Guru Mantra 5- Understanding Financials
Part II of Financials
Power of Simplicity
Simplicity is most the sophisticated thing, friend of Guruji (investor of course) made a point to me over a discourse. This was a reference when I wanted to show a seedbed of ideas (or mental model what ever we call). He quipped why you make things maddeningly so unhelpful?
Simplicity is the ultimate sophistication – Leonardo Da Vinci.
One of major pillar of value investing is finding out a competitive advantage. Warren Buffett coined a word moat to look out for companies having unique product, unique service or a better-cost producer. But some one who has invented the broader word “Competitive Advantage” is none other than legendary Management Guru Michael Porter. And guess what, his landmark book “Competitive Strategy” provides a formula for sustainable growth. Yet no one use, but strangely it’s a very simple formula. Want to try?
Asset Turnover X After Tax Return on Sales X Asset/Debt X Debt/Equity X Fraction of earnings retained.
No one dares to ask Prof Porter whether it’s right or wrong. Even if it’s true still we will not follow it. We all have a habit of liking strong vocabulary and complex things.
But does simplicity creates knowledge and wealth? Of course yes, simplicity is adaptive, enduring and transmitting!
We can’t build a paper box without setting up few principles, accounting does have few. They run through every financials, these are basic rules and assumptions which decide the what, when and how to measure. The principles have serious impact on preparation of financials. Let us understand them:
First is accounting entity. Every company builds a chart of accounts (this is a list of accounts going to be used by company e.g. Trade payable –Number 10000, Raw Material- Number 20000). Accounting entities are different sections of business for which management need financials. For example ITC have Cigarette and FMCG. Both Cigarette and FMCG becomes accounting entity. Now trade payable will be linked to both accounting entity.
Second is going concern. Accounting by default believes unless there is an evidence otherwise every company life is for long time. Now no one can say this for sure but we need to assume. If you believe the company is sick (not commodity type, a company where net worth has eroded completely) auditor will point in their report (called as qualification).
Third is measurement, everything under the sun has to be quantified to be accounted. This has also become biggest pitfall for accounting as well. Unless we have agreed upon value we can’t record in financials. For example if a mine value can not be estimated it would be shown as either nil value or purchase price what ever is available which may not reflect true value.
Fourth is reporting currency, due to foreign operations every company deals with multiple foreign exchange rates e.g. US dollar, Euro, Yen etc. But Indian companies need to report only in Indian rupees as it will file financials with Indian authority.
Fifth is historical cost, meaning everything is recorded at original cost with no adjustment for inflation. Now take a land bought in Andheri back in 1955 at 1000 Rupees will still show as 1000 in 2016 even. This sometime understate asset value and depreciation grossly.
Sixth is materiality, this is basically relative importance of financials. We don’t have to break our head for 100-200 rupees. We will record big ticket items only when small ticket information are not available.
Seventh is** estimate**, assumptions and judgments, things change here as we move to unknown territory. What best you can do when we don’t have exact information and at the same time not much expected error will come. But estimates etc should be consistent across the years.
Eighth is consistency, now one year say 10000 is materiality next year 1 lac. Or tables or chairs are not assets, next year they become assets.
Ninth is conservative, we accountants are downward looking not because we wear specs. We don’t like to over value anything; hence we will recognize loss even at slight hint, wont record gain even with a big hint.
Tenth is periodicity, financials are prepared for a particular period. Say a financial year (Jan- Dec). Regulators enforce most of the time periodicity.
Last is substance over form, this means we want to book economic substance not what looks to our eyes. Long shot to claim☺.
There is something also called restatements, the moment we recognize mistakes we rectify and restate the financials. But it has a heavy implication for regulation, audits etc.
And pillar of all these is accrual accounting, this means recognize the moment you use the asset or liability rather waiting for payment. For example the moment your raw material is accepted vendor becomes liability and raw material cost is recognized. This time difference between actual usage and payment has resulted another statement Cash Flow Statement. This is the key reason why profits are not cash. Accrual concept includes matching principle, this means if you recognize revenue you cant say no to costs incurred. You have to record both. Allocation, lot of costs are not associated with a specific product e.g. though insurance is paid in full at beginning the expenses are recorded as they arise.
