Forensic Analysis of financial statements - Understanding Business

UNDERSTANDING BUSINESS OF THE COMPANY AND INDUSTRY IN WHICH COMPANY OPERATES

In the previous article, we had discussed basics of financial analysis i.e. meaning and Users of financial analysis, in case you have missed the previous article, you can get from below mentioned link:
Forensic Analysis of Financial Statements - Can I do?

OBJECT OF BUSINESS UNDERSTANDING

Our object here is about how to understand business and industry & its impact. Since there is no standardize method, so I will share some example so that method can be understood.

WHY IS BUSINESS & INDUSTRY UNDERSTANDING REQUIRED?

• It provides the base for rational assumption taken for predictive analysis or projected figures for futures or to understand the effect of various line items on the business of the company.
• Understanding Company business takes into consideration Micro Factors while understanding Industry takes into consideration Macro Factors. (Will discuss later on with example)
• Past numbers are just numbers based on that, one cannot solely predict or estimate financials in future, one ought to have considered the Qualitative aspect of Business and Industry.

Some important questions:

How is the company placed in Industry? What is cost component of product? What are the strength and weaknesses of the company? Any future business plans? Proposed regulatory changes etc.

Since understanding business is not the easy task, It requires time and experience to understand. Keep one thing in mind that each industry has operating parameters based on which performance evaluation is done. There are various freely available resources which will help you in business understanding.

EXAMPLE: Refer below-mentioned examples (indicative) for understanding impact of various factors on business.

IT Software Development

Software development can happen at own site or Client's site. In technical terms, it is known as Offshore and Onshore development i.e. developing software at client's site is known as Onshore or Onsite development, if software developing at own site then it is known as Offshore or Offsite development.

Considering above things, Say Company X derives more than 80% revenue from onshore development as against industry standards of approx. 55-60%. Now think what could be the possible impact.

1. Since Company X has significant revenue from onshore development so having own premises or buildings are not required so it would have saved CAPEX outlay and its consequent effect of depreciation every year.

2. And another way of looking is, Since Company is in onshore development then it may have saved rent expenses on premises in case of own building would not have purchased as required in the offshore development of Softwares.

These parameters will add positive margin to Company as compared to peers.

Cigarette or Tobacco Manufacturing

Since Smoking is injurious to Health of human beings, various governments started Campaign for awareness of side effects of smoking or have increased excise duty & various other duties on tobacco products to reduce consumption of these things.

Considering above things, think about the possible impact on Company who had a successful profitable business in past and earned ample profits.

1. Since Govt. has increased various duties on these products so that it becomes costly and thereby consumption get reduced, Company may not be able to pass on increased cost due to taxes on these products to Customers which ultimately reduce profit margin of the company.

2. Another way around, even though Company was able to pass on the increased cost to the customer, but due to various govt. the awareness campaign, Customers started giving up consumption habits of these products. In these case, a rather going concern of the company affected if the company is not able to survive.

Textile Manufacturing

Textile is one of the largest sectors in India which contributes 4% to GDP, employing 45 million people being the largest source of employment generation in the country. Govt. provides continued support for the textile sector by way of various schemes. Say, for example, there is interest subvention/subsidy scheme of 4% if the investment is done with respect to specified area or time etc.

Textile Manufacturing Company who borrowed funds from Banks for a project which falls under this scheme. Average borrowing cost of funds in India is 12-14% i.e. interest rate. Now 4% interest subsidy provided government will save interest cost, and in turn, will positively affect profit margins of the company.

Above examples are for reference purposes, there are numerous examples depending upon industry like:

• Liquor banning in various states
• Technological changes in various electrical consumer durables
• Changing customer preferences
• Availability of cheap substitutes etc.

GROWTH DRIVERS OF ANY BUSINESS

As the name suggests drivers, growth drivers are various key changes in micro and macro factors that drives positively to Organization. Each industry has some unique growth drivers:

Taking example of Textile Industry (Source: IBEF)

Demand Side Drivers

• Rising demand for exports
• Increasing and changing demand in domestic market due to changing taste and preferences
• Growing population driving demand for textiles

Policy Side Drivers

• 100% FDI in Textile Sector
• Government setting up SITPs and Mega Cluster Zones
• Increasing loans under TUFS (Technology Up gradation Fund Scheme)

Supply Side Drivers

• Growing domestic and foreign investments
• Various government investment schemes (TCIDS and APES etc.)

MODELS FOR BUSINESS UNDERSTANDING

There are various models, which are useful in understanding qualitative factors

• SWOT Analysis
• Porter's Five Forces model
• PESTLE Analysis

There are other models as well but we will cover above mentioned models in next coming articles.

SOURCES FOR GAINING BUSINESS UNDERSTANDING

IBEF - trust established by government provides comprehensive Industry reports (free)
Analyst Reports - available for company as well as industries (some brokerage houses provides free access)
Annual Reports - Listed companies annual reports (free)
News reading - to understand day to day changes taking place with respect to company and sector
Premium Service Providers - there are various database companies which charge fees for their reports

The author can also be reached at tehsinblog@gmail.com or https://knowledgekhan.blogspot.in/

Note: No part of this article or any article in series is allowed to be copied and share in public (e.g. on any blog or website) without written prior permission of the author in whatsoever manner and, this article strictly meant for Personal use only, not for commercial purpose.