End-term suggested answers and common mistakes

Approaching financial statements analysis:

1. What is the purpose of financial statements and their analysis?

To understand the goings-on in the business via numbers, read symptoms, diagnose problems
and come up with possible solutions.
2. What could be some approaches to financial statements analysis?
a. Compute all possible ratios; benchmark them against standards and/or peers and isolate the
ones that are significantly away from average; dig deeper into them. This is not the most
efficient or smart way of approaching the issue. This is akin to a doctor running all possible
tests on a patient and checking out which test is indicating a problem and then digging
deeper into that aspect.
b. Do a first level study of the financial statements to see possible symptoms1. Based on the
symptoms, run diagnostics (compute ratios in this case) around that problem area to
reconfirm or understand the underlying problem. Most of the time, the problems are not
independent but interconnected.

Q1. This required you to compute necessary ratios based on a first level study of the financials of
Bhushan Steel. Almost all the papers Ive seen so far have used approach a rather than b, which was
asked for.

Suggested answer: Some of the important symptoms or indicators based on first level study of the
financials are:

a. Balance sheet: Reserves depleting, preference shares being issued every year; significant
increase in long term and short term borrowings; significant increase in contingent liabilities
b. P/L statement: EBIT reducing since 2014 despite increase in revenues; interest expenses rising
exponentially leading to pre-tax losses in the last two years
c. Cash flow statement: CFO meandering between positive and negative; inventory pile-up; capex
continuing each year (other factors already indicated in B/S and P/L)

Ratios to be computed based on:

a. ROE, maybe ROA too; Debt/Equity or other leverage ratios; Price/book ratio
b. Operating profit margin, maybe EBITDA and GP margin too; Interest cover ratio (very important)
c. Inventory turnover ratio, fixed assets and/or total assets turnover ratio

This is a good place to compare these ratios to peers and industry averages to assess whether this is an
industry wide problem or a company specific problem. When comparing with industry averages, it is
important to see if the average is being influenced by an outlier. If so, that may be removed and an
assessment made.

1What is the difference between a symptom and a problem? When youre unwell, high temperature, nausea, etc.
are symptoms. The problem is unearthed only when diagnostics are applied and analysed.
Some common mistakes here:

1. Ratios without units are meaningless (%, times, Rs..)

2. When we use different ratios to investigate the same problem, each ratio should provide a new
set of information. E.g. high debt seems to be a problem so we compute leverage ratios. How
many and which all should we compute and what do each of those mean?
D/E typically counts long term debt in the numerator. What is the difference between
long term debt and long term liabilities? You can have a variation of the ratio where you
also include ST debt in the numerator, especially for a firm like Bhushan Steel. But non-
debt liabilities should not be included.
Non-debt liabilities can be included in the leverage ratio i.e. Total assets/ Total equity.
Here, everything on the liability side other than equity shows up as the difference
between the numerator and the denominator.

So here, both ratios are providing you different pieces of information for analysis. If you use all liabilities
in D/E, whats the point of computing the second ratio?

3. A combination ratio (that has one variable from the P/L or CFS and the other from the B/S), is
inconsistent if the B/S variable is taken as at one point in time. Therefore, we use an average
number for the B/S variable. E.g. ROA = EBIT/Average total assets or Inventory turnover = COGS/
Average inventory.
4. Unless we compare a ratio to a set standard e.g. current ratio below 1 or to peers, it is not
possible to say whether it is too low/high/good/ bad.
5. It makes no sense to compare Bhushan Steels gross revenues to that of say, Tata Steel or JSW
and say that its lower and hence, bad. Being a smaller company is not a disqualification or
doesnt indicate poor performance.

Q2: Based on the ratios, to identify two problem areas that need immediate attention and reasons.

Firstly, low ROE or negative net margin are not problem areas. They are symptoms. When you put
symptoms together, you identify problem areas.

Second, you cannot identify a problem without running the required diagnostics. E.g. you cannot say
that the firm is carrying high receivables reading it off the balance sheet unless you compute the
receivables turnover ratio or days sales outstanding AND comparing this to peers. Since RTR is not
provided, it is not possible to make a judgment on this parameter for this case.

Possible problem areas:

1. Combining high D/E, leverage, ICR, we identify high indebtedness as a problem area. This is
further substantiated by the fact that while operating profit margins are still positive, PBT and
PAT are increasingly negative because of interest expenses.
2. Combining ATR, Inventory turnover, we can identify poor asset utilization/ efficiency as a
problem area.
 3. ROA of about 2% is better than industry average, which is negative. Thats the good news. But it
is too low to bear the cost of debt and poorer than two peers who also have positive ROA. Their
numbers indicate that the industry is going through a slowdown, so there is only so much that
Bhushan can do to improve that situation. So indebtedness becomes a graver problem.
4. Some of you have indicated low current and quick ratio and hence, short term liquidity as a
problem. This is also correct.
5. Finally P/B ratio is a very low 0.22X (better than industry average through)that indicates stock
market investors lack of confidence in the firms future outlook.

Q3: Du Pont Analysis and CFS Analysis to identify underlying dynamics and what might have caused
these problems.

We have discussed the 3-way and the 4-way Du Pont in class. The latter helps break down the net profit
margin effect into operating profitability and interest expense effects. Especially for a firm that has such
high interest expenses, this level of breakdown and analysis was absolutely essential. (This hence, may
not make sense for a firm that carries negligible debt on its balance sheet).

Secondly, some of you have conducted a 4-way Du Pont that isolates the tax effect. While it is okay, in
my opinion, it is not very useful from a problem solving perspective for a firm like Bhushan that is
looking to come out of insolvency. This may be relevant for a firm thats doing very well and is paying
huge taxes.