Who is making all these rules?
First foremost The Institute of Chartered Accountants makes all accounting standards for India. The institute is empowered by constitution through Companies Act. What you know them otherwise as CA or Chartered Accountants. Accounting standards are the rules, guidance to recognize asset, liabilities or any other item related to financials.
Next are Tax authorities, in few cases they don’t believe certain practices adopted by financial accountants. For example depreciation rates are different for tax purpose and other purpose. Many says tax accounting is more realistic. A fresh set up of books is not written, what happens we create another accounting entity for tax and pass the differences as adjustment entries to main financials.
Creative Accounting Practices
As we saw accounting principles are not straight forward, a good amount of estimation, fit for purpose application some times lead to creative accounting practices to suit management need. When creativity becomes manipulation with a mala fide intention fraud occurs. Fraud practice is popularly called as forensic. Forensic is a special subject, lot of people focus their career on this. Three famous books you can go through to understand. I will try to create a separate subject on this, I am not aware of forensic much!
Quality of Earnings by Thornton Glove
Financial Shenanigans by Howard Schilit
Creative Cash Flow reporting by Charles Mulford
But for basic foundation to analyze a stock, at least let us understand how accounting principles can be misused.
- Concluding a going concern is estimating future. Auditors and management use a yardstick of net worth erosion (this means liabilities exceed assets). But negative net worth may not always be a bad factor e.g. this negative comes with a sharp provision entry for non collectability of receivables. We should be more worried about negative net worth with more interest bearing third party liabilities (debt from out siders).
- Quantification or measurement is done is based on available information on a particular date. Now just because information is not available we can’t give a guarantee for accuracy of these measurement (for individual also its called as availability bias- park this behavioral finance).
- Currency usage can lead to confusion as well, say fluctuations in foreign currency while buying an asset is charged off to P&L account. Earlier in India it was capitalized. Any of these application will create a understatement (lower profit than actual) of over statement (higher profit than actual) of profit.
- Historical cost is one of biggest reason for not relying balance sheet valuation. As I said earlier assets like land, mines purchased long time back must have become a fortune over the years. Sometimes management does a revaluation of assets but again discretionary practice.
- A decision towards estimates, judgments can have far reaching impact on financials. For example I was depreciating an asset over 5 years, suddenly changed to 10 years, this would mean my depreciation will come down by certain amount which will overstate the profit. Auditor does qualify in his report, then how many times people go back and normalize this for calculating net profit margin!
Indian Financial Accounting Structure
All of us are familiar with two things at least:
One is quarterly financial report submitted to stock exchange. But more importantly annual report, this is a package of many things (we will touch them sometime else) including financials of company. Schedule VI is the key format where company’s financials are presented and what you see in annual report as well.
But even before we take a stab at Schedule VI, we must understand underlying ethos of management behind financials i.e. otherwise called financial statement assertions (FSA). These are claims by management saying we are responsible for preparation of financial statements and they are appropriate. You may why do I believe so, here may be why:
Many ways you will find management talks about assertion. Let us not confused by these internet sites and blogs. There are only FIVE fundamental FSA, which are certified by COSO (the biggest body for accounting committee) and testified by Auditors (something called key controls for financial reporting under Sarbanes Oxley Act, Indian name is IFC or Internal Financial Control).
Five FSA tell us management believes and it is tested that:
- All the transactions recorded are complete and nothing is missed out (Completeness).
- Transaction has been recorded in right period i.e. 2015 transactions recorded in 2015 not 2016. (Existence or Occurrence)
- The accounts are disclosed and presented in right place i.e. cash is suppose to be part of current assets , its not included within fixed assets. (Presentation and Disclosure)
- Accounts and transactions are valued accurately, 100 purchase is shown as 100 not 200 (Valuation or Allocation).
- Asset means I own, liability means I owe. My rights on asset or obligation for liabilities is fool proof and supported by evidence (Rights and Obligations)
Despite of management assurance there is no guarantee that management wont do any other things which you and me don’t want☺.
Now Schedule VI
In lay man’s word format of Balance Sheet, Profit & Loss Account, Cash Flow and associated items. Let us not get into individual elements, it wont help. Rather look at holistically to have a view, we have loads of chance again to look at individual items when we get into actual methods of stock analysis.
