Introduction:

I regret to inform you that I missed last week's newsletter due to unexpected personal commitments. While my goal is to post every Sunday, there might be occasional gaps. I appreciate your understanding and patience during these times. Thank you for your continued support, and I'm excited to bring you more content this Sunday.

If you're a regular reader of my newsletter, you've likely noticed that I conduct thorough research on companies before making investment decisions. My strategy involves long-term investments, often spanning a decade or more. If you're new here, I recommend exploring my fragility series, which delves into the intricacies of my investment methodology. In this post, I'll delve into a particular aspect of investing that concerns all of us.

After conducting extensive research on a company and checking all the boxes, we make the decision to invest. However, amid this process, a specific question arises, one among many: "How frequently should we monitor the company's performance?"

This post aims to address precisely that.

Companies are more Animal than Robot

When analyzing a company and projecting its future performance, it's easy to fall into the trap of assuming they'll operate like machines—consistent and linear growth in sales and profits. Yet, companies are more akin to animals, and their behavior is slightly unpredictable. Volatility characterizes a company's sales and profits. Growth percentages aren't steady; they fluctuate annually.

A robot can be programmed to wake up and sleep at precise times each day. Animals, on the other hand, display variations in their waking and sleeping routines. While we can approximately estimate that an animal will wake up and sleep at least once daily, pinpointing the exact timings remains difficult.

Hence, while we can estimate a company's performance over a 5 to 10-year span, predicting its quarterly or annual performance with precision is a challenge.

To illustrate this point, I have plotted the profits of top 10 listed companies for the past 10 years in below chart. 

If you closely observe the chart, profits did not grow in a straight line for any of the top 10 companies. While profits of all 10 companies were higher than that of 10 years ago, the path is not a straight line. There is an unpredictable element in companies performance. 

With such volatility in performance, does it justify tracking companies performance every quarter? Or does it even make sense to track performance even yearly?

Considering the instability in a company's performance, one can only imagine the impact on its share price. Valuing such a company becomes a complex task for the market. Consequently, the market tends to overreact to a company's performance.

If a company slightly underperforms market expectations, its share price takes a hit. Conversely, if a company outperforms, the share price is likely to surge.

Look at the volatility in share prices of top 10 companies for last 5 years plotted below.

How investment journey in one company looks like

Let me take you through a journey of one investment in my portfolio. I deliberately did not reveal the name of the investment so that the point I wanted to make does not get diluted. 

In July 2015, I invested in a company that had witnessed a 50% drop in share price over the previous year. The decline was attributed to a reduction in profits. My rationale for investing rested on the belief that this profit reduction was temporary and would rebound. Unexpectedly, over the next year, the share price plummeted another 50%! Conventional wisdom would have dictated a cut-loss move, especially since sell ratings dominated research reports.

However, fueled by my independent research and a strong conviction in the company's business model, I held onto my investment. It took four years for the company's profits to recover, just as I had anticipated. Consequently, the market's overreaction manifested, leading to a tenfold surge in share price. Recognizing an overvaluation, I partially exited my position. With the market showing signs of cooling down, I re-entered, steadily accumulating shares over the past year.

My research, conviction, and investment were all established in July 2015. Had I scrutinized the company's performance quarterly or annually, anxiety might have driven an early sell-off, resulting in losses. Instead, I remained impervious to the company's performance and share price fluctuations, ultimately reaping substantial gains in the sixth year.

I learned this lesson, in my previous investments wherein I sold early before reaping benefits as I had given importance to others conviction rather than my own conviction. 

Conclusion

It's crucial to acknowledge that companies don't adhere to robotic predictability; they behave more like animals, displaying a degree of unpredictability. 

Equally important is cultivating personal conviction and adhering to it. Borrowed or weak conviction can lead to early divestment, ultimately making us sell early before reaping benefits.

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Introduction

At a February 12, 2002, news briefing, United States Secretary of Defense Donald Rumsfeld explained the limitations of intelligence reports: 

There are known knowns. There are things we know we know. We also know there are known unknowns. That is to say, we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know.

We can apply this same logic for analysis of a company. There are known knowns like past financial performance of the company which we can analyse by looking at the past few years financial statements. There are also other known knowns like present management of the company, present business model of the company, present market share, etc. There are also known unknowns like future growth potential of the industry, future market share of the company, succession plan of the management, sustainability of profit margins, etc.

We can arrive at estimated future cash flows of the company based on these known knowns and known unknowns. We can arrive at the present value of the company based on the same. One of the reasons why stock prices fluctuate is due to known unknowns. Mr Market’s opinion on known unknowns keeps changing every often. If our estimate of known unknowns is better than that of Mr Market i.e. if our estimate on the value of the company is more accurate than that of Mr Market, then we tend to beat the Market in the long term. We sometimes find that the value provided by Mr Market is lower than our estimates i.e. we find the company to be undervalued. We can take exposure in such companies and then exit once the company is being overvalued by Mr Market. This is how fundamental analysis works.

