December 22, 2017

How to interpret delay in payment of undisputed taxes and payment of dividends out of debt? Are Reserves and Cash the same? What's the role of WACC & ROCE? (Q&A)

www.drvijaymalik.com has a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. I have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:
  • What should an investor interpret when a company delays the deposit of undisputed statutory dues?
  • Are reserves & surplus and cash & bank balances the same? How should investors correlate them?
  • Why do companies with negative free cash flow pay dividends out of debt?
  • What is the role of weighted average cost of capital (WACC) & return on capital employed (ROCE) in our stock analysis 
Delay in deposit of undisputed statutory dues, Are reserves & surplus and cash & bank balances the same? negative free cash flow pay dividends out of debt?
What is the role of weighted average cost of capital (WACC) & return on capital employed (ROCE)





Subscribe for email updates at our website to get the FREE e-book: "Case Studies: Applying Peaceful Investing Approach"


What should an investor interpret when a company delays the deposit of undisputed statutory dues?


Sir,

I am going through one of the older annual reports of a company. It has a comment from the auditor that the company has not been regular in depositing undisputed statutory dues including provident fund, investor education etc.

How big is a bummer an observation like this?

A line of guidance will be much helpful.

Author’s Response:

Hi,

Thanks for writing to us!

A delay/irregularity in depositing undisputed statutory dues means that the company has not deposited the taxes on time, which the company agrees that it is liable to pay. For example, the services tax collected from customers, TDS collected from vendors, income tax payable, excise/sales tax etc. An auditor needs to comment on the status of payment of statutory dues in its report of the company.


It indicates that the company might be facing a liquidity crunch.

Therefore, if the company has a lot of debt, then it might be a sign of cash crunch in the company.

Hope it answers your queries.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Are reserves & surplus and cash & bank balances the same? How should investors correlate them?


Hello Dr. Vijay Malik,

While looking at the annual report of a company, I could not tally the amount at Reserves and Surplus to Cash and Bank Balances.

The Director's Report of the company mentions that it has transferred Rs.1,000 Lakhs to the general reserves. The company has reiterated the same on the Note 4 for Balance Sheet.

However, in the Assets section of Balance Sheet, the "Cash and cash equivalents" does not show it. Can you please explain where the company has been moved its cash?

Was the cash, which was moved to Reserves and Surplus already spent in the year or is it moved to any other account?

I do not have any accounting background, so could not understand it.

Thanks,

Author’s Response:

Hi,

Thanks for writing to us!

We have provided an example of fund flow analysis in the following article:


The increase in reserves and surplus is a source of funds whereas the increase in cash is a usage of funds.

If the increase in reserves is the only inflow and the company has not used this fund for any other purpose but only holding it as cash, then the investor would find that increase in reserves is equal to increase in cash balance.

However, in real life, companies get money from many other avenues than only reserves and surplus (i.e. profits) and use it for many activities other than holding it as cash.

The fund-flow analysis may show that the company has received funds from sources like:
  • Reserves (net profits – dividends paid)
  • Inventory (used in creating goods for sales)
  • Fixed assets (depreciation – noncash expense in P&L)
  • Long-term loans & advances (recovered money back, sold long financial products) 

The analysis also indicates that the company may have used the funds during the period on following items: 
  • Payment of long-term debt
  • Payment of short-term debt
  • Payment of other current liabilities (primarily current maturity of long-term debt and customer advances that are recognized as sales and therefore removed from balance sheet liabilities)
  • Payment of trade payables to the vendors
  • Providing credit to customers (trade receivables)
  • Deposits in banks (cash and equivalents)
  • Given as short-term loans and advances

You may notice the many sources of funds and many usages of funds. This would help you appreciate that increase in reserves is only one out of many sources of funds and cash is only one out of many usages of funds.

Hope it answers your queries.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Why do companies with negative free cash flow pay dividends out of debt?


Hi Dr,

I found it interesting to find you, a medical person, so methodical & scrupulous in accounting.

