Financial Reporting and Analysis

Hero Honda Motors Ltd

Dheeraj Arora Dilip Singh N. Mahesh Senthil Kumaar Punit Shukla Rachit Sharma Sairam Kandaswami Submitted to Prof. Manoj Kumar PGP27078 PGP27079 PGP27092 PGP27098 PGP27101 PGP27102 PGP27113

Section B 29th September, 2011

Indian Institute of Management, Lucknow

Table of Contents
1. 2. 3. 4. 5. 6. 7. 8. 9. Annual Report Disclosures......................................................................................................... 3 Corporate Governance Disclosures ............................................................................................ 3 Comparison of Schedules ........................................................................................................... 4 Revenue Recognition ................................................................................................................. 4 Deferred Taxes ........................................................................................................................... 5 Depreciation and Amortization .................................................................................................. 6 Inventory Valuation .................................................................................................................... 6 Fixed Asset Accounting.............................................................................................................. 6 Ratio analysis.............................................................................................................................. 7

10. Conclusion ................................................................................................................................ 11 Appendix A........................................................................................................................................12 Appendix B .......................................................................................................................................13 Appendix C .......................................................................................................................................14

1. Annual Report Disclosures

Item Technical Know How Balance Sheet Disclosures Bad Debts Voluntary Retirement Expenditure Profit and Loss Account Disclosures Exceptional Items Energy Consumption and Conservation Measures Stock Market information General Disclosures Abridged Profit and Loss Statement manufacturing facilities Remuneration of Executive Directors Hero Honda Bajaj Auto Ltd

Comparing the mandatory and voluntary disclosures made by the two companies, we can say that Bajaj Auto Ltd appears to be more transparent than its peer. One important difference between the two is that BAL balance sheet includes the Technical Know How in its balance sheet under the heading Application of Funds, thus attributing the future economic benefits of the R & D expenditure, which is generally quite high in automobile sector. Another important difference is the provision for bad debts being included in the BAL balance sheet. Apart from these disclosures, there is a small difference between the way general info is reported in the annual reports of the two companies: Hero Honda Motors Ltd discloses the stock market data, dividend payments, stock market listings, fluctuations in the share price and shareholding pattern in the company, This is because the general movement in the share price is good for them and they want to highlight this fact to the share holders and investors. On the other hand, Bajaj Auto provides an abridged Profit and Loss Statement in its annual report, thus helping to form an idea of the operating profitability of the company.

2. Corporate Governance Disclosures

When we compared the Corporate Governance Disclosures of the two companies, Hero Honda clearly has better CG Disclosures. The disclosures made by Hero Honda that are not present in Bajaj Auto Ltd are: Shareholding percentages for the members of the board Roles and terms of reference for Audit committee Details of information to be provided to the board Risk management activities Tasks performed by each board committee

Code of conduct of the organisation with regard to Insider Trading Means by which information to be provided to the media and other regulating bodies

The Corporate Government Disclosures point that the Hero Honda is more closely governed by the Munjral family, evident by two facts: lesser number of independent Directors and absence of Employee Stock Options Plan in the company. Also, the non-executive directors of the board are paid 0.1% of profits in Hero Honda. Although most of the extra information provided by Hero Honda wont make that big a difference to investors, but still, these detailed disclosures would make the annual reports look more credible.

3. Comparison of Schedules
Both Hero Honda and Bajaj declare more or similar schedules apart from a few minor differences. Bajaj gives a proper classification of Other Liabilities as into Advances received against Orders, Annuities payable to VRS optees, Investor Education protection Fund and Temporary Overdrafts, thus helping the investor understand the liabilities of a company better and realise and predict the companys performance in future years better. The inclusion of a provision for losses that can be incurred in derivative hedging instruments makes the Bajaj balance sheet more credible and closer to the reality. On comparing the schedules related to Other Income, inclusion of the technical know-how fees received or Royalty received by Bajaj Auto Ltd makes the company look technologically more advanced than Hero Honda. Similarly, break down of the Interest received on long term investments by Bajaj gives an insight into the Companys investment strategy.

