Why an 'Analyst' should dig deeper?

Looks can be deceptive. It is human tendency to believe what one wishes to believe or take what is shown at its face value. Often this can lead to wrong conclusions. Major companies publish their results every quarter. Based on the reported results the newspapers make certain comments and many of us take these comments at their face value and form our opinions. In this article we will see why we should dig deeper.

The report in the newspapers always present facts and generally there is no attempt to twist the facts but, nevertheless, the comments tend to be superficial and therefore a shareholder or an analyst has to see beyond the published report to see how the matters really stand. A deeper study sometimes unearths other details, which sing a different tune.

It is very important for an analyst to know where the profit is coming from or what is causing the loss. Improvement in the bottom line could be on account of 'other' income, lower depreciation or lower interest burden and not due to improvement in the core activity of the business. The sales may show an impressive growth but the amount spent on manufacturing the goods and its relation to sales may not be visible readily.

To see how a deeper study can reveal a different picture we shall take up a concrete case. The company chosen for study is Kirloskar Cummins Limited, manufacturers of high horse power diesel engines, and the reports chosen are for two consecutive years, 1995 and 1996. The details are from the published annual report of the company.

Let us first take a superficial glance at the results. We will see the total sales income and net profit for these two years. Please note that we are considering the net profit at profit before tax (PBT) level. This is to eliminate the effect of government decisions and policies. Our main interest is to find out how the company is performing. See Table 1.

Table 1. Figures in Rs. Million

s	1996	1995	% change
Total Sale	6703.6	5551.4	20.8
Total Expenses	5654.0	4693.0	20.5
Profit before tax	1049.7	858.4	22.3

These figures are impressive. A 21% rise in Total Sales and 22% rise in PBT is definitely impressive for an engineering industry. However we have not seen the relation of profit to sales. When we take Profit percentage, which represents the residual amount left from sales after meeting all expenses, per every 100 Rs. of sale, we see a slightly different picture. Let us add a row indicating percentage to the above table.

Table 2. Figures in Rs. Million

s	1996	1995	% change
Total Sale	6703.6	5551.4	20.8
Total Expenses	5654.0	4693.0	20.5
Profit before tax	1049.7	858.4	22.3
PBT% to Total sale	15.7	15.5	3.2

We now see a different picture. Though Sales and profits have grown in volume the ability of the company to make greater profits out of every 100 rupees of sale has almost remained unchanged. Increase of 0.2% is marginal. This broadly indicates that the efficiency of inner working has not improved. The initial rosy picture in Table 2 has definitely faded a little.

We shall now go to the deeper level of profit viz. The profit before interest, depreciation and tax (PBIDT) and weigh it against the total sale. Given below are the figures for Kirloskar Cummins Limited for 1995-96.

Table 3. Figures in Rs. Million

s	1996	1995	% change
Total Sale	6703.6	5551.4	20.8
Total Expenses	5377.2	4416.6	21.7
PBIDT	1326.4	1134.8	16.9
% of PBDIT to Total sale	19.78	20.44	-3.22

The above table reveals an interesting fact. Though an impressive increase is seen in sales and PBT from 1995 to 1996, as seen in Table 1, there is a drop in the percentage of PBIDT in 1996. Very broadly, the company is unable to cover the costs to the same extent as the previous year through its income.

The newspaper comments may read some thing like "Increase in total Sale of 21%. Increase in Gross Profit of 17%. Increase in net profit of 22% etc.", yet the same report may remain silent on declining PBIDT percentage.

We notice that though the PBT percentage shows a slight improvement (15.7% from 15.5%) the PBIDT percentage shows a slight fall (19.78% from 20.44%). Logically, the next question should be, "If the profit percentage at PBIDT level has declined what has reversed the trend to improve the profit percentage at PBT level?" To answer the question let us go through the other components of expenditure which are deducted from the PBIDT viz. Interest and depreciation.

Subtracting the interest component from PBIDT we come to PBDT i.e. profit before depreciation and tax. Interest is an expense which has to be settled whether a sale is made or not. Excessive interest burden in a slump year can bring the company under great strain.