What about unknown unknowns and how to deal with them?

Like Mr Donald Rumsfeld said, unknown unknowns are the ones we don’t know we don’t know. If we don’t know that we don’t know them, then how can we deal with them? There is an indirect way of dealing with unknown unknowns. 

There are two types of unknown unknowns explained as under:

1. Negative unknown unknowns i.e. unknown unknowns which have a negative impact on the company

2. Positive unknown unknowns i.e. unknown unknowns which have a positive impact on the company

To explain the phenomenon better, we can use the present COVID-19 pandemic as an example. The COVID-19 pandemic situation is a negative unknown unknown for few companies like Shopping Malls, multiplexes, amusement parks, tourism, aviation sector, restaurants, etc wherein a few months of revenue has been wiped out.  COVID-19 pandemic is also a positive unknown unknown for few companies like food delivery apps, online education, OTT, broadband, sanitizers, etc. No financial model could have predicted this unknown unknown. All valuation models done in 2019/20 could have gone for a toss. In fact, Mr Market was also not sure of how the pandemic situation pans out. 

Because of the uncertainty there is a huge spike in volatility in the market. Nifty VIX even reached 70 as against 10 to 20 during normal days. 

The idea is to mitigate the impact of negative unknown unknowns and at the same time take exposure to positive unknown unknowns.

How to mitigate the impact of negative unknown unknowns?

We can mitigate the impact of negative unknown unknowns to an extent by looking at margin of safety in everything like as under:

1. Balance sheet strength link

2. Gap in actual sales vs breakeven sales link

3. Surplus cash flows being generated by existing businesses of the company link

4. Strength of the business model of the company using tools like Porter's five forces model link

5. Margin of safety in valuation i.e. gap in value arrived by us vs value provided by Mr Market

6. Comfort from past decisions of management, etc

Apart from all of the above, there should be margin of safety at a portfolio level also which help us avoid impact of negative unknown unknowns to an extent:

1. Avoiding excessively concentrated portfolios i.e. no single stock having significantly higher share in the portfolio. This will help us in restricting losses in case of a single company not performing due to negative unknown unknowns. 

2. Timing i.e. an investor should not be in a situation wherein he/she is required to withdraw funds from the stock market to meet personal needs at the wrong time. An investor should build enough contingency funds to meet such requirements. Imagine withdrawing funds from the market during March/April 2020 when Mr Market is at its multi year low.

3. Regularly monitoring the portfolio companies to check whether our fundamental assumptions still hold good. If there is a change in any of our underlying assumptions while arriving at the estimated value of the company, then we will need to exit. While doing such monitoring exercises, we also need to learn to differentiate between short term blips vs long term trends (i.e. signal vs noise). We should not end up exiting a company due to short term blips.

The above mitigating factors at both company level and portfolio level will help us deal with negative unknown unknowns.

How to gain from positive unknown unknowns?

For a company to take advantage of positive unknown unknowns, the company should be at 

The right place at the right time

When is the “right time” is not in a company’s hands, it is an external factor. When we are dealing with unknown unknowns we don't know what we are dealing with. Nobody knows when the Right time occurs.  Instead what a company can do is to be at the right place “always”. This way, when the “right time” occurs, then the company can take advantage of the opportunity.

Now, how to be at the “right place” always? Following is what a company can do to be at the “right place” always.

The company should have an existing business which is generating surplus cash flows year after year. This existing business should have sustainable competitive advantage (i.e. moat). The company should use this existing surplus cash flows generated every year to maintain a strong balance sheet i.e. having zero or near zero debt and having surplus cash reserves which are not required in existing business. Once the company has a strong balance sheet with adequate surplus cash reserves, then the company can use remaining surplus cash being generated every year to take multiple small bets. This strategy will help the company in two ways:

1. Surplus cash reserves will help the company grab an opportunity (positive unknown unknown) when it knocks the door.

   1. Surplus cash reserves will also help the company deal with negative unknown unknowns.

2. One of the multiple small bets can end up being a positive unknown unknown. 

   1. Single large leveraged bet will put a company in a situation where it will not be able to deal with negative unknown unknowns. It'll end up ruining the company during a negative unknown unknown event. Instead, unleveraged multiple small bets avoid such situations.

Let us understand this strategy using a few examples.

Info Edge (India) Limited

Info Edge has a very strong existing business i.e. naukri.com which keeps generating surplus cash flows every year. The company uses these surplus cash flows to make multiple small bets. The company over the years made multiple bets in various businesses like 99acres.com which is in real estate sector; jeevansathi.com which is a matrimonial website; Zomato.com which is into restaurant listing and food delivery; siksha.com which is into education space, etc.

