India Inc.: How Real Are Corporate Profits?

In the aftermath of the Satyam episode doubts are being raised about the corporate governance standards followed by the India Inc. The shareholders' concern is: "How real are those profits that are declared in the profit and loss accounts?" In other words, an investor needs to check if the company's profit growth is matching with similar buoyancy in cash flows from operations. To check the veracity of the balance sheets of the companies, investors need to distinguish between 'profits in the book' and 'profits in the bank.'

We at ET Intelligence Group are making the task easier for you. We take you through the balance sheet and profit & loss account of India's top 100 companies that form part of the BSE 100 index. We did this through two rounds of screening in order to distinguish between 'real' and 'accounting' profit. In addition to BSE 100 companies, we have also considered companies, like Britannia and Colgate Palmolive, which have earlier been in the index.

The logic is simple. A double or triple digit profit growth is impressive, but if it comes on the back of huge investments in working capital or fixed assets, then so much is less available for distribution to shareholders in the form of dividends or to plough back. Moreover, a faster growth in working capital or fixed capital may jeopardise future profit growth of a company.

In the first round of screening, the trends in reported cash profit and net cash flow from operations are analysed. Cash profit is calculated by adding depreciation to net profit, and net cash flow from operations is calculated by deducting working capital investments from the cash profit. It's obvious that if cash flow from operations is not growing in tandem with cash profit, then the company is investing more in its working capital. Typically, it happens by the way of extending more credit to the debtors. This helps companies to boost the topline and bottom line in the near term, thereby, they keep the investors and the market happy.

Our analysis revealed that many companies invested so much in their working capital that there is a huge gap in the growth in cash profit and the growth in cash from operations. The adjoining chart shows the combined cash from operations and reported cash profit of BSE 100 companies. It is clearly visible that cash flow from operations was more than cash profit in FY03 and FY04. However, after FY04, cash from operations was much lesser than cash profit indicating that India Inc. has aggressively invested in working capital in its growth phase.

In the adjacent tables, the best and the worst performers in the first round of screening are listed. Best performers are companies like Reliance Industries, ACC and NTPC among others. In case of such companies, the growth in cash flow from operations has kept the pace with growth in cash profit. With worst performers, the case is exactly opposite.

We then did a second level of screening, which involved estimating the free cash flows for the companies, which passed through the first round. Free Cash Flow is calculated by deducting the investments in fixed assets from net cash flow from operations. Simply put, it is the amount left with the company—either to be distributed among shareholders as dividend or to be reinvested in the business.

Some of the findings seem pretty obvious. For instance, none of the capital goods companies could clear the first round of screening. This tells us that they had to invest more in working capital to either execute the order book or clear backlogs.

More importantly, it indicates that the capital goods industry is grappling not only with fixed investments but also with investments in current assets.

Similarly, the performance of auto companies is marred by the cyclical nature of the industry. For instance, Tata Motors and Mahindra & Mahindra (M&M ) had negative free cash flows in the recent past. In fact, M&M's growth in cash from operations was a mere fraction of growth in cash profits. On the other hand, Hero Honda's performance was stable even in terms of cash flows. Their working capital investment was actually negative in FY08 and this shows its ability to get a better deal from its suppliers. The company has also posted positive free cash flows in all of the last ten years and this is one of the reason it has weathered the current slowdown.

In metals, the picture is a bit different, as most of the companies have managed the working capital quite well. However, due to a spate of acquisitions, the capital expenditure has skyrocketed resulting in negative free cash flows. In the past, SAIL and Tata Steel (prior to the acquisition of Corus) had reported positive free cash flows.

FMCG industry is considered to be far more stable when it comes to cash flows. This is the reason that in bad times, investors flock to FMCG counters. But a closer look reveals that better working capital management is far more crucial for survival of such companies than fixed asset investment. And this has been the differentiating factor among the FMCG companies in our universe of stocks. For instance , the growth in cash flow from operations of ITC, Nestle and Colgate Palmolive was far behind the growth in profits. This mismatch wasn't there in case of Asian Paints, which clearly shows that Asian Paints is one of the safest bets in the sector.

Similarly, in the pharmaceutical industry, quite a few companies don't have a very promising cash position as compared to their profitability. While Cipla and GlaxoSmithkline lead the pack with the most stable cash flows, with Glaxo better placed than Cipla, others like Dr Reddy's and Ranbaxy still have a lot of catching up to do. Analyzing cash flows can help the investors in separating wheat from the chaff much in the way Asian Paints turned out to be much better than others. Though, it may not make one a millionaire overnight, it won't reverse the order.

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