Over my limited experience in equity markets, I have come to conclusion that earnings power box is a powerful tool to analyse authenticity of corporate earnings. While I am not going to repeat much of much I have written earlier, you can go through it here and here
One of first things I do after getting annual reports of the companies I hold is to update their earnings power box (EPB)
Updating it sets me in right frame of mind to query annual reports, let me run through an example to elucidate my point
In 2014 this is how Kitex ‘s EPB looked like
A company in wealth maximizing quadrant 2, the more number of years it continues its advance in this quadrant the more it will continue to create value for owners
2015 EPB will blow your mind away
The company made a significant advance in quadrant 2, no wonder stock market rewarded the stock in the bull market
This is where we start our investigation
First let’s look at raw data for per share earnings
The accrual EPS (one which is reported as diluted EPS in Profit and loss account) had a significant jump from INR 12.08 /Share to INR 20.74 / Share however what was even more staggering was a fourfold jump in defensive EPS from INR 6.37 /Share to INR 22.61 / Share
What led to this ?
On opening annual report this is what you find
Reduction in working capital to the tune of ~INR 17 Crores (Note the company already is a negative working capital company and continues to improve this situation)
Let’s look at component by component
Current assets excluding cash increased by ~24 Crores
Loans and advances increased by INR ~13.25 Crores largely on account on advance taxes paid (No surprises here)
Inventory increase of ~INR 1 Crores
Trade Receivables increased by INR ~9 crores, (expected as sales increased)
Current Liabilities increased by ~41 Crores
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Provisions increased by ~18 Crores (Due to higher profitability)
Short term borrowing increased by ~23 Crores (Packaging credit – This is favourable rate loan available to exporters, key tracking item to see if an exporter is doing well)
Trade payable reduced by ~5.5 Crores (Was large inventory bought at discount for cash as ideally this should have increased with increase in sales ?)
Other liabilities increased by ~5 Crores
The company continues to be smart in managing working capital prudently funding it via huge packaging credit
Steep reduction in Fixed investment to depreciation ratio – There was no huge capex spend this year, Also in Annual report company claimed
– New sewing machines have been installed to increase from 7000 stitches per hour to 9000 per hour
– A bow making automated machine that reduces manual effort by 1/50th , yes you read it right 1/50th
See this
Revenue increased by 16%
Assets increased by 3% only
Is plant running at full capacity can sales be increased with limited capex in future as well? Nothing in annual reports to come to a conclusion however management has indicated that they can double capacity in same campus
One thing is clear increase in defensive profits indicates that capex is internally funded
Now turning my attention to enterprising profits
Like last year again a 100% jump from INR 6.59/ Share to INR 12.18 / Share, indicating that company is expanding its ROIC and earning greater economic profits.
In simple terms additional capital retained in business is getting put to good use
My conclusion – Like last year Kitex Ltd has authentic earnings power and now it’s no longer a secret as the stock has become darling of markets !
Do you want to use EPB analysis to evaluate how your portfolio companies are doing ? Buy an easy to use ready-made template which can be used for any company – here
Hi Vivek,
Good Article, May i know at which rate you considered WACC for Debt and Share holders equity for calculating interest expense?
Thanks
Ravi
Hi Ravi,
I didnt calculate interest what are you referring to ?
My bad that i did not explain my question fully. while calculating Enterprise income statement, one should not consider the share holders equity as free. So we should calculate the share holders equity as rate to arrive the cost of capital. So i am referring to the cost of capital that you considered ( 20 or 30% etc) for the share holders equity.
Infact, i have calculated Defensive EPS and Enterprise EPS, they are different from yours. so wondering about the rate.
I have followed the points mentioned in the “Its Earnings that count” book and prepared the Defensive and Enterprise EPS for Kitex but the values yours is a bit different. If you would like to check my file, i can share it with you.
Thanks
Ravi
Yes pls share vivek[dot]bothra[attherate]outlook[dot]com
Sent. please let me know your comments
To calculate whether Workin cap. is negative or not, we should also exclude short term borrowings from calculation as they are interst bearing. If we do so, Kitex is not a negative working cap. co.
Krishan,
By principle short term borrowings are used to fund day to day operations so whether they are interest bearing or not have no relevance for working capital calcs
If a Co. is having negative WC, the general implication is that it is having some sort of moat and that can be implied only when the current liabilities consist of OPM “OTHER PEOPLES MONEY ” which is free of cost. Kitex is a good co. but cannot be termed as having negative WC. Colgate whose results are published in today’s papers has real neagitive WC and also has a MOAT. This is my understandin of negative WC.
Unfortunately we would not be able to build a model on general implications we need to put in a set standard which can be used across companies
I concur with Krishnan thoughts here, we cannot consider it as negative working capital as we exclude cash and equivalents for calculation purpose. Negative working capital when company receives advances in the case of DFM foods etc.
You may disagree with me 🙂 My theory is investment in WC is use of cash so I can’t use cash as use of cash
Working Cap for fy 15 = Current asst – Cirrent Liability
=341.19-218.7 = 122.71
How come wc came negative(Note the company already is a negative working capital company and continues to improve this situation)
wc for fy 14 =217.33-176.72=40.61
Kindly explain Formula for Defensive Earnings
Hi Arvind,
I always take Current Assets – Cash ( as cash is not operating asset) = Current assets
Thanks
Thnak you Vivek…
Kindly give Formula for Defensive Earnings
On Internet also lot of people write about it.
But no one explains it by taking real company examples form India
If you write one blog on Defensive and Entrprise Value .It will be useful for retail investors……
Does EPB analysis include Excel file.
Yes Jacob