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Table of Contents
Welcome to a New Chapter in Your Investing Journey i
Business Models & Economic Moats
Chapter 1
Introduction to Value Investing............................................... 3
Chapter 2
Analyzing Business Models..................................................... 9
Chapter 3
Identifying Economic Moats I................................................. 23
Chapter 4
Identifying Economic Moats II................................................ 33
Chapter 5
Identifying Economic Moats III............................................... 51
Accounting Basics & Financial Analysis
Chapter 6
Accounting Basics................................................................... 65
Chapter 7
Financial Ratio Analysis I......................................................... 69
Chapter 8
Financial Ratio Analysis II........................................................ 81
Chapter 9
Identifying Accounting Red Flags.......................................... 91
Separating Good Management from Bad
Chapter 10
Separating Good Management from Bad I........................ 105
Chapter 11
Separating Good Management from Bad II....................... 113

Chapter 12
Separating Good Management from Bad III...................... 127
Valuation Methods
Chapter 13
Introduction to Valuation.......................................................... 141
Chapter 14
Earnings Power Value and Franchise Valuation................ 155
Chapter 15
Franchise Valuation With
Growth & Multiple-based Valuation...................................... 165
Stock Screeners
Chapter 16
StockScreeners.......................................................................... 181
Behavioral Finance
Chapter 17
Behavioral Finance.................................................................... 195
Portfolio Analysis
Chapter 18
Portfolio Analysis........................................................................
209

i
Dear Reader,
When we launched Equitymaster in 1996 - India’s first financial
website - we could not have imagined we would emerge as one of
India’s most trusted research houses.
Our vision…to empower the small investor…to be ‘investor’s best
friend’…has guided us through many challenges these past two
decades.
And today, when we look back, we take immense pride in what
we’ve delivered. And how we’ve remained committed to delivering
clear, honest, and unbiased views.
This book, which commemorates our 20th anniversary, has the
potential to change the way you invest. That’s because these
pages include the culmination of our two decades of experience
picking out money-making opportunities.
In these pages, we reveal the complete Equitymaster Way…the
secrets we’ve run our business on for 20 years.
We hope you find these lessons richly rewarding in your wealth-
creation journey.
Happy investing,
Rahul Shah & Tanushree Banerjee
Co-heads, Equitymaster Research Team
Welcome to a New Chapter
in Your Investing Journey

ii
PS: Three years ago, we decided to put together the best investing
secrets, lessons, and experiences we’ve gathered over the years.
We wanted to keep it simple and practical for the lay investor. As
such, the examples explained in the book pertain to that period.
While some facts may have changed, the essence of the lessons is
timeless.
We have strived to present the book in a highly objective and
concise manner, and as a result, have used bullet points in many
chapters. We hope you find the reading experience easy and
enriching.

Business
Models
&
Economic
Moats

Chapter 1: Introduction to Value Investing 3
Definition of Value Investing
“An investment operation is one which, upon thorough
analysis, promises safety of principal and a satisfactory
return. Operations not meeting these requirements are
speculative.”
- Benjamin Graham
Value investing is an investment approach that seeks to profit from
identifying undervalued stocks. It is based on the idea that each
stock has an intrinsic value, i.e. what it is truly worth.
Through fundamental analysis of a company, we can determine
what this intrinsic value is. The idea is to buy stocks that trade at
a significant discount to their intrinsic values (i.e. they are cheaper
than their true value).
Once we buy an undervalued stock, the stock price eventually rises
towards its intrinsic value, and makes a profit for us in the process.
Value investing is conceptually simple, though requires effort to
implement. Research process focuses on finding out the intrinsic
value of a company. Primary tool for researching a company is
called fundamental analysis.
Chapter 1
Introduction to Value Investing

4 Equitymaster’s Secrets
Philosophy of Value Investing
Benjamin Graham - The founder of Value Investing
4 components that define the philosophy behind value investing:
First component: Mr Market
Imagine you are in a partnership with Mr Market, where you can
buy or sell shares. Each day, Mr. Market offers you prices for shares
depending on his mood. If Mr Market is in a very optimistic mood,
he will offer very high prices. In this case, an investor should cash
out of shares. If Mr Market is in a very pessimistic mood, he will
offer low prices, and this is the time to buy.
Second component: Intrinsic Value
Intrinsic value represents the true value of the company based on
fundamentals. In the short term, market prices deviate from their
intrinsic values due to changing market sentiments. In the long
term, market prices return to intrinsic values. This process allows us
to make profits, because we can buy stocks when they fall below
their intrinsic values. We then hold them until they return to their
intrinsic values in the long term.
Third component: Margin of Safety
Margin of safety is the difference between the current market price
and the intrinsic value.
“A margin of safety is achieved when securities are
purchased at prices sufficiently below underlying value
to allow for human error, bad luck, or extreme volatility
in a complex, unpredictable and rapidly changing
world.“ - Seth Klarman

Fourth component: Investment Horizon
“In the short run, the market is a voting machine but in
the long run it is a weighing machine.”
- Benjamin Graham
Value investing works in the long term, because that is when
prices return to their intrinsic value. Value investing does not aim
to predict what stock prices will do 2 days or 2 months from now.
Instead, it aims to pick undervalued businesses that will outperform
in the long term. This will eventually reflect in the stock price.
Evolution of Value Investing
Value investing started as a purely quantitative approach that
has now evolved to incorporate a qualitative approach. Benjamin
Graham’s view was that one only needed to look at the financial
statements of a company in order to determine its value. There
was no need to analyze qualitative factors such as a company’s
management, future product offerings, etc. The numbers told the
investor everything they needed to know about whether they
should invest in a company or not. This approach is known as the
cigar butt approach. The advantage of the quantitative approach
is that it is based on hard facts alone. The analysis is objective,
and less reliant on assumptions. Unfortunately, the quantitative
approach does not account for all the factors that determine a
company’s true value. Qualitative factors such as the management
quality, industry dynamics, competition, future products, consumer
behavior, etc. are all relevant to a company’s performance. Warren
Buffett’s approach incorporated these qualitative factors into his
analysis, along with the quantitative factors.

Concept of ‘Economic Moat’
A company‘s ability to maintain competitive advantages over its
competitors to protect market share and long-term profitability.
If a company has a high economic moat, it means it has an edge
over its competitors. Warren Buffett’s approach aims to identify
companies with a high moat that are trading at reasonable prices.
The moat is inherently a qualitative factor, and this represents the
difference between Buffett’s and Graham’s approaches.
Coca-Cola Company - A classic Buffett stock
One of Buffett’s most successful investments. Exemplifies the
difference between the approaches of Graham and Buffett. Buffett
admired the company due to the presence of a strong economic
moat. He also analysed other factors like management quality,
consumer behaviour, scalability of business, long term growth
visibility, etc. He was able to conclude that Coca-Cola could earn
much more 10 years from now than today. Graham on the other
hand would have seen Coca-Cola as just another company. He
would have analysed it based on existing earnings and ignore
future growth potential. Graham was of the view that competition
does not allow any company to earn extra profits for a prolonged
period of time. Hence, he did not believe in paying any premium
price. Buffett, however, focused on just those companies that could
keep competition at bay for a prolonged period of time due to the
presence of a strong economic moat. He was also willing to pay a
slightly higher price for them.

Warren Buffett’s Four Filter Approach
Warren Buffett’s four filter approach is a process by which we can
arrive at an investment decision. It is like a checklist that we apply
to any stock we are interested in. We identify companies that have:
1. A business we understand
A business we understand is critical because we need to know
what we are buying into.
We stay away from companies that have overly complicated
products and business models.
2. Favorable long-term economics
Favorable long-term economics means the company should have
a competitive advantage (economic moat) that we believe is
sustainable over the long-term.
3. Able and trustworthy management
Able and trustworthy management means that management
consistently demonstrates competence and works in the interest
of shareholders.
4. A sensible price tag
Finally, a sensible price tag is nothing more than having a margin
of safety.

Equitymaster’s Approach
Here at Equitymaster, we closely follow Warren Buffett’s investing
approach for many of our recommendation services. We believe
in identifying companies that have a high moat and sell for
reasonable prices. Our investment philosophy can be summarized
as follows:
“Don’t try predicting where markets will go
tomorrow or 6 months from now...Don’t lose
your calm over changing market sentiments...
Buy stocks as if you are buying businesses...only
the ones with solid long term fundamentals...
only when they’re selling cheap...
And stay invested for the long term...Period”

Chapter 2: Analyzing Business Models 9
Investing in a Business
When you invest in a stock, you become a part-owner of the
business. Would you ever put money in a business that you don’t
understand? Understanding businesses thoroughly and investing
in only those businesses that you understand is the cornerstone of
value investing.
Analysis of Business Models
When we study a company, we start by analyzing its business
model and the industry structure. A company’s business model
is a description of how a company operates within an industry/
economy and creates value for its shareholders. Porter’s Five
Forces is a very powerful framework that can help you analyze a
company’s business model and the overall industry dynamics.
Porter’s Five Forces- Basics
Firms in an industry compete for profits. Competition is not limited
to direct competitors alone. Factors such as potential new entrants,
customers, suppliers and substitute products also impact an
industry’s profitability. An analysis of Porter’s Five Forces gives us
a solid understanding of a company’s business model, the industry
structure and the long term profitability.
Chapter 2
Analyzing Business Models

Porter’s Five Forces- Benefits
√√ Helps analyze a company’s business in the context of the
industry in which it operates
√√ Helps filter away short term market trends and understand
root factors that affect long term profitability of firms in an
industry
√√ Helps understand why some sectors command premium
valuations while others do not
Porter’s Five Forces
Bargaining Power of
Customers
Bargaining Power of
Suppliers
Threat of New
Entrants
Threat of Substitutes
Competitve Rivalry
1. Threat of New Entrants
The barriers to entry determine how likely it is that new firms will
enter the market. The threat of new entrants determines how long
high profitability in an industry can last. If a company is making high
profits, this will attract other firms into the market, ultimately driving
profits lower. Factors such as high fixed costs, distribution network,
network effects, use of patented technologies, brand loyalty,
government regulations, etc. tell us how easy it is for new firms to
enter the market.

