According to Clause 41 of the equity listing agreement, listed companies in India are required to bring out their financial results in the public domain.
The results need to be published in at least one national English daily and a vernacular daily from the region where the company’s registered office is located.
Financial statements include quarterly, half-yearly, yearly standalone and consolidated results. So, what should an investor look at in them?
Top line and bottom line
An investor needs to focus on sales growth (top line) and profit-after-tax growth (bottom line) on a quarter-on-quarter or year-on-year basis. As the name suggests, top line means revenues and bottom line means the profit out of such revenues. These two numbers tell you whether a company is on the growth trajectory or not.
Let’s suppose that while sales growth is falling, the company is able to increase its bottom line — this means it is keeping costs under control. The reverse also stands true. A company’s earnings and revenue can be compared with its stock price to ascertain whether a share is expensive or reasonably priced.
Debt and equity components
To buy any asset, the company invests either its own funds (equity) or borrowed funds (debt). For an investor, the debt and equity components are important numbers. If a company’s debt component is increasing over time, one needs to exercise caution; try to find out why this is happening.
Having debt is not necessarily a bad thing, as long as the company generates enough cash flow to service it. The debt component also provides a tax shield. An investor needs to worry only when the debt component exceeds a particular level, as it might drag the company into bankruptcy.
Operating cash flow
There is a big difference between what a company says it has earned and how much cash it has generated from operations. Essentially, the difference arises because of the accrual accounting concept adopted by companies listed on stock exchanges. So, apart from looking at the bottom line growth, investors should pay attention to operating cash flow, which describes how much cash is generated from core business activities. If a company’s net profit is much higher than the operating cash flow, investors need to find out why.
Working capital movement
This is part of the capital required to run the day-to-day affairs of the company. It is defined as current assets minus current liabilities. Current assets include debt, inventory and prepaid expenses (assets that can be converted into cash within an accounting year). Current liabilities include credit, short-term loans and expenses outstanding (liabilities that need to be paid within an accounting year).
A significant increase in debt and inventory signals that the company’s cash is locked up in these assets. If there is a reverse trend — current liabilities are higher than current assets — this is known as negative working capital, an ideal scenario for a company.
Investors should look at other parameters, such as earnings per share (EPS), return on equity (RoE) and return on capital employed (RoCE), for a
better understanding of the earnings statement.
The writer is associate professor of finance and accounting at IIM Shillong