Understanding the Company beyond Balance Sheet

Reflects the historical value of assets, liability and net worth of the company at particular point of time.

Reveals the revenue and the details of the various expenses and the net surplus/loss.

Shows the cash, which is generated from the operating activities, investment activities and from financing activities under various heads.

Forms part of the Balance Sheet and Profit & Loss Accounts, revealing the accounting policies, accounting standards and accounting practices adopted by the company.

Part A: Internal Factors (15 Dimensions)

Factors originating within the enterprise encompassing operating capacity, human capital, governance, off-balance liabilities, restructuring, R&D, and promoter alignment.

Part B: External Factors (6 Dimensions)

Macroeconomic forces, brand premiums, rating agencies, credit/forex/market risks, raw material security, regulatory licensing, and product approvals.

1. Installed Capacity and Utilisation

The installed capacity and understanding at what capacity utilisation the company functioning is important to understand the growth prospect. No company would like to keep its production capacity idle if it has good business operations. It is always considered good to work with full capacity. However, the company which is utilising its full capacity, offer little or no scope for growth at its present capacity. Any spurt in the demand of the products, the company which is utilising its full capacity will not be able to participate in additional business, where the company which is having surplus capacity, will benefit from the spurt in demand. Projects like cement, steel, textile, speciality chemicals etc. require large investments and time to create additional capacity. Therefore, companies having surplus capacity get immediate benefits in the boom period.

2. Human/Industrial Relation

Human capital is now one of the most invisible assets of any company and difficult to be assessed. It is very difficult to understand human behaviour and their competency. However, studies on employee training, reward and recognition policy, performance appraisal methodology, employee turnover and attrition rate, Stock Option Scheme, etc. may be helpful to understand the HR Policy of the company. These are very important for the valuation of the companies engaged specially in IT Sector as they are assessed and valued based on employee strength and their quality. Markets do take cognizance of the HR policies for the companies like Infosys, Wipro, TCS etc.

Similarly industrial relations are also the judge on the history of the lock outs, strikes and labour unrest occurred in the company during past periods.

3. Reading Notes to Accounts

The Notes to accounts forms part of the balance sheet and profit and loss accounts. Apart from the statutory disclosure as required under the schedule II of the Companies Act 2013, the Notes to accounts makes many disclaimers and disclosures, which may be necessary to understand the company performance and position. The size of these notes to accounts are many times larger than the size of the financial statements and thus there is a possibility that the important disclosures or contingent liabilities affecting the company may remain unnoticed.

Pending court cases and litigations, huge demands from revenue authority, any legal proceeding taken under the Insolvency and Bankruptcy Code, etc, as disclosed in the note to the accounts, may affect the working or survival of many companies as going concern.

4. Chairman Statement

Though it is not mandatory, Chairmen of many companies share the vision of the company in their statement to investors. This statement is sometimes given along with the annual report or it may be published in prominent newspapers. This is a forward-looking statement on the current performance of the company and its future business outlook and strategy as well. This is widely read by the well-informed investors.

5. Segment-wise Performance / Product Diversification

If the company is operating in more than one segment, segment wise reporting is provided in the annual report. This will facilitate to understand the contribution of each segment in the revenue and growth of the company and help the investor make a better analysis of the risk and returns of the organisation.

Many companies also adopt the route of the subsidiary company for the different and diversified activities/products and many times it is also noticed that companies go for demerger for different segments for better management. As per the market report, Mahindra & Mahindra is initiating a restructuring plan to trifurcate its flagship automobiles business into electric vehicle, tractor and passenger vehicle business into three independent companies via a demerger process.

The evaluation of the performance of these subsidiaries are equally important to understand the performance of the holding company.

6. Events Occurred after Balance Sheet Date

The economic and political situations keep changing at national and international levels and it may have a favourable or adverse effect. The situation may be:

1. Government of any country may put restrictions on exports/imports.
2. Imposition of anti-dumping duty by the importing country.
3. Banning of use of any products, like ban on use of certain plastic products in India.
4. Any major break down due to nature calamity, fire or labour unrest.
5. Any major legal actions or proceeding against the company.
6. Occurrence of pandemics like COVID.

