Talking about numbers reminds us of the mathematics classes in school days, when we would invariably get lost in a maze of numbers?mensurations, formulae, graphs et al. Numbers still remain a put-off. And yet, we seem to share a love-hate relationship with them; otherwise, why do we use them so much and so often?
Through the following story, we will try and demystify some of the most important numbers used in the world of business. The story would come in several episodes. You would find an interesting tale behind each number, only if you care to listen. Our objective is to help you evaluate businesses for investment purposes by making numbers easy to comprehend. After all, ?Owning equity is akin to owning a company?. And it is imperative that you understand the numbers of the company that you invest in, no?
A business can actually be assessed on the basis of several parameters?profitability (whether it is making money), efficiency (if it?s making the best possible use of its resources), leverage (whether it has the right mix of debt and equity), solvency (whether it can pay off its debts), liquidity (whether it has cash to meet its day-to-day needs) and so on. All these point to the overall health of a company?and hence, to the health of its shareholders.
In order to interpret the company on these parameters, we need to know what goes behind the numbers in the balance sheet and the profit & loss statement.
Let us talk about a company that seeks to manufacture soaps. To begin with, it will need a plant in place. Without the plant there would be no operations, right? To know what the company has, the best place to look for is its balance sheet.
Balance sheetA Balance sheet is like a snapshot that captures a mood at a particular instant. It is a financial snapshot of a company at a given point of time.
Gross fixed assets: Coming to our example, to make soap, the company needs a plant. It also requires some land along with other infrastructure to set up an office. Other facilities like pipelines and waste disposal systems are also essential. These together constitute the gross fixed assets of the company.
Accumulated depreciation: But nothing lasts forever, the assets wear and tear and need to be replaced at a future date. So, every year, an amount is set aside to meet these expenses. This amount is known as depreciation charges for the year. And the cumulative amount collected for the given period shows up in the balance sheet as accumulated depreciation.
Net fixed assets: These are nothing but the gross fixed assets less the accumulated depreciation. All they connote is the book cost of the existing assets.
Capital work in progress: When the company grows and expands its operations, there are often unfinished plants, buildings under construction and so on. These are clubbed under capital work-in-progress.
Meanwhile, the plant is ready to commence operations. But can we straightaway get into the act of manufacturing soaps? Not really. Some other current requirements, those of raw materials, need to be met first. The suppliers of raw materials also need to be paid.
Current assets, current liabilities: Liabilities like the creditors (suppliers of raw materials, fuel, etc. on credit) and provisions for tax that need to be paid immediately are called current liabilities. Similarly, there are some current assets. Unlike plants or buildings some assets like debtors and inventory of soaps that are in the company?s godown can be converted into cash more easily. What is crucial here is that the company?s current assets and liabilities balance comfortably; so that it does not face a cash crunch or has surplus of cash. The difference between the current assets and current liabilities is called net current assets.
But all this can happen provided there are funds. So, the company raises funds?
Equity: This is the amount contributed by the shareholders of the company at the initiation of the business. This is simply the number of shares multiplied by the face value.
Reserves and surplus: As we saw in the profit and loss statement, from the total proceeds received, all the expenses have to be taken care of, tax has to be paid, and dividend has to be given to shareholders. The balance is called the retained profit. This is what the company would retain to re-invest in the business to propel further growth. This would get reflected in its balance sheet as reserves and surplus.
Equity and reserves are together known as shareholders? funds?funds at the command of shareholders to be invested in the business. They are also referred to as net worth.
Loans: But the entire business can rarely be funded by shareholders? funds alone. A company usually resorts to debt to bridge the gap between the requirement and the supply. These are called loan funds. Thus, we have the liabilities?funds owed to shareholders and debt holders?these constitute the company?s debts.
Investments: After the operations start, money begins to flow in. Just like you put your surplus cash in stocks and other investment avenues, so does the company and the amount is shown as an asset (hopefully, the company makes sound investment decisions!).
The statement that takes stock of the operations of the company during the entire given period is called the profit and loss statement.
Profit and loss statementWe are very familiar with the figure called net profit. So, what is the story behind this number? We have to cross several hurdles before we can actually understand what net profit means (remember, it is also called bottom line!). Let us take a fast local and halt at important stations that would help us understand net profit better.
Operating profit: It is one of the prime drivers of profitability at the end of the day. If the company produces 10 soaps at a cost of Rs2, spends Rs0.50 on advertising them and pays a commission of Re1 on each soap to the retailer/dealer, then its total production cost works out to Rs35. It then sells each soap for Rs10, earning a total of Rs100, which is its net realization. But, its operating profit works out to only Rs65 (net realisation minus total production cost). Thus, operating profit is a good indicator of a company?s ability to make money from its core operations.