One such bet turned out to be a blockbuster hit. It is none other than Zomato. The company first invested in Zomato in 2010 with an amount of Rs 4.7 Crs. The company clocked returns of 1050 times in its Zomato investment. This is one of the primary reasons for appreciation of  stock price of Info Edge over the past few years.

During the past 10 years, naukri continued to be a cash generating machine for Info Edge. All its multiple bets are yet to generate sustainable positive cash flows. The positive unknown unknown here is the change in business model of Zomato. Zomato’s business model when Info Edge first invested in 2010 is to provide information on restaurant menus, food reviews and dining options. Zomato in 2015 pivoted into the food delivery business for restaurants. Info Edge or Zomato or anyone could never have imagined this pivot. This is how positive unknown unknowns work.

Reliance Industries Limited

Reliance Industries also has an existing strong sustainable business i.e. petrochemical, refining, oil and gas-related operations  which keeps generating surplus cash flows every year. It used these cash flows to take multiple small bets (small when compared to its balance sheet size). One such bet is Jio which is the primary reason for a spike in share price after multiple years of negligible returns. Jio was launched in Sep 2016. Jio’s share in EBITDA is now nearly 35% of that of Reliance Industries Limited.

No one could have imagined the kind of impact Jio would create in the telecom industry back in 2015. That is the reason the stock returns were negligible from 2007 till 2015. Post 2015, the market capitalisation of the company multiplied 4 times which is not a small feat when we consider the fact that Reliance Industries is one of the largest companies in India. This is a positive unknown unknown.

Launch of Jio is however a negative unknown unknown for another company i.e. Vodafone Idea Limited.

Apart from Jio, the company is also suffering from another negative unknown unknown i.e. AGR issue.

Eicher Motors Limited

The company in 2008 had one main business i.e. Trucks and one small business i.e. motorcycles. Its truck business is a cash generating machine.  

Motorcycles contributed to a small percentage in revenues and profits back in 2010. Now it is a major contributor to revenue and profits of the company. Motorcycle business is the primary reason for stock price appreciation in the past few years. Whoever analysed the company in 2009 or earlier would not have attributed any value to its motorcycle business. This is another example of positive unknown unknown.

What can an investor do to gain from unknown unknowns?

Invest in companies which are:

• undervalued based on analysis of known knowns and known unknowns

• having strong balance sheet and surplus cash reserves

• atleast one existing cash generating business with strong moat which generates surplus cash every year

• management who is willing to take multiple small bets without leveraging their balance sheets

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Return on Capital Employed (ROCE) is the single most important financial ratio. Through this post, I will try to explain how to calculate ROCE. I will also explain how ROCE is a summary (cocktail) of all ratios and is sufficient enough to analyse any company irrespective of industry.

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Return on Capital Employed

Return on Capital Employed can be divided into two key parts as under:

1. Numerator: Return generated by business

2. Denominator: Capital Employed in business i.e. amount invested in running business operations

Numerator: Return generated by business

Free cash flow generated by business in any given year gives us a good indication of return generated by business. Free Cash flow is the money left with the company at the end of the year after meeting operating expenses and capex. 

Textbook definition of Free Cash Flow is Cash Flow from Operations minus Capex. I use a slightly modified version of Free Cash flow as under:

Free Cash Flows = Cash Flow from Operations minus Replacement/maintenance capex 

Capex can be bifurcated into Expansion Capex and Replacement/Maintenance Capex. We may not subtract expansion capex as it can generate incremental cash flows to business unlike replacement/ maintenance capex. A company is mandatorily required to incur replacement/maintenance capex to maintain its existing cash flows. Replacement/maintenance capex can be in the form of upgradation of machinery to maintain competitive advantage, wear and tear of existing machinery, etc.

Hence Replacement/Maintenance Capex helps maintain existing cash flows from operations. Whereas Expansion Capex helps generate incremental cash flows from operations.

Denominator: Capital Employed in business

Capital Employed in business  = Core Fixed Assets plus Core Current Assets minus free float (i.e. other people's money)

While arriving at Core Fixed assets, we need to subtract capital work in progress as the same is yet to generate cash flows. We also need to subtract recently completed expansion capex if the same has not generated any cash flows during the year. We also need to subtract non core fixed assets or unutilised fixed assets like unutilised land. Basically, we need to subtract all fixed assets which are not generating operating cash flows.

While arriving at Core current assets, we need to subtract surplus cash in business. We also need to subtract assets which are not related to business like loans and advances to related parties, ICDs, etc.

Some businesses generate free float like say advances from customers. Sometimes core sundry creditors can act as free float. Free float is the money which a company receives without interest and can partly fund the business operations. While Core Fixed assets plus Core current assets gives us the gross capital employed in business. We can subtract free float to arrive at net capital employed in business.