A footnote was provided saying that a constant tax rate will not be applicable to Bhushan, so the (1-t)
formulation will not work. So you were required to take the tax amounts instead. Many of youve done
that.

Also, when we take average equity and average assets to compute ROE and ATR respectively, but one
years figures to compute Leverage ratio, this LHS and RHS will not be equal. This is especially when the
change in equity is significant. But we can ignore that and focus on the indicators instead.

The Du Pont you get for FY2016 is as under:

ROE = (1 Int/EBIT) * (EBIT Tax)/Revenues * Revenues/ Avg assets * Assets/Equity

= (3.65) * 13.1% * 24.5% * 14.6X (If taxes are ignored, EBIT margin is 7.5% for FY2016. This may
be a better number to go with as the huge tax credit in FY2016 is not an indicator of operational
efficiency).

For FY 2015: ROE = (1.03) * 10.5% * 22.6% * 8.09X

Key observations: Interest cover has dropped significantly making the first term go further into the
negative. EBIT margin is positive and better than industry but is dipping. ATR is marginally improved but
still very low. Leverage has substantially increased.
(Remember, leverage is a double edged sword. When your ROA is positive and interest cover >1,
leverage helps magnify ROE for shareholders. When ROA is negative and/or interest cover goes <1, ROE
for shareholders is magnified in the negative zone i.e. it becomes more negative than if the firm did not
have leverage). This is what is happening with Bhushan and many others in the industry right now.

Cash Flow statement analysis:

Common mistakes:

1. Capex has been given as a negative in the CFS because it causes a cash outflow. To the question
Is Capex >0?, the answer is a resounding YES! Many of you have interpreted the negative sign
as capex being <0! And to top it, youve said Yes for the question Is Capex> Depreciation?!
How can both these co-exist?
2. If EBITDA is positive and significant, it is the most important source of cash. This has been
ignored by most students.
3. It is important to understand how a balance sheet indicates sources and uses of funds and how
a cash flow statement indicates sources and uses of cash. The former shows us the status of
various sources and uses as at a point in time while the CFS shows how the change in various
B/S items resulted in flow of cash during the period. The template were working with is meant
to analyze the latter. So sources and utilization of cash have to be determined from the positive
or negative signs appearing in the CFS and not based on numbers in the balance sheet.

Some of the important inferences from the CFS template for Bhushan Steel are as follow:

1. Operations are okay, especially considering peers EBIT margins. EBITDA has been so far positive
despite industry slowdown.
2. Working capital management is precarious and volatile movement of payables and OCL
indicates possible loss of confidence by suppliers and service providers.
3. Company seems to be still in an investing mode as capex > depreciation in both years, inventory
also rising. It is important to see if these investments can pay off sufficiently, soon enough. ATR
very low is a caveat.
4. While EBITDA is decent at about 15%, firm has been heavily borrowing to manage operations
and investments. Unless the capex and working capital investments yield more than the cost of
debt, this will lead to an erosion of net worth and shareholders wealth. Evidenced by low ROA.
5. Interest expense has been the largest outflow in the last two years. Is the firm getting into a trap
where it is funding its interest expenses using fresh debt?

The question expected you to clearly come out with managerial decisions that may have led up to this
situation.

1. One is of continuing expansion capex even in a downturn. Since operations have been hit, this
capex had to be funded by debt,
2. The company has been significantly loading up on leverage (possibly hoping the economic
downturn will end and operating margins will climb up before the excessive leverage catches up
 with them), including preference share capital. They very clearly have been avoiding equity as a
source of funding, including equity contribution by promoters.
3. While they are loading up on fixed assets and current assets, still their current ratio <1. This
seems to be because they are heavily reliant on their suppliers and other service providers for
liquidity. So on one hand, their assets are not yielding enough revenue (which could mainly be
because of external environment), they are relying on external debt and liabilities to manage
short term liquidity and long term solvency.
4. Having said this, some of the good decisions by the management are: they have stopped
dividends, they are not investing in financial assets like stocks or bonds, they still have
operations that are better than many of their peers.

Q4. Recommendations to management:

First, any recommendation you make has to flow from symptoms youve unearthed and problems
youve identified. If you havent computed asset turnover ratio at all, how can you identify asset
underutilization as a problem and recommend its improvement as a solution?

Second, there is a difference between preaching (what I call motherhood statements) and actionable
recommendations. E.g. the firm has to improve asset utilization is a useless statement. We all know
that ATR is very low, so it needs to be improved. Why will a client pay you big bucks to tell this? He
wants to know how to do it.

Approaches one can think of could be:

1. Restrict capex to only maintenance or maybe even wind down assets by selling off non-core
plants/ assets. This will improve ATR, hence, ROA. This will free up cash that should be used to
reduce debt. Reducing debt burden is absolutely essential. This will in turn, reduce interest
burden, improve ICR and ROE.
2. Improve operational efficiency and reduce costs. We are assuming revenues cannot be grown
faster because of industry and macroeconomic factors. Certain expenses like SG&A have grown
significantly in the last couple of years that can be reduced. This will improve EBITDA, EBIT
margins and hence, CFO.
3. Manage working capital better by reducing inventory holding and working with suppliers to
smoothen inventory flow. Reducing current assets will automatically reduce the need for short
term borrowings and reliance on other current liabilities too. Bringing current ratio to 1 may not
be easy soon though.
4. Promoters to bring in more equity capital and use it to first of all, pay off some debt. This is not a
good time to issue share capital in the market as evidenced by their very low price/book ratio.
Promoters bringing in capital also signals that they have skin in the game and intend to get the
firm out of insolvency.

Someone has suggested buyback of shares to improve stock market sentiments. What do you think of it
as an option at this stage? What is the need of the hour here? Perception management or saving the
firm from sinking? Secondly, where is the cash for the buyback going to come from?