Depreciation: For its operations, the company uses capital?like plant and machinery. Depreciation is a cost that is charged for use of plants and building. It is not cash expenditure. Any asset?be it a plant or a machinery?eventually wears off and needs to be replaced. Depreciation is an amount set aside every year towards replacement of the assets.
Finance charges: The company requires funds to invest in assets and to run its day-to-day operations. After all, a plant has to be put in place and costs incurred in producing and selling the products, before the company can reach the final consumer?and more importantly, before money can be realized! These expenses are funded by a mix of shareholders? funds (called equity) and borrowings from others (debt). Sometimes, the company might also lease a plant from a different party for a periodic payment (just like you might rent a flat). While the company is not obliged to pay its shareholders (after all, it is their company and hence, its risks and rewards are also their own!), it has to pay for using others? funds. Thus, the company has finance charges like interest and lease rentals.
Other income: While operating income can be viewed as salary, other income can be compared to bonus. The company invests its surplus cash in several avenues like debentures and equity of other companies. These investments yield dividends and interest income, which together constitute other income.
Adjustments for extraordinary items: Sometimes, there are one-time expenses in the form of provisions (for tax, dividends, bad debts, etc.), write-offs (treating some bad loans as permanent losses), etc. Then, there may also be a one-time income from sale of certain assets. All these classify as extraordinary items. While analysing performance, one should discount these items to get a better picture of a company?s business operations.
PBT: After paying for all the expenses, this is what is left in the company?s kitty.
Tax: But then, do you carry your entire salary home? Neither does the company. Based on tax regulations it has to shell out Income Tax ? its contribution to the state kitty.
Net profit: Well, home at last! This is one number that summarises the company?s operations.
Dividends: After paying all the other stakeholders in the business, the company pays dividends to its shareholders. But, how often have you bought a stock for dividend purposes only? If fixed payment is what one is looking for, then there are debt instruments after all! So, how else do the shareholders benefit? They gain from capital appreciation, which is linked to the fortunes of the company.
Thus, we see that a company?s net profit is dependent on several factors and prudent management of each would adds to its growth.
Moral of the story:
§ A company invests money in assets to commence operations that are financed through debt and equity.
§ Balance sheet gives a snapshot view of a company?s financial health at a particular point of time.
§ The profit and loss statement summarizes a company?s operations.
Through the following story, we will try and demystify some of the most important numbers used in the world of business. The story would come in several episodes. You would find an interesting tale behind each number, only if you care to listen. Our objective is to help you evaluate businesses for investment purposes by making numbers easy to comprehend. After all, ?Owning equity is akin to owning a company?. And it is imperative that you understand the numbers of the company that you invest in, no?
A business can actually be assessed on the basis of several parameters?profitability (whether it is making money), efficiency (if it?s making the best possible use of its resources), leverage (whether it has the right mix of debt and equity), solvency (whether it can pay off its debts), liquidity (whether it has cash to meet its day-to-day needs) and so on. All these point to the overall health of a company?and hence, to the health of its shareholders.
In order to interpret the company on these parameters, we need to know what goes behind the numbers in the balance sheet and the profit & loss statement.
Let us talk about a company that seeks to manufacture soaps. To begin with, it will need a plant in place. Without the plant there would be no operations, right? To know what the company has, the best place to look for is its balance sheet.
Balance sheetA Balance sheet is like a snapshot that captures a mood at a particular instant. It is a financial snapshot of a company at a given point of time.
Gross fixed assets: Coming to our example, to make soap, the company needs a plant. It also requires some land along with other infrastructure to set up an office. Other facilities like pipelines and waste disposal systems are also essential. These together constitute the gross fixed assets of the company.
Accumulated depreciation: But nothing lasts forever, the assets wear and tear and need to be replaced at a future date. So, every year, an amount is set aside to meet these expenses. This amount is known as depreciation charges for the year. And the cumulative amount collected for the given period shows up in the balance sheet as accumulated depreciation.
Net fixed assets: These are nothing but the gross fixed assets less the accumulated depreciation. All they connote is the book cost of the existing assets.
Capital work in progress: When the company grows and expands its operations, there are often unfinished plants, buildings under construction and so on. These are clubbed under capital work-in-progress.
Meanwhile, the plant is ready to commence operations. But can we straightaway get into the act of manufacturing soaps? Not really. Some other current requirements, those of raw materials, need to be met first. The suppliers of raw materials also need to be paid.