Generally the Sales Departments of companies with high interest cost are under pressure to sell and collect debts. If the sales receivables climb, it can lead to distortions like excessive sundry debtors and pressures on the cash flow. These are also the times when excessive discounts are offered to customers for settlements of dues.

A low interest burden indicates low borrowings, which in turn indicates that the company can survive in a slump year that much easily. It may also mean that the company is using its own money for expansion. However, the analyst should see where the profits are going.

If the profits are invested in new machinery, he should feel encouraged. If not then it is a matter of concern. If borrowings are low and new investment in plant and machinery is also low but profits are high, then an outsider feels a little uneasy because old dilapidated machinery can not improve efficiency of the plant. The future becomes a little uncertain and investors don't like that.

We also see some conservative companies who like to keep their borrowings to the minimum and increase their cash assets. If the company persists in such a policy, it ends up starving the plant and growth gets restricted.

'Zero Debt' situation probably saves sleepless nights for the CEO and CFO but makes the shareholder worried. Please note that we are discussing an engineering company. Infosys, a leading IT company, has no borrowings and considerable cash assets, but the reasons there are different.

When the depreciation is deducted from PBDT, PBT is obtained. With this much discussion let us study the figures of Kirloskar Cummins at greater detail.

Table 4. Figures in Rs. Million

s	1996	1995	% change
Total Sale	6703.6	5551.4	20.8
Total Mfg Expenses	5377.2	4416.6	21.8
PBIDT	1326.4	1134.8	16.9
% of PBDIT to Total sale	19.78	20.44	-3.22
Interest	113.0	125.6	-11.2
Depreciation	163.8	150.8	8.6
Total Expenses	5654.0	4693.0	20.5
Profit before tax	1049.6	858.4	22.3
% PBT to total Sale	15.7	15.5	3.2

It is very clear that the lower interest burden has changed the picture. Interest charges have come down by 11%. By paying less interest the expense was curtailed and the bottom line was improved. Thus the credit for the improved PBT does not go to the manufacturing activity but to the lower borrowings.

To complete the picture let us see the profit after tax (PAT), for academic interest if for nothing else. This is the amount shareholders are interested in. Theoretically this belongs to them. Part of this is transferred to the Reserves and part is distributed as dividend.

Table 5. Figures in Rs. Million

s	1996	1995	% change
Total Sale	6703.6	5551.4	20.8
PBT	1049.6	858.4	22.3
Tax and provisions	416.7	359.2	18.3
PAT	632.9	499.2	25.1
PAT % to Total  Sale	9.4	9.0	3.3

The picture becomes complete now. Though there is a drop in PBIDT percentage, a rise, though marginal, is seen in the net profit percentage. Will an analyst be happy at seeing the bottom line? Not really because he sees that the profit percentage is maintained (the rise is marginal and therefore we say it has been maintained) because of lower borrowings and not because of any improvement in the manufacturing activity.

The exercise also shows the importance of percentages. They allow analysts to make quick and easy comparisons. One may compare two or more businesses, or even the performance of the same business from one year to another, without getting entangled in unwieldy figures.

Profit can be represented simply by the amount that is left after deducting all expenses from sales and other income, but this amount by itself does not satisfy the analyst. He is interested in the relationship between sales and profits. In other words, an analyst wishes to know how much of every rupee of sales income was retained by the company and the reasons why it was higher or lower than previous year and most important, where did it come from.

Basic source of profit is the main activity of the company, and the efforts should always go in improving the efficiency of that activity. If the efficiency shows a declining trend it is definitely a matter of concern, no matter how rosy the bottom line looks. For an analyst this is a signal to go deeper into the report.

A word of caution will not be out of place here. In the life of a good company like Kirloskar Cummins Limited, a result like the one cited above for one particular year is really not worth much concern. The company has shown a consistent growth pattern for almost forty years. Good companies are capable of taking such setbacks in their stride and spring back. Moreover we have not studied the annual report in its entirety to know the precise reasons for higher cost of manufacturing. Our purpose was to show how superficial study could lead to wrong impressions and that was served well by this concrete example.