4. Revenue Recognition
The revenue recognition policies employed by both companies are quite similar, barring a few fine points, as shown below: Item Domestic Sales Export Sales Sale of investments Accrued Interest Accrued Dividend Service income Sale of scrap Hero Honda Motors Ltd Point of dispatch of finished goods to the customer On the date of the Mates receipt Bajaj Auto Ltd On dispatch from the point of sale On the date of the Mates receipt

The policies of both the companies are conservative. The underlying fact to this is that BAL has been in the automobile industry for a very long time and due to the old policies, it is quite conservative. The companies that followed BAL like Hero Honda, Suzuki, Yamaha chose their accounting policies similar to that of the BAL. So, the revenue recognition policies of two wheeler manufacturing companies in India are generally conservative in nature. One important policy of Hero Honda is that Service income is recognized when the services are rendered. This includes sales from the workshops, parts etc and is in line with the conservative nature of policies adopted by them.

5. Deferred Taxes
Hero Honda Motors Ltd recorded Deferred Tax Assets worth INR 7.88 crores. The reason for the creation of these deferred tax assets has not been clearly disclosed by Hero Honda. A portion of these assets, amounting to INR 1.38 crores is on account of timing differences in accrued expenses and the remaining portion has been attributed to Other Sources. It has also recorded Deferred Tax Liabilities worth INR 160.63 crores which are mainly attributed to timing differences in depreciation and amortization. A small portion of the deferred tax liabilities have been attributed to OtherSources which have not been disclosed by the company. For the same period, Bajaj Auto Ltd recorded Deferred Tax Assets amounting to INR 324 crores. The reason for the creation of these deferred tax assets is attributed to a variety of reasons i.e. Voluntary Retirement Scheme Inventory valuation Diminution in the value of investments Provision for bad and doubtful debts Provision for decrease in value of investments Provision for privilege leave etc. Taxes, duties etc. Amortization of premium / discount on acquisition of fixed income securities Adjustments on account of gratuity provisions In the same period, it has recorded Deferred Tax Liabilities amounting to INR 270.2 crores. These have been attributed to timing differences in depreciation and amortization. Both companies have not recorded operating losses in its previous financial years and so there has been no balancing out of any operating losses against the deferred tax assets of the current period. Also, both companies have not included any footnotes regarding the recognition of deferred taxes in the respective annual reports. Bajaj Auto Ltd takes into account the degree to which the deferred tax assets are likely to materialize in the future periods. This has been clearly stated in its Deferred Taxation Policy. Hero Honda Motors, on the other hand, has not provided any such details in the annual report.

6. Depreciation and Amortization

Hero Honda Motors Ltd accounts for fixed assets at the cost of acquisition less accumulated depreciation. This cost is inclusive of freight, duties, taxes and other incidental expenses. The assets are depreciated using the Straight line method at a rate of 5.28% per annum which is in accordance with the guidelines laid out in the Companies Act. Also, assets that cost less than INR 5,000 are fully depreciated in the year of purchase by Hero Honda Motors Ltd. Leasehold land is amortized over the period of the lease by Hero Honda Motors Ltd. Bajaj Auto adopts the same policy with regard to depreciation of fixed assets and leasehold land. In addition to this, Bajaj Auto also provides details on depreciation of assets that are sold, discarded or demolished within the year. Both companies adopt moderate policies with regard to depreciation of fixed assets, which is in line with requirements as laid out by the regulatory authorities. There have been no changes in the depreciation policies of the two companies in the past few years and the contribution of depreciation expenses to the overall expenses in the income statement has been more or less constant. As there has been a significant increase in the profit after tax for both companies over the same period, it can be said that the companies have not used depreciation policies to record higher or lower net income in the current financial period.

7. Inventory Valuation
Hero Honda Motors Ltd values inventory i.e. Raw materials, work-in-progress and finished goods at lower of cost and net realizable value. For determining cost, raw materials and components are valued using the weighted average cost while the finished goods and work-in-progress are valued by adding the material costs, share of labor and manufacturing overhead. Stores and Tools are valued at cost arrived at on weighted average basis. Bajaj Auto Ltd values the finished stock and work-in-progress at cost or net realizable value whichever is lower. However, raw materials and components arrived at on weighted average basis or lower of cost and net realizable value. Goods in transit are valued at actual cost incurred till the date on which it is recorded i.e. the date of the balance sheet. The implication of the assumption regarding lower of cost or market for valuing inventory is that the companies would book the inventory at the market value if the prices of the inventory are to plummet in the near future as against booking inventory using weighted average or FIFO method.