2. Bargaining Power of Customers
The bargaining power between a firm and its customers can
affect the company’s profit margins. In particular, if buyers are
concentrated (i.e. a small number of buyers), they are likely to
have considerable bargaining power. Other factors include how
easy it is for buyers to switch suppliers, whether buyers are price
sensitive, whether they can afford not to buy temporarily, and how
dependent the firm is on individual customers.
3. Bargaining Power of Suppliers
The bargaining power between a firm and its suppliers also
significantly impacts the company’s profitability. The concept is
similar to the analysis of the bargaining power of customers; the
difference is that the company is a customer of its inputs. If there
are a small number of suppliers, then they will hold considerable
bargaining power. Also important is how easy it is for the firm
to switch inputs and suppliers; the harder it is to so, the more
bargaining power the supplier has.
4. Threat of Substitutes
A company faces competition from not just other firms in the same
industry but also firms from other industries that have products that
offer the same benefits as the company’s products. The threat of
substitute products determines whether profit margins can remain
high over long periods of time. The more likely a customer is to
switch to a substitute product, the lower the company has to keep
its prices (and thus profit margins) to attract the customer. If profit
margins are low, it is more difficult for a company to withstand
external shocks; e.g. a rise in the price of its inputs.

5. Competitive Rivalry
Competitive rivalry looks at the way in which companies compete
with each other within the industry. If companies compete
heavily on price, this is likely to keep profit margins low; this
occurs primarily when the companies’ products are very similar.
Competitive rivalry is low if there is differentiation between
products and brand loyalty is significant. Competitive rivalry is also
low if exit barriers are low and vice versa.
Applying Porter’s Five Forces:
We have selected three companies - Arvind Ltd, Nestle India
Ltd, and Asian Paints Ltd, due to their distinct business models.
Let us see how they fare as per Porter’s Five Forces model. The
analysis is performed as of June 2013. Many of the facts come from
company websites, annual reports, data providers, etc.
Arvind Ltd
• World’s fourth largest denim manufacturer.
• India’s largest denim exporter.
• Annual capacity: 110 m metres of denim and over 72 m
metres of shirting fabric.
• Vertical integration in garments, strong brand franchise and
a wide distribution network in branded apparels has placed
the company in a strong position in domestic as well as
global markets.
• Well-known in-house brands like Flying Machine, Excalibur,
Newport University and Ruggers.
• Licensed brands such as Geoffrey Beene, Cherokee, Elle, US

Polo Association, Arrow, Izod, Energie, and Gant.
• Master franchisee of Tommy Hilfiger through a joint venture
(JV).
• Business-to-business clients include brands such as Miss
Sixty, Diesel, Gap and Zara for denim.
Despite having a leadership position in the denim industry,
company has failed to create value for shareholders. Once a large
cap stock, Arvind Ltd was part of the BSE-Sensex from 1996 to
1998. However, company has consistently lost value and today is a
mid cap stock. Porter’s analysis helps understand how the adverse
dynamics of the textile industry have impacted the company’s long
term profitability.
Arvind Ltd - Porter’s Five Forces
1. Threat of New Entrants - Very high
• Denim is a highly commoditised product and does not
require a lot of capital investment. It is easy for any new
player to enter the market and take away market share from
existing players.
• Even in apparel retailing, threat of new entrants is high on
account of numerous Indian and global brands entering the
market across all price points.
2. Bargaining Power of Customers - High
• Given that there are several players in the denim space
starting from those vending unbranded, low priced ones
and going up to higher priced branded ones, the bargaining
power of customers is especially high in the mid-market
segment, where Arvind operates.

3. Bargaining Power of Suppliers - High
• Cotton and power costs put together comprise nearly 40% of
Arvind’s manufacturing expenses. The volatility in the prices
of cotton due to shortage in global markets has made the
bargaining power of suppliers very high. Also, the bargaining
power of the foreign licensee companies is very high.
4. Threat of Substitutes - Very High
• Most other fabrics can act as substitute for denim.
• Demand for denim tends to move as per fashion trends in
global markets.
5. Competitive Rivalry - High
• There exists a huge unorganized market for both denim and
shirting in India.
• In each of the product segments, there exist other players
that compete in both the premium end space as well as in
the economy space.
• An apparel manufacturer without strong brand recall
amongst customers and a strong retail franchise has very
little pricing power.
Nestle India Ltd
• Indian arm of Swiss MNC Nestle S.A.
• Largest food company in India.
• Third largest FMCG company in India.
• Leader in branded processed foods.
• Commands a large market share in products such as instant
coffee, weaning foods, instant foods, milk products.

Nestle India has been among the best shareholder wealth creators
with over 2300% returns in 18 years (19% CAGR). Low capex model
with excellent return on capital. For nearly two decades, Nestle has
paid out on average 76 out of every 100 rupees of net profits as
dividends to shareholders. How has the company managed to do
this? Porter’s Analysis provides some useful insights…
Nestle India - Porter’s Five Forces
1. Threat of New Entrants - Low
• Although launching a product is relatively easier, making it a
success is based on establishing its brand presence.
• The brand equity is built over a period of time through
promotions that develop a brand recall and a robust
distribution network to ensure availability.
• Nestle with its 100 years presence and powerful brands,
enjoys a definitive advantage over entrants.
2. Bargaining Power of Customers - Moderate
• In mass segments where volumes play a major role,
customers enjoy bargaining power.
• Customers also benefit in well penetrated and mature
product categories that are relatively more price sensitive.
• Barring instant noodles, majority of the company’s products
are in the premium categories.
• As such, the bargaining power of customers is moderate.
3. Bargaining Power of Suppliers - Low
• Since there are no major suppliers of inputs, they do not
have considerable clout and hence have low bargaining
power.

4. Threat of Substitutes - Low
• Most of the food products do have readily available
substitutes but it is difficult to rid people of their deep rooted
habits.
• Those who prefer coffee over tea or instant noodles over
any other snack will seldom give up their preferences.
• Threat of substitutes, therefore, is low for company’s
products.
5. Competitive Rivalry - Low
• The competitive rivalry is low in all product categories such
as noodles, chocolates and milk & milk products.
• This is borne by the company’s dominant market share in
most of the categories it is present in.
• In instant noodles, it enjoys a market share of about 80%.
• Nestle is also the market leader in other categories like baby
food, instant coffee and milk products.
Asian Paints Ltd
• Founded in 1942, market leader in paints since 1968.
• India’s largest paint company and Asia’s third largest.
• Nearly 4 times the size (in terms of FY13 sales and net profits)
of its biggest competitor in India.
• Manufactures a wide range of paints for decorative and
industrial use.
• Operates in 17 countries, has 24 paint manufacturing facilities
and services consumers in over 65 countries.

• Driven by its strong consumer-focus and innovative
strategies, it has several strong brands and has consistently
pioneered new concepts in the industry.
Asian Paints ranks among leading shareholder wealth creators with
over 3300% returns over 18 years (22% CAGR). It was included in
Forbes Asia’s ‘Fab 50’ list of Companies in Asia Pacific in 2011 and
2012. It has a low capex model with excellent return on capital.
Over last 12 years, Asian Paints has paid out on average 45 out of
every 100 rupees of net profits as dividends to shareholders. How
has the company managed to do? Porter’s Analysis provides some
useful insights...
Asian Paints - Porter’s Five Forces
1. Threat of New Entrants - Moderate
• Since there are no major regulatory hurdles and relatively
low fixed costs, starting the business is easy.
• However, scale, reach and brand are major barriers to entry.
• Also, there is some element of technology involved in
industrial paint segment which may act as a barrier.
2. Bargaining Power of Customers - Low
• Asian Paints is the largest player in the decorative segment.
Since individuals are typical customers here, they lack
bargaining power.
• However, in the industrial segment, the customers have high
bargaining power since they buy in bulk.
• The company has strong presence in the decorative
segment. Hence, bargaining power of customers could be
deemed as low.

3. Bargaining Power of Suppliers - High
• Major raw material inputs include crude-based derivatives
and certain solvents.
• Crude prices move based on global demand-supply
dynamics.
• Availability of titanium dioxide is also scarce.
• Hence, bargaining power of suppliers is high.
4. Threat of Substitutes - Low
• The use of limestone as a substitute is limited to rural
markets.
• In urban markets there is no real substitute to paint.
• As such, the threat of substitutes is virtually absent.
5. Competitive Rivalry - Moderate
• There is stiff competition in organized market since there are
many players.
• Advertising and distribution are the key to attract customers
as there is minimal product differentiation.
• Asian Paints has certain advantages because it is the largest
player and also has the biggest distribution network.
• But margins are not very lucrative and hence, the
competitive rivalry can be termed as moderate.

Conclusion
Understanding businesses is fundamental to value investing.
Porter’s five forces is a powerful framework to analyze business
models & industry structures. The five forces are: Threat of New
Entrants, Bargaining Power of Customers, Bargaining Power of
Suppliers, Threat of Substitutes, and Competitive Rivalry. How
companies rank on the five forces impacts long term profitability
and shareholder returns.

