An institution resists any change in its current direction.

Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds.

Any business craving of the leader, however foolish, will quickly be supported by detailed rate of return and strategic studies prepared by his troops.

The behavior of peer companies whether they are expanding, acquiring, setting executive compensation, will be mindlessly imitated.

Financial Tenets

Customarily, analysts measure annual company performance by looking at earnings per share. But earnings per share is a smoke screen is what Buffet opines. Since most companies retain a portion of their previous year's earnings as a way of increasing their equity base, there is no reason to get excited about record earnings per share. The primary test of managerial economic performance is the achievement of high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. Hence, it is imperative that the focus is on Return on Equity not Earnings per share. Return on equity is the ratio of operating earnings to share-holder equity.

A business should achieve good returns on equity while employing little or no debt. Whereas companies can increase their return on equity by increasing their debt-to-equity ratio, the idea of adding a couple of points to ROE simply by taking on more debt is not right. A good business, according to Buffet, should be able to earn a good return on equity without the aid of leverage.

While measuring accounting earnings, it is only useful to the analyst if they approximate the expected cash flow of the company. Even cash flow is not a perfect tool for measuring value. Often it misleads investors. Cash flow is an appropriate way to measure businesses that have large investments in the beginning and smaller outlays later on. Companies such as real estate, gas field and cable companies, manufacturing companies on the other hand, which require ongoing capital expenditures, are not accurately valued using only cash flow.

A company's cash flow is customarily defined as net income after taxes plus depreciation, depletion, amortization and other non-cash charges. The problem with this definition is that it leaves out a critical economic fact - Capital Expenditures. How much of the year's earnings must the company use for new equipment, plant upgrades and other improvements needed to maintain its economic position and unit volume? These capital expenditures are as much an expense to a company as are labour and utility costs. Cash flow numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable and thereby sell what should be un-salable.

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* Contributed by: -
Gomathi Krishnamurthy is B.A. and L.L.B., and holds PGDBM (Finance) qualifications from BIM, Bangalore (Batch of 2006). Has 10 years experience in various departments of Indian Railways, and is currently working as Consultant - LEGAL with Ma Foi Management Consultants Limited.