Significance of ROCE

Return on capital employed (ROCE) = Return generated by business / Capital employed in business

Analogy to ROCE is interest earned on Fixed Deposit during a year. ROCE is like the rate of Interest on Fixed Deposit.

Businesses which generate high ROCE attract a lot of competition due to supply/demand economics. In the long term, due to competition, ROCE keeps reducing year on year on account of supply and demand. 

If a company is able to generate high ROCE year after year, then we can safely conclude  that there is some inherent sustainable competitive advantage (in other words moat) in the business due to which it is generating high ROCE over multiple years.

As a general thumb rule, companies with ROCE greater than 20% over multiple years have a very good moat. Companies with ROCE between 10 to 20% have moderate moat. Companies with ROCE less than 10% are generally in highly competitive businesses.

There are few businesses which even generate ROCE of more than 100%. For example CRISIL Limited in CY2019 generated cash flow from operations of Rs 446 Crs against Capital employed in business of Rs 312 Crs indicating ROCE of 143%!!!

Before we jump to the conclusion that good ROCE means good moat, we need to first understand that financial statements give us an indication of the past performance and not the future performance of the company. Hence, good ROCE only indicates presence of good moat in the past. We need to further analyse and satisfy ourselves on whether the moat is still present in the company and is going to remain so in the future as well.

Why ROCE is cocktail of all financial ratios?

Financial Statement ratios can be broadly classified into four types:

1. Profitability ratios

2. Efficiency or Operating ratios

3. Leverage ratios

4. Liquidity ratios

For detailed explanation of various ratios, you may refer to various resources available online. One such resource is Zerodha varsity. Here, I will try to explain how ROCE is a summary (cocktail) of all ratios.

Profitability ratios

Profitability ratios are Operating profit margin, Net profit margin, etc. These ratios are generally the percentage of sales i.e. topline. These ratios vary for each industry and give us an indication of profitability performance of the company as compared to peers in the industry. Shareholders are generally concerned only about the profit i.e. bottomline generated in absolute terms irrespective of profit as percentage of sales.

Numerator in ROCE provides us with the bottomline in absolute terms.

Efficiency or Operating ratios

Efficiency ratios indicate the efficiency with which assets of the company are utilised. Hence, these ratios measure sales relative to each asset.

While profitability ratios can be represented as Profits / Sales

Efficiency ratios can be represented as Sales / Assets

Profitability ratios X Efficiency ratios = Profit / Sales X Sales / Assets = Profit / Assets

Profit / Assets is nothing but ROCE. Hence, ROCE is also a summary of Profitability and Efficiency ratios.

Leverage ratios

With leverage ratios we can gauge the debt levels of the company. A company which keeps generating high ROCE over multiple years can fund its own growth. Hence, such high ROCE companies generally have low debt levels. We can indirectly arrive at leverage levels through ROCE.

Liquidity ratios

Liquidity ratios reveal the level of current assets in relation to current liabilities. Companies with high ROCE generally generate enough cash flows to fund its growth and also to build surplus cash reserves. Hence, such high ROCE companies have surplus cash in their books. Surplus cash reserves ensure good liquidity ratios. Hence, we can indirectly gauge liquidity ratios through ROCE.

Conclusion

As we have seen, ROCE is a summary of all ratios and acts as a cocktail of all financial ratios. ROCE is the single most important financial ratio which can be used across industries. However, ROCE does not work for businesses which are into lending. That is the only drawback of ROCE.

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Cash Flow statement forms a key part of financial statements of the company. In this post, I will explain how to assess the level of margin of safety available in a company  from a cash flow statement.

Accrual method is followed for preparing a Profit & Loss statement i.e. it includes sales and expenses incurred during the year on both cash and credit basis.  For example, if a good or service is sold in March (which is the last month of the financial year) wherein money is to be paid by the buyer in 2 months (credit basis) i.e. by May (next financial year). Then this sale transaction is also included in the Profit and Loss statement for the financial year even though money will be received in the next financial year. Hence, Profit and Loss statement also includes non cash based transactions.

Cash Flow statements provide us with a view of only cash based transactions during the year. It includes 3 key parts as under:

1. Cash Flow from Operating Activities

2. Cash Flow from Investing Activities

3. Cash Flow from Financing Activities

Cash Flow from Operating Activities further comprises two parts namely Operating cash flows (before working capital changes) & Working capital changes. Operating cash flows (before working capital changes) is arrived at by making additions/subtractions  of non cash items (excluding working capital related items) like depreciation, unpaid taxes, mark to market forex losses, etc to profit after tax. 