ArvindLtd.
(Consolidated)Mar-04Mar-05Mar-06Mar-07Mar-08Mar-09Mar-10Mar-11Mar-12Mar-13
NetProfitmargin(%)5.35.53.85.70.7-4.01.64.08.74.6
ReturnonEquity(%)9.810.16.39.21.5-9.64.912.827.913.4
DividendPayoutratio(%)0.017.225.50.00.00.00.00.05.817.1
TotalDebttoEquity1.51.61.41.61.72.31.81.61.21.2
KeyPerformanceIndicators-10years
Appendix1
DataSource:AceEquity

(Standalone)Dec-03Dec-04Dec-05Dec-06Dec-07Dec-08Dec-09Dec-10Dec-11Dec-12
NetProfitmargin(%)11.510.611.710.711.311.912.512.812.512.4
ReturnonEquity(%)84.377.091.984.8102.5119.8124.2114.090.369.5
NestleIndiaLtd.
(Consolidated)Mar-04Mar-05Mar-06Mar-07Mar-08Mar-09Mar-10Mar-11Mar-12Mar-13
NetProfitmargin(%)5.56.26.16.98.76.912.410.19.49.2
ReturnonEquity(%)28.733.034.739.848.638.460.745.241.437.8
AsianPaintsLtd.

Chapter 3: Identifying Economic Moats I 23
The Way Capitalism Works
“The dynamics of capitalism guarantee that competitors
will repeatedly assault any business “castle” that is
earning high returns.”
– Warren Buffett
Money flows where it sees the highest possible return. High
return on capital in an industry leads to entry of new players. As
competition intensifies, return on capital shrinks. However, some
companies do manage to earn high returns for long periods
of time. What is it that protects them from the onslaught of
competition? The answer is economic moat!
What is an Economic Moat?
The term ‘economic moat’ coined by Warren Buffett refers to the
competitive advantage a firm has over its peers. It is a structural
feature that helps to ring-fence a firm’s profitability and enables it
to earn return on capital much higher than the cost of capital.
We can also think of moats as entry barriers that prevent
competitors from reducing the firm’s profitability. If there is no
moat, competition will eventually drive return on capital down to
the cost of capital or even lower.
Chapter 3
Identifying Economic Moats I

Why do Economic Moats Matter?
Assume two companies that are growing sales and profits at
the same rate employing the same amount of capital. The only
difference is that one company (A) has a moat while the other
(B) does not have one. While B will see its returns decline with
rising competition, A will manage to earn superior returns for
long periods of time. Economic moats show the durability of a
company’s future earnings. Companies with wide moats are
the most resilient businesses and the best shareholder wealth
creators.
Types of Economic Moats
The two main factors that define a firm’s profitability are Price and
Cost. Firms can boost their profitability in two ways:
√√ Increase product prices
√√ Cut down costs
But not many firms can do this. The one’s that can do so on a
sustainable basis can be said to be enjoying an economic moat. All
moats can be divided on the basis of price and cost advantages.
Let us discuss them in detail…
Types of Moats: Price Advantages
Economic moats that allow a firm to charge a premium over its
competitors could be referred to as moats arising from price
advantages. The most important moats under this type:
I. Real Product Differentiation
II. Intangible assets

• Brands
• Regulatory licenses
• Patents & Intellectual Property
III. Switching Costs
IV. Network Effects
I. Real Product Differentiation
Real product differentiation refers to distinctive attributes in a
company’s product that set it apart from competition. Differentiating
factors could include appearance, features, durability, performance
quality, technology, etc. Product differentiation enables a firm to
command a premium price over its competitors. Firms can earn
very high returns by staying ahead of competition in terms of
quality and innovation.
However, this kind of moat may not ensure long term durability
due to the following reasons:
• Competitors will replicate the product and grab market
share.
• Customers may be unwilling to pay a high premium if
competitors’ products are only slightly inferior and may be
selling at a significantly lower price.
• It is pertinent to constantly innovate, improve the product
and add new features in order to stay ahead of competition.
• Innovation requires substantial R&D expenditure.
A market leader today may be replaced by a competitor who
manages to offer better products at a lower price. Hence, a moat
arising out of product differentiation is not only difficult to sustain

over the long term but also requires huge capital investments.
Example: Consumer electronics, technology sector, etc. Companies
such as Nokia and RIM were once ahead of the curve but later on
failed to adapt themselves to changing customer preferences and
needs.
II. a) Intangible Assets: Brands
A brand is a name (or other feature) that creates a perceived
product differentiation in the minds of the consumers. The
company’s products may or may not be very distinct from those
offered by competitors. But the perceived superiority and
trustworthiness of the product allows the firm to charge a premium
price. Because customers have loyalty towards a particular brand,
they may be reluctant to switch to other similar products. Brands
tend to create a moat by not only making it difficult for new
competitors to enter the market, but also limiting the scope of
existing players to expand. But do all brands imply an economic
moat? A well-known brand does not imply an economic moat
unless it gives the company pricing power and brand loyalty
(repeat business).
Examples of brands that have an economic moat: Coke, Colgate,
Nestle, Titan, Cadbury etc. Examples of well-known brands that do
not have an economic moat: MakeMyTrip, Flipkart, Videocon, etc.
II. b) Intangible Assets: Regulatory Licenses
Regulatory licenses can create a strong moat as new players
cannot enter the market without the requisite approvals. As a
result, a few number of firms have control over the entire market.
This must, however, not give the impression that all sectors that
require regulatory licenses may enjoy a strong moat. The key
condition that makes regulation a strong moat is when only entry

to the market is regulated, whereas there is no regulatory control
on pricing of products or services.
Take the case of state-run electricity boards and private banks.
Entry to both sectors is highly regulated. But most utility companies
are under heavy losses because they have no pricing power.
On the other hand, profitability in the private banking sector is
determined largely by market forces and as such, banks tend to
enjoy higher returns. However, the moat in case of regulatory
licenses is dependent on an external factor and as such any
adverse change in regulation could be a major risk.
II. c) Intangible Assets: Patents & Intellectual
Property
When a company innovates a new product, it can patent the
product so that no other firm is legally allowed to sell this product.
Think of a patent as the financial reward for creating a new
product, or as intellectual property the company can use. The
pharmaceutical industry makes heavy use of patents whenever
they create a new drug. The patent allows them to recoup the high
capital expenditure that goes into research and development of
new drugs. Companies that have a patent on a particular good are
immune from competition.
Patents provide a very strong moat and allow the firm to earn very
high returns. However, moats arising out of patents do not assure
long term durability because patents have a finite duration. Once
a patent expires, it brings in heavy competition in that market and
drives down the profitability. As such, a company has to keep
innovating new patented products to enjoy high returns. Patents
are often vulnerable to legal battles and could be revoked. As
such, the moat of firms that have just a few patented products may
lack long term durability.

III. Switching Costs
Switching costs refer to factors that make it difficult or undesirable
for consumers to switch to the products/services of a competitor.
The factors include time, capital, convenience, etc. If the switching
costs are high, a firm is able to lock in its customers. It can
charge its existing customers higher prices because it knows the
customers are reluctant to switch to competitors.
Think about the difference between a bank and a retailer. Do
you change your bank account every time some bank offers
higher interest and lower fees? Would you continue to buy things
from the same retailer even if he charges more than his next-
door competitor? Another example is Microsoft Office. Users are
reluctant to switch from Microsoft as learning a new product would
be inconvenient and time-consuming.
IV. Network Effects
Network effects refer to the fact that the value of a product or
service increases with the increase in the number of users. This
effect is largely observed in fields where businesses rely on
information sharing or linking users together. Consumers are
unlikely to move to a new competitor because there would be very
few people using the new product/service.
Take the example of the National Stock Exchange. The higher the
trading volumes on the exchange, the more efficient is the pricing
process. This creates a self-reinforcing pattern, bringing in more
volumes on the exchange.
Another example is Facebook. Facebook is valuable to a user
because many other people they know also use it, making it
difficult for new social networking sites to succeed in the market.

Types of Moats: Cost Advantages
While price advantages refer to how a firm can charge a premium
to its customers, cost advantages refer to supply-side factors that
enable a firm to be a low cost player. The most important moats
under this type:
I. Economies of scale
II. Cheaper access to resources
III. Process-based cost advantages
I. Economies of Scale
In an industry where the fixed costs are relatively much higher
than the variable costs, the greater the size of the firm, the greater
are the cost benefits that it can enjoy over its peers. Due to high
fixed costs, new competitors are discouraged from entering the
market. The absolute size of a firm is not as important as its size
relative to its competitors. For instance, a small cap firm could be
a dominant player in a niche industry and enjoy scale advantage
within that industry.
Cost advantages based on economies of scale can be divided into
two main types:
a) Large distribution network
A firm that possesses an extensive distribution network
can enjoy a remarkable edge over competitors and new
entrants. The higher volumes and lower lead times thus
enable companies to cut costs. It can not only achieve
higher volumes but can also introduce various new products
through the same channel. Example: ITC Ltd

b) Large scale operations
For a manufacturing firm with high fixed costs, the average
cost per unit decreases as the output increases. Example:
Maruti Suzuki
For a retailer, the cost advantages lie in its ability to procure
merchandise on a large scale at a price that is significantly
lower than what its competitors can get. Example: Wal-Mart
II. Cheaper Access to Resources
In many commodity businesses, the access to key raw materials
or assets is an important component of their success. Usually,
firms will buy/lease access to a land/onshore/offshore asset and
use that asset to access raw materials. Cheap access to a resource
or raw material can lead to significant cost savings and, in turn,
high profitability. Examples: oil, gas, mining companies. Energy
and mining companies can be very profitable due to their ability to
cheaply access raw materials.
III. Process-based Cost Advantages
Process-based cost advantages refer to cost savings occurring
due to efficient and cheaper production or supply processes.
By innovating and building better processes, a firm can produce
or supply its products more cheaply than other competitors.
Competitors may not have access to these processes, and cannot
necessarily implement it themselves. However, competitors could
catch up and erode the moat over time. Example: Amazon.com
(online retailer), Toyota (Total Quality Management), Dell (sold direct
to buyers) Tata Steel (low cost steel producer), etc.

Determining a Moat
√√ Has the company consistently earned high returns on
capital?
√√ Does the company enjoy better profitability relative to its
competitors?
√√ Identify the key factors that enable the company to earn such
high returns.
√√ Can the company continue to enjoy these high returns for a
long time?
If the answer to these questions is in the affirmative, the company
under consideration does have an economic moat.
Note: Certain industries, by their very inherent structural
characteristics, offer economic moats to a relatively large number
of firms. Example: Consumer goods, pharma, etc.
Durability of a Moat
Once we identify a company with a moat, the next step is to
determine its long term durability. How long can the company earn
higher returns while keeping competitors at bay? Certain moats
tend to erode over time, while few get more durable over time. The
Buffett test: Can a well-financed competitor erode the company’s
profitability?
“Give me $10 billion dollars and how much can I hurt
Coca-Cola around the world? I can’t do it.”
– Warren Buffett

Avoiding False Moats
√√ Temporary favourable economics should not be confused for
moats. Example: High profitability due to supply shortages
will end once new capacities come on stream.
√√ Advantages that cannot be scaled up do not imply a moat.
√√ Popular products, strong market share or technological
superiority do not guarantee a durable long term moat.
√√ Never confuse a great management for a moat.
“Go for a business that any idiot can run -- because
sooner or later, any idiot probably is going to run it.”
– Peter Lynch
Conclusion
• Moats are entry barriers that prevent competitors from
eroding a firm’s profitability.
• Economic moats are indicative of the durability of a
company’s future earnings.
• Price advantage moats are competitive advantages that
allow a firm to charge a premium price from its customers.
• Cost advantage moats are supply-side factors that ensure a
firm’s high profitability.
• It is important to determine durability of a moat & avoid
getting trapped by false moats.
• Now that we have discussed the conceptual framework
of economic moats, the next two chapters will be entirely
dedicated to discussing practical examples of economic
moats in listed Indian companies.

Chapter 4: Identifying Economic Moats II 33
Examples of Price Advantage Economic
Moats:
1. WABCO India – Real Product
Differentiation
Company overview
• WABCO India, a majority owned subsidiary of WABCO
Holdings Inc., is a leading manufacturer of air-assisted and
air brake systems for commercial vehicles in India.
• It has about 85% market share in the original equipment
manufacturers (OEM) market.
• It also enjoys a market share in excess of 75% in the
replacement market segment
• The company has a strong aftermarket network with more
than 7,000 outlets and 320 service centers all over India.
Economic Moat- Real Product
Differentiation
• WABCO’s strength is the performance quality and the
technology behind its products that sets it apart from
competition.
Chapter 4
Identifying Economic Moats II

• The company’s parent has been a pioneer of breakthrough
electronic, mechanical and mechatronic technologies for
braking, stability and transmission automation systems for
over 140 years.
• WABCO’s track record of technology leadership features
many of the commercial vehicle industry’s most important
innovations.
• With intensive R&D efforts and high quality standards,
its products have found global acceptance. It exports to
countries such as Australia, Malaysia, UK, Singapore, South
Asia, North America, Venezuela and the Middle East.
• It consistently tries to increase revenues per vehicle through
introduction of new products and upgradation to higher end
technologies.
• Given the support of its parent company in terms of
technology and brand name, we believe it would not be so
easy for one to displace WABCO from its leadership position.
Financial performance
• WABCO India has generated returns on equity (ROE) of
around 30% on average over the last five years.
• It does not have any debt on its books.
• Its profit margins are way higher than its peers in the
industry, indicating strong pricing power.
( Please see table in Appendix 2 on page 46 )

2. Colgate-Palmolive (India) – Brands
Company overview
• Promoted by Colgate-Palmolive USA, the 51% subsidiary
company commenced its Indian operations in 1937.
• Colgate manufactures and distributes oral care, personal
care & household care products.
• In oral care, the company is the market leader with 55%
share in the Indian toothpaste market, and 42% share in
the toothbrush market.
• The oral care segment contributes over 95% of the
company’s total sales.
• Colgate has a wide distribution network of 4.9 million
stores.
• Its flagship brand, Colgate Dental Cream, is the largest
distributed product in the toothpaste market, and is available
in 4.1 m stores.
Economic Moat- Brands
• Colgate has built an extremely powerful brand over its 75
years of existence. The brand is consistently ranked among
the most trusted brands in India.
• Its products are approved by the Indian Dental Association
and this lends strong brand equity. Medically approved
dental products find greater acceptance and act as powerful
entry barrier for new launches.
• The company has oral care products straddling price points
and catering to niche categories.

• The company partners with dentists and schools to increase
oral care awareness, thereby promoting its products.
• Over last 10 years, Colgate has generated a return on net
worth (RONW, same as return on equity) of over 90% on
average.
• As of year ended March 2013, Colgate had zero debt on its
balance sheet.
• The company spends heavily on advertising and sales
promotion, averaging nearly 16% of sales over the last 10
years.
• Colgate’s brand value coupled with one of the widest
distribution networks in the country has resulted in a strong
economic moat for the company and has led to significant
shareholder wealth creation over the long term.
3. Solar Industries - Regulatory Licenses
Company overview
• The company is the largest and the fastest growing
manufacturer of industrial explosives and initiating
systems in India.
• The company commands 29% market share in the domestic
explosives market. Apart from 17 manufacturing facilities
in India, Solar exports explosives to over 19 countries and
enjoys about 70% market share in exports from India.

• The company also has two overseas manufacturing units in
Zambia and Nigeria, Africa.
• The company is also in the process of setting up a
manufacturing plant that would supply specialty chemicals to
the defence sector.
Economic Moat- Regulatory Licenses
• Government regulations provide a strong moat. The
industrial explosives sector is one of the very few industries
that require industrial licenses. It is mandatory to get
clearance from the Home Ministry.
• Given the hazardous nature of the product, clearance from
the Intelligence Bureau (IB) is required regarding safety of
location.
• A lot of other permissions, NOCs (No Objection Certificates)
and licenses are required from various other government
agencies. This creates a strong barrier against new players
planning to enter this industry.
• In addition, the pricing is not subject to regulatory
oversight. This allows the company to earn high returns on
capital.
• Solar Industries’ robust financial performance is testimony of
its economic moat.
• The company’s return on capital has been robust, while
operating margins have remained within a stable range.

4. Bosch Ltd – Patents and Intellectual
Property
Company overview
• Bosch Ltd is a subsidiary of German auto components firm
Robert Bosch GmbH.
• It manufactures fuel injection systems with focus on both
diesel and gasoline.
• It is the market leader in this field and has a share of around
70% in the diesel space.
• Given the increasing dieselization in the country, the
company stands to benefit as diesel systems account for
around 85% of the company’s total revenues.
• It has supply contracts with most of the major players in
the commercial and passenger vehicles segment and even
caters to three wheelers.
Economic Moat- Patents and Intellectual
Property
• Bosch Ltd’s strength is the patented technology of its
parent firm, the German auto components behemoth Robert
Bosch GmbH.
• In terms of patent application numbers, Bosch occupies a
leading position in important markets.
• Bosch Group associates had together filed 4,700 patent
applications in 2012 alone.
• The Bosch Group spends over 8% of its sales revenue for
research & development. As the leader in the fuel injections

space, Bosch Ltd has continuously improved technology and
introduced new products in this area.
• The company has been working closely with most original
equipment manufacturers (OEMs) to introduce products that
will help smooth the transition to Bharat Stage 3 and Bharat
Stage 4 emission norms.
• Given the support of its parent company in terms of patented
technology, we believe it would not be so easy for one to
displace Bosch Ltd from its leadership position.
• Bosch Ltd has generated a return on equity (ROE) of over
25% on an average during the past 10 years.
• This is commendable given the cyclical nature of the
industry.
• It has ample cash and investments and virtually no debt on
its books.
• Whatever capex requirements it has had in the past have all
been met through internal accruals with no recourse to debt.

5. HDFC Bank – Switching Costs
Company overview
• Incorporated in 1994, HDFC Bank is the second largest
private sector bank in the country in terms of asset size.
• HDFC Bank has very successfully merged with Times Bank
and much later acquired Centurion Bank of Punjab. On both
occasions the bank benefitted from the expansion of its
franchise.
• Its group companies, HDFC Standard Life (insurance), HDFC
AMC (mutual funds) and HDFC Securities (equities) add
scalability to the bank’s offerings.
• The bank is well-positioned in urban and rural markets with a
nationwide network. It is a leading player across retail loan
categories.
• Besides the extensive branch network, the bank has made
significant headway in its multichannel servicing strategy,
such as ATMs, internet, phone and mobile banking to serve
their banking needs.
• The bank boasts of a total customer base of 28.7 million.
Economic Moat- Switching Costs
• HDFC Bank’s strength is its strong national network with
expanding semi-urban and rural footprint.
• The bank at present has an enviable network of 3,062
branches and 10,743 ATMS spread across 1,845 cities. 88%
of the bank’s new branch setup is located in semi-urban and
rural areas.

• The bank enjoys a market share of 4.1% and 4.7% in total
banking system deposits and advances respectively, offering
competitive rates.
• Given the market leadership, accessibility and wide range of
product offerings, it is very unlikely that the customers may
switch to the competition for a few more percentage points
on deposit rates.
• Parent HDFC, which is a significant player in retail home
loans, distributes its loans through HDFC Bank. Hence the
customer stickiness tends to be high.
• Additionally, the bank benefits from cross-selling
opportunities through its parent’s subsidiaries that are
into life and non-life insurance and broking services. This
provides a wide and sticky customer base. The variety and
quality offers competitive advantage.
• HDFC Bank has demonstrated a proven ability to generate
shareholder value over the past 17 years of its operations.
• With a healthy balance sheet and consistent profitability
growth, the bank’s return ratios are the highest in the
private sector space. For last 10 years, the bank has
recorded average return on assets (ROA) at around 1.5%, and
average return on equity (ROE) at above 15%.
• Supported by a rich liability franchise, HDFC Bank enjoys
highest current and savings account (CASA) ratio of 47%
(FY2013) in the industry.
• HDFC Bank has historically had higher net interest margins
between 4.0% to 4.4% over the last 5 years.

• The bank has, over the last 10 years, had net non-performing
assets (NPA) levels below 0.6% and has one of the most
conservative provisioning norms.
• Note: The banking industry, due to its inherent structural
characteristics, tends to offer this economic moat to most of
the firms in the space. Evidently, HDFC Bank has managed to
capitalize well on this characteristic feature of the industry.
6. Info Edge (India) Ltd - Network Effects
Company overview
• Established in 1995, Info Edge Ltd is India’s premier on-line
classifieds company in recruitment, matrimony, real estate,
education and related services.
• The company runs India’s largest job site - Naukri.com. It is
the market leader in this field with over 60% traffic share.
• Its matrimony website, Jeevansathi.com is currently ranked
at number 3 in the country.
• The property listing service for real estate purchases, sales,
and rentals is conducted through the website 99acres.com.
• Shiksha.com is the company’s offering in the space of
education. It carries online education classifieds.
• In recent times, the company has invested in different start
ups as well as new businesses that present opportunities for
scaling up. This includes leading names like Zomato.com,
mydala.com, Happily Unmarried, etc.

Economic Moat- Network Effects
• The network effect is significant in this business. Because
Info Edge has the maximum number of listed jobs, it is able
to attract the largest share of traffic.
• As it is able to attract the largest share of traffic, its users get
the most responses.
• Because they get the most responses, the company gets
more clients.
• This virtuous cycle enables the company to make higher
profits and earn higher returns on capital than its peers
even through times of slowdown and economic recession.
• The online portal is complemented by a strong sales force.
• The company has a nationwide network through 57 branch
offices in 36 cities.
• This makes it the only online (dot com) company with such a
strong sales force.
• As other players do not have such a strong network, Naukri
has the largest database of both jobs as well as resumes.
• The network helps it maintain a leadership over its peers.
• The traffic gap with Monster India and Times Jobs (its closest
competitors) has widened from a mere 10% in 2007 (only
with Monster India) to 45% and 52% respectively in March
2013.
• The company’s increasing market share is the result of a
strong moat due to network effects.

• Info Edge has generated a return on equity (ROE) of around
18% on average over the past 6 years.
• The company has been completely debt-free post its initial
public offering.
• Its operating margins have averaged at over 30% during
the past 6 years.
• As of year-ended March 2013, the company had a cash
balance of Rs 3.1 bn (cash + short term investments).
• It has been investing a part of this cash in investee
companies which are predominantly startups or small but
powerful brands that present opportunities for scaling up.
Despite the investments, the cash balance remains strong.
• With minimal capex requirements and negative working
capital, the cash pile is just set to grow. This provides
adequate safety to the company when the times get tough.
Conclusion
• We discussed price advantage economic moats with
examples of listed Indian companies.
• WABCO India’s moat is its superior technology.
• Colgate’s moat arises from its strong brand and extensive
distribution network.
• In case of Solar Industries, regulatory licenses deter new
player from entering the market.
• For Bosch Ltd, the patented technology of its parent firm is

the moat.
• HDFC Bank enjoys the high switching costs that are inherent
in the banking sector. Its vast branch network further widens
the moat.
• Info Edge benefits from the network effect on its online job
portal Naukri.com.
• Companies that have multiple moats tend to enjoy much
higher return on capital.
• In the next chapter, we will discuss examples of cost
advantage economic moats.

Operatingmargin(EBITDA,%)FY09FY10FY11FY12FY135-YrAvg
WABCOIndia15.221.221.120.319.419.4
RaneBrakeLinings9.811.810.811.08.510.4
SundaramBrakeLinings9.811.09.58.22.78.2
ReturnonEquity(ROE,%)FY09FY10FY11FY12FY135-YrAvg
WABCOIndia19.533.438.833.522.229.5
RaneBrakeLinings4.414.118.817.79.212.8
SundaramBrakeLinings6.37.46.70.6NA5.2
ComparisonofKeyFinancialRatios
Appendix2

ColgatePalmolive(India)Ltd-10YrKeyFinancialRatios
FY04FY05FY06FY07FY08FY09FY10FY11FY12FY13
10-Yr
Avg
ReturnonNetWorth(RONW,%)44.245.350.857.1140.9132.2130.5104.8102.5100.190.8
DividendPayoutratio(%)75.684.174.180.775.071.763.175.075.076.775.1
OperatingProfitmargin
(EBITDA,%)
15.618.017.316.117.016.822.220.319.418.218.1
Advertising&Sales
Promotion/NetSales(%)
15.714.217.616.017.416.015.315.315.315.515.8

SolarIndustries-KeyFinancialRatios
(Consolidated)FY08FY09FY10FY11FY125-YrAvg
ReturnonCapitalEmployed(ROCE,%)15.223.730.631.533.326.8
ReturnonEquity(ROE,%)12.220.821.924.528.921.7
Operatingmargins(EBITDA,%)16.222.018.018.920.419.1
BoschGroup-R&DExpenditure
DataSource:Companywebsite
(Figuresinmillioneuros)20082009201020112012
Research&Developmentcost3,8103,3483,0734,1904,787
SalesRevenue45,12738,17447,25951,49452,464
R&Dcostasa%ofSales8.48.86.58.19.1

(Standalone)CY03CY04CY05CY06CY07CY08CY09CY10CY11CY12
10-Yr
Avg
ProfitafterTaxmargin(PAT,%)11.2014.510.413.812.812.511.612.112.810.212.1
ReturnonEquity(ROE,%)29.034.624.530.526.522.418.223.025.418.625.3
TotalDebttoEquityratio
(times)
0.110.120.110.100.100.090.080.070.060.040.09
BoschLtd-KeyFinancialRatios
(Standalone)FY04FY05FY06FY07FY08FY09FY10FY11FY12FY13
10-Yr
Avg
NetInterestMargins(NIMs,%)3.93.94.04.34.44.34.44.24.14.04.2
CASA/TotalDeposits(%)54.760.755.557.754.544.452.052.748.447.452.8
ReturnonEquity(%)20.618.517.719.517.717.216.316.818.720.318.3
HDFCBANK-KeyFinancialRatios
DataSource:Companywebsite,AceEquity

(Standalone)FY08FY09FY10FY11FY12FY13
6-Yr
Avg
ReturnonEquity(ROE,%)20.718.314.918.121.315.418.1
Operatingmargin(EBITDA,%)29.527.329.534.138.334.332.2
ProfitafterTaxmargin(PAT,%)14.529.525.430.527.328.225.9
InfoEdge(India)Ltd-KeyFinancialRatios
DataSource:EquitymasterResearch,AceEquity

Chapter 5: Identifying Economic Moats III 51
Examples of Cost Advantage Economic
Moats:
1. Container Corporation of India Ltd –
Economies of Scale
Company overview
• Container Corporation of India (Concor) is a public sector
undertaking under the Indian Ministry of Railways.
• Primary business is transportation through containerization.
Also offers terminal and warehousing services in India.
• Concor uses the Indian Railway’s network for its operations
for more than 90% of its inland transportation, and also
gets wagons and operational support.
• Market leader in container rail business segment, with a
market share of 75%.
• Huge network of around 62 terminals and over 9,600 high
speed wagons. The company does business through two
main segments – EXIM (export-import) segment (80% of the
business) and the Domestic segment.
Economic Moat- Economies of Scale
• Company has unmatched pan-India strategic assets and
Chapter 5
Identifying Economic Moats III

network of rail terminals that provide a strong moat.
• High cargo volumes (75% market share) bring down average
cost per tonnage.
• Before 2006, Concor had a monopoly in containerized train
transport. In 2006, the sector was opened up to private
players.
• However, Concor continues to be the lowest cost operator
as the new players have not even achieved minimum
economies of scale.
• Scale advantage and lower costs compared to peers allow
the company to dominate a market where competition is
mainly price-based.
• Being the pioneer, it also has the benefit of getting Indian
Railways’ surplus land at key locations at very attractive
long-term lease rates.
• The company is debt free and its average return on equity
(ROE) over the last 7 years is about 21%, signaling a strong
moat.
• The competitors do not have such high returns, and they are
also highly leveraged.
• The company’s dominant market share gives it considerable
bargaining power.
• Despite a tough macroeconomic environment, the
company’s financials have not been very severely hit.

2. Coal India –
Cheaper Access to Resources
Company overview
• Established in 1973, Coal India Ltd (CIL) is a state controlled
coal mining company in India.
• It is the largest coal producing company in the world (based
on raw coal production).
• Coal India has the largest reserves of coal in the world at
67 bn tonnes, with proved reserves of 52 bn tonnes (47% of
India’s proved reserves) and extractable reserves of 22 bn
tonnes.
• CIL operates 471 mines in 21 major coal fields across
8 states in India, including 163 open cast mines, 273
underground mines and 35 mixed mines.
• It is the primary supplier of coal in India, accounting for 82%
of the country’s coal production.
Economic Moat-
Cheaper Access to Resources
• Coal India’s cheap access to raw materials creates a strong
moat.
• Given India’s abundant coal reserves and the absence of
other sustainable fuel sources, the company plays a strategic
role in meeting India’s energy requirements.
• It has one of the lowest strip ratios at 1.69x. The strip
ratio refers to how much waste they have to mine per unit
of what they want to extract. The low strip ratio ensures

easily extractable reserves and high margins due to lower
production costs.
• Nearly 90% of the company’s production is from open cast
mines. Most of these open cast mines have low stripping
ratios, which provide the company with a significant cost
advantage.
• Coal India is expected to contribute 80% of the Indian coal
production in FY14, and thus maintain its dominant position.
• Despite the economic slowdown, profit margins and ROE
remain high.
• The company is almost debt free and has an average return
on equity of over 32% over the last 8 years, signifying a
strong moat.
• The company makes further profits due to auction sales, as
they can sell at a much higher price than the reserve price of
coal.
• Due to their monopolistic business model, high reserve to
production ratio, and cash rich balance sheet, they are well
poised for future success.
3. Ambuja Cements –
Process-based Cost Advantages
Company overview
• Founded in 1983, Ambuja Cements is today one of the

leading cement manufacturers in India.
• Ambuja has been a pioneer in the Indian cement industry
with several laurels to its credit. It is one of the most
profitable and innovative cement companies in India.
• The company has grown at a rapid pace over the last three
decades and its cement capacity stands at 27.3 mtpa.
• Ambuja has a pan-India with 5 integrated cement
manufacturing plants, 8 cement grinding units and 3 bulk
terminals.
• The company is particularly strong in the northern and
western markets of India.
Economic Moat-
Process-based Cost Advantages
• Ambuja is one of the most efficient and low cost cement
manufacturers in the world.
• Strong management focus on continually fine-tuning
efficiencies and upgrading facilities.
• Ambuja Cements pioneered the concept of transport of
cement by sea. This has not only led to lower freight costs
but has also brought the coastal markets of India within its
reach.
• Moves like owning ships for movement of cement within
India, early emphasis on captive power plants, captive jetties
and emphasis on branding have yielded rich dividends.
• Swiss-based global cement major Holcim acquired
management control in 2006 and now holds a 50.6% stake
in the company. Post Holcim acquisition, Ambuja Cements
has benefited from the MNC’s expertise in several areas

including waste-based power generation.
• Ambuja Cements is ahead of its competitors on some of
the most important financial parameters, indicating a strong
economic moat.
Example of a false moat:
Suzlon Energy
Company overview
• Suzlon Group was ranked as the world’s fifth largest wind
turbine supplier, in terms of cumulative installed capacity, at
the end of 2011.
• The company has over 21,500 MW of wind energy capacity
installed in 30 countries, across Asia, Australia, Europe,
Africa and North and South America
• Suzlon has operations across 33 countries and a workforce
of over 13,000.
• Regulatory mandates in the US, Europe and India for
investments in green energy projects were a huge positive
for Suzlon, which until a few years back had the first mover
advantage in wind energy capacities.
False Economic Moat
• Suzlon Energy’s first mover advantage in being able to
capitalize on the worldwide regulatory support to the fast-

growing wind energy sector was considered to be its
biggest moat.
• The company, however, failed to deliver on quality and lost
customer trust. There were several legal cases filed against
the company over the poor quality of wind turbines.
• Suzlon also went on to do big ticket acquisitions (Hansen
Transmission in 2007 and REpower Systems) which took its
debt to equity ratio to unreasonable levels.
• Finally the stimulus packages awarded by governments
in the US, Europe and India to the wind energy sector
eventually dried out as the focus shifted towards the
economic crisis in 2009.
• After earning healthy profits and return on capital, Suzlon
Energy’s fortune tumbled in the aftermath of the financial
crisis.
• The company has been loss-making over the last four
financial years.
• The company’s debt to equity ratio has shot up substantially
over the years.
• Despite the bleeding bottomline and negative return ratios
the management refused to restructure the businesses.
• Finally Suzlon had to accept a corporate debt restructuring
package of Rs 95 bn from its bankers in April 2013.

Conclusion
• We discussed cost advantage economic moats with
examples of listed Indian companies.
• Container Corporation’s moat is its scale of operations and
its extensive rail network.
• In case of Coal India, the cheap access to vast reserves of
coal is the company’s competitive advantage.
• Ambuja Cements’ moat arises from its highly efficient low
cost processes and pan-India reach.
• Suzlon Energy is a classic example of how first mover
advantage and market leadership are not sustainable moats.
• All moats are not equally durable; it is important to evaluate
the quality of a company’s moat.
• Long term trends in the financial performance of a company
often indicate if the moat is eroding or strengthening over
time.

Appendix3
ContainerCorporationofIndia-KeyFinancialratios
(Consolidated)FY07FY08FY09FY10FY11FY12FY13
7-Yr
Avg
ProfitafterTaxmargin(PAT,%)23.021.822.620.822.521.120.921.8
ReturnonEquity(ROE)26.825.322.619.419.016.515.020.6
ReturnonCapitalEmployed(ROCE)33.231.829.124.722.822.219.426.2

CoalIndiaLtd-KeyFinancialRatios
DataSource:EquitymasterResearch
(Consolidated)FY06FY07FY08FY09FY10FY11FY12FY13
8-Yr
Avg
Operatingmargin(EBITDA,%)23.621.517.66.121.819.625.126.520.2
ReturnonEquity(ROE,%)41.335.230.510.937.232.636.635.832.5
TotalDebttoEquityratio(times)0.20.10.10.10.10.10.10.10.1

AmbujaCem*ACCLtd**UltraTech#MadrasCem^
ReturnonCapitalEmployed(ROCE,%)30.728.022.319.2
Operatingmargin(EBITDA,%)27.621.020.724.9
Profitaftertaxmargin(%)16.812.19.310.3
TotalDebttoEquityratio(times)0.20.50.81.6
Dividendpayoutratio(%)34.933.18.116.7
ComparisonofKeyFinancialRatios-10YearAverage
*Consolidated,Jun2004toDec2012;**Consolidated,Mar2004toDec2012;#Consolidate,
Mar2004toMar2013;^Standalone,Mar2004toMar2013

(Consolidated)FY03FY04FY05FY06FY07FY08FY09FY10FY11FY12
OperatingProfitmargin
(EBITDA,%)
15.918.925.424.817.717.212.46.26.49.1
ProfitafteTaxmargin(PAT,%)14.316.918.819.810.87.41.6-4.8-7.3-2.2
ReturnonEquity(ROE,%)15.046.062.843.528.317.75.2-13.1-20.1-8.1
Returnoncapitalemployed
(ROCE,%)
15.235.345.939.321.013.38.63.91.38.0
TotalDebttoEquityratio
(times)
0.40.60.40.21.51.21.71.91.92.7
SuzlonEnergy-Key10-YrFinancialRatios

Accounting
Basics
&
Financial
Analysis

Chapter 6: Accounting Basics 65
Accounting
• Accounting is the reporting of the financial statements of a
company.
• A company’s accounts are a summary of all the transactions
conducted by the company. They provide us with a picture
of how the company is performing.
• When we analyze a company, the first place to start is the
company’s accounts. We use accounts to come up with a
valuation for the company.
• All company accounts are audited, but sometimes they can
be misrepresented. A company’s financial statements consist
of four elements.
• The first is the Balance Sheet, the second is the Profit and
Loss Statement, the third is the Cash Flow Statement,
and the fourth is Notes to Financial Statements (including
changes in Equity).
• Companies publish a summary of their accounts every
quarter, and a full set of accounts every year.
Balance Sheet
• The Balance Sheet is a snapshot of the company’s financial
balances at a particular point in time.
Chapter 6
Accounting Basics

• It is composed of three parts: assets, liabilities, and
shareholders’ equity.
• Assets represent items of economic value that can be
converted into cash. Assets are used to generate income.
• Assets include current assets, long-term assets, and
intangible assets.
• Liabilities represent the firm’s financial obligations that have
resulted from previous transactions.
• These include current (short-term) and non-current (long-
term) liabilities.
• Shareholders Equity is equal to Assets minus Liabilities
and is the book value of the firm.
• It consists of investment from shareholders and retained
earnings.
Profit and Loss Statement
• The Profit and Loss statement summarizes the company’s
revenues, expenditures, taxes, and profits over a particular
period of time.
• They include non-cash transactions such as depreciation.
• The Profit and Loss Statement is measured over a time
period (e.g. one year or one quarter), whereas the Balance
sheet is a snapshot and measured at a single point of time.
Cash Flow Statement
• The Cash Flow statement is a summary of all the cash
inflows and outflows by the company over a particular
period of time.

Chapter 6: Accounting Basics 67
• There are differences between cash flows and profits.
• Revenues can be recorded before the actual cash is
received and vice versa.
• Cash flow is more difficult to manipulate as compared with
earnings.
Cash versus Accrual Accounting
Method
• Imagine being asked to run your Dad’s set up for one year.
You are a complete novice in accounting. This is how your
financial statements would look:
• Business related cash flows
Cash received from customers ------------------ Rs 6,000,000
Cash paid to suppliers ---------------------------- Rs (3,000,000)
Tax outflow (this year plus some of last year) -- Rs (500,000)
Interest on working capital ------------------------- Rs (200,000)
Other expenses -------------------------------------- Rs (1,000,000)
Total cash inflow/ (outflow): -------------------- Rs 1,300,000
• What we just saw was cash based financial reporting. It
is useful but suffers from a serious drawback. It records
transactions based on when cash was received or paid out.
It does not record it when the actual transaction happens.
For instance, in cash received from customers in the previous
slide, some of the cash could be from sales of previous year.
Also, the company must have bought raw materials on credit
which is not reflected in cash based accounting because
cash has not yet gone out.

• So, what to do in such a scenario? The answer is accrual
based accounting. In accrual based accounting, the
transaction is recorded when it actually happens and not
when cash is received or paid.
• E.g. If a customer buys goods on credit, the company will
record it even though the cash has not been received for it.
Also, the company will also record expense related to sales
even if the cash has not gone out yet.
• Cash based accounting suffers from a disadvantage that
it is not good at tracking historical growth. It is difficult to
compare quarter on quarter or year on year sales using this
approach. Accrual based accounting records transactions as
they happen and hence, is a better system of providing like
to like comparison.
• A statement that is prepared based on accrual based
accounting and the one that shows whether a firm is making
profit or not is known as the income statement or the Profit
& Loss statement.
Notes to Financial Statements
• Most companies usually have additional statements to
supplement the first three.
• These include more detail on how certain items were
calculated, etc.
• As a result, they are very important for valuation analysis.
• Companies may also include a statement of changes in
equity within this.
• Notes also include various provisions that the company has
made.

Chapter 7: Financial Ratio Analysis I 69
Financial Ratios
• Financial Ratios examine the relative magnitude of two or
more variables related to a company.
• These can include accounting based variables (e.g.
earnings) and market based variables (e.g. stock price).
• Financial ratios allow us to draw conclusions about a
company’s stock that we are interested in analyzing.
• We can think of them as summary statistics that paint a
picture of a particular company.
1. Profitability Ratios –
Operating Profit Margin
• Operating profit margin is the ratio of operating profit to total
revenue.
• Operating profit is profit before depreciation, interest and
tax.
• So from revenues, you deduct all expenses related to
operations, such as cost of raw materials, manufacturing,
salaries, marketing, logistics, etc.
• Operating profit is the most important profitability ratio since
it gives a clear picture about the health of the company’s
core business. It also reflects the management’s efficiency.
Chapter 7
Financial Ratio Analysis I

• It does not include expenses such as interest and taxes
which depend on external factors.
2. Profitability Ratios – Net Profit Margin
• Net profit margin is the ratio of net profit to total revenue.
• Unlike operating profit margin, it takes into account all of a
company’s costs.
• Net Profit Margin = Profit after tax/Revenue
• It measures the percentage of sales that the company keeps
in profits.
• For both Operating and Net profit margin, higher numbers
are obviously better.
3. Profitability Ratios – Effective Tax Rate
• Effective tax rate is the average rate at which a company’s
profits are taxed.
• Effective Tax Rate = Tax Expenses/Profit before Tax
• Marginal rates vary for companies, and there are many
deductions, tax incentives that can determine how much a
company pays in tax.
• The effective tax rate is an easy way to summarize how much
tax a company pays.
4. Profitability Ratios (Banks) -
Net Interest Margin
• Net interest margin examines how much a firm makes from
its investments relative to how much it pays on its debt.

• For a bank, it represents how much they earn from making
loans to borrowers, versus what they have to pay when
taking deposits from savers, and what they pay to their
creditors.
• Net Interest Margin = (Interest Income– Interest Expenses)/
Average Earning Assets
5. Profitability Ratios (Banks) -
Net NPA to Loans
• NPA refers to non performing assets, which means loans
that may be in default.
• From the perspective of a bank, they expect that these loans
they have made will not be repaid.
• Net NPA to Loans = Net Value of Non Performing Assets/
Total Value of Loans.
• If this ratio is high, the bank may have to write off bad loans,
and this will reduce its future profitability.
6. Return Ratios – Return on Equity
• Return on equity measures the net profit generated by the
company relative to the shareholders’ funds.
• Return on Equity = Net Profit/Shareholders’ Funds.
• It is another measure of profitability, and it measures how
productively a company uses its equity capital.
• Limitation: The ratio does not take into account debt capital.
As such, if a company’s growth is heavily funded by debt, it
will boost the ROE. Hence, one must consider other ratios as
well.

7. Return Ratios –
Return on Capital Employed
• Return on capital employed measures how much profit the
company has generated relative to the capital it uses.
• Return on Capital Employed = Net Operating Profit After
Tax (NOPAT)/ Capital Employed
• NOPAT= Profit before interest and tax (PBIT)*(1-tax rate)
• Capital employed= Shareholders’ funds+ Total debt
• ROCE provides a more complete assessment of how well a
management is deploying capital.
8. Return Ratios – Return on Assets
• Return on assets measures how much profit a company
generates relative to its total assets.
• Return on Assets = Net Profit/Total Assets
• We include all assets to calculate ROA, including productive
and non-productive ones.
• For example, if a company has a large cash balance that it is
not investing, this will increase total assets and bring down
ROA.
9. Debt Ratios – Debt to Equity
• Debt to equity measures how much leverage a company has.
• Equivalently, it measures what proportion of its assets are
financed with equity or debt.
• Debt to Equity = Total Debt/Shareholders’ Equity

• Using higher levels of debt is more risky, as interest liabilities
go up.
• However, debt can be cheaper due to the tax deductibility of
interest, as well as lower returns for investors as compared
to equity.
10. Debt Ratios - Interest Coverage
• The interest coverage ratio measures how easy it is for a
company to meet its debt obligations.
• Interest coverage = Earnings before Interest and Taxes/
Interest Expense
• If this ratio is close to 1 (or below 1), then the company is
having problems meeting its debt obligations.
• In general, companies with higher debt to equity ratios will
have lower interest coverage ratios.
11. Debt Ratios – Free Cash Flow to Debt
• Free cash flow is the cash a company generates after paying
for its capital expenditures.
• It is the operating cash flow minus capital expenditures
• Cash flow is more difficult to manipulate than earnings.
• Free Cash Flow to Debt = FCF / Total Debt
• FCF= Cash flow from Operations Minus Capex
• The ratio measures the ability of a company to finance its
debt obligations from its cash flow.

12. Liquidity Ratios – Current Ratio
• The current ratio measures the ability of a company to meet
its short term obligations.
• Current Ratio = Current Assets/Current Liabilities
• If this ratio is less than 1, it indicates that the company would
be unable to meet its current obligations if they came due.
• Short term usually refers to any obligations due in the next 12
months.
13. Asset Utilization Ratios –
Fixed Asset Turnover
• Fixed asset turnover measures the company’s ability to
generate sales relative to its fixed assets.
• Fixed assets include property, plant, and equipment.
• Fixed Asset Turnover = Net Sales / Fixed Assets
• A higher number indicates that the company is more
effective in using its assets to generate sales.
• This is a common ratio used for manufacturing companies.
14. Asset Utilization Ratios – Inventory Days
• Inventory days represent the average number of days that a
company’s goods remain
• in inventory.
• Inventory Days = (Inventory/Cost of Sales) *365 Days
• In general, a lower figure is better, as it implies the company
can shift its stock quickly.

• We would usually use average inventory over the relevant
time period.
15. Asset Utilization Ratios –
Receivables Days and Payables Days
• Receivables days measures how long it takes for a company
to collect revenue after a sale has been made.
• Receivables Days = (Accounts Receivable/ Revenue) *365
Days
• Payables days measures how long it takes on average for a
company to pay its creditors for inputs purchased.
• Payables Days = (Accounts Payable/Cost of Sales)*365 Days
16. Cash Flow Ratios –
Operating Cash Flow to Sales
• Operating cash flow to sales measures how well a company
is able to turn its sales into cash.
• OCF/Sales = Operating Cash Flow/Revenue
If we see a rise in a company’s sales, we should see a
corresponding rise in operating cash flow.
• If this is not the case, then we need to understand why sales
are not converting into cash, and question how sustainable
their sales might be.
17. Cash Flow Ratios –
Free Cash Flow to Operating Cash Flow
• Free cash flow is equivalent to what is left over from
operating cash flow after capital expenditures.

• FCF/OCF = (Operating Cash Flow – Capital Expenditures)/
Operating Cash Flow
• The higher the ratio, the greater the financial strength of the
company.
• New businesses are likely to have high levels of capital
expenditure, pushing this ratio lower.
18. Cash Flow Ratios – Dividend Payout
• The dividend payout ratio measures the proportion of the
company’s earnings that are paid out as dividends.
• Dividend Payout = Total Dividend/Net Profit
• Most companies like to maintain a steady dividend payout
ratio, and a fall in this ratio is often a bad sign for a company.
• Falls in this ratio also hurt the stock price, as investors will
seek higher dividend paying stocks.
19. Valuation Ratios – Price to Earnings
• The price to earnings ratio measures the price of a
company’s stock relative to the earnings per share.
• P/E = Market Price per Share/Earnings per Share
• From an investor’s perspective, it measures how much we
are paying for a given level of earnings.
• Higher P/E ratios indicate that we pay more for a given level
of earnings, and vice versa.
• However, a high P/E stock is not necessarily expensive and
vice versa. It is important to consider future earnings growth
while evaluating P/E.

• It is generally relevant to compare the P/E multiples of
companies within the same industry.
20. Valuation Ratios – Price to Book Value
• The price to book value measures the market price per share
relative to the book value per share.
• The book value is equal to a company’s net worth or
shareholder’s funds.
• It is the value of the company that would remain if it were to
go bankrupt immediately.
• P/BV = Market Price per share/Book Value per share
• A higher P/B means we are paying more for the stock
relative to its book value.
21. Valuation Ratios – EV to EBITDA
• Enterprise Value (EV) is the sum of market capitalization,
debt, minority interest, and preferred shares, less cash.
• It measures the takeover value of a company (i.e. how much
one would pay to takeover the company)
• EBITDA is earnings before interest, taxes, depreciation, and
amortization.
• EV/EBITDA ratio is used to determine the company’s value,
in a similar way to the P/E ratio.
22. Valuation Ratios – Price to Sales
• The Price to Sales ratio the measures the price per share
relative to the sales per share of a company.

• Price/Sales = Market Price per Share / Sales Per Share
• It measures how much we are paying for a given level of
sales.
• The P/S ratio is used as an alternative to the P/E ratio.
• Sales are more difficult to manipulate than earnings, but
don’t provide as much information.
23. Valuation Ratios – Dividend Yield
• The Dividend Yield measures the dividend per share relative
to the market price per share.
• Dividend Yield = Dividend per Share / Market Price per
Share
• It measures the dividend return from holding the stock.
• Note the difference between the dividend yield and the
dividend payout. The first uses market prices, the other uses
net profit.
24. Valuation Ratios –
Price to Free Cash Flow
• The Price to Free Cash Flow measures the market price per
share relative to the free cash flow per share.
• Price/FCF = Market Price per Share / FCF per Share
• It tells us how much we are paying for a given amount of
Free Cash Flow.
• It is used an alternative to the P/E ratio, primarily because
FCF is more difficult to manipulate and may be a better
representation of the company.

