Financial Statement Analysis

For Equity Investment and Credit Decisions

Sunder Ram Korivi
Presentation Structure
• Perspectives on Financial Statement Analysis
• Analysis for Equity investment decisions
• Analysis for Credit decisions
Question
• Financial Statement Analysis v. Financial Analysis
Perspective
• Participants in Equity and Credit Markets are focused on transacting, with the
attendant monetary, liquidity and time constraints
• The Efficient Market Hypothesis (EMH) is a hypothesis, not always a fact in all cases
at all times. EMH assumes all fundamental information to be embedded in the prices
• Behavioural aspects such as “greed & fear”, and corporate governance
(mal)practices, tend to move asset prices away from their intrinsic values
• As a result, transactions in Equity and Credit markets may be made on a shallow
basis (e.g. Global Financial Crisis, and debt crises in several countries such as China,
Japan, crony capitalism in ASEAN in 1998)
• This brings the focus back to financial statement analysis: sound financial analysis
must be at the backbone of Equity and Credit decisions
Perspective
• Q1, Q2, Q3, Q4 results of a period are compared with the corresponding Quarter of
the preceding year (Q-o-Q) and also the immediately preceding Quarter (Sequential
Quarter). EPS is also computed on a Quarterly basis and also a Trailing Twelve Month
period (TTM), instead of annualizing
• Managements are excessively concerned with Quarterly results, and so also the
shareholders. This leads to a collective myopia or short-term-ism. This is known as
Quadrophobia, a phenomenon not known until the 1970s
• Quadrophobia leads to actions such as wrong Investment Decisions, Financing
Decisions and Dividend Decisions
• Financial statements may also be exaggerated, through front-loading of incomes,
deferment of expenses, non-recognition of liabilities and non-recognition of depletions
in asset values. The Satyam case may be seen as a symptom, rather than as a disease
Equity Investment Decisions
• Benjamin Graham, the dean of Financial Statement Analysis, pioneered this field
in the stormy period between 1929 and 1945, of severely stressed financial
markets. Companies with low earning power and high debt got exposed
• Graham would invest in companies that could sustain the storm, but were
severely undervalued. He profited when the market recognized the undervalued
stocks, over a 2-year investment horizon. His dictum was to buy a good stock at a
cheap price(called the Margin of Safety)
• Warren Buffet, his student, modified this approach, to include companies that
could maintain a sustainable advantage even in growing markets over a long
term, thereby increasing the holding period return manifold. This meant, he was
willing to pay a good price for a great stock
Graham Ratios
Quantitative Approach, Value Investing
• Low Price/Book Ratio (P/B)
• Low Price/Earning Ratio (P/E)
• Low Debt/Equity Ratio (D/E)
• High Dividend Yield Ratio (D/E)
Philip Fisher
Qualitative Approach, Growth Investing
• Philip Fisher was another great investor of the Depression era (1929-1945)
• He believed in visiting companies, meeting managements and various
stakeholders
• Tried to find information not usually contained in the financial statements.
Even used informal information, in a process he called scuttlebutt
• Tried to estimate financial prospects such as sales growth, profit growth,
profit margins, cost advantages, unique advantages, superiority of
personnel and R&D, future capex commitments and management
integrity. Also stressed on Dividend Yield.
Warren Buffet
Combined Approach
• “I’m 85% Benjamin Graham, 15% Philip Fisher”
• Modified Graham’s approach, stating that all cheap stocks are not great stocks
• Adopted Fisher’s approach by stating that great stocks can be acquired at
good prices for higher returns
• Also adopted Fisher’s approach of meeting managements and visiting
companies and stakeholders to fill gaps left by financial statement analysis
• But financial statement analysis continues to be the bedrock of his approach.
He challenges EMH, stating that most people do not know enough about the
companies whose shares they trade
• Objective: to find companies with sustainable competitive advantage
Warren Buffet’s Approach to FSA
Start with the Income Statements