Working capital changes primarily consist of three key elements i.e. changes to inventory, changes to receivables (credit sales) and changes to creditors (suppliers). Working capital changes conceptually gives us an idea of incremental working capital requirements of a company. For example, if for a revenue of Rs 1000 Crs, a company needs net working capital (inventory plus receivables minus creditors) of Rs 100 Crs (10% of revenue), then if revenue increases to say Rs 1100 Crs, then net working capital requirements will typically increase to Rs 110 crs.  This increase of net working capital requirements by Rs 10 Crs (i.e. from Rs 100 Crs to Rs 110 Crs) gets reflected in the working capital changes of cash flow statement of a company. 

If we observe that there are working capital changes which are not in commensurate with change in revenue, then the reason might be due to pile up of inventory or receivables or stretching up of creditors by the company. The reason can also be due to increasing bargaining power of the company with its customers and suppliers. If we observe such a phenomenon, then we need to further analyse to satisfy ourselves on the reason.

Cash Flow from Investing activities typically comprises two parts namely Capital expenditure (Capex) and investments in surplus cash. 

Capex can include capex related to expansion of capacity i.e. a company setting up a new factory. Capex can also include replacement capex i.e. a company procuring new machinery to replace old machinery. Replacement capex is something which a management cannot avoid and is required for running day to day operations. But expansion Capex is a choice of the management of the company. Management can choose to invest in expansion capex from surplus cash accumulated over the years or by raising long term debt. Long term debt as we have seen in balance sheet analysis reduces the margin of safety of the company.

Some companies try to grow inorganically wherein they acquire other companies. This is an alternative method for growth as compared to expansion capex. 

If a company is left with surplus cash from operations after providing for working capital changes, capex and debt payments, then this surplus cash is generally invested in Fixed deposits or liquid funds. We can make out the surplus cash generated in the year by looking at these changes in Cash Flow from investing activities.

Cash Flow from Financing activities typically comprises of three parts namely, funds raised through equity (ie. IPO or FPO or private placement), availing new debt or repayments of existing debt & dividend payments.

A company can raise funds from capital markets through IPO or FPO or private placements for meeting its requirements. Such sources of funds generally improve the margin of safety of a company.

A company can also raise new debt to meet its cash flow requirements. Debt generally reduces the margin of safety of a company. 

If a company is left with surplus cash from operations after meeting its various requirements like working capital changes, capex and debt payments, then management can choose to pay dividends or invest the same in cash reserves. Some companies which have enough cash reserves and don't have any capex or other requirements generally pay a significant portion of surplus cash flows as dividends.

Based on the above understanding, we need to modify the visual representation of cash flow statement as under to better analyse the same:

If a company keeps generating surplus operating cash flows (before working capital changes) every year which is more than sufficient to meet its incremental working capital requirements, replacement capex and then expansion capex, then the company is self sustainable i.e. company need not look for raising funds through external sources like debt or capital markets. Such surplus cash flows are typically utilised to build cash reserves, pay dividends and/or buy back shares. 

We can conclude that the level of margin of safety in a company is high if there are surplus cash flows generated every year after meeting various requirements like incremental working capital requirements, replacement and expansion capex. Balance sheets of such companies typically have high levels of margin of safety.

Cash flow statement is better analysed by aggregating the same over a period of 5 to 10 years rather than analysing the same for each year. The reason being some high value items like capex typically takes 2 to 3 years to implement. The effects of such variations are nullified over a period of 5 to 10 years.

Lets look at the cash flows of Symphony Limited for the five year period FY2017 to FY2021.

The company generated operating cash flows after taxes of Rs 638 crs in the last 5 years. The company incurred cash outflows of Rs 309 crs towards meeting incremental working capital requirements (Rs 53 Crs), capex (Rs 47 Crs) and acquisition of new companies (Rs 209 Crs). 

The company generated surplus cash flows of Rs 329 Crs. The company raised new net debt (after repayments of existing debt) of Rs 80 crs even though the same is not required. As we observed in balance sheet analysis of the company, the company has total debt which is less than cash reserves in its balance sheet. Out of surplus cash flows generated, the company chose to pay dividends of Rs 258 Crs and increase  cash reserves by Rs 136 crs.

We can conclude that Symphony Limited has high levels of margin of safety from the cash flow analysis.

Few examples

High margin of safety

We can observe from the past 5 years cash flow statements of Bajaj Auto Limited that the company hardly required any cash outflow towards incremental working capital requirements or capex. Entire cash generated from operations is surplus cash which is partly used to build cash reserves and the remaining portion towards dividends. There is a high level of margin of safety in the company.

TCS like Bajaj Auto Limited generated surplus cash flows of Rs 1,36,485 Crs over a period of 5 years  after meeting its incremental working capital and capex requirements. The surplus cash flows were primarily given back to shareholders in the form of dividends payout (Rs 81,814 Crs) and share buyback (Rs 52,125 Crs).