8. Fixed Asset Accounting

Hero Honda Motors Ltd follows the revaluation model of accounting for its fixed assets and other investments. The fixed assets are physically verified every three years and according to the company, the frequency of the verification is reasonable with regard to the size of the company and nature of the assets.

The company has not disclosed the details about the verification process i.e. the authority carrying out the verification, coverage of the verification etc. Also, as there has been no revaluation of the fixed assets in past few years, no particular reasons are provided for which revaluation is carried out. There has been no change in the revaluation and impairment policy for Hero Honda Motors in the past few years. Bajaj Auto Ltd also follows the revaluation model of accounting for its fixed assets and other investments. However, no revaluation has been done on any of the fixed assets belonging to Bajaj Auto. The company has not provided any details regarding the policies adopted in determining the need for revaluation. Also, no information has been provided regarding the authority verifying the need for revaluation or the frequency of the verification process. Investments made by Bajaj Auto in its subsidiary PT. Bajaj Auto Indonesia have been revalued and corresponding impairment losses have been booked as a diminution in the value of the investments. The diminution in the value of investments has been adjusted against a provision created from the general reserve. The details regarding the revaluation have been provided by Bajaj Auto as a part of the footnotes and are adequate. In the Indian two wheeler segment, TVS Motor Company has revalued its fixed assets in the financial year 2008-09. There was also diminution in the value of investments which was recognized as an impairment loss for the year. No particulars have been provided regarding the category of fixed assets that have been revalued and only the net value of the revaluation has been added/deducted from the total assets. The losses occurred owing to restatement of external commercial borrowings attributable to plant and machinery.

9. Ratio analysis
Liquidity ratio: These are the ratios that help to evaluate a companys ability to meet its short term financial obligations. A companys ability to convert assets to cash is essential to meet the payment demands of its creditors. i. Current ratio: Company Hero Honda Bajaj Auto Limited FY 09-10 0.7 0.69 FY 08-09 0.63 0.84

The current ratio of Hero Honda has been above 0.65 from 2006 onwards. Bajaj has also had a ratio of around 0.8 except for 08-09. Companies like TVS which are the in the two wheeler segment have had ratio above 1 from 2007 onwards. To further ascertain the ability of company to meet its short term obligations quick ratio is to be looked at. ii. Quick ratio: Company Hero Honda Bajaj Auto Limited FY 09-10 0.48 0.55 FY 08-09 0.23 0.73

The quick ratio of Hero Honda is lesser than some its competitors in the segment. Bajaj and TVS have had quick ratio above 0.5 for nearly all years from 05-06. The higher quick ratio for Bajaj and TVS indicates that they are in better position to meet their short term obligations compared to Hero Honda. iii. Days inventory: Company Hero Honda Bajaj Auto Limited FY 09-10 11.66 12.6 FY 08-09 12.01 12.74

Hero Honda had Inventory turnover ratio of 31.3 and 30.38 for 09-10 and 08-09 respectively. The days inventory of Honda is however less than TVS motors for which this value is 20 days. Thus Hero Honda is better than other companies as its inventory has moved out faster compared to its competitors( This value is lesser than that of car manufacturers like Maruti Suzuki which have it around 28 days). It can be said that Hero hondas inventory is more liquid than other companies in the industry. iv. Days sales: Company Hero Honda Bajaj Auto Limited FY 09-10 2.99 9.5 FY 08-09 6.62 13.2

Hero Honda has days sales value which is much lower than Bajaj and TVS limited. Thus Hero Honda is able to get payments from its dealers much earlier than its competitors. This would also reduce the cash conversion cycle for the company there reducing the companys dependence on credit. v. Days Payable: Company Hero Honda Bajaj Auto Limited FY 09-10 27 47.19 FY 08-09 27.18 41.4

The days payable of Hero Honda is lesser than Bajaj and TVS. Both Bajaj and TVS have days payable above 45 days which indicates that these companies have been able to use credit more effectively. Moreover as both TVS and Bajaj are healthy companies financially the higher days payable also indicates better relationship with their suppliers. vi. Cash conversion cycle: Company Hero Honda Bajaj Auto Limited FY 09-10 -12.35 -25.09 FY 08-09 -8.55 -15.46

