Before starting, remember that the idea behind this article is to help you analyze numbers in an Annual Report and see through irregularities before making an investment decision.
I’ve taken a jewelry company as a case study because it will help you catch the areas that need to be focused on.
However, this article is not just about that company – the goal of this post is to inform you that it is COMPULSORY to read the Annual Report (AR) before buying a stock.
I’ve correlated different finance heads and applied common sense, because it is all boils down to common sense and a very basic understanding of business.
Here are some areas that seemed glaringly out of the place:
SHORT TERM LIQUIDITY
Any company must have the capacity to meet short-term obligations.
If the company does not have enough liquid assets to pay short term liabilities, it shows inefficient cash management.
(Cash + Investments + Debtors) which are liquid assets, must exceed Current Liabilities (trade payables, short term borrowings and other current liabilities that are payable)
Inventories do not count because selling these will seriously impair its business.
Also, if at all it has to sell inventory then it will take time and huge losses because no one will buy stock in trade at market rates.
So let’s take a look at this company’s short term liquidity:
Investments + Debtors + Cash/Bank + Other Liquid assets = 2511 crores
Short term borrowing + Creditors + other short term liabilities = 3785 crores
So if there’s a run on this company, it would have been short 1274 crores.
There are comments below that gold could be sold to meet the shortfall. But if the company starts selling its gold, it won’t get the market price and would incur a loss. Moreover it would jeopardize their business and the brand name.
INTEREST ON BORROWINGS
Typically a company obtains long term loans to invest in capital assets and short term loans to finance the working capital.
The interest on long term loans is lower than the interest on short term loans. Given the present day interest regime (mid 2018), the rate of interest would work up to a maximum of about 13%.
Let’s now check how much this company has paid:
It has paid 274 crores on account of interest. Now let’s check its loans:
It has obtained loans of Rs 634 crores.
Interest Paid for the year = 275 crores on loan of 634 crores.
Works out to a 43.35% rate of interest. Looks abnormal.
There were tweets that the company takes gold on lease instead of buying stock. And then someone tweeted that jewelry company take gold leases and therefore let’s explore that angle as well:
So let us work out how much the company took gold on lease.
Standalone sales are 8105 crores. Exports make up 34%.
Cost of goods sold is 7400 crores. It is not specified in this account head how much represents making charges, and how much are purchases of gold.
Now, making is a value add activity and it should result in a higher profit margin. But if you correlate the cost of goods sold to the sales, we get a margin of 9% on standalone basis. Therefore, it can be safe to assume that the the cost of goods sold includes purchases of gold and diamonds.
Now, in a gold lease, the bank leases gold to the jewelry maker and in turn the jewelry maker has to secure the bank with some collateral that covers the cost of the gold.
Now let us assume that this company took gold on lease and it was shown in the inventory (asset).
Will it not be safe to assume that the bank demanded a collateral and the company created some charge on FDs or some other assets?
It will be safe to make this assumption. Let’s look at the companies assets (standalone) (no major divergences in consolidated figures).
Which asset could have been pledged against the gold leases?
The investments represent investment in a subsidiary – THIS CANNOT BE PLEDGED
The loans represent loans to related parties – THESE CANNOT BE PLEDGED
Deferred assets, trade receivables, loans CANNOT BE PLEDGED.
Other assets represent mostly prepaid expenses – CANNOT BE PLEDGED
Inventories are assumed to have been taken on lease – CANNOT BE PLEDGED
Cash is required for the business – CANNOT BE PLEDGED
Bank Balance is 555 crores and is represented by deposits below 3 months. This CAN BE PLEDGED.
Therefore I am assuming that 555 crores or thereabouts is the value of the gold leases and assuming the highest rate of interest @ 8%, which is 44 crores.
THEREFORE THE TOTAL INTEREST PAID CAN BE ABOUT 10% ON 634 CRORE (LOANS) plus THE ASSUMED INTEREST ON GOLD LEASES OF 44 CRORES.
Note that though gold leases are for a short period, I am assuming the company kept rolling over gold leases and obtained 555 crores for 1 year and paid the highest rate of interest.
Therefore the total interest that I can assume is about Rs 107 crores while the interest provided is Rs 274 crores.
Even if you assume 1% LC charges on exports booked as interest, we can add another 27 crores to the interest taking it to 134 crores, while the interest paid is 274 crores.
INFERENCE: OBVIOUSLY THERE IS SOMETHING THAT DOES NOT ADD UP.
Sales for the YE 31.3.17 are 8104 crores
The cost of sales is 7409 crores, which implies that this company makes about 9% gross profit margin.
Inventory as on 31-3-17 is 4119 crores. Let us add 9% and reconcile it with the selling rate. We get inventory at 4526 crores at market prices.
Every company holds inventory in the hope of selling it quickly and turning around the cash with which it can do more business.
Heavy inventories are a sign of inefficient inventory management.
In the case of this company, the inventory held represents 6.5 months of sale. This is an extraordinarily high level of inventory and a sign that inventory management needs to sharpen up .
Remember that high value inventory like jewelry and diamonds are surrounded by negative factors such as high storage costs, fear of theft, interest to pay, etc.
Clearly, the 6.5 months of inventory seems high.
There is a comment below that you need this kind of inventory in the jewelry business.
Let us take the case of Titan:
Sales 12717 crores
Inventory 4807 crores
That’s 4.5 months of inventory for 640+ jewelry and Fasttrack stores. The company in this example has 75 stores and remember, 34% of its products are exported. Titan too exports but I don’t have the percentage at this moment.
In any case, I do feel that in the Jewelry business an inventory of 4.5 to 5 months is acceptable. Anything over that suggests that operations must be optimized.
MARKET CAPITALIZATION TO TOTAL LIABILITIES
Actually, this check wouldn’t have applied last year when the this company’s AR was released and its its stock price was very high that time.
However, you should apply it to all companies in the news for the wrong reasons to get a understanding of what would happen to them if there’s a run on their finances.
The current market cap of this company = 2450 crores
Total Liabilities = 3850 crores
(excl equity cap + reserves)
INFERENCE: There’s a shortfall of 1400 crores, which means that the confidence of investors in this company’s assets is not high. This correlation shows how much the company’s assets can possibly decline in value in case there’s a run on it.
By now you would have realized that this company was holding very high inventory levels, paying a high rate of interest and its short term liquidity was not good.
What should this company do in such circumstances?
Use cash for optimizing operations, wiping off debt, etc.
Therefore let’s check the company’s cash flow statement.
The company has invested in a subsidiary and handed over a loan to a group company, both transactions amounting to 293 crores, and it ended up taking a new loan (net) of 180 crores to fund the transactions.
INFERENCE: Cash management does not meet accepted norms.
Would you have invested in this company last year when it was peaking even after analyzing this information?
Of course, you wouldn’t have.
So, this post is not to take you into the past and give you lectures about any company. The objective of this post is to make you understand that it is extremely important to read and analyze Annual Reports before making an investment.
I’ll leave you with these resources: