April 5, 2018

Ideal Level of Promoters' Remuneration, Application of Capitalization to Inventory, QIP Pricing (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. We 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 be the ideal level of promoters’ remuneration?
  • Does capitalization apply to inventory as well?
  • QIP: How do companies determine QIP pricing and does it impact the company’s growth 
What is ideal appropriate level of promoters' remuneration salary, does capitalization apply to inventory, how is QIP price determined



What should be the ideal level of promoters’ remuneration?




Good points, Sir. In the above article, you have mentioned that
“After analysing many companies as part of my stock selection process and for answering queries of readers, I notice that the usual salary range for promoter directors/management is about 2-4% of net profit after tax (PAT). The salary generally contains 2% commission on PAT and a fixed monthly component along with other perquisites.”
My query is that when you say 2-4% of net profits as promoter's salary, do you mean one key promoter? I have seen this figure to be a bit high for promoter directors and key management personnel. I referred Companies Act 2013, section V wherein these details are mentioned, but I could not arrive at a conclusion.

What should be the permissible limit of salary for promoter directors and key management personnel? Can this salary include commissions/other re-reimbursement/sitting fees?

Thanks & Regards,


Author’s Response:


Hi

Thanks for writing to us!

The permissible limit of the remuneration is calculated as per section 197 of the Companies Act 2013 by making certain adjustments in the net profits of the company. Investors do not need to calculate it on their own. Companies provide the limit/ceiling value in the annual report in the section detailing the remuneration of key management personnel. Investors may use the data in the annual report to compare and make an opinion. In a few cases where due to any reason, the company has not provided the limit/ceiling value, then the investors may write to the company to get this data.

The above discussion relates to the legal provision. However, while doing our analysis, we compare the remunerations with the profit after tax (PAT), which is declared by the company in its P&L.

The assessment of remuneration is a subjective exercise and has many case-to-case based subjective interpretations.

We believe that the level of 2-4% is highly relevant for companies, which are run by a single entrepreneur/promoter. However, even in such cases the absolute amount of profits and the absolute amount of remuneration is important before we arrive at any conclusion.

E.g. A company earns a PAT of Rs. 1 cr. and the promoter takes home Rs. 20 lac as salary, then even though the remuneration is 20% of PAT; still it is not a high salary as MBA graduates of tier-A business school take a higher salary than Rs. 20 lac when they start their first job after graduation. Rs. 20 lac may be essential to living in a metro city while taking care of family and kids.

On the contrary, if a company has a PAT of Rs. 10,000 cr., then we do not expect the promoter to take remuneration of Rs. 200-400 cr. (considering 2-4% of PAT as an acceptable limit). We believe that remuneration levels should be lower in such cases and promoters should earn additional money through dividends, which are shared equally among all the shareholders.


The assessment becomes a bit tricky when many members of the family are a part of the company's senior management and each one takes a remuneration from the company. In such cases, we believe that an investor should assess the individual salaries of each of the promoter family members and then arrive at her conclusion about whether the salaries are appropriate or the salaries are being taken as a means of taking money out of the company by the promoters.

Moreover, an investor should always look for signs that may indicate to her whether the names of the promoter family members shown as employees/senior management of the company are merely on the rolls of the company in order to withdraw money from the company without adding any value to the company. OR these family members are truly working as value-adding resources/employees for the company.

An investor should go through the following analysis of Ruchira Papers Limited to understand more on the above point:


Therefore, the management remuneration is a subjective assessment and the investor would be able to differentiate different cases from each other once she analyses the remuneration levels of many company promoters as a part of her analysis.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


Does capitalization apply to inventory as well?



Dear Doctor,

Thanks for your in-depth analysis. We understand that the companies capitalize the interest and other related costs while setting up a plant or machinery.

Is such an application of “capitalization” limited only to plant creation? Or similar mode of treatment can be applied to other “operational expenses “as well, like procurement of raw materials, as indicated in below mentioned hypothetical scenarios.

Scenario 1

A company in anticipation of a price hike of raw material costs in the forthcoming years accumulates bulk of quantities in advance. However, the realization of lower prices is likely to be at a later stage only. Does the company show such cost in P&L Statement of Account on the same financial year or recognize in Balance Statement, till it realizes (similar to the treatment of CWIP/Fixed Asset)? If the company mentions it as one time cost, does it distort the principle of accounts?

Scenario 2

Another instance is that of the recent quarterly result of Purvankara Limited, which shows a substantial increase in the land purchase cost, compared to the previous quarters in P&L Statement (presumably as raw material, considering the kind of business they execute). Does this figure of ₹168 Cr, arrive on account of the transaction carried out during the third quarter or derived from the same principle of capitalization?

What is ideal appropriate level of promoters' remuneration salary, does capitalization apply to inventory, how is QIP price determined

Appreciate your inputs, when time permits.

Regards,


Author’s Response


Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

We believe that any definite answer to your queries may be provided only by a chartered accountant. However, we would attempt to provide our views:

The concept of capitalization is applicable to fixed assets, which lead to the generation of economic value to the firm for more than one financial year. Such fixed assets include plant & machinery, which once created, keep on producing economic value for many years to come.


The concept of capitalization is not applicable to inventory/raw material. The purchase cost of raw material during a quarter is deducted in the P&L during the period it is incurred as "purchase of raw material". However, if a company has purchased excess inventory than what it could use during the period, then it deducts the purchase cost of such excess inventory from the "purchase of raw material" under the head "increase in inventory" in the P&L. In such cases, you would appreciate that the amount of inventory in the balance sheet increases by the amount, which is deducted from P&L under "Increase in inventory". This treatment ensures that the purchase cost of only that raw material is deducted from the income, which is used during the period to produce finished goods.


In case of the example cited by you, it seems that the land purchase cost is the cost incurred during the reported period. You may also notice the impact of the reduction of "increase in inventory" in the example cited by you.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


QIP: How do companies determine QIP pricing and does it impact the company’s growth 



Hi Vijay,

Thank you for your support. I have a couple of questions on investment technical. It would be helpful if you could throw some light on this.

1) Impact of QIP on stock price: Most of the time we have seen that a company’s stock price does not move at normal pace post their QIP issue. You will find almost all the companies (except two companies) struggled once they complete the QIP (recent ex - L&T Finance). I just want to know what exact reason triggers a company to go for QIP. Why usually the QIP price is in some lower band even if the market and the company both are doing well? In addition, what is the rationale, which actually slows down the company’s growth post QIP period?

I did a research on this but most of the research covers the examples but not on the rationale, (although I know the market is irrational :-)). So just, want to check the reason behind it that helps in future to select a stock properly.

2) Also another question: How do you view promoter's pledge? What are the points we need to check to assess whether promoter's pledge is indeed good for the company?

Thanks in advance.

Regards,


Author’s Response


Hi,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts.

Regarding QIP:

QIP is a method of raising additional equity by the company. All the factors, which necessitate additional equity infusion by company shareholders like reducing the debt to equity ratio, repay existing lenders, capitalize on current high share price etc. will impact companies' decision to go for QIP.

QIP pricing is guided by SEBI guidelines and is based on a formula factoring in the weekly highs & lows of the certain period before the board meeting approving the QIP issue for allotment. (You would find many articles about it on the internet).

Regarding "what is the rationale which actually slows the company’s growth post QIP period?", we are not sure whether raising additional equity via QIP would result in a slowdown of the future sales/business growth of the company.

Regarding pledging of shares by promoters:

You may read our views in the following article: Preference Shares and Pledging of Shares by Promoters (Q&A)

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

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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