A negative value for cash conversion cycle ensures that the company always has excess cash due to the business model of the company. The negative value has been mainly due to the ability of the companies to make their purchases on credit basis with high days payable. Moreover in some cases the customers place orders and pay token payments for the vehicles in advance. This negative cash conversion cycle helps the company to meet its short term obligations with lesser dependence on external credit sources. Bajaj auto limited has better cash conversion cycle as its value is more negative compared to that of Hero Honda. TVS also has cash conversion cycle in the range -10 to -22 in the last five years. This difference is mainly due to the lower value of days payable for Hero Honda. vii. Debt equity ratio: Company Hero Honda Bajaj Auto Limited FY 09-10 0.016 0.46 FY 08-09 0.018 0.84

Debt to equity ratio underlines the aggressiveness with which the company has used debt to finance its operations. Hero Honda has used debt very conservatively as shown by the ratio (highest has been 0.08 in 06-07).TVS has been very aggressive in using debts and this ratio has been above 1 in 09-10 and 08-09 (least being 0.72 in 06-07). Aggressive usage of debt by a company will result in higher ROE only when the company is able to use funds effectively and is able to generate more returns than the rate of interest. viii. ROE: Company ROE Hero Honda 52.76% 58.15% Bajaj Auto 29.51% 58.15%

Both companies exhibit a fall in ROE of around ~6%, the reasons for which can be analysed using the Du-Ponts 3 ratio analysis. On breaking up the ROE into Du-Ponts 3 ratios, we find the ratios to be Company Net Profit Margin Asset Turnover Financial Leverage Hero Honda 14.17% 10.28% 1.82 2.01 2.05 1.43 Bajaj Auto 7.33% 1.52 3.15

14.14% 1.41 2.92

The Primary factor for decrease in ROE is seen to be the higher Financial Leverage ratio, which shows that the companies are more debt-based than before. As can be seen from the Vertical Size Analysis, Current Liabilities increased from ~26% to ~48% for HH Motor Corp from 2008-09 to 1009-10, which is almost a 200% increase.

ix.

Profit Margins: Company Gross Profit Margin Net Profit Margin Hero Honda 24.01% 20.58% 14.17% 10.28% Bajaj Auto 27.64% 7.33%

32.99% 14.14%

The profit margins have increased for both companies by some margins, more notably for Bajaj Auto Limited. The increase is seen across Gross Margin as well as Net Margin which indicates that the material (and other COGS) expenses have been cut down to achieve this increase. Also, a point to note is that Bajaj has caught up with HH in terms of Net Profit Margin, by cutting down on other expenses. x. ROCE (Return on Capital Employed): Company ROCE Hero Honda 63.74% 40.12% Bajaj Auto 33.17%

60.13%

This ratio gives a clearer picture of the reasons for decreasing ROE of the companies. ROCE is calculated as EBIT/(Total Assets Current Liabilities) and shows that the Return on Long Term Liabilities has increased meaning the companys capital investments have become more profitable, but nonetheless if ROE has decreased, it is due to the Current Liabilities which have increased disproportionately. xi. Price to earnings ratio: The ratio has been calculated on 31 March,2010 and 31 March,2009 for the respective financial years. Company Hero Honda Bajaj Auto Limited Closing price Company Hero Honda Bajaj Auto Limited FY 09-10 1948.90 1005.55 FY 08-09 1072.1 309.23 FY 09-10 17.42 8.54 FY 08-09 16.89 6.84

The share prices of TVS, Bajaj and Hero increased in FY 09-10 owing to the recovery from the financial meltdown of the previous year.Both Bajaj and TVS (11.07 for Fy 09-10 and 8.64 for FY 08-09) have had lower P/ E ratios. The higher P/E ratio of Hero Honda indicates higher investor confidence in the company.

10.

