Decoding Order Books and Balance Sheets in Heavy Industry

 

Some businesses are easy to understand: a restaurant sells meals, a shop sells goods. Heavy engineering companies are different. They build massive machines over many months, bill in stages and wait for payment from large customers. Many investors scanning market news see movements in the BHEL share price or the Suzlon Energy share price and assume the reasons are simple. In truth, behind every swing lies a combination of orders, execution, working capital and sentiment. Learning to read the financial documents of such companies lets you look past the headline and judge whether a business is building lasting value.

What an Order Book Really Tells You

An order book is a repository of contracts that a company has bagged but not yet executed. If the order book is three times the annual revenue, it means the firm has enough work to last it about three years. This gives comfort on the sales front but one still has to probe further to gauge quality.

Ask who the customers are as government-linked buyers tend to be slow payers but reliable, while private developers may be quicker but riskier. Ask about the pricing as well since orders secured at barely viable prices to beat competition will leave the company with little profit. In addition, ask about the vintage of the orders because contracts lingering for years in the pipeline should not be considered as reliable sources of future revenue.

The Working Capital Conundrum

Heavy industries are notoriously voracious in their consumption of cash. The company buys raw materials, pays wages and subcontractors before getting a single rupee from the customer. This is known as working capital and constitutes one of the most important but under-exploited areas for analysing a company.

Look out for receivables days, which is an indicator of how much time lapses before the company gets paid. A rising trend here means that the company is funding its customers' working capital needs, which is bad news for the investor. Inventory also provides crucial information. A build-up of stocks (raw materials, work-in-progress and finished goods) is a sure sign that the company is unable to sell them, which means a cash lock-up as well as the risk of obsolescence. A company that consistently records profits on paper but finds itself perennially short of cash invariably has problems in this area.

Cash Flow versus Profit

Profit is a matter of accountant's opinion while cash is a fact. A company can report rising profits while finding itself in a worse position with respect to liquidity, because cash received from customers could be far lower than the sales reported on paper. Compare the net profit with cash flow from operations for the past few years to identify such trends.

Capital expenditure is yet another important determinant of cash flow. Heavy industries need to spend consistently on upgrading their production facilities and this outlay has to be evaluated in terms of the returns generated. Free cash flow, which is cash flow from operations minus capital expenditure, is an important indicator of how much cash is being generated for distribution to shareholders after meeting the needs of the business. Companies that consistently report positive free cash flows tend to be more credible.

Decoding Debt and Contingent Liabilities

While borrowings are visible on the balance sheet, contingent liabilities need to be probed in detail by reading the footnotes. Contracts entered into by the promoters for project financing, tax disputes and litigation are some examples of contingent liabilities that can crop up suddenly to affect profitability.

Look out for interest coverage ratios as well. While a declining trend in this ratio is a matter of concern, the ideal ratio should always be higher than the annual interest payments by several times. This way, the company will not find itself in a position where it has to raise fresh capital to pay off old dues, which could prove to be dilutive to existing shareholders.

Using Ratios without Getting Duped

While ratios are useful indicators, one has to be careful not to get misled by window-dressing. Return on equity (ROE) could be artificially inflated by taking on large amounts of debt, which will distort the ratio since equity will be relatively low. Similarly, price-to-earnings (P/E) ratios tend to be artificially manipulated by companies reporting higher earnings due to one-time gains or lower earnings to reflect lower P/E.

Compare a company's ratios with its own historical data and with peer companies on a cyclically adjusted basis. Use both quantitative and qualitative analysis for valuation.

Getting into the Habit of Reading

It is important to make it a habit to read through the details of result announcements, investor presentations and management commentary. Maintain a simple excel sheet for tracking order books, margins, debt and cash flows for each company. After a few quarters, one will be able to spot patterns and have a better understanding of what is happening when it comes to investing.

This habit helps one be patient when it comes to selling as well as buying. In the short term, markets are a casino but in the long term, they are a temple.