The business snapshot

Now that you've mastered the mysteries of the Profit & Loss Account, let's move on to the Balance Sheet. This gives you a picture of the size of the company's assets and liabilities, and the sources and uses of the company's funds

Unlike the P&L account, which shows the profit or loss a firm has incurred over a period of time, the balance sheet is a snapshot of the firm at A POINT OF TIME. As on a particular date, the last date of the accounting period, the assets and liabilities of the firm are all added up and presented in the balance sheet. The capital and reserves are added to the liabilities side to balance the two sides. In other words, Capital + Liabilities = Assets.

To illustrate, let us take the Balance Sheet of Reliance Industries.

	As at 31st March 1999		As at 31st March,1998
	Rs.	Rs.	Rs.	Rs.
SOURCES OF FUNDS :
Shareholders’ Funds
Share Capital - Equity	933.39		931.90
Share Capital - Preference	252.95		187.95
Reserves and Surplus	11,183.00		10,862.75
		12,369.34		11,982.60
Securitisation/Advance Against Future Recievables Loan Funds		965.02		300
Secured Loans	5,477.64		2,736.78
Unsecured Loans	5,207.65		5,510.55
		10,685.29		8,247.33
TOTAL		24,019.65		20,529.93

APPLICATION OF FUNDS:

Fixed Assets
Gross Block	18,650.33		17,848.33
Less:Depreciation	6,691.93		4,944.47
Net Block	11,958.40		12,903.86
Capital Work-in-Progress	3,437.83		2,069.43
		15,396.23		14,973.29
Investments		4,294.59		4,282.33
Current Assets, Loans and Advances
Current Assets
Interest Accrued on Investments	25.61		21.07
Inventories	1,408.61		1,343.96
Sundry Debtors	457.10		642.72
Cash and Bank Balances	4,897.60		2,133.51
	6,788.92		4,141.26
Loans and Advances	1,676.26		991.05
	8,465.18		5,132.31
Less: Current Liabilities and Provisions
Current Liabilities	3,591.98		3,382.01
Provisions	544.37		475.99
	4,136.35		3,858.00
Net Current Assets		4,328.83		1,274.31
TOTAL		24,091.65		20,529.93
Significant Accounting Policies
Notes on Accounts

You'll notice it's divided into two broad sections- Sources of Funds and Application of Funds.

Sources of funds

What are the sources of funds? Obviously share capital is one of them. In the Reliance balance sheet, there are two types of share capital-- equity and preference. Equity shares are ordinary shares. Preference shares, on the other hand, are so called because they get preferential treatment when it comes to paying dividend. Preference shareholders are paid a fixed dividend, unlike ordinary shareholders, whose dividends vary according to how well the company has performed.

However, preference shareholders, because they opt for the security of fixed dividend payments also forgo capital appreciation -their shares are typically redeemed at a fixed price (often no different what they paid for it).

Profits retained by the business over the years are also a source of funds. These are included under the head "Reserves and Surplus". Loans, secured and unsecured, constitute the other source of funds. Secured loans are those in which the lender has a charge on the company's assets as security, while unsecured loans are those where there is no security, for example fixed deposits from the public.

There's yet another source of funds. You'll find, towards the bottom of the balance sheet, an item called Current Liabilities and Provisions, which are deducted from Current Assets. Current Liabilities are things like Sundry Creditors, or those to whom the company owes money. In other words, you owe someone money, but you haven't paid him yet. So he becomes a source of funds.

The other item, Provisions, is a bit trickier. These are sums set aside but payments have not been made. In other words, you need to pay income tax, wealth tax, dividend, leave encashment etc, and make provisions for them, but because you haven't yet paid these sums, they become a source of funds.

Uses of funds

Now we come to the applications side of the balance sheet. Here we have the uses to which all those funds, which have been sourced, have been put. There are two broad classifications--fixed assets and current assets.

Fixed assets are things like plant and machinery. Total depreciation on these assets (see article on P&L account) is deducted from gross assets to arrive at net assets or net block. To that is added capital work-in-progress, that is, the projects going on at the balance sheet date. Investments in stocks or bonds are another way in which funds can be used. And lastly we have current assets, so called because they form part of the working capital cycle which transforms raw materials to finished goods. Current assets consist of inventory, people who owe the company (sundry debtors) and cash and bank balances. Loans and advances given to others is also a use for funds.

How do you use this information?

Now you have all this information about where the company has got its money from and how it has used it. But what use is it? You'll notice there are two columns in the balance sheet, with the previous year's figure also being given. Comparing the two sets of figures leads to some insights.

For instance, in the Reliance balance sheet, the amount of secured loans has gone up from Rs2736cr to Rs5477cr. How did it use this money? The balance sheet shows that part of it went towards increasing gross block, part towards the higher capital work-in-progress a bit on inventories and a large part was held in cash and bank balances. You can make a similar analysis for every source and use of funds, checking out how funds were sourced and how it was spent during the year. For instance, if a company siphons out money by giving loans to associate companies, the balance sheet will tell that to you.

