When it comes to equity investing, for most of us, the starting point is either an analyst call, a news item or a journalist covering some unheard of company. I was told about Equitas by the promoter of another Nbfc. I was told about SREI about an analyst. I was told about Kwality raising money by a venture capitalist.

The starting point of course is the published balance sheet – the unabridged version, and it is BORING to read a balance sheet.

Let me tell you that I do not know of a single good investment adviser (who also invests his own money) who is not a good accounts person. Of course it is an advantage that Vallabh Bhansali and Rakesh Jhunjhunwala are Chartered Accountants, but Naren’s ability to understand accounts is extremely well learnt in his investment journey.

What does one really need? well, a good feel for numbers, understanding percentages, changes, manipulative accounting policies, oft changing assumptions, oft changing methods of depreciation, non provision of some important liabilities (which means you read the notes on accounts too).

All this will lead you to a very important number: FREE CASH FLOW. fcf. You can arrive at this by adding the investments made, the depreciation, etc. to the NPAT. If you are not comfortable, pick simple companies like Colgate to start with. Do not get to complicated balance sheets like Reliance. FCF is impacted by the change in working capital, and fresh investments made. Remember a company can ‘show’ growth while simultaneously destroying value – if the cost of funds is higher than the returns that they are getting on the margins. Of course some industries need a lot of patience – look at the Mutual fund industry, Hdfc Ltd made its investments in 1991..and it could IPO /OFS in 2018. Do you have that kind of patience?

One more thing to see (and this is more difficult) is whether the company’s director’s report or Chairman’s speech match the Profit and Loss account, cash flow and balance sheet. If the company is talking about entering a new business while using the existing cash flows, you need to see whether the balance sheet will really take the stress. Go and see the Hindalco balance sheet for 3 years and see whether it can REALLY pay for their latest acquisition abroad. Compare the details of expenses item by item with a competitor and see how there is a change in strategy or whether the same strategy is being used well. For e.g. Asian paints does not use wholesalers – it goes to the dealers directly. HUL uses super wholesalers/dealers who deal further down. Nothing wrong, but once in a while you should see the expenses of companies in similar business, and see how the strategy is impacting the bottom line.

Of course you can do analysis like RoE, RoNw, RoA, etc – but you need to do it carefully. For e.g. a Fmcg company or even a pharma selling in domestic markets – could be using different strategies for different businesses. In one part of the business they may be using differentiation – having a high margin and poor velocity of capital, and in one business be having a low margin but high capital velocity. One of course is the cake business, and one is the bread business. To do this kind of an analysis, one will have to either see the detail segment wise data or have the luck of knowing an analyst who interacts with the company. Long ago when we did the analysis of Supreme Industries, we had the luck of meeting the CFO who could tell us why which factory was being used. Sometimes you will have to live with gut feel and experience.

Another worry is the amazing changes in the accounting rules and regulations that various law enforcing authorities have brought about. So companies are asked to give too much information – and some of the information is just an opinion. This is worrisome. Somewhere the facts and opinions get mixed. When I was younger the balance sheets were easier to understand. Now every piece of math is accompanied by a page of assumptions and explanations.

Surely, our life was easier.

Understanding accounts is just one of the many attributes in being a good investor…others will follow.