The Hindu Business Line : ROE = ROS x ATO x FL

OVER 7,000 years ago accounting was done in Babylon using cuneiform on clay tablets. These were marked with a seal and fired. Already, there were resources owned by some but operated by others; thus, when "the owner of a herd of goats sought to monitor and evaluate the stewardship of the operating manager (the shepherd)," he would have resorted to accounting, write George T. Friedlob and Lydia L. F. Schleifer in Essentials of Financial Analysis, published by Wiley (www.wiley.com).

Similarly, Queen Isabella, who supplied ships and provisions to Columbus, was interested in ascertaining the result of the venture when he returned: "The worth of the New World booty was compared to the cost of the initial provisions. The difference was profit."

Accounting is a post-mortem job, but it would be wrong to presume that it is static. It is "an ever-changing communicative system" because all the stakeholders keep pressing for "improvements in the information that accounting systems provide."

In chapter 1, the authors discuss the equation: Cash + Other assets = Liabilities + Owners' equity + Revenues - Expenses. Double entry in accounting, that ensures the equation to hold good, is like "Newton's Third Law of Motion" — that every action must have an equal and opposite reaction.

To analyse a company you need to measure. "There are five ways to measure an economic event, though not all events have all five attributes." The different ways are: Historical cost, current replacement cost, current market value, net realisable value and present (discounted) value. "Even if all these values are about the same for an asset when it is purchased, business and environmental conditions may cause these five values to diverge over time."

The divergence creates a problem of reliability. "For example, information about the market value of an investment in currently traded stock is more reliable than information about the appraised market value of an old building."

Operating income and income from continuing operations may sound alike but they are different, explains the book. "The latter is further down on the income statement, because it is the result of subtracting interest expense and income taxes from operating income."

Analysis of profitability involves calculation of ROE, that is, return on equity. ROE = ROA x FL, that is, return on assets multiplied by financial leverage. ROA, in turn, is a product of PM and ATO, that is, profit margin and asset turnover, which reflect the operating and investing successes respectively. Don't weep as yet, there is the RONA, return on net assets, also known as ROC, not the registrar of companies, but return on capital. There is another name for PM; not Atalji, but ROS, meaning return on sales.

Do you know that there are three types of leverage? Physical leverage gives mechanical advantage, as when using a crowbar to lift a boulder. Financial leverage gives capital structure advantage, and increases return on equity. Operating leverage offers the asset mix advantage by raising return on investment.

In the long run, we are all dead, but that is when "net income should be about equal to cash flows". Timing creates anomalies. Thus, "a company may get cash and subsequently do something to earn it" or vice versa. "The closer the amount of net earnings is to the amount of cash flow in the short run, the higher the perception of the quality of earnings."

Moral: If you own chicks, check them routinely for flu!

BookValue@TheHindu.co.in

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