A snapshot as on a particular date

One important caveat. The balance sheet is a snapshot, as on a particular date. For instance, if you had checked the balance sheet a few days earlier, the cash and bank balances may not have been so high. Or a company may have repaid a loan just for a few days to show lower indebtedness as on a particular date. Doing up the balance sheet in this fashion is known as window dressing. So now that you can read a balance sheet, keep a pinch of salt handy.

Back to basics

The profit & loss account

Introduction

If you own shares, you'll remember that the company sends you a booklet called an annual report just before the annual general meeting. Most of the time, all you've done is admired the glossy pictures before adding it to the pile of newspapers for the raddiwala.

That's a pity, because a company's annual report can be a great source of information, helping you to decide whether to stay invested in the company. At the very least, it'll help you ask some tough questions to the management at the AGM.

We know the problem. You'll be thinking that's a lot of unreadable stuff! Not to worry, accountants are in business by making it difficult for ordinary people to understand accounts! All of us can learn to read accounts. We'll show you how.

The profit & loss account

At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about.

No company can exist for long by continuously making losses, and the P&L account shows the extent of profit or loss made by the company in a particular year. To illustrate, let's take the Reliance Industries annual report for 1998-99.

	1998-99		1997-98
	Rs.	Rs.	Rs.	Rs.
INCOME
Sales		14,553.26		13,403.78
Other Income		607.55		335.60
Variation in Stock		(152.43)		368.28
		15,008.38		14,107.66
EXPENDITURE
Purchases		190.32		14.19
Manufacturing and Other Expenses		11,500.52		11,206.93
Interest		728.81		503.55
Depreciation	1,776.66		1,460.27

Less : Transfered from General Reserve (Refer Note 3, Schedule 'O'){	921.62	855.04	792.95	667.32
		13,274.69		12,391.99
Profit Before the year		1,733.69		1,715.67
Provision for the year		30.00		63.00
Profit for the year		1,703.69		1,652.67
Add:Taxation for the earlier years		-		(85.67)
Balance brought forward from last year		1,047.89		662.79
Investment Allowance(utilised)		-		-
Reserve written back		-		36.00
Amount available for Appropriation		2,751.58		2,265.79
APPROPRIATIONS
Debenture Redemption Reserve	204.50		64.47
General Reserve	1000.0		752.65
Interim Dividend	23.39		10.33
Proposed Dividend	350.16		326.81
Tax on Dividend	40.86	1,618.91	63.64	1,217.90
Balance carried to Balance Sheet		1,132.67		1,047.89
Significant Accounting Policies
Notes on Accounts

You'll notice there are two main heads - income and expenditure. Simply put, the difference between the two is the profit (if income exceeds expenditure) or loss (if expenditure exceeds income). And losses, as you know, are bad.

Income

The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits.

"Other income" is accountantspeak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets, sale of scrap and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of one-off income.

The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account.

Expenditure

The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. But that's not all. Interest costs incurred on the company's debts are also included here. Further, there's an item known as depreciation, which is nothing but a notional estimate of the wear and tear of the equipment used by the company. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. Clearly, keeping costs in check will add to the bottomline.

You'll notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc.

Profit and EPS

Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholder's funds.

A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year.

Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company.

That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account.

Graduating in Risk Premium

In case you have reached this vantage point after having understood the basics of 'risk premium', we offer you our hearty congratulations on having made such outstanding progress!

Now, picking up the thread from where we left off, investors get compensated only for the market risk that they bear. Market risk is the only risk that cannot be reduced through diversification in your portfolio (by including a set of stocks from different businesses), like business risk can.

However, the influence of the market varies for various stocks. Some stock movements are exaggerated compared with market movements while others are subdued.

We understood last time that the 'beta' of a stock measures this relative movement of a stock vis-?is the market. Hence, 'beta' measures the tendency of the stock to participate in the market movement.

Let's work this out using an example...

Hyper Ltd., Tracker Ltd. and Sober Ltd. are three stocks that trade in the stock market of Shareland. Sharex is the stock market index in Shareland. Hyper has a beta of 1.3 while Tracker has a beta of 1. On the other hand, Sober has a beta of 0.7.

First stop, what do these values mean?

Hyper's beta value of 1.3 indicates that it is far more sensitive to market movements than Tracker and Sober. In other words, if the market as measured by Sharex goes up by 10%, Hyper will go up by 13%. Tracker will go up as much as the market, i.e. 10%, while Sober gains a mere 7% in relation to the market.

Who commands the lower risk premium?

After having come so far in the lesson, we expect that you will flip this situation to its negative face and look at the situation when the stock market in Shareland drops by 10%.

In this case, Hyper drops the most (by 13%) as it has a higher beta of 1.3. Since Tracker has a beta of 1, it drops by 10%, the same as the market. On the other hand, Sober drops by a mere 7%.