7. Captive Power Plant

Power is an important input for many industries and forms the major cost of production, especially in aluminium and steel industries, power cost is substantial. It is observed that if the power is produced in house for captive consumption, it is much cheaper than the purchasing the power from outside. Further, captive power plant reduces the dependency on the outside supply and ensures uninterrupted power supply.

Solar power is much cheaper now and many companies are installing solar power and opting net metering arrangement to reduce the power cost. Also they are selling surplus power to stakeholders outside. Almost all the business houses like Tata Steel, Hindalco, M&M, Reliance, etc have power plants for captive consumption and also installing green energy plants to save power cost and reduce the load on the environment as well.

8. Family / Professional Management / Governance

In India, family managed companies play a vital role and influences the vision and mission of the company. Some groups control the management through the holding company and give the subsidiary sufficient autonomy for day-to-day functioning. In case of family managed company, people look at the succession management planning for sustainability.

There are professionally managed companies also which are very successful without being associated to any business family, like Larsen & Toubro (L&T).

For listed companies, the appointment of independent directors are mandatory and the composition of Board of these companies also affect the market perception. Hence corporate governance is becoming prominent in the corporate world.

9. Collaborations

The nature and type of collaborations, the company have entered also decide their superiority in terms of technology, finance, marketing, etc. Looking at these collaborations shall help in understanding the strength of the company. For example the Japanese subsidiary of Mahindra & Mahindra, Mitsubishi Mahindra Agricultural Machinery Co., Japan and Kubota Co., Japan have entered into a business collaboration arrangement for the Japanese market. Similarly, severance of the collaboration agreement may happen affecting the business as occurred in the case of Hero group and Honda group.

10. Out-Licensing

Out-licensing is a relatively new phenomenon in the Indian market. Due to lack of required in-house facilities to develop patented products, companies are adopting out-licensing strategy for production. As it becomes more expensive to develop new products, out-licensing collaborations are fast becoming a favoured option specially for pharmaceutical companies to save on research and development investments.

11. Research & Development (R & D)

Research and development is a continuous process which keeps the company ahead of competitors in terms of technology and innovation. Through R & D, the company may:

1. Develop new products,
2. Modify/change product design,
3. Design new process to improve quality,
4. Reduce operating cost by substituting the cheaper raw material,
5. Reduce production cycle time,
6. Develop/explore new markets etc.

The company which has in house R & D facility finds preference, since it ensures confidentiality and continuity.

12. Incentives & Production Linked Incentive (PLI) Scheme

Government of India (GOI) and many state governments offer various incentives for the development of certain sectors and undeveloped areas. These incentives play a very vital role for the growth and economic viability of the company. Central Government offers incentives for agro-processing sector, horticulture sector, development of North-Eastern region, etc. Similarly, state governments offer incentives to MSME, large, and mega units to attract investments in their states. Availability of such incentives shall be studied to understand the benefits to the company.

13. Merger / Amalgamation / Acquisition

The value of the company changes with the change in the management. These changes may have occurred due to merger, amalgamation or acquisition. Such developments should also be kept in mind. It helps companies gain access to a larger market and customer base, reduce competition, and achieve economies of scale in a shorter time.

Illustrative M&A Precedents: For example, L&T has acquired Mindtree, Patanjali Ayurveda Ltd. acquired Ruchi Soya, Godrej Agrovet acquired stakes in Astec Life Science Ltd., Tata Steel acquired Bhushan Steel, etc. leading to more value creation in the market through these mergers, amalgamations and acquisitions.

14. Shareholding Pattern and Pledging of Promoters’ Holding

The shareholding patterns and any change therein is also given in the annual report under Corporate Governance Report. This should also be studied to know the promoters holding in the company and any change that took place during the year. The higher the promoters holding, the larger is their commitment in the company and viewed as positive.

15. Replacement Cost

The present cost of replacement of setting up of the similar units is sometimes considered by the market forces. However, with the technological development and innovation, replacement cost theory is losing its relevance as new technology has reduced the operating cost substantially with improvement in quality and functional utility.

1. Brand Value

Branding is important when trying to generate future business. A strongly established brand increases the business value by giving the company more leverage in the industry. Many times brands enjoy more independent value than the name of the company manufacturing the branded products.