Conclusion

It is found that with regard to disclosures in the annual report, Bajaj Auto Ltd has more transparent policies. This will result in more confidence on the part of the investors when considering the company for future investments. With regard to Corporate Governance, Hero Honda Motors has included disclosures regarding various factors like tasks to be performed by various committees set up by the company, the code of conduct within the organization etc. This implies a more robust corporate governance framework being employed by Hero Honda Motors. This would result in greater investor confidence in the future of the company. As the other disclosures in the annual report in which Bajaj Auto has fared better are not as important as corporate governance, we can safely recommend Hero Honda Motors with regard to these factors. In the comparison of schedules, it was found that Bajaj Auto provides more details about the individual items in its balance sheet. This provides more information to the investor about the long term plans of the company. Also, when comparing the deferred taxation policies of the two companies, Bajaj Auto has provided more information about the items causing timing differences. Key Ratios influencing Investor decisions The better level of disclosures provided by Bajaj Auto Limited, in combination with the lower PE ratio suggest that Bajaj Auto is undervalued compared to Hero Honda Motors Limited, and can provide better returns if invested in. The profit margin for Bajaj has gone up in 2009-10 and is similar as Hero Hondas profit margin (Gross margin is higher for Bajaj), which indicates a better operational efficiency of the company to earn profits through. A higher ROE means Bajaj Auto is in a better position to convert equity invested in it to Sales (and hence Profits), making it a better company to invest in.

Moreover, Bajaj is a relatively new entrant into the motorcycle industry, which now contributes significantly to its performance and hence seems a better proposition than Hero Honda for an investment similar risk levels, but better future returns seem likely in case of Bajaj. Hence, we suggest Bajaj Auto Limited from the Investors perspective.

Appendix A
Common Size Statement Analysis Hero Item on B/S or P/L Statement Cash Equivalent Acc Rec Inventories Other Current Assets Total Current Assets PPE Other Long Term Assets TOTAL ASSETS Current Liabilities Long Term Debt Other Long Term Liabilities Preferred Share Total Equity Capital TOTAL LIAB & EQUITY Net Sales Cost of Sales Other Expenses Interest Expense EBT Taxes Extraordinary Items NET INCOME 2009-10 22.0% 1.3% 5.0% 5.3% 33.6% 19.5% 46.8% 100.0% 48.3% 0.5% 2.3% 0.0% 48.9% 100.0% 100.0% 76.0% 6.2% -0.1% 18.0% 3.8% 0.0% 14.2% 2008-09 3.6% 2.4% 5.3% 5.2% 16.5% 27.4% 56.0% 100.0% 26.2% 1.0% 2.7% 0.0% 70.1% 100.0% 100.0% 79.4% 6.4% -0.3% 14.5% 4.2% 0.0% 10.3%

Appendix B
Balance Sheet and Income Statement Hero Item on B/S or P/L Statement Cash Equivalent Acc Rec Inventories Other Current Assets Total Current Assets PPE Other Long Term Assets TOTAL ASSETS Current Liabilities Long Term Debt Other Long Term Liabilities Preferred Share Total Equity Capital TOTAL LIAB & EQUITY Net Sales Cost of Sales Other Expenses Interest Expense EBT Taxes Extraordinary Items NET INCOME ROE Net Profit Margin Asset Turnover Financial Leverage Gross Profit Margin Net Profit Margin Return on Capital Employed Interest Coverage 2009-10 19072.12 1083.88 4364.04 4605.78 29125.82 16919.54 40547.54 86592.9 41813.5 475.37 1977.88 42326.15 86592.9 157581.6 119749.34 9703.82 -206.2 28334.64 6004.15 22330.49 52.76% 14.17% 1.82 2.05 24.01% 14.17% 63.74% -138.41 2008-09 2195.72 1499.38 3268.34 3171.48 10134.92 16790.44 34321.3 61246.66 16040.7 599.97 1671.49 42934.5 61246.66 123191.2 97838.08 7852.02 -316.8 17817.9 5148.18 12669.72 29.51% 10.28% 2.01 1.43 20.58% 10.28% 40.12% -57.24 2009-10 1014.1 23473.6 4462.1 1059.7 30009.5 15211.1 40215.2 85435.8 42749.7 13385.8 16.9 29283.4 85435.8 120434.8 80704.4 13944.3 59.8 25726.3 7084 1615 17027.3 58.15% 14.14% 1.41 2.92 32.99% 14.14% 60.13% 429.21 Bajaj 2008-09 1368.7 17238.8 3388.4 1256.8 23252.7 15480.9 20080.8 58814.4 24375.6 15700 41.9 18696.9 58814.4 89322.6 64634.7 12845.9 210.1 11631.9 3035.9 2051 6545 35.01% 7.33% 1.52 3.15 27.64% 7.33% 33.17% 54.36

Appendix C
Cash Flow Statement