• This is where the Revenue starts flowing

• Cost of Goods Sold (COGS): the lower, the better
• Gross Profit Margin: the higher, the better
• Operating Expenses: keep a watchful eye
• Selling, General and Admin (SGA) Expenses: keep a watchful eye
• R&D: Not popular with Buffet
• Depreciation: A cost Buffet can’t ignore
• Interest Expenses: What Buffet doesn’t want
• Profit Before Taxes (PBT): The number Warren uses
• Income Tax: How Buffet knows who’s telling the truth
• PAT: What Buffet is looking for
• Earnings Per Share (EPS): Telling the winners from the losers
Buffet
Balance Sheet Analysis
• Assets (the goodies): Cash, Receivables, Inventories, PPE, Intangibles. TA – Liabilities = NW
• Current Asset Cycle: How money is made
• Cash & Cash Equivalents: Pile of money. Is cash being generated or consumed more? Look
at the cash pile generation in relation to debt
• Inventory: What needs to be bought and sold. Chances of an inventory pileup?
• Receivables: Money owed to the company. Compare with competitors
• Prepaid Expenses/Other Current Assets: keep it low
• PPE: having less can be a good thing. Chewing-gum v/s Cars
• Goodwill: a good thing if it keeps revenues and cash inflows buoyant
• Intangible Assets: internally generated assets are the best form growth engines (e.g. Coke)
• Long Term Investments: one of the secrets to success. Can be a goldmine (carried at BV)
Buffet:
Balance Sheet Analysis/2
• ROTA: if very high, look at entry barriers
• Short Term Debt: It can kill
• Long Term Debt: It can cause trouble. Great companies don’t have too much of it.
Leverage brings in pressure, does not nurture businesses
• Current Ratio: a low Current Ratio can be a good thing. But does not tell us much about
durable competitive advantage
• Total Liabilities + Debt /Equity Ratio: Lower is better. In troubled times, leveraged
companies fall faster
• Retained Earnings: Buffet likes it
• ROE = true measure of wealth creation (efficiency in capital allocation). Higher is better.
• The problem with leverage and the tricks it can play (growth with steroids)
Buffet:
Cash Flow Statement
• Follow the Cash, because accrual-based accounting can mislead
• Not having too much capex is the secret to get rich
• Share buybacks: the way to riches
Other Buffet Ideas
• “Franchise”, “Moat” and bond-like regular returns
• Ever increasing yield arising from competitive advantage
• Other sources of competitive advantage
• Right time to buy a fantastic business: develop long-term perspective
• Right time to exit: when P/Es get insane and businesses unsisttainable
Peter Lynch:
Growth though Mid & Small Cap Stocks
• Index stocks are over-researched and over-valued
• If one follows the Fisher & Buffet styles into small cap investing, we
get the Peter Lynch approach
• Categorize P/Es correctly
Credit Decisions
• When we follow a statistical approach for credit based on mass-
lending, the role of FSA becomes secondary
• Historically, collateral-based lending has also rendered FSA as
secondary
• As a result, loan portfolios are not cherry-picked
• Ever-greening and round-tripping of loans
Credit Analysis
• Same Buffet approach, starting with P&L, moving on to B/S and CF
• Beware of “Other Income” and Accruals
• Take a segmental and consolidated view
• Read all footnotes and Notes to Accounts
• TL/NW, Adjust, Adjust Contingent Liabilities
• Estimate ICR and DSCR for cash flow comfort
• Read Directors’ Report, MDA, Statistical Highlights and Trends, Industry
Reports etc., Demographics, to look at quality of projections
• Projections beyond year 3 need a reality check, due to disruptive technologies
Recent Perspectives on Credit
• Roofit – Balance Sheet fraud
• Essar Oil – Equity Rs.2,000 cr; Debt Rs.45,000 cr
• REI Agro – only 2% of profit from core business, balance steel trading. Rating without accounts?
• Are there unreported assets?
• NPAs are higher in government-owned banks
• With these largest lenders down, credit growth is stunted
• No stringent appraisal. Followed the lead bank
• Dearth of credit skills. DFI-skilled lost in universal banks
• Most NPAs arising from 2010-2011 loans
• Only 25% SMEs get formal credit
• Things are changing. Large corporates are raising bonds
• Cash Flow Statement better than Ratio Analysis