Low or Moderate Margin of Safety

Sanghvi Movers is barely generating sufficient cash flows from operations to meet its capex and debt payments requirements. To meet part of the shortfall, it raised fresh debt of Rs 165 Crs.

Cash flows generated from operations by Tata Motors is not adequate to meet working capital requirements, capex requirements and legacy debt payment requirements. The company had to dip into existing cash reserves and also raise fresh debt to the tune of Rs 2,11,452 Crs to meet the shortfall in cash flow requirements. Tata Motors based on this analysis has low levels of margin of safety from its cash flows.

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To arrive at the level of margin of safety, we need to find out the cushion available between breakeven sales and actual sales. The break-even analysis determines what level of sales are necessary to cover the company's total fixed expenses. 

However, if we take a practical view, then there are various levels of breakeven sales. For this, we need to subdivide the expenses into variable expenses, semi fixed expenses, fixed expenses (non cash) and fixed expenses (cash).

Variable Expenses are those expenses which are required to be incurred depending on sale of goods or services. For example raw material consumption is a variable expense. With variable expenses, we can calculate contribution margin i.e. Sales - Variable expenses. 

Fixed Expenses are incurred irrespective of sale of goods or services like for example, interest on Debt, staff salaries, power consumption for running machinery, depreciation of fixed assets, etc.

While most of the fixed expenses are required to be incurred in case of marginal decline in sales like say 10% decline in sales, there are certain fixed expenses which can be reduced in case of drastic decline in sales during extreme scenarios like present COVID-19 pandemic. These expenses can be termed as Semi Fixed Expenses. One example of semi fixed expenses is staff salaries wherein a company can cut down manpower incase of drastic decline in sales. Another example of semi fixed expenses is Power consumption wherein a company can run the factory for a single shift of 8 hours instead of 3 shifts to reduce power consumption. Advertising expenses can also be classified as semi fixed expenses.

Certain fixed expenses are non-cash in nature like depreciation and amortisation wherein a company incurs the cost of acquiring fixed assets at the time of purchase. The cost is however depreciated over a period of time based on the useful life of the asset.

Semi fixed expenses and non cash based fixed expenses give us an idea of operating leverage of the company.

Fixed expenses which are other than non cash and semi fixed are generally finance costs i.e. interest cost on debt raised by the company. We can arrive at financial leverage based on such expenses.

We can observe that a company can avoid operating expenses (fixed or variable) during tough times, but cannot avoid finance costs. Hence, financial leverage reduces the margin of safety available in a company.

After categorising the expenses into above categories, we can visually plot the Profit & Loss statement as a graph with Sales on X - Axis and Contribution Margin on Y - Axis. For example, I have visually plotted Profit and Loss statement for FY2020 of consolidated financials of Symphony Limited as under:

Dotted line in the above visual representation is actual sales in FY2020. Level 1 line represents breakeven sales considering total fixed expenses comprising of semi fixed costs, fixed expenses (non cash) & fixed expenses (cash). Level 2 line represents breakeven sales considering fixed expenses (cash) and fixed expenses (non cash). Level 3 line represents breakeven sales considering only fixed expenses (cash). 

The wider the gap between actual sales and Level 1, 2 & 3 breakeven sales, the more the level margin of safety. With this visual representation, we can easily make out the level of margin of safety available in the company. Level 1 breakeven sales is Rs 721 Crs as against actual sales of Rs 1102 Crs. Level 2 breakeven sales is Rs 68 Crs and Level 3 breakeven sales is Rs 23 Crs.

Note: For actual sales, we need to exclude non-operating income like income from surplus cash, etc and only include operating income for better representation.

Few Examples

Below are examples of visual representation of Profit & Loss statements of companies falling under various levels of margin of safety i.e. low, moderate & high level of margin of safety.

High Margin of Safety

As we can observe, Bajaj Auto Limited has an adequate margin of safety. 

For Tata Consultancy Services (TCS), the gap between Actual sales and Level 1 Breakeven sales is not so wide. However, the same is mainly because TCS being a services company, the semi fixed costs are majorly in the nature of salaries. The company will be able to cut down manpower if required incase of drastic decline in sales. This is the reason the gap between actual sales and level 2 and level 3 breakeven sales are also equally important as they give us the level of margin of safety available in the company.

Low or Moderate Margin of Safety

As we can observe, Sanghvi Movers and Ramky Infrastructure are incurring operating losses due to which the Level 1 Breakeven Sales is more than Actual Sales in FY2020. The level of margin of safety in Sanghvi Movers is slightly higher than Ramky Infrastructure due to higher Fixed Expenses (non cash) and lower Fixed Expenses (Cash) i.e. lower financial leverage. Hence, based on Level 2 and Level 3 breakeven sales, we can conclude that Sanghvi Movers has relatively higher margin of safety as compared to Ramky Infrastructure.

