Guru Mantra 4- The Soch (Thought) behind Financials
Arguably this is a long subject- Part I for now
Armored with a bit of business and user (who consumes services or products) knowledge always helps moving forward. Financial statements may be paradox but that’s the only way transactions are recorded and reported.
Guruji said let’s move to your fiefdom, financial reporting. What you feel about it? I felt proud for a while as accountant, I said what exactly you want me to explain? Financial reporting? Re-statements? Adjustments? Balance Sheet Reviews? US GAAP? He said hang on, all these term I don’t even know. Why are you embarrassing me? You just convince me what are different ways of looking at financials? I asked what do you mean by “different ways”?
This is what Guruji says, one-way is Seedhi (Straight), second is Tedhi (Reverse) and I am a Yeda (Contrarian here, Mumbai yeda stands for “dumb”). Fine, putting simply business drives accounting not vice a versa. Financial reporting or in short financials is consolidation, elimination and grouping of information so that it can be disseminated. Unless we understand business we will never understand economic view accounting or finance. The numbers appear in Balance Sheet and Profit & Loss is summation of a company’s state of affairs for a particular period and for a particular date (Balance Sheet-BS).
To understand a business you need to be novice, just like friend @romy messaged here, or even sense of acceptance like @vikskukreja said, even positive mind frame like @govindarajanv & @Aksnehru or @v4value , even @jainaj @Rounak . See we just listed so many wannabe Warren Buffett’s!
Let us a simulate a company before getting into a room called financials surrounded by confusing screens of compliance and accounting standards.
Recently I was analyzing a company called TVS Shrichakra, which makes tyres for 2 and 3 wheelers. It’s fresh in mind (otherwise called recency bias), I will walk you through to justify the concept before we land in a exclusive educational territory neither will help me or you to learn.
To understand a business and answer all Seedhi and Tedhi questions by a Yeda like me best way is inquisitiveness. Ahan, I wont ask you create compartments inside brain, I don’t have a brain in first place! Inquisitiveness means ask question….management consultant said for long time 5 W and one H.
What is 5W and 1H?
W1: Who did that?
W2: What happened?
W3: Where did it take place?
W4: When did it take place?
W5: Why did that happen?
H1: How did that happen?
Does this sound reasonable? Mckinsey added 2 more Ws to make it 7W…. that’s way too complex for me to understand. If you can please explore sometime.
Let us give an attempt to understand whether 5W and 1H can explain or help even in understanding financials.
The name of Company is TVS Shrichakra or even called TVS Tyres. Even before going to Google TVS is a famous group. TVS stands for T V Sundaram Iyengar .
He was born in 1877 and known as automobile pioneer. Hang on , no one will call anyone blindly as pioneer, must be something out there.
Mr TVS started a bus service in 1911 called as TV Sundaram Iyengar & Sons
1955 operated a number of buses and lorries under Southern Roadways limited. Then produced a gas plant, a factory for rubber retreading, Sundaram motors.
After Mr TVS expired what happened? Here is the balance story:
1978- TVS Motor
Middle 1980’s – TVS Shrichakra
Apart from this a host of other companies group boasts about, business accepts this is biggest business Automobile conglomerate in India.
First a possible list of “Seedhi Soch”, please keep on adding.
(all that are required to run the business)
Which all information we need?
- Raw material
- Other than raw material
- People
- Assets
- Sales
Next another list of “Tedhi Soch”, please feel free to add:
(all that required for existence)
- Imagine when TVS Shrichakra started; TVS Motor was in place already. The tyre factory started then had a pedigree of family known for automobiles in India, must have deputed it’s satraps including the family members from head quarter and other factories to build the factory.
- Also I am sure by the time factory and plant is ready, operations would have taken its sweet time to settle down. It’s not a Formula 1 tyre fixing, 20 seconds…. boom and vroom.