In the apparel market, brands like Van Heusen, Louis Phillipe, Allen Solly, Peter England, Pantaloons are owned by Aditya Birla Fashions Ltd. Arrow is owned by Arvind Fashions Ltd. Park Avenue, ColorPlus, Parx, are owned by Raymond Ltd. These brands are recognised by the public by their brand name rather than the name of the company owning the brands. Also, manufacturers push the brand name rather their company name.

2. External Credit Rating

The credit rating assigned by the external rating agencies like CRISIL, CARE, ICRA, FITCH, etc. is important to understand safety of the investment. They evaluate the project according to their strength and do SWOT analysis and assign the rating according to risk perception. The higher the rating, the safer is the investment and such companies can obtain loans at lower interest rates. Especially regarding the debt instruments, rating plays a vital role for the investors’ safety. The ratings are assigned for long term loans and short term loan facilities separately.

The ratings assigned signify as under:

3. Risk Analysis

Understanding the nature of a company’s business and the inherent risks is important when analysing financial position. The nature of a company’s business depends on many factors, including the size of the company, where the company is in its life cycle, the geographic areas it operates in, and the competitive landscape in which it operates. Risks are inherent in the business. The risk may be market risk, credit risk, environment risk, Forex risk, etc. Management Discussion Analysis make a special mention about risk management policy and should be read carefully. Few examples are:

• Credit & Leverage Risk: A highly leveraged company may be exposed to a great credit risk in terms of timely repayment obligation. The enactment of Insolvency and Bankruptcy Code and the right conferred to the secured and unsecured, has made the situation more vulnerable which are not meeting their financial obligations in time. There are many companies which change hands in management and NCLT has ordered for liquidation.
• Geopolitical & Country Risk: Companies operating international trade are subject to country risk. The recent war between the Russia and Ukraine and the involvement of many other countries in the war has affected the international trade and both importing and exporting countries are facing lot of problems. The automobile sector is facing a dramatic shortage of microchips and components globally.
• Forex & Unhedged Borrowing Risk: External commercial borrowings in foreign currency may subject to currency fluctuation risk, if not hedged. The impact may be positive or negative.
• Market & Customer Concentration Risk: Market risk may cover the client concentration, distribution channel and policy, product life cycle, change in customers choice, development of substitutes with improved features. etc. The companies engaged in consumer products are more prone to market risk due to change in customer behaviour.
• Environmental & Regulatory Lease Risk: The Government has begun stipulating stringent norms and regulations to control environmental regulations and many times it is observed that working of the companies are suspended due to non-compliances of these norms. Many mining companies are also facing the same environmental problems in their operation or renewal of lease from the Government.

4. Control over the Raw Materials

Uninterrupted availability of raw material is vital for the running of units of the company. Companies having in-house supply of raw materials will be more valuable than the company sourcing from outside.

Captive Sourcing Precedents: For example, there are many steel making companies like JSW, Tata Steel, etc which have their own mines for the supply of raw materials like iron ore, manganese, coal etc. Such companies which have captive arrangement for supply of raw materials are less dependent on the market for the supply and they command the premium in the market.

5. Patent / Licence / Entry Barrier

The points to be considered are:

1. Patents: The companies that have patented their products or process, restrict the entry of others till the validity of patent period. The unexpired period of the patent is important to understand its long-term impact.
2. Operating Licences: There are sectors like banking, telecom, Airlines etc which require licence to operate. It is a time-consuming process to get the new licence. Therefore acquisition routs are adopted to enter into these fields. Recently Tata has acquired Air India from the GOI.
3. FDA Approvals: Pharmaceutical companies require approval from the FDA, in India or abroad, before launching the product for commercial application.
4. Capital Intensity as Entry Barrier: The requirement of large investment and innovation creates entry barrier for new-comers. Projects like refinery, semiconductors, integrated steel plant, etc. fall under this category.

6. Product Approvals

There are products which require prior approval from the competent authority before its commercial production. The process may take a long time to get the required approvals. For example, for making supply for defence use, products are to go through the stringent safety and quality norms of the Defence Procurement Policy of Ministry of Defence, Government of India.

Similarly in the pharma sector, approval process takes a long time and on approval, market capitalisation increases.