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If we think of a company as a movie, then the Balance sheet represents a single frame in the movie. It gives us a view of a company on a particular date which is generally end of financial year (March 31st for most of the companies in India).

Balance sheet can be better analysed by subdividing into 8 key categories and can be visually represented as under:

The size of each sub category can be based on the percentage contribution to Asset side/ Liability side of a balance sheet. For example, I have visually plotted balance sheet as on March 31, 2020 of consolidated financials of Symphony Limited as under:

Liabilities or Sources of Funds:

Equity: Equity generally includes paid up share capital, reserves and surplus and other reserves. Share capital is the initial capital brought in by the promoters. Share capital increases with issuance of new shares during IPO or FPO and reduces with purchase of shares during share buybacks. Reserves and surplus is created from retained profits over the years. There are other reserves like share premium reserve which is created if shares are issued in IPO or FPO at a premium to book value i.e. say shares are issued at Rs 70 per share as against book value of Rs 10 per share.

The higher the equity as a % of balance sheet size, the more margin of safety available in the company. The reason being equity is a liability which the company need not pay. There is no stipulated time limit for payment of equity. Equity is repaid to an extent in the form of dividends or share buy back from the profits or surplus cash available in the balance sheet. Equity acts as a margin of safety during tough periods of a company. 

When calculating equity we can subtract revaluation reserves from equity and to balance the balance sheet, we can reduce Fixed assets to the same extent. Revaluation reserves are created by revaluing fixed assets of a company wherein fixed assets are increased by considering the present market value instead of depreciated value. This is a non cash item and only a balance sheet entry. This reserve is often created by management to improve financial ratios of the company. To better understand the balance sheet, we need to subtract this reserve and also reduce fixed assets to that extent.

Ideally, for high margin of safety, Equity should be able to fund entire non core assets, fixed assets and a portion of surplus cash or current assets (if surplus cash is not present in the balance sheet).

In the example of Symphony, we can easily realise that there is an adequate margin of safety as equity is funding more than 60% of the balance sheet and is also funding entire non core assets, fixed assets and a portion of surplus cash.

Some companies have negative Equity due to losses over multiple years. Such companies can be considered as low margin of safety companies without requirement of any visual representation

Long Term Debt (LTD) generally comprises loans taken for funding fixed assets. Tenure of these loans is more than one year and can range upto 15 years. While the principal of these loans is paid over a period of time, interest on these loans is required to be serviced every month. Due to this LTD has a bearing on the cash flows of the company during tough times.

There are often other long term liabilities in a balance sheet which are not debt or equity. One such item is deferred tax liability. Other such items are advances paid for capital expenditure, mobilisation advance for long term projects, long term lease obligations, etc. We can club these items with current liabilities to get a conservative view of the company. 

Whether to raise Debt for expansion or capital expenditure is the choice of the management. A company can choose to delay expansion by a few years and then fund it entirely through cash generated in business (i.e. retained profits or equity). Generally, companies which have good return on capital employed generate adequate cash flows from operations which can even fund expansion plans. Such companies need not raise any external debt or other sources of funds.

Few companies even go ahead and raise funds through FPO or IPO or other means for funding capital expenditure or expansion plans. Take the example of La Opala as per their Annual Report for FY2015.

The management of La Opala went for Private Placement instead of raising debt to strengthen the balance sheet and raise funds for meeting expansion requirements. By doing so, the company chose to remain debt free and continued to maintain a high level of margin of safety. When the market overvalues a company, then companies can use this approach to raise cheap capital to meet expansion plans.

While Symphony Limited raised Long Term Debt and Short Term Debt, the same is less than surplus cash in the business. Hence net debt is Zero for the company.

We might argue that the cost of debt is less than the cost of equity. While cost of debt is lower and is a cheap source of funds, availing debt also increases risk of ruin and hence thereby reducing the level of margin of safety of a company.

Short term Debt (STD) generally comprises loans taken by a company for working capital purpose i.e. to fund working capital gap in a company. Working capital gap is the difference in current assets and current liabilities. While these loans are revolving in nature and there is no repayment stipulated for these loans, the interest is required to be serviced on a monthly basis.

As explained in Long Term Debt, raising short term debt is also a choice for the management. Companies which can self fund its business requirements through operating cash flows without looking for external sources like Long Term or short term debt have high level of margin of safety.

Current liabilities: Sundry Creditors form a major portion of current liabilities. Sundry creditors are created from the credit period given by suppliers for raw materials purchased by a company. They fund a portion of working capital of a company. 

During tough times, companies generally tend to stretch their sundry creditors i.e. delay payments to suppliers. If we observe that sundry creditors are increasing year on year without any increase in sales or current assets, then the company is facing cash flow issues and funding the same by stretching sundry creditors. 