Conclusion
• In this chapter, we have discussed many different types of
financial ratios.
• It is important to know that some ratios are more relevant for
certain companies and industries.
• Also, ratios will vary a lot between industries.
• Usually, these ratios are best used when comparing
companies in the same industry.
• In the next chapter, we will give you an overview of DuPont
Analysis, a useful financial performance measure along with
some examples.

Chapter 8: Financial Ratio Analysis II 81
Return on Equity
• Return on Equity measures how well a company uses the
shareholder’s funds to generate profits.
• It is calculated as Net Income (Profit After Tax) divided by
shareholder’s equity (Share Capital + Reserves).
Keep in mind that shareholder’s equity is the book value of
equity, not the market value.
• In general, a higher ROE implies that the company is better
at generating returns for a given book value.
DuPont Analysis
• The DuPont identity breaks down ROE into three
components.
• The purpose is to understand what exactly is driving the ROE
for a particular company.
• ROE = Net Profit Margin * Asset Turnover * Financial
Leverage
Chapter 8
Financial Ratio Analysis II
ROE =
Net Income Sales Assets
Sales Assets Equity
* *
Return on Equity =
Net Income
Shareholder’s Equity

• This is an accounting identity and always holds.
a) Net Profit Margin
• Net Profit Margin measures a company’s profits as a
percentage of total sales.
• For example, if a company earns revenues of 100, and after
all its costs it has 15 left over, the net profit margin is 15%.
• Net Income is listed on a company’s financial statements,
and is the profit after interest, depreciation, and taxes.
b) Asset Turnover
• Asset turnover is equal to sales as a percentage of total
assets.
It measures how well a company uses its assets to generate
sales.
• It is often the case that companies with low profit margins
have high turnover (e.g. grocery shop) and vice versa.
• In general, a higher asset turnover is better. We can use
average total assets to calculate this.
c) Financial Leverage
• Financial leverage measures total assets over equity.
Net Profit Margin =
Net Income
Sales
Asset Turnover =
Sales
Assets

• It is implicitly measuring how much debt a company has
relative to its total assets, since assets are equal to equity
plus debt.
• When financial leverage is higher, it implies that the company
has higher debt levels. But this is not always true as we will
see in the case of Hindustan Unilever.
• Higher leverage leads to a higher ROE.
Using DuPont Analysis
• The purpose of DuPont analysis is to understand how
exactly a company is generating its return on equity.
• What we will usually find is that there are stark differences
depending on the industry.
• For example, retailers tend to generate ROE through high
asset turnover.
• Luxury industries tend to generate ROE through high profit
margins.
• Financial companies (i.e. banks) tend to generate ROE
through high leverage.
• As a result, DuPont analysis is not very useful for comparing
companies across different industries.
• However, it is very useful when comparing companies in the
same industry.
• Higher ROE may not always be a good sign – it depends on
what is generating it.
Financial Leverage =
Assets
Equity

• For example, if a company’s ROE is higher as compared with
its industry peers due only to higher leverage it could be
interpreted as excessively risky.
Examples
• We’ll look at three companies all in different industries, with
the aim of showing how they generate ROE in different ways.
• The companies we will discuss are: HDFC Bank, Hindustan
Unilever, and National Mineral Development Corporation
(NMDC).
1. HDFC Bank
• HDFC Bank is a financial services company, and one of the
largest in India.
• They have operations in retail banking, wholesale banking,
and treasury services.
• As a financial company, they generate their ROE primarily
through high leverage.
• HDFC Bank’s 5-yr avg. financial leverage is 11.2 times.
• This is not unusual for a bank.
• Banks primarily receive deposits that they lend to their
customers, which means that most of their loans are funded
with liabilities rather than equity.

2. Hindustan Unilever Ltd (HUL)
• Hindustan Unilever is India’s largest consumer goods
company.
• They sell foods, beverages, personal care products, and
cleaning agents.
• As an FMCG business, their ROE is driven primarily by high
asset turnover.
• Their 5-yr avg. asset turnover is 2.1, meaning that their total
sales is just over double their total assets.
• However, if one considers just operating assets, this ratio
would be even higher
• This type of number is typical for FMCG companies.
• Another contributor to the high ROE is the company’s
financial leverage.
• The high financial leverage is not because of debt. In fact,
the company is virtually debt free.
• The leverage is high on account of presence of large non-
interest bearing liabilities.
• The company is able to extract very favorable terms from its
creditors due to its high bargaining power. Thus, most of its
assets are funded by its creditors.
• This is also an indication of the presence of a very strong
economic moat.

3. National Mineral Development
Corporation (NMDC)
• National Mineral Development Corporation (NMDC) is a
state-run company involved in mining and producing various
minerals.
• These include iron ore, copper, and many others.
• They are India’s largest iron ore producers, and have high
exports in this area.
• NMDC generates its ROE primarily through high profit
margins.
• Their 5-yr avg. net profit margin is 58.8%, and this is due to
the fact that the cost of mining and producing the minerals is
much less than what they earn in revenues from selling them.
Conclusion
• DuPont analysis breaks down ROE into the product of three
components: net profit margin, asset turnover, and financial
leverage.
• The purpose of DuPont analysis is to understand the
factors that drive the ROE for a particular company.
• The primary factors vary considerably depending on the
industry.
• The next chapter is on Identifying Accounting Red Flags.

Appendix4
DuPontAnalysisMar-09Mar-10Mar-11Mar-12Mar-13
NetProfitMargin(1)13.7%18.2%19.7%18.5%19.2%
AssetTurnover(2)0.10.10.10.10.1
FinancialLeverage(3)12.210.310.911.311.1
ReturnonEquity=(1)*(2)*(3)14.9%13.7%15.5%17.3%18.6%
InterestEarned163,323161,727199,282278,742350,649
ProfitAfterTax22,44929,48739,26451,67167,263
TotalAssets1,832,7082,224,5862,773,5263,379,0954,003,319
Shareholder'sFunds150,527215,225253,793299,247362,141
HDFCBankLtd(Standalone)
[INR-Millions]

ReturnonEquity=(1)*(2)*(3)117.0%78.8%84.3%73.1%132.5%
NetSales202,393175,238197,355221,164258,102
ProfitAfterTax25,00721,02723,06026,91437,967
TotalAssets81,93792,580101,405111,973118,833
HindustanUnileverLtd(Standalone)
[INR-Millions]

ReturnonEquity=(1)*(2)*(3)37.6%24.2%33.8%29.8%23.0%
NetSales75,64062,391113,693112,619107,043
ProfitAfterTax43,72434,47364,99672,65663,405
TotalAssets168,254213,976283,429351,588407,978
NationalMineralDevelopmentCorporation(Standalone)
[INR-Millions]

Chapter 9: Identifying Accounting Red Flags 91
Accounting Red Flags - Introduction
• Financial statements are a snapshot of the complex web of
financial activities of a business.
• They help us understand how the company is earning its
revenue, incurring expenses, raising and allocating capital,
and what all it owns and owes.
• But do financial statements always depict an appropriate and
transparent picture of the company?
• Many corporates tend to exploit accounting loopholes to
misrepresent or manipulate their financial statements.
• Accounting red flags are signs of potential trouble that
should draw the caution of investors.
• These could be misrepresentation, omission of information
and aggressive accounting techniques that may be within
the purview of the accounting standards.
• In certain cases, there could be outright financial fraud. But
these are usually difficult to detect well in advance.
• However, by identifying potential red flags, investors could
do their best to keep away from dubious companies and
protect their capital.
Chapter 9
Identifying Accounting Red Flags

Why do Companies Distort
Financials?
• The most basic factor that prompts corporates to resort to
financial misrepresentation is excessive greed and fear.
• Senior managers often have bonuses and incentives linked
to sales and profits. This could lead them to inflate revenues
and profits.
• Reporting favourable financial performance also helps
companies to get better terms from lenders and premium
valuations from investors.
• In certain extreme cases, promoters may resort to fraudulent
practices to siphon off money from the company to their
personal accounts.
• Let us discuss some of the key accounting red flags that
could help investors identify potential trouble.
1. Dubious Related Party Transactions
• Every company, in its annual report, is required by securities
law to report all related party transactions (RPT). These are
transactions that have happened between the company
and its insiders.
• The insiders are the promoters and their families, the top
executives of the firm, and the directors on the board.
Such transactions may include but are not restricted to:
• Providing loans to insiders at favourable interest rates.
• Providing grants or donations with the cash from the firm
to other firms controlled by the promoters.

Chapter 9: Identifying Accounting Red Flags 93
• Using the company’s cash to buy stakes in entities
promoted by the friends or families of the insiders.
• An unusually large number of such transactions should be a
red flag to investors. It might indicate that all is not well within
the company.
Example: The Satyam Scam
• The Satyam Computer Services scam provides a valuable
lesson to investors regarding the implications of related party
transactions.
• The Satyam scam was India’s biggest corporate scandal.
• It came to light in January 2009 when the then chairman of
Satyam, B Ramalinga Raju, confessed in a letter to the stock
exchanges, that the company’s accounts had been falsified
by US$1.47 bn.
• Let us discuss some of the fraudulent techniques employed
by Mr Raju…
• Numerous bank statements were created to advance the
fraud.
• Bank accounts were falsified to inflate the balance sheet
with balances that did not exist.
• The income statement was inflated by claiming interest
income from these fake bank accounts.
• About 6,000 fake salary accounts were created over many
years and the money deposited in them by the company was
appropriated.
• Fake customer identities and fake invoices to them were
created to inflate revenue.

Biggest lessons-of-20-years investing

Biggest lessons-of-20-years investing

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