Tuesday, March 23, 2010

Balance Sheet

Balance Sheet Basics

Balance Sheet is the snap shot of financial strength of any company at any point of time. It gives the details of the assets and the liabilities of the company. Understanding balance sheet is very important because it gives an idea of the financial strength of the company at any given point of time. Following is the balance sheet of Global Telesystems for the year ending on 31st Mar' 2000:

As on


Gross Block 3978.55
Net Block 2790.57
Capital WIP 66.72
Investments 454.33
Inventory 610.81
Receivables 1546.81
Other Current Assets 3673.67
Balance Sheet Total 9142.92
Equity Share Capital 434.12
Reserves 5815.65
Total Debt 2096.69
Creditors and Acceptances 393.91
Other current liab/prov. 402.55
Balance Sheet Total 9142.92

Let us take a look at each of its components.


Gross block is the sum total of all assets of the company valued at their cost of acquisition. This is inclusive of the depreciation that is to be charged on each asset. Net block is the gross block less accumulated depreciation on assets. Net block is actually what the asset are worth to the company.

Capital work in progress, sometimes at the end of the financial year, there is some construction or installation going on in the company, which is not complete, such installation is recorded in the books as capital work in progress because it is asset for the business.

If the company has made some investments out of its free cash, it is recorded under the head investments. Inventory is the stock of goods that a company has at any point of time. Receivables include the debtors of the company, i.e., it includes all those accounts which are to give money back to the company. Other current assets include all the assets, which can be converted into cash within a very short period of time like cash in bank etc.

Equity Share capital is the owner's equity. It is the most permanent source of finance for the company. Reserves include the free reserves of the company which are built out of the genuine profits of the company. Together they are known as net worth of the company.

Total debt includes the long term and the short debt of the company. Long term is for a longer duration, usually for a period more than 3 years like debentures. Short term debt is for a lesser duration, usually for less than a year like bank finance for working capital.

Creditors are those entities to which the company owes money. Other liabilities and provisions include all the liabilities that do not fall under any of the above heads and various provisions made.

Role of Balance Sheet in Investment Decision making

After analyzing the income statement, move on to the balance sheet and continue your analysis. While the income statement recaps three months' worth of operations, the balance sheet is a snapshot of what the company's finances look like only on the last day of the quarter. (It's much like if you took every statement you received from every financial institution you have dealings with — banks, brokerages, credit card issuers, mortgage banks, etc. — and listed the closing balances of each account.)

When reviewing the balance sheet, keep an eye on inventories and accounts receivable. If inventories are growing too quickly, perhaps some of it is outdated or obsolete. If the accounts receivable are growing faster than sales, then it might indicate a problem, such as lax credit policies or poor internal controls. Finally, take a look at the liability side of the balance sheet. Look at both long-term and short-term debt. Have they increased? If so, why? How about accounts payable?

After you've done the numerical analysis, read the comments made by management. They should have addressed anything that looked unusual, such as a large increase in inventory. Management will also usually make some statements about the future prospects of business. These comments are only the opinion of management, so use them as such.

When all is said and done, you'll probably have some new thoughts and ideas on your investments. By all means, write them down. Use your new benchmark as a basis for analyzing your portfolio next time. Spending a few minutes like this each quarter reviewing your holdings can help you stay on track with your investment goals.

The FCCB issue

If FCCBs offer advantages to both lenders and borrowers, why did they run into trouble during the credit crisis?

FCCBs were also a cause for the battering that stocks of some highly leveraged companies received last year. So what are FCCBs and how do they impact companies you invest in?

What is an FCCB?

FCCB is a foreign currency-denominated bond issued by an Indian company. The bondholder can either convert the bond into a fixed number of equity shares in the company (the price is preset) or give up the conversion option and retain it as a bond; in which case, it will be repaid at maturity.

If the market price of the stock, at a future date, manages to rise past the "conversion price" for the bond, the bondholders may grab the option to switch to equity shares.

FCCBs are usually issued with the expectation that the company's stock price will continue to rise with profits. However, if that does not happen and the conversion does not go through, these bonds are to be retired at a premium over their face value.

Consider the FCCB issue of Suzlon Energy. The company issued a zero coupon FCCB with June 2012 as redemption date. However, these zero coupon bonds would be redeemed at 150.24 per cent of the principal amount if the bond does not get converted into equity.

What went wrong?

If FCCBs offer advantages to both lenders and borrowers, why did they run into trouble during the credit crisis? Simply because the prices dropped heavily and became unattractive for conversion into shares.

For instance, Subex's FCCB initially had a conversion price of Rs 656.2 as against the current price of Rs 64 (as a result of the 2008 correction). At the same time, the due dates of these bonds were fast approaching conversion.

Now, if the companies are forced to repay on due date, they would have to pay a premium on such redemption. However, some companies did not put away a sum as premium redemption reserve, believing that their bonds would be converted into shares.

To make matters worse, fall in rupee inflated the oustanding loan amount and interest payouts. The company's ability to service its debt/repay its debt is a key indicator of its financial health.

In the 2008-09 financial scenario, quite a few companies were at risk of committing default if they did not restructure their FCCB terms. This was the key reason why companies with FCCBs due for redemption were beaten down by the market.

Given the 2008 crisis, companies were allowed to either pre-pay FCCBs or restructure them by replacing with new set of FCCBs having lower conversion price (which would involve issuing more shares causing equity dilution). The RBI also allowed them to pre-pay debt by raising external resources and extended the time-frame for such pre-payment to December 2009.

In the case of Subex, the company resorted to revision of conversion price toRs 80.31 from Rs 656.2 to bring it closer to the current market price.

