Examining costs in Company Financial Analysis:: Business Line,

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Continuing with our series on aspects of fundamental analysis, here's a look at how expenditure may be analysed to evaluate companies.

Overall picture

Expenses which relate directly to the operations of the company are operating costs. These include cost of raw material, staff costs, advertising costs, manufacturing and related costs such as power, and administrative costs. Chart how total operating costs moved over the years. Compare that to revenues growth. If growth in expenditure consistently outpaces that of revenues, i.e., if expenses growth beats revenue growth by a wide margin, then the company will be hard-pressed to maintain profitability.

Breaking up costs

In such a case, you may need to look into the reasons to behind explain such rise in expenses. But how? Break up the cost structure. While all cost heads are important, the degrees to which they affect the workings of a company depend on the sector the company is engaged in. For instance, staff costs make up the majority of costs for service companies such as IT. Consumer-oriented companies such as FMCG players would have to juggle raw material and advertising costs. Manufacturing companies would be particularly susceptible to higher commodity prices.

To get an idea of how much a particular cost head could impact profits and margins, work out how much of sales it takes up. The higher the proportion, the greater will be the impact of fluctuations in those costs on profitability. For instance, input costs of Titan Industries shot up to 78 per cent of revenues in FY-11 against the 73 per cent in FY-10 on increase in gold and rough diamond prices. Promotion costs made up the next biggest component at 11 per cent.

Next, check whether the rise in costs is a one-off occurrence or could persist in the coming quarters. For instance, spending on a massive branding campaign now could yield the benefit of higher sales going forward and need not necessarily be viewed with suspicion. Continuing with Titan, as gold and diamond prices are showing no signs of tiring of their march upward,, it has to actively manage other costs to maintain profitability.

Interest and depreciation

Interest costs could take away a huge chunk of earnings if debt levels are high. Here too, calculate interest costs as a proportion of sales. If the proportion remains steady and is under 4-5 per cent of revenues, then interest is not likely to become a harbinger of trouble. A rising or high proportion leaves little room for comfort. It indicates a company's inability to manage debt or its increasing dependence on debt for operations. Another tool to gauge interest impact is interest cover, as we detailed in this column last week.

A company with a high asset base, such as manufacturing companies which have heavy investments in plant and machinery, will typically have higher depreciation costs. . Spikes in depreciation could be due to plants set up or equipment bought. Check if fixed assets have grown. Sometimes, accounting policy changes – switching between written down value and straight line methods of calculation – could explain swings in depreciation. These details are usually found in the notes to accounts.