If you are looking at just the reported numbers, look again. Companies' reported earnings might not reflect the true profit from core operations if there are changes in the accounting policy or a one-time other income.
Reported numbers have to be analysed in detail before investors take informed decisions about revenues and profit growth. Many a times, investors might overlook small changes in accounting policy. Here is what you should you watch out for.
High "other", one-time or extraordinary income: Revenue sources under "other income" are non-recurring and may be earnings from sale of assets, property, etc. This is not part of a company's core earnings and could inflate the total income. Pharmaceutical companies such as Pfizer and Piramal Healthcare had high "other income" as they had sold off one of their pharmaceutical divisions. Some had sold their brand to another company. In the year of sale, the extraordinary income was very high, resulting in higher EPS. In subsequent years this was tempered.
Change in accounting policies: Earnings and assets could be inflated by alternative accounting policies. At times, companies adopt innovative accounting policies in order to boost income or reduce expenditure. A change in the depreciation policy is one of the most common methods to boost profits. For example, a leading tyre manufacturer changed its depreciation policy from written-down value (WDV) to straight-line method (SLM) in the reporting year 2010-2011 to tide over the increase in input costs of rubber. Similarly, as reported in Business Standard recently Go Air could show profit in FY 2012-13 (compared to FY 2011-12) because of the change in accounting for lease rentals.
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According to contracts, a portion of the lease rent paid by an airline to the lessor is recoverable for the cost of repairs and maintenance of aircraft. Till FY 2011-12, GoAir treated this entire supplementary lease rent as an expense. However, in FY 2012-13 the management changed the policy and treated only the non-recoverable lease rent amount as an expense. The balance was treated as contribution received from the lessors.
Too many off-balance-sheet transactions: If a company has been expanding by creating special purpose entities and has entered into many lease contracts, it is possible that many liabilities are not reflected on its balance sheet. Also, it may have taken many derivatives contracts, which are off-balance-sheet items. Companies such as Welspun and Ranbaxy have been hit by foreign-exchange covers.
High foreign exchange or debt exposure: Companies such as Wockhardt and Suzlon have been affected by their foreign currency convertible bonds (FCCBs). Similarly, Kingfisher high debt has turned into a classic case of a debt-trapped company. Always invest in companies which do not have high debt exposure.
Round-tripping: This means getting into fictitious transactions with related parties to inflate revenue. In round-tripping, a company sells unused assets to a party with the promise of buying them back later at the same price. This can happen where there are web of companies and there are inter-company sales. This is common in many mid-sized Indian companies. Apple too had utilised subsidiaries to dodge taxes. In India one of the largest industrial groups with diversified interests such as telecom, financial services and media is known for this.
Non-performing assets: With banks and NBFCs, the percentage of non-performing assets (NPA) is important from a financial analysis point of view. A bank may have shown below-average profits but if NPAs improve, the stock may not be battered.
State Bank of India declared a below-par result for Q2 FY2013-14; however, the stock did not slip much as the NPA ratio was not as dismal as was anticipated.
The main reasons for rising figures could be any of the following:
- Anticipating listing or for a Follow-on Public Offer (FPO). This ensures richer valuations
- To privately place shares with venture capital or foreign institutional investors (FIIs)
- For better leverage in raising debt
- To conceal management inefficiency
- To meet regulatory criteria such as net worth, profitability threshold, etc
- To inflate the compensation paid to executives
- To meet targets set by big-ticket investors such as VC, PE, HNI, etc
Generally, IFRS reporting is considered more transparent and standardised, though it is not mandatory in India. In an era when Indian companies are own global, the need for IFRS is more keenly felt. As it is, accounting practices should be conservative rather than innovative when an element of uncertainty prevails. Bharti Airtel, Infosys, Wipro and Mindtree are some of the few Indian companies which voluntarily follow IFRS standards. Some other companies too have begun adopting IFRS standards for financial reporting. IFRS is more relevant to companies which operate in many countries, or those that wish to raise capital overseas.
Another aspect is to look at Notes to Accounts, a textual narration of financial practices. See whether practices deviate from normal accounting practices. For example, PSU banks in India do not fully recognise pension liability on their books. Such a huge amount erodes profitability.
At times, statutory auditors qualify accounts in case accounting practices are not in step with accepted standards or proper disclosures are not forthcoming. It is important to look at these. Some of the qualifications also offer a quantitative effect.
At times, companies report high profits but their cash flows are a crucial issue. If a company is faced with a cash crunch, this can be seen from the cash-flow position.
Another aspect is the sales growth in the sector. For example, an industry body such as the Automobile Association publishes periodic sales figures. From this, one can decipher if sales are in line with the industry, or above or below the average.
Another benchmark is financial ratios, compared with peers in the sector. If a company's ratios do not match industry peers, probing its accounting practices is a good safeguard. This could be due to inflated earnings, asset valuations or understating of expenses and liabilities.
With incidents such as the Satyam fiasco and the NSEL, investors need to be cautious and look beyond financial results. And companies should know that better disclosure and transparency always help in creating long-term wealth. By doing so they ensure peaceful times for themselves and for investors.