While companies such as Reliance Communication and Financial Technologies took the prepayment route by paying part of their debt at a discount, Suzlon, Aurobindo Pharma and Subex are some instances where the companies drastically cut the conversion price.

Companies whose FCCB redemption did not fall within, say, the next two years, remained neutral and did not resort to restructuring.

So what does this mean for investors? If the company you are investing in has outstanding FCCBs, look at the following:

Has the stock price remained far below the conversion price? If so, what would be the interest outgo on the FCCBs and would that affect profitability?

FCCB, until converted, is a debt. Hence, when looking at the debt:equity position, or leverage, do not assume that the bonds will be converted.

If the FCCBs are being converted into shares in tranches, what would be the ultimate equity expansion and would it dilute earnings?

For what are the FCCB funds being utilised? If they are being used effectively for expansion purpose, chances are that any equity expansion (on conversion) would be compensated by earnings expansion.

How and What to Look into Annual Reports

How  to Look into Annual Reports?

The thought of poring over annual reports to glean information about a company or its growth prospects may seem terribly dull to most new investors.

Nevertheless, the annual report remains the most authentic source of information about a company and contains important facts about its financial condition, growth strategy and current challenges that are not readily available upon an Internet search. A well-written report can give you a rare glimpse into the management's outlook for the industry or its views on new trends in the market. So for those who do not know (or remember) what an annual report looks like, here is a quick guide to reading this document.

The manner of presentation differs from one annual report to the other; some are mini opuses that promise to be a one-stop guide to the industry and company, others barely make the cut when it comes to providing crucial information. Most reports, though, will have the following important components:

The director's report, which will detail the company's operational performance in the year gone by.

Management Discussion and Analysis, where the management provides an outlook on the industry, competitive scenario, new challenges and risk factors and outlines its future strategy.

Detailed financial statements of the company and its subsidiaries, as well as consolidated financials, along with the auditor's report.

The basics, for starters

You may also find pictures of happy employees participating in corporate events. Heart warming, but we suggest that you skim through all that gloss and start with the director's report. This will give you an overview of the co mpany's performance across various segments and an idea of the factors that drove performance.

If you are unfamiliar with the industry the company operates in, then the Management Discussion and Analysis (MDA) is the best place to begin. Clueless about the pig iron industry? Read the Tata Metaliks report for data on the globa l pig iron and foundry market and pig iron price trends. The report also includes an interview with Tata Metaliks' management, which discusses some of the key events that took place during the previous year and its perception about the competitive scenario.

Companies put forth their views on a variety of topics that concern their industry, be it Government regulation, consumer or user industry trends or changes in the global picture in the MDA. They then articulate their own plans to capitalise on unfolding opportunities.

Between the director's report and MDA, you will get a fairly good idea of the businesses the company operates in, its key focus areas, the challenges ahead and the measures it has in place to improve financial performance in the year ahead.

For number-crunchers

For those who believe that it is numbers that do all the talking, the financial statements in the annual report provide you with details that you are unlikely to find on the BSE or NSE Web sites. For instance, you can figure out the extent to which a company is able to fund its expansion plans on the strength of its current operations by looking at its cash flow statements.

The schedules to accounts provide break-ups of income, expenditure and other items. For instance, you may want to know what components constitute "other income", particularly if it has been a significant contributor to profits that year. The item-wise split-up of the components classified under other income will help you decipher how much of the non-operational income is recurring in nature. You are also provided with segmental information — both geographic and business.

Similarly, schedules elaborate on balance sheet items such as long-term and short-term loans. For retailing companies, for instance, inventory management is crucial and you may have to compare the inventory positions over a three-year period to understand how efficiently the retailer manages its stores. Or for cash-rich companies, the quality of their investment book may well play a role in valuations.

The annual report also discloses the financial information of the company's subsidiaries, besides providing financials on a consolidated basis.

As new, high-growth ventures are typically routed through subsidiaries, companies are beginning to command valuations based on their consolidated numbers.

Be sure to look at the notes to accounts to understand the accounting treatment of various revenue and expenditure items. Those who are unfamiliar with accounting practices can make-do with looking for changes in accounting policies . This might tip you off on the impact of one-time earnings or expenses.

Also look for the auditor's qualifications to accounts for any assumptions that have been made while preparing or auditing accounts.

Nooks and corners

The annual report also contains little nuggets of information that could provide you with additional insight into the company.

Management background: For instance, you can find brief profiles about the directors on the board of the company. The presence of directors with strong industry standing lends credibility to the management of the company.

The shareholding pattern of the company will reveal the extent of promoter holding and the extent of institutional interest in the company.

Production and utilisation figures: For manufacturing concerns, the production figures assume significance. The production as a proportion of installed capacity (utilisation) could give you an idea of the efficiency at which the compan y is operating and the headroom for further volume growth. This information is particularly pertinent if the company is planning further expansion.

IPO proceeds utilisation: For newly listed companies, the progress on the expansion plans that had been outlined in the offer document and the utilisation of the IPO proceeds are also disclosed in the annual report.

Notices to resolutions: Some special resolutions passed at the annual board meeting also merit attention. For instance, resolutions passed to increase borrowing limits are cues to the company's desire to leverage its balance shee t.

Explanations are also available on why the resolution has been mooted. For example, Colgate Palmolive India's latest annual report explains the reasons for its declaration of a special dividend and a capital reduction.

This list is far from exhaustive. Going through all this might mean a lot of time and work. But it does make your information more authentic than the tip from your broker friend or the analyst on TV.