- Once it rolls out tyre, can we say customers standing outside a factory with gunny bags to collect tyres (with a chanting “here come tyres”
).We are sure some people would have gone miles and miles to consumer dealer and customer. - During last thirty years, people would have got disappointed with TVS Tyres, send them back to Tyre factory, company would have spend something to fix these defects.
- Thirty years would have also seen ups and downs of economic cycle. TVS Tyres would have gone door-to-door, trumpet via Television, newspapers to tell people you need tyres and we are there with one Actor posing with a tyre.
).We are sure some people would have gone miles and miles to consumer dealer and customer.Finally list of “Yeda Soch”, please feel free to add:
(all that required to be answered )
- Do I need bank loan? Why and for what? Isn’t Mr. Iyengar supposing to billionaire?
- Do I need multiple energy sources for running? Why and for what?
- Am I giving lots of discounts to some one else to sell my tyres?
- Am I paying excess money to employees? Is there a justification behind doing so?
- Am I spending a lot of money to maintain my assets?
- Am I spending on a lot on sophisticated software to run the business? Why so?
- Am I able to increase the price as and when required, if not why so?
- Is my cost of materials coming down? If not what’s the problem?
Don’t worry about completeness of questions, there is a long rope going forward. In case something gone amiss we have sufficient tool to captures information. What is idea behind these questions,….as we said we need a “information” from financials. Do they exist? Let’s check it out☺
Peeking into financials for answers
My suggestion use a copy of TVS Shrichakra Annual Report and please do a check for my answers below to ensure whether I am have improved from being a duffer.
Without even going further take the first category of “Seedhi Soch”, from 5W and 1H you will get only 1H from financials.
E.g. Raw Material- who supplies raw material? Why they supply raw material? What raw material got supplied? When did the raw material got supplied? Where did raw material got supplied? How much raw material got supplied?
Apart from last question (H) we wont get answer for anything else or may be partially. Now we understand the limitations of financials. Why this happens then, aren’t financials suppose to disclose everything:
Financial Reporting is a cluster of accounting transactions. An activity is initiated first, then processed, afterwards recorded which may or may not result an accounting transaction. In other words though organization captures a lot of data its not necessarily reported which we know. But the problem we need answers.
Think about this: I need to buy rubber as raw material for making tyres.
What would be the sequence of transactions? The bracketed ones is information published in financials.
Step 1: Identify a vendor (not available)
Step 2: Ascertain the requirements for purchase (not available)
Step 3: Decide a price to buy (not available)
Step 4: Place the order to vendor (not available)
Step 5: Receive raw material (partially, inventory is reported as aggregated- opening, consumption and closing—quantity is not mandatory disclosure from last year) ……Inventory DR Goods Received Not Invoiced (GRNI) CR------here we have accounting entry……
Step 6: Recognize the vendor in system (accounts or trade payables)……another accounting entry here……GRNI DR Vendor CR.
Step 7: Pay the vendor (inventory, consumption, payables)……last leg of entry……Vendor DR Bank CR.
Step 8: During a month end accruals is posted which is all those GRNI which are not recognized as vendor liability. Once next month kicks entry gets reversed.
(For non accountants DR is Debit and CR is Credit which is our trump card, if you Google it you will get lots of information may be not relevant for you).
Apart from this we do have inventory accounting to record inventory in, used and out. You can see accounting kicks off after deciding price, vendor, quantity etc which are significant for understanding our business.
Second category which is bit tedhi. We are saying Mr Iyer and his battery of people set up the plant, spent crores in convincing customer to buy. Where are these costs? Accountants will argue they are all written off during the year or amortised over a period of time. But as investor I need them, if one Mr. Vikas has to start another TVS he may not have Mr. Iyer, his battery of people, his commendable associate companies!
Finally the yeda man’s dream….bit dicey. The information is there and not there. For example simple ones bank loans would be there but again why may be absent.
What message we are getting finally, sufficient information may not be available to a decision as business owner. Get ready to scratch information from all other places available. In other words-
- we have to refer to multiple places to obtain information.
- The information recorded may not be suitable for my purpose e.g. writing off Mr Iyer’s initial expenses for his legendary skill set.
- We may not get a lot of information and we should mentally prepared to handle them for our decision making.
Now one can say if we don’t get all these information then what is financials available to investor and how do we look at them.
A better organization ideally will have following accounting systems (simulation considering TVS, banks are different Animal, insurance is alien to this):
- General ledger and financial accounting (record of accounting transactions captured from all processes, now transaction can come automatically or manually entered). Ultimately it leads to a Trial Balance, Profit & Loss Account and balance sheet.
- Management accounting( this is the one we investors should be more interested, which has all sort of business analytics underlying transactions……e.g. sales per region, pricing of products and so on. Unfortunately not reported anywhere in world…we need to fight for ourselves).
Structure of Financial Statements
First few bloopers:
- Revenue and Sales are same word , also called as top line
- Profits, earnings and income are all same, we call them bottom line
- Costs are money (people, operations) spent for making a product or services.
- Sales order and purchase orders do not have impact (we saw above sequence of entry for purchase) on accounting.
- Revenue and billing are different animal. Billing is what is billed to customers, revenue is what is recognized☺. That’s accounting, revenue is accounting recognition triggers basis the framework developed by Chartered Accountants . E.g. unless delivery takes place you cant recognize revenue. Though you can bill and collect money.
- Profits are different from cash.
- Expenses are different from costs.
We will cover each of these elements and much more with detail. I hope this will help non accountants if any who are not familiarize either. I am not familiar too, let us learn together.
At any point of time if you feel this is meaning less just put me to hook. I will change my direction. Also request you add all your own understanding, I will add back to my practice book.
Loads to talk about, this is just beginning. This is my practice book currently, let me know if you want to see anything else. Or even you add all subjects that is relevant for investing….only request with a sequence!
What all you can expect me to write after financials
Investment Philosophy (KYF- Know Yourself First)
Investment Philosophy (Personal Financial Planning)
Investment Philosophy- (Popularity may be illusion)
Investment Philosophy (CAP Plan- Capability Building, Active Investment Management, Portfolio Management)
The Value Investing
Building Nest (Portfolio seedbed)- allocation, comfort, security, entry and exit.
CBR1 – Competitive Advantage
CBR 1- The Competitive Strategy
CBR 2- Quality of Management- The Person
CBR 2- Quality of Management- Performance
CBR 3- Risk Management- Financials
CBR 3- Risk Management- Operational
CBR 3- Risk Management- Compliance
CBR 3- Risk Management- Strategy
CBR 4- Future Catalysts- Business
CBR 4- Future Catalysts- Management
CBR 4- Future Catalysts- Industry
CBR 4- Future Catalysts- Markets
CBR 5- Margin of Safety- Understanding Price
CBR 5- Margin of Safety- Psychological Valuation
CBR 5- Margin of Safety- Business Valuation
CBR 5- Margin of Safety- The Safety Net
CBR 6- Special Situation- Subsidiary
CBR 6- Special Situation- Merger and Acquisitions
CBR 6- Special Situation- Demerger
CBR 6- Special Situation- Wishful Thinking
- CBR is Concentration Band Requirement (band is a section of business risk which needs to be managed within a portfolio).
Case Studies – Ten Companies (Sick- Commodity, Hot Guys-IT/Ecommerce, Cross Road- Auto, Evergreen- FMCG, No Choice-Pharma, Aspiration- Housing Finance, God father- Banks, Curiosity- Travel, Borrowed Conviction, Not So hot)
Establishing KPI for Portfolio Management- track portfolio
Opportunity Sourcing- Moat based
Opportunity Sourcing- Low Valuations
Opportunity Sourcing- Thematic
Opportunity Sourcing- Borrowed
The Behavioral Finance
The BUCK STOPS HERE (Philanthropy)
Unlearning- Sector Thinking