounts Payable (A\P) 100.00

Receivable (A\R) 370.00 Accrued Expenses (A\E) 250.00

Inventory 235.00 Short-Term Debts 300.00

Other Current Assets 145.00 Total Current Liabilities 650.00

Total Current Assets 800.00 Long-Term Liabilities

Fixed Assets Long-Term Debt 760.00

Property, Land 650.00 Total Long-Term Liabilities 760.00

Equipment 410.00 Capital (Common Equity)

Other Long-Term Assets 490.00 Capital Stock 300.00

Total Fixed Assets 1,550.00 Retained Earnings 430.00

Year to Date Profit/Loss 210.00

Total Equity Capital 940.00

TOTAL ASSETS 2,350.00 TOTAL LIABILITIES 2,35

Slide 9 of 21
---------------------------------------------------------------------------------
Step 1: Calculate Net Operating Profit After Taxes (NOPAT)
Net Sales 2,600.00

Cost of Goods Sold -1,400.00

SG&A Expenses -400.00

Depreciation -150.00

Other Operating Expenses -100.00

Operating income 550.00

Tax (40%) -140.00

NOPAT 410.00

Note: This NOPAT calculation does not include the tax savings of debt. Companies
paying high taxes and having high debts may have to consider tax savings effects, but this
is perhaps easiest to do by adding the tax savings component later in the capital cost rate
(CCR)
Slide 11 of 21
Step 1: Calculate Net Operating Profit After Taxes (NOPAT) (Cont.)
An alternative way to calculate NOPAT:

Net Profit After Tax 210.00

Interest Expenses +200.00

NOPAT 410.00

Slide 12 of 21
Step 2: Identify Company’s Capital (C)
Company’s Capital (C) are

Total Liabilities less Non-Interest Bearing Liabilities:

Total Liabilities 2,350.00

less

Accounts Payable (A\P) -100.00

Accrued Expenses (A\E) -250.00

----------

Capital (C) 2,000.00

Slide 13 of 21

Step 3: Determine Capital Cost Rate (CCR)

In this example: CCR * = 10%

Because:

Owners expect 13 % return* for using their money because less are not attractive to
them; this is about the return that investors can get by investing long-term with equal risk
(stocks, mutual funds, or other companies). Company has 940/2350 =40% (or 0.4) of
equity with a cost of 13%.
Company has also 60% debt and assumes that it has to pay 8% interest for it. So the
average capital costs would be:
CCR ** = Average Equity proportion * Equity cost + Average Debt proportion * Debt
cost = 40% * 13% + 60% * 8% = 0.4 * 13% + 0.6 * 8% = 10%
* Note: CCR depends on current interest level (interest higher, CCR higher) and
company’s business (company’s business more risky, CCR higher).
** Note: if tax savings from interests are included (as they should if we do not want to
simplify), then CCR would be:

CCR = 40% * 13% + 60% * 8% *(1- tax rate) =

0.4 * 13% + 0.6 * 8% * (1 - 0.4) = 8.08 % (Using 40 % tax rate)

Slide 14 of 21

Step 4: Calculate Company’s EVA

EVA = NOPAT - C * CCR

= 410.00 - 2,000.00 * 0.10

= 210.00

This company created an EVA of 210.

Note: this is the EVA calculation for one year. If a company calculates
EVA e.g. for a quarterly report (3 months) then it should also calculate
capital costs accordingly:
Capital costs for 3 months: 3/12 * 10% * 2,000 = 50
Capital costs for 4 months: 4/12 * 10% * 2,000 = 67
Capital costs for 6 months: 6/12 * 10% * 2,000 = 100
Capital costs for 9 months: 9/12 * 10% * 2,000 = 150

Slide 15 of 21