Current assets, current liabilities: Liabilities like the creditors (suppliers of raw materials, fuel, etc. on credit) and provisions for tax that need to be paid immediately are called current liabilities. Similarly, there are some current assets. Unlike plants or buildings some assets like debtors and inventory of soaps that are in the company?s godown can be converted into cash more easily. What is crucial here is that the company?s current assets and liabilities balance comfortably; so that it does not face a cash crunch or has surplus of cash. The difference between the current assets and current liabilities is called net current assets.
But all this can happen provided there are funds. So, the company raises funds?
Equity: This is the amount contributed by the shareholders of the company at the initiation of the business. This is simply the number of shares multiplied by the face value.
Reserves and surplus: As we saw in the profit and loss statement, from the total proceeds received, all the expenses have to be taken care of, tax has to be paid, and dividend has to be given to shareholders. The balance is called the retained profit. This is what the company would retain to re-invest in the business to propel further growth. This would get reflected in its balance sheet as reserves and surplus.
Equity and reserves are together known as shareholders? funds?funds at the command of shareholders to be invested in the business. They are also referred to as net worth.
Loans: But the entire business can rarely be funded by shareholders? funds alone. A company usually resorts to debt to bridge the gap between the requirement and the supply. These are called loan funds. Thus, we have the liabilities?funds owed to shareholders and debt holders?these constitute the company?s debts.
Investments: After the operations start, money begins to flow in. Just like you put your surplus cash in stocks and other investment avenues, so does the company and the amount is shown as an asset (hopefully, the company makes sound investment decisions!).
The statement that takes stock of the operations of the company during the entire given period is called the profit and loss statement.
Profit and loss statementWe are very familiar with the figure called net profit. So, what is the story behind this number? We have to cross several hurdles before we can actually understand what net profit means (remember, it is also called bottom line!). Let us take a fast local and halt at important stations that would help us understand net profit better.
Operating profit: It is one of the prime drivers of profitability at the end of the day. If the company produces 10 soaps at a cost of Rs2, spends Rs0.50 on advertising them and pays a commission of Re1 on each soap to the retailer/dealer, then its total production cost works out to Rs35. It then sells each soap for Rs10, earning a total of Rs100, which is its net realization. But, its operating profit works out to only Rs65 (net realisation minus total production cost). Thus, operating profit is a good indicator of a company?s ability to make money from its core operations.
Depreciation: For its operations, the company uses capital?like plant and machinery. Depreciation is a cost that is charged for use of plants and building. It is not cash expenditure. Any asset?be it a plant or a machinery?eventually wears off and needs to be replaced. Depreciation is an amount set aside every year towards replacement of the assets.
Finance charges: The company requires funds to invest in assets and to run its day-to-day operations. After all, a plant has to be put in place and costs incurred in producing and selling the products, before the company can reach the final consumer?and more importantly, before money can be realized! These expenses are funded by a mix of shareholders? funds (called equity) and borrowings from others (debt). Sometimes, the company might also lease a plant from a different party for a periodic payment (just like you might rent a flat). While the company is not obliged to pay its shareholders (after all, it is their company and hence, its risks and rewards are also their own!), it has to pay for using others? funds. Thus, the company has finance charges like interest and lease rentals.
Other income: While operating income can be viewed as salary, other income can be compared to bonus. The company invests its surplus cash in several avenues like debentures and equity of other companies. These investments yield dividends and interest income, which together constitute other income.
Adjustments for extraordinary items: Sometimes, there are one-time expenses in the form of provisions (for tax, dividends, bad debts, etc.), write-offs (treating some bad loans as permanent losses), etc. Then, there may also be a one-time income from sale of certain assets. All these classify as extraordinary items. While analysing performance, one should discount these items to get a better picture of a company?s business operations.
PBT: After paying for all the expenses, this is what is left in the company?s kitty.
Tax: But then, do you carry your entire salary home? Neither does the company. Based on tax regulations it has to shell out Income Tax ? its contribution to the state kitty.
Net profit: Well, home at last! This is one number that summarises the company?s operations.
Dividends: After paying all the other stakeholders in the business, the company pays dividends to its shareholders. But, how often have you bought a stock for dividend purposes only? If fixed payment is what one is looking for, then there are debt instruments after all! So, how else do the shareholders benefit? They gain from capital appreciation, which is linked to the fortunes of the company.
Thus, we see that a company?s net profit is dependent on several factors and prudent management of each would adds to its growth.
Moral of the story:
§ A company invests money in assets to commence operations that are financed through debt and equity.
§ Balance sheet gives a snapshot view of a company?s financial health at a particular point of time.
§ The profit and loss statement summarizes a company?s operations.