Overall, I have learned some fundamental principles of accounting, reading BS, PL account. Now I am confident of reading annual reports, which earlier I used to shun away as I am from a science background.

I would request you to clarify the following:

In companies with negative free cash flow (FCF), which have taken debt to fund their expansion projects, we assume that the dividends are also funded out of the debt. I wish to know why did that promoter take debt to give out dividends. Is it just to create a rosy picture? In addition, how did bankers or financiers kept on funding? They must be clever than a poor retail investor!

Author’s Response:

Hi,

Thanks for writing to us! We are happy to know that you found the workshop value adding.

One of the reasons for promoters to give dividends despite poor operating cash flows can be that they would be the largest beneficiary of such payments considering that promoters are the largest shareholders of the company. Bankers might have kept on funding assuming that in future the business cycle will revive and the company might make up for all the interest payments and loan repayments etc.


All the best for your investing journey!

Regards,

Dr Vijay Malik

What is the role of weighted average cost of capital (WACC) & return on capital employed (ROCE) in our stock analysis


Dear Sir

My viewpoint is that there are 2 critical factors: Weighted average cost of capital (WACC) & return on capital employed (ROCE), which need evaluation for any and every company and all other factors will fall into place.

Why don't we focus on these two factors only?

Kindly advise.

Regards

Author’s Response:

Hi,

Thanks for writing to us!

We do not use either the weighted average cost of capital (WACC) or the return on capital employed (ROCE) in our stock analysis. This is because:

1) One of the key components of WACC, the cost of equity, is a highly subjectively estimated figure unlike the other component, the cost of debt. We are not able to put any precise estimate to the cost of equity of any company, which can be used in a mathematical formula as is prevalent to calculate WACC. We are only able to opine that the cost of equity for a well-managed fundamentally sound company is higher than a poorly managed company facing stress. Beyond that, we are not able to have an opinion on the cost of equity and hence on WACC.

2) We do not use composite ratios like ROE & ROCE as a parameter in our stock analysis. This is because; these ratios usually represent the compound impact of individual components ratios like profitability margin, asset turnover and leverage. We prefer to analyse each of these component ratios individually in our analysis. To elucidate further, we prefer companies with high profitability margin, high asset turnover but with low leverage. Therefore, if there are two companies with equal profitability margin and equal asset turnover and the ROE/ROCE of one company is higher than the other company only due to the higher leverage on its books, then we would prefer the company with lower leverage and in turn the one with lower ROE/ROCE.


Hope it helps you understand our views about WACC and ROE/ROCE.

All the best for your investing journey!

Regards,

Dr Vijay Malik 

P.S:
  • To know about the stocks in my portfolio, their relative composition, cost price, details of all our buy/sell transactions since August 1, 2017 as well as to get updates about any future buy/sell transaction in my portfolio, you may subscribe to the premium service: Follow My Portfolio with Latest Buy/Sell Transactions Updates (Premium Service)
  • To learn our stock investing approach “Peaceful Investing” in detail at any time & place of your convenience, you may subscribe to “Peaceful Investing” Workshop-on-Demand, which allows subscribers to watch the recorded videos (9h:30m) of a complete full-day “Peaceful Investing” workshop. You can watch the FREE Sample Video (16min) of the workshop where we have discussed the basics of balance sheet along with fund flow analysis and read about other details of this premium service at the following page: “Peaceful Investing” Workshop-on-Demand
  • The excel template that we use in our stock analysis is now, compatible with screener.in. This customized Excel template is now available for download as a premium feature. For further details and download: Click Here
  • You may learn more about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
  • You may read more company analyses based on our stock investing approach in the Company Analysis e-book series, which is spread across multiple volumes: Click Here
  • To pre-register/express interest for a “Peaceful Investing” workshop in your city: Click here
  • Subscribe for email updates at our website to get the FREE e-book: "Case Studies: Applying Peaceful Investing Approach"

  

DISCLAIMER


Registration Status with SEBI:

I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:

Currently, I do not own stocks of any of the companies discussed above