A higher beta means higher risk and hence a stock with higher risk needs to command a higher 'risk premium'. And obviously, since Hyper reacts in a manner true to its name for every drop/gain in the market, it is the riskiest stock and should command the highest premium, followed by Tracker with Sober being the least risk option of the three.

Moving on to CAPM

So if the risk premium commanded by the stock market is x%, then the risk premium that investors should demand for a particular stock is beta times x%. CAPM states that the expected return on a stock is the sum of a `risk-free rate' and `stock beta times market risk premium'.

This, in essence, is the capital asset pricing model (CAPM). After all, why should anyone expect to earn more by investing in one stock as opposed to another? You need to be compensated for doing badly when times are bad. The stock that is wont to do badly just when you need money in trying times is a stock you should hate, and there had better be some redeeming virtue or else who would want to hold it?

How is beta calculated?

Oh, we are not going to give you some longwinded formula. After all these days, you do not need to know how a computer works to actually use one. So, we shall never trouble you with formulae, but just explain the concept.

An analyst calculating the beta of a stock obtains the historical returns of that stock over a period and then compares them using 'linear regression' to the returns on the index. It is just enough for most of us to know that linear regression is a statistical tool for estimating beta.

Some pertinent questions to ask at this stage

Q: Is the beta of a stock constant?

A: The beta of a stock can change over time as the stock's characteristics transform. For example, a stock moving from the B1 group to the A group sometime back would have changed the beta of the stock. After all, the underlying liquidity of the stock would have changed as A group stocks have this carry forward mechanism that attracts a whole host of speculators.

Q: Can a low beta stock be more volatile than a high beta stock?

A: Interestingly, a low beta stock could be more volatile than a high beta stock. Remember, the beta measures only the systemic risk or the influence of the market on the stock whereas a stock on its own might have a very high unsystemic risk because of the risk associated with the company's business.

Wrapping up today's spoils

The key insight of the capital asset pricing model is that higher expected returns go with the greater risk of doing badly in bad times.

Beta is a measure of a stock's tendency to move with the market. Stocks with high betas tend to do worse in market downturns than those with low betas.

Our advice: If your heart has a high beta level, invest in a stock that has a low beta!

Back to basics

The profit & loss account

Introduction

If you own shares, you'll remember that the company sends you a booklet called an annual report just before the annual general meeting. Most of the time, all you've done is admired the glossy pictures before adding it to the pile of newspapers for the raddiwala.

That's a pity, because a company's annual report can be a great source of information, helping you to decide whether to stay invested in the company. At the very least, it'll help you ask some tough questions to the management at the AGM.

We know the problem. You'll be thinking that's a lot of unreadable stuff! Not to worry, accountants are in business by making it difficult for ordinary people to understand accounts! All of us can learn to read accounts. We'll show you how.

The profit & loss account

At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about.

No company can exist for long by continuously making losses, and the P&L account shows the extent of profit or loss made by the company in a particular year. To illustrate, let's take the Reliance Industries annual report for 1998-99.

	1998-99		1997-98
	Rs.	Rs.	Rs.	Rs.
INCOME
Sales		14,553.26		13,403.78
Other Income		607.55		335.60
Variation in Stock		(152.43)		368.28
		15,008.38		14,107.66
EXPENDITURE
Purchases		190.32		14.19
Manufacturing and Other Expenses		11,500.52		11,206.93
Interest		728.81		503.55
Depreciation	1,776.66		1,460.27

Less : Transfered from General Reserve (Refer Note 3, Schedule 'O'){	921.62	855.04	792.95	667.32
		13,274.69		12,391.99
Profit Before the year		1,733.69		1,715.67
Provision for the year		30.00		63.00
Profit for the year		1,703.69		1,652.67
Add:Taxation for the earlier years		-		(85.67)
Balance brought forward from last year		1,047.89		662.79
Investment Allowance(utilised)		-		-
Reserve written back		-		36.00
Amount available for Appropriation		2,751.58		2,265.79
APPROPRIATIONS
Debenture Redemption Reserve	204.50		64.47
General Reserve	1000.0		752.65
Interim Dividend	23.39		10.33
Proposed Dividend	350.16		326.81
Tax on Dividend	40.86	1,618.91	63.64	1,217.90
Balance carried to Balance Sheet		1,132.67		1,047.89
Significant Accounting Policies
Notes on Accounts

You'll notice there are two main heads - income and expenditure. Simply put, the difference between the two is the profit (if income exceeds expenditure) or loss (if expenditure exceeds income). And losses, as you know, are bad.

Income

The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits.

"Other income" is accountantspeak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets, sale of scrap and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of one-off income.

The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account.

Expenditure

The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. But that's not all. Interest costs incurred on the company's debts are also included here. Further, there's an item known as depreciation, which is nothing but a notional estimate of the wear and tear of the equipment used by the company. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. Clearly, keeping costs in check will add to the bottomline.

You'll notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc.

Profit and EPS

Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholder's funds.

A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year.

Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company.

That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account.