Analysing A Few Financial Statements

If you are a beginner and would like to understand how to read the profit and loss statement, the cash flow statement and the Balance sheet you can read our previous blogs on the same. In the blog I have looked at some actual statements to further your understanding but please note most companies don’t follow rules religiously and often write entries in the wrong places (you as a diligent investor must make these adjustments yourself to ascertain the correct version of the statements). You’re also expected to read between the lines, pick up trends and understand the reasoning behind the growth or decline in reported numbers.

This is a snapshot of the P/L account of Vedant Fashions, the owner of Manyavar brand. As an example some important metrics and insights that can be derived from here are:

1. 1. Watch the Sales Growth rate – in 1 year it has increased by 75% which is fantastic. This figure is closer to 85% if you exclude other income. This has resulted in a PAT which has more than doubled over the previous year!
   2. Track the growth trends in inventory, employee benefits expenses, depreciation, other expenses. Read the detailed explanation as given by the notes number. Watch for abnormal rates of growth which are significantly less or more than Sales & PAT growth.
   3. Ask yourself – what has been the main driver of margin expansion? 

Here’s a snapshot of the Balance Sheet of Affle India, a consumer technology company that provides in-app advertising services.

As an example some metrics to track and insights to derive are:

1. 1. Note the major jump in Goodwill and Intangible assets. As you read annual reports, you’ll notice this feature is common in acquisitive IT companies. A peculiar thing you’ll notice is the small amount of fixed assets like plant and equipment and that’s common in all service companies who don’t need a lot of heavy machinery to run their asset light operations.
   2. Trade Receivables has doubled. Normally this is not a good sign, but if you read the P/L statement, you’ll notice Sales have also doubled, so in that context trade receivables doubling is nothing out of the ordinary. 
   3. In the liabilities section, check for abnormal growth and read the notes for their explanation. For eg. other financial liabilities have grown by 3x. If you dig deeper and read the accompanying note. You’ll understand why so. 

Here’s a snapshot of the Cash Flow section of APL Apollo, a structural steel tubes manufacturer.

As an example some metrics and insights that can be tracked and derived are:

1. 1. Non-cash charges like Depreciation are added back to get a real measure of the cash profits earned by the business.
   2. Entries such as Interest income from Fixed Deposits are not a core business operation. Hence, it has been reported in the wrong section. It should be placed in the Cash Flow from Financing section (however significant the number is).
   3. Closely track changes in working capital in CFO and capital expenditure in CFI. Loan increase/decrease can be seen in changes in CFF.
   4. An important thing to note: the above metrics and insights are not exhaustive, and they are just an indication of the different possibilities that you as a smart investor can explore when you’re conducting your own in-depth research. 

There are 2 things to keep in mind – (a) businesses are never static, they are always evolving. Just because the financials of the previous years look ugly doesn’t mean the future will be the same. This is also true for vice versa. (b) always check for trends and abnormal changes. Are the numbers trending upwards or downwards and their respective implication? What has caused abnormal rates of growth/decline? As repeated earlier ‘abnormal’ rates need to be looked at within the context of Sales & PAT growth and not in isolation. So, the ‘abnormal’ rate of change could vary from one company to another.

The Financial statements serve as the starting point of your business analysis and not the end. They give you an initial picture of where the business stands today. Based on this information, you as a smart investor need to hypothesize what the future could look like. You’re not expected to be fully right because as businesses grow they might enter different verticals, or pursue inorganic growth opportunities (some of which may or may not work out). Based on today’s available data both quantitative i.e. financial statements as well as qualitative (we’ll discuss this in a later chapter), you have to mentally chart out what the next 5-10 years could look like under different scenarios. It is here where the strength of the company’s business model and offerings will be tested. Is the company strong enough to survive tough times of economic slowdown? 

As your understanding of its annual and quarterly financial statements deepens, your conviction to hold it despite bear markets will also increase. Remember, qualitative data needs to be backed by numbers. If you don’t have numbers to justify your holdings, then after hearing a few rumors, you’ll be very eager to sell your position. Therefore, even though quarterly updates are not substantial, one needs to be mindful of them and stay keenly aware of the significant changes being brought about in the business. Most of them will appear through the numbers with a lag (for eg. a significant capex being undertaken which could result in 3-4 times growth in sales will take a couple of years to fully operationalize will initially show up in the company’s balance sheet as capital work in progress). The astute investor will track this and will slowly increase his position keeping the capex schedule in mind.