Few companies, due to their increasing bargaining power towards their suppliers, can demand higher credit period from their suppliers. In such scenarios, sundry creditors are stretched without any stress in cash flows. We can identify whether a company stretched its creditors due to stress or not by looking at other factors like return on capital employed, surplus cash in balance sheet, debt levels, cash flow from operations, credit rating, etc. I will cover this aspect in detail in a separate post.

Some of the items in current liabilities or long term liabilities can act as a float, i.e. interest free money from other people. One such item is advances from customers. Some companies due to their bargaining power with customers can even attract advances from customers for the goods or services sold by them. Such advances can fund a portion of the balance sheet. Such float can be treated on par with equity. It also indicates there is inherent strength in the business. 

Assets or Uses of Funds:

Non Core Assets: There are certain assets in the balance sheet which do not contribute to business operations. These can include unused land bank, closed factory, goodwill, investments & loans and advances to group companies or subsidiaries, etc. These are termed as non core assets. As a thumb rule, these assets should be entirely funded by equity. For a better visual representation of a balance sheet, we need to remove this item from Asset side and also subtract the same from Equity in Liability side (i.e. if Equity is more than non core assets).  If Equity is less than Non Core Assets, then it can be concluded that the company has a low margin of safety.

Fixed Assets as per accounting standards are those assets which are required in the business for more than a period of 1 year. I use a different methodology to define Fixed Assets. The assets which are utilised to generate multiple sales i.e. sell multiple goods or services can be defined as Fixed Assets. For example a machine in a factory  can be utilised in production of multiple finished goods thereby contributing to sale of multiple goods or services. Whereas a raw material can be used/ or rather consumed in producing a single finished good thereby contributing to only sale of a single good or service. Hence, current assets are those assets which are consumed for contributing to single sale or service like say raw material, work in progress or finished goods.

The level of margin of safety is low in a company if Fixed assets are funded by short term sources like current liability instead of long term sources like Equity or Long Term Debt. In the case of Symphony we observe that entire fixed assets is funded through Equity.

Funding of Fixed Assets through short term sources also indicate less than  one current ratio i.e. (current assets plus surplus cash / current liability) < 1.

Reasons why a company ends up with less than 1 current ratio are generally negative in nature. Three primary reasons for the same are as under:

1. Company stretched its creditors to meet cash flow problems

2. Company utilised short term sources of funds for long term purposes, resulting in asset liability mismatch

3. Company incurred losses due to which Equity deteriorated

We might argue that a company due to its bargaining power with suppliers stretched its creditors to an extent that the current liabilities are more than current assets i.e. such companies have negative working capital cycle. However, such companies having negative working capital cycle generally also have surplus cash maintained in their balance sheet which ensures that current assets plus surplus cash / current liabilities is more than 1.

Surplus Cash: Few companies have cash and bank balances and financial investments in their balance sheet which is not required for day to day operations of the company. Such surplus cash acts as a margin of safety during tough times. Symphony Limited has a surplus cash which is 40% of the balance sheet size. The higher the surplus cash the more the margin of safety the company has. 

Surplus cash can also be used as an offensive tool during downturns when there are multiple opportunities available for inorganic growth at cheap valuations.

Rajiv Bajaj, MD of Bajaj Auto Limited explains this in article dated June 5, 2015 in economic times titled “Government on right track from a long term perspective: Rajiv Bajaj”

Note: Apple Inc had more than USD 100 billion in surplus cash in its balance sheet at the time of the article.

Current Assets: Current assets as explained above are those assets which are consumed/required for contributing to single sale or service like say raw material, work in progress, finished goods or debtors. If a company does not have surplus cash, then part of the current assets is required to be funded through long term sources of funds to ensure adequate margin of safety. If a company has surplus cash, then surplus cash plus current assets is required to be partly funded through long term sources of funds to ensure adequate margin of safety.

Key Pointers

Key pointers to look at for arriving at level of margin of safety available in a company:

1. Whether equity is only funding non core assets or; non core assets plus fixed assets or; non core assets plus fixed assets plus a portion of surplus cash/ current assets. The more the Equity funds the asset side of the balance sheet, the higher the margin of safety available

2. Whether current assets plus surplus cash / current liabilities is more than 1 or less than 1. A ratio of less than 1 indicates low levels of margin of safety

3.  Whether there is any debt in the balance sheet. If yes, then what is the size of debt. Low or zero debt indicated high levels of margin of safety

We can broadly conclude the level of margin of safety available in a company with this visual representation method of the balance sheet.

Few Examples

Below are examples of visual representation of balance sheets of companies falling under various levels of margin of safety i.e. low, moderate & high level of margin of safety.

High Margin of Safety

Low or Moderate Margin of Safety

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