It tells us basically what I own (assets), what I owe (liabilities) and this is my worth (equity of net worth). Equity is the one we own as shareholder in any given company.
At any point of time assets will be equal to liabilities as for every debit there is a credit somewhere.
View balance sheet as a snapshot of history, a financial picture on a particular day when its written.
Balance sheet boasts mainly these items:
- Assets are the one we got like cash in bank, inventory, machines, building- all of them.
- Assets are also rights we have on monetary value, for example we can collect cash from customers if sold on credit.
- Assets are valuable and must be quantified in reporting currency
What assets tell us further about their characteristics:
- liquidity meaning can be sold easily like cash, investments etc.
- productive e.g. plant and machinery.
- Assets for sale e.g. inventory
Trade receivables is the obligation of a customer to pay whom we sold on credit.
In our Indian financials Assets are shown in order of safety i.e. first fixed asset followed by current asset. Where as in US you will find reverse, first liquid asset then fixed asset.
Are the ones which can be converted to cash within next 12 months. This includes cash, trade receivables, inventory etc.
Inventory includes raw material for to be used in manufacturing, finished goods to be sold, work in progress inventory, other spare parts and consumable which will be used for manufacturing.
Prepaid expenses are the ones where we have paid already in advance like insurance premiums, rent, deposits etc. This means we don’t have to pay in near future.
Cash is required to buy inventory which gets manufactured to become finished goods, once sold called receivables, on collection we get cash again! Cash is king and please always ultimate motto is to see cash.
There are few other categories of assets, we have enough opportunity to discuss in future.
Fixed costs are stated at cost value, they are used over again and again for making goods and produced. Cost means original purchase price. On balance sheet fixed cost is shown as original cost minus depreciation.
Depreciation is the decline in value of asset due to wear and tear and the passage of time.
Patent, copyright, software have a value but not tangible (cant touch or feel). These are valued by management according to various conventions bit complex for now.
Liabilities are categorized mainly:
- to whom the money is owed
- when the money is payable (current and long term liabilities)
Current liabilities are the one which needs to be paid within a year. Chief inclusions are accounts payable or trade payables owed to supplied. Accrued expenses owed to employee and other service providers, current debt owed to lenders, taxes owed to the government.
The amount of money left over once you subtract current liabilities from current assets. This is the money company has to work with to manage day to day operations.
- every increase in current asset increase the working capital or every decrease in liability does same thing.
This has two component, one is capital i.e. the original amount we contributed as investment in company. Second is retained earnings which are earnings earned and retained but not paid as dividend. Retained earnings is critical component of value investing.
Now one may think capital is shown as 1,2, 5, 10 rupee per share but I pay 2000 to buy. Where is the rest money! Your share is capital and retained earnings, if you pay high you have to justify some reason why are you paying high.
I will cover Profit & Loss, Cash Flow next time and much more.
I have attached a Schedule VI for further understanding, please feel free to raise questions if any.
Now, without application theory is of very little use. All of us will disperse if these theories doesn’t create a wealth (money or knowledge), knowledge getting acknowledged by self becomes wealth.
I will take a live example and simulate , so that we keep on going with these mantras together to have a better view.
Here it is: the company name is International Travel House (ITH here onwards). Why I selected this, and what is there let us discuss in a separate thread or topic. As that would be stock specific information it will not be appropriate to club along investment learning. That will also keep me going, as I need to survive from investing as well.
Kindly note I don’t know even whether ITH is a good company or bad company. It’s a completely live simulation, please make it interactive. Allow all of us to learn from each other. As usual no buy or sell, nothing. Owning a stock is congregation of multiple decisions, ultimate outcome of which significantly vary from person to person. So when someone says buy or sell, its nothing more than entertainment, don’t fight….just take a bow and pass. All will be happy☺.
A stock analysis results:
- certain positive points about business, industry and management, importantly the characteristics of element there.
- Certain negative points on the same line as above.
- Unanswered questions and points, of course same as above.
Happy investing tribes!Format_of_Financial_Statements_under_the_Revised_Schedule_VI.xlsx (311.7 KB)
This file I have collected from Google, not developed by me.