India Inc.: How Real Are Corporate Profits?
The Satyam episode has investors worried about incorporated governance. Here’s how to distinguish between "real" and "accounting" profits
By Karan Sehgal and Supriya Verma Mishra
In the eagrass of the Satyam episode doubts are being raised about the incorporated governance standards followed by the India Inc. The shareholders’ concern is: “How veritable are those profits that are declared in the profit and ruin accounts?” In other discourse, an investor of necessity to check on the supposition that the company’s profit vegetation is matching with similar buoyancy in cash flows from operations. To check the veracity of the weighing sheets of the companies, investors need to distinguish between ‘profits in the volume’ and ‘profits in the do banking.’
We at ET Intelligence Group are workmanship the task easier for you. We take you from one side the balance sheet and profit & loss account of India’s top 100 companies that form part of the BSE 100 index. We did this through brace rounds of screening in order to distinguish between ‘real’ and ‘accounting’ profit. In addition to BSE 100 companies, we have also considered companies, like Britannia and Colgate Palmolive, which have earlier been in the index.
The science of the laws of thought is simple. A double or triplicate digit weal produce is impressive, but if it comes on the on the frontier of huge investments in working capital or fixed assets, then so much is less suitable for apportionment to shareholders in the configuration of dividends or to plough back. Moreover, a faster growth in working capital or fixed involving death may jeopardise that will be profit growth of a company.
In the first round of screening, the trends in reported cash improve and net pay in money flow from operations are analysed. Cash improvement is calculated by adding depreciation to net profit, and net ready money flow from operations is calculated by deducting working capital investments from the cash profit. It’s obvious that if cash flow from operations is not growing in tandem with coin service, then the company is investing more in its working capital. Typically, it happens by the agency of the way of extending more credit to the debtors. This helps companies to boost the topline and bottom cover by lines in the near term, thereby, they keep the investors and the emporium happy.
Our analysis revealed that many companies invested so much in their working capital that in that place is a huge lacuna in the germination in cash profit and the growth in cash from operations. The adjoining chart shows the combined cash from operations and reported cash profit of BSE 100 companies. It is clearly visible that cash grow from operations was greater amount of than cash profit in FY03 and FY04. However, after FY04, ready money from operations was much lesser than cash profit indicating that India Inc. has aggressively invested in acting capital in its improvement phase.
In the adjacent tables, the best and the worst performers in the first round of screening are listed. Best performers are companies like Reliance Industries, ACC and NTPC among others. In case of such companies, the growth in cash have existence derived from operations has kept the pace with growth in turn into money profit. With worst performers, the case is exactly irreconcilable.
We then did a second level of screening, which involved estimating the free cash flows for the companies, which passed through the first round. Free Cash Flow is calculated by deducting the investments in fixed assets from net cash flow from operations. Simply put, it is the substance left with the company—both to be distributed among shareholders as dividend or to be reinvested in the business.
Some of the findings appear pretty obvious. For instance, not any of the capital merchandise companies could clear the first established succession of screening. This tells us that they had to beset more in laboring capital to either seal the order book or clear backlogs.
More importantly, it indicates that the capital goods industry is grappling not sole with fixed investments but also with investments in current assets.
Similarly, the performance of auto companies is marred by the cyclical nature of the industry. For instance, Tata Motors and Mahindra & Mahindra (M&M ) had negative free cash flows in the recent past. In deed, M&M’s growth in cash from operations was a mere fraction of growth in cash profits. On the other hand, Hero Honda’s work was stable even in terms of cash flows. Their working capital investment was actually negative in FY08 and this shows its ability to receive a better deal from its suppliers. The company has also posted positive free money flows in all of the last ten years and this is one of the reason it has weathered the current slowdown.
In metals, the picture is a bit different, as most of the companies have managed the working capital totally well. However, just title to a spate of acquisitions, the capital expenditure has skyrocketed resulting in negative free pay in money flows. In the past, SAIL and Tata Steel (prior to the acquisition of Corus) had reported absolute sincere cash flows.
FMCG habitual devotion to labor is considered to be far more stable when it comes to pay in money flows. This is the reason that in bad times, investors flock to FMCG counters. But a closer look reveals that better working capital care is far more crucial for survival of such companies than fixed asset investment. And this has been the differentiating factor among the FMCG companies in our universe of stocks. For instance , the growth in cash flow from operations of ITC, Nestle and Colgate Palmolive was far after the advance in profits. This mismatch wasn’t there in case of Asian Paints, that clearly shows that Asian Paints is single of the safest bets in the sector.
Similarly, in the pharmaceutical industry, quite a few companies dress in’t have a very promising cash post as compared to their profitability. While Cipla and GlaxoSmithkline lead the pack with the most stable cash flows, with Glaxo better placed than Cipla, others like Dr Reddy’s and Ranbaxy quiescent have a allot of catching up to do. Analyzing ready money flows can help the investors in separating wheat from the chaff much in the way Asian Paints turned out to be much better than others. Though, it may not do the part of one a millionaire all night, it won’t reverse the order.
Original text: http://rss.businessweek.com/~r/bw_rss/asiaindex/~3/523645